Thoughts on the financial sector

The growth of the financial sector has been one of the more disturbing trends in the American economy over the past several decades. Why? I’ll start by asking a seeming unrelated and simple (probably too simple) question: How many people enroll in Harvard University and dream of working for a hedge fund or investment bank? And in an ideal world, what should that number be? It’s certainly greater than zero, but one would think (and hope) that it ought to be pretty close to zero, unless the Harvard Admissions Office is doing a really terrible job. The world does need smart accountants, investors, and thinkers on Wall Street, but there are certainly other sectors of the economy where most would be more socially beneficial. However, in 2008 almost a full third of Harvard graduates were going into finance. Another sizable portion heads into consulting, and much of that world may be quite close to finance in spirit. This was not always the case. It’s worth noting that these numbers have dropped in recent years amidst the financial crisis of 2008 (or The Great Recession or the Little Depression or whatever else you’d like to call it) as firms have cut back and repaired their balance sheets. But finance and its massive profits have rebounded strongly in the ensuing economic ‘recovery’, a term I use lightly given the miserable job situation. And as finance’s profits return, one can rest assured that the salaries that lured in bright and promising graduates will rebound as well, sooner or later.

The financial sector’s employment numbers have grown since 1980, which isn’t alarming in of itself. According to the Bureau of Labor Statistics, financial activities employment totaled over 8 million at its peak in recent years, up from about 4 million in the mid 1970s. The following shows private sector financial activities employment as a share of total private sector employment.

As John Cassidy of the New Yorker notes, however, that’s not nearly the whole story.

Think of all the profits produced by businesses operating in the U.S. as a cake. Twenty-five years ago, the slice taken by financial firms was about a seventh of the whole. Last year, it was more than a quarter. (In 2006, at the peak of the boom, it was about a third.)

This massive increase in profits has spurred banks to offer salaries that are luring in all kinds of talent, including graduates from fields like math, physics and engineering.

It’s difficult to be unsympathetic towards a recent college graduate entering an uncertain world with debts and bills, deciding to accept an offer at major Wall Street firm. For a society and an economy’s long-term viability, though, this has real costs that are worth exploring. All of this leads one to think hard about why all of this happened when it did, and what should be done about it. These are all very difficult questions to answer.

It’s worth thinking about the costs in a rudimentary but illustrative example. Imagine an economy with some base of a financial infrastructure in place. In other words, there are well-functioning banks with insured deposits from the government, people can get loans if they are worthy of credit, and viable businesses can raise capital without too much of a hassle or exorbitant interest rates. In other words, we have a functional financial sector that is arguably doing its job. Now suppose a college graduate can either become an educator or join a hedge fund. It’s worth asking what is actually gained from the college graduate going into each profession. In teaching, what’s gained is, on average, smarter and more capable children and young adults. That’s a positive externality that’s not necessarily priced into the teacher’s salary. The students may go on to become valuable writers, engineers, or even teachers or financiers, but society gets some utility out of ultimately having the more and better educated children than it would have otherwise had. The teacher gains a salary as well any other benefits or perks the job might provide. The opportunity cost is that the graduate did not go to work for a hedge fund, and thus foregoes that much greater salary. And the hedge fund industry, we could say, was effectively deprived of a quality workman. Is society any worse off for it? What would society have gained from another person entering the field?

Consider the scenario where the graduate goes to work for the hedge fund. Society has lost a possible educator, but it has gained someone working in the hedge fund industry. Should society value this as a positive externality? John Cassidy, in another piece for the New Yorker, talked to a very successful hedge fund manager, Ray Davios. He notes that by being successful, Davios’s hedge fund generates good returns for those institutions and investors who entrust him with their money. Pension funds, for instance, benefit from Davios’s ability to do well in the world of finance. But this is not the entire story, for it is at the expense of other hedge funds that he may do well. Cassidy quotes Davios: “In order to earn more than the market return, you have to take money from somebody else.” Cassidy asks: “If hedge-fund managers are playing a zero-sum game, what is their social utility?” So an individual going to work for a hedge fund could very well help improve that particular hedge fund’s performance, but what about the industry as a whole, or society as a whole, if it is indeed just a zero-sum game? This is the ultimate question about the worth of finance that extends beyond the basics of providing loans and taking deposits. And finance has been doing a great deal beyond the basics, by the way. I won’t retread too much of Cassidy’s articles, but it’s perhaps unnecessary to mention that many financial innovations have not been particularly beneficial to society as a whole. It’s also worth noting that a significant part of the increase in income inequality in the past several decades has had to do specifically with the financial sector and its incredible salaries. There are another set of issues and consequences that arise from this which I won’t go into here (perhaps at a later date). I will quote and link to an interesting article by Tyler Cowen in The American Interest, who also talks at length about the financial sector:

For instance, for 2004, nonfinancial executives of publicly traded companies accounted for less than 6 percent of the top 0.01 percent income bracket. In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning more than $100 million a year was nine times higher than the public company executives earning that amount. The authors also relate that they shared their estimates with a former U.S. Secretary of the Treasury, one who also has a Wall Street background. He thought their estimates of earnings in the financial sector were, if anything, understated.

I am compelled to ask why, after decades of post-WWII growth and prosperity in the American economy, did finance start to move towards its current form? I quote Peter Temin, economist at MIT, who writes:

Reforms to the financial system produced a half-century free from financial crises. The Federal Deposit Insurance Corporation (FDIC) gave most people faith in the safety of their bank accounts. Deposit insurance was complemented by bank regulation to substitute for critical investors and depositors. The Glass-Steagall Act separated commercial and investment banks. The Federal Reserve System was restructured to empower its central office; the Securities and Exchange Commission (SEC) was created to regulate financial investments. Banking became a boring industry, and more people invested safely in the stock market. There was little excitement in the financial markets, and the economy grew rapidly and consistently after the war. [. . .] Nothing lasts forever, and prosperity generated a desire for more independent dealings. Economic turmoil in the 1970s hastened the transition, and the Washington Consensus arose in the 1980s. The Glass-Steagall Act was repealed, and the SEC’s regulation relaxed. Americans urged the rest of the world to follow suit and deregulate both domestic and foreign capital movements. The distribution of income widened, the size of the financial sector rose, and a string of small-scale (at least to the United States) financial crises ensued.

Temin’s explanation of events is undoubtedly accurate in a broad sense, but what happened took place across several decades, and part of me is slightly unsatisfied with his explanation. Part of me wants something more precise: was there a piece of legislation in the 1970s and early 1980s that really caused all of this? Glass-Steagall was repealed in the late 1990s, and no doubt contributed to the overall problem, but it did not start the chain of events. I don’t suppose such a singular event really exists. It was, like most things, a string of bad decisions driven by bad ideology that had long-lasting consequences for the world, and Temin aptly describes this for reader.

I’m merely an interested observer of these events, and have by no means read exhaustively on the subject. Recommendations for reading and other items are highly appreciated, as is good discussion.

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