Quantifying financial sector excesses

Jerry Rao in Mint says:

For two decades now, wages in the financial industry have been too high. In the 1970s, it was not uncommon for people to move from banking to manufacturing or retailing, and back. By the 1990s, this became impossible as the wages in banking (and in the entire financial services business) went through the roof while other folks had more modest gains. The curious fact to note was that there was no special expertise or skills that justified this.

There have been number of comments on the financial sector excesses in US. So much so, economists like Rogoff have said it has to shrink. I have myself written a number of posts on the financial sector excesses.

Jerry Rao further says:

This two-decade-long persistence in irrationally high wages in the financial industry has not been explained by any economist, except to whisper under the breath that there are labour market rigidities. Presumably, labour markets (unlike financial markets) are not information-efficient; they can be fooled for 20 years, and serially correlated error terms can persist.

No economist has been able to explain why equity holders allowed financial sector executives to get away with this really good deal. Where are the Michael Jensens and the William Mecklings to explain this aberration in managerial incentives?

There may be no explanation from Jensens or Mecklings but surely there is some from Thomas Philippon, an econ professor at Stern School, NYU. Thanks to this Justin Lahart article for the pointer which is a good read on the topic as well.

I have been trying to read Philippon but haven’t had the time given the conditions. Whatever little I could, will try and point in this post.

In this paper he tries to answer why finance has grown so much? 

The paper focuses on the role of corporate finance,  because the evidence suggests that other explanations for the evolution of the financial sector are either incorrect or incomplete. Contrary to common wisdom, there is neither theoretical nor empirical support for the idea that total factor productivity (TFP) growth in the non financialsector has a direct influence on the size of the  financial sector. Neither fi nancial globalization, nor increased trading of securities, nor the development of the mutual funds industry can account for the increasing share of finance in GDP.

To further motivate the focus on corporate finance, I present new evidence on the evolution of the cross-sectional distribution of cash flows and investment expenditures. I find that firms with low cash flows account for a growing share of total capital expenditures. In the 1950s, most corporate investment was done by incumbents with high cash flows. In 2000, half of total investment was done by (young) firms whose cash flows covered less than a third of their capital expenditures….

His study shows as young firms require more financial intermediation, the demand for it has grown. This explains much of the rise in finance.

In another paper (which is more relevant to Rao’s and others questions), he looks at skills, wages and jobs in financial sector. He says:

Controlling for education and observable characteristics, we find that employees of the financial sector earned 3 to 4% more than employees in the rest of the private sector during the 1970s. At that time, however, they also enjoyed substantially lower unemployment risk.

After 1980, the unemployment risk in the financial sector started to catch up with unemployment risk in the rest of the private sector.

Over the same period, the finance wage premium (controlling for education and observable characteristics) increased to 20%. A simple calibration suggests that the increase in relative unemployment risk could account for one half of the increase in the finance wage premium. The remaining half probably reflects unobserved heterogeneity in the labor force.

Though the main qs still remain:

Overall, the share of talented individuals hired by the financial sector has increased very signficantlyover the past three decades. This finding raises several questions for future research. First, does the increase in skilled labor in the financialsector lead to more innovations in this sector? Second, how do financial innovations affect the rest of the economy? Finally, what are the welfare consequences of the shift in the allocation of talent?

I expect a fresh round of research from Philippon seeing the present set of events. If corporate finance explains the growth of finance, then are we wrong to say that there are excesses in finance? The unemployment risk may have increased in finance jobs, but what has been seen is that a person gets a much higher salary joining another firm. As Rao points:

I know of a senior foreign exchange trader who got a huge bonus one year when he made a lot of profits for his bank. The next year, he was making losses. Instead of his bonus getting clawed back, he simply moved to another bank that gave him a joining bonus larger than the “performance” (performed by putting the bank’s capital at risk, needless to say) bonus he got from his previous employer.

He seems to be working on it already. In this Lahart article Phillipon says:

surge of financial activity that began in 2002 created an employment bubble that is now busting. His model suggests total employment in finance and insurance has to fall to 6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector.

So, there is an economist who is monitoring this “financial sector excesses” pretty closely.


One Response to “Quantifying financial sector excesses”

  1. Emmanuel Saez gets Clark Medal for 2009 « Mostly Economics Says:

    […] U shaped inequality curve reminded me of the research work by Thomas Philipon who said share of financial sector in total economy has followed a U shaped pattern since 1900s. […]

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