A Striking Picture of Pay and Deregulation in Finance

April 12th, 2014 at 2:41 pm

I’m crunching on a longer piece on “rents” versus merit in US high-end salaries and their role in our uniquely high levels of inequality (“rents” here means being paid above your marginal product, or your individual contribution to your firm’s bottom line).

Anyway, for good and I think obvious reasons, a strain of this literature focuses on the finance sector, where there’s very compelling evidence of highly inefficient rent seeking.

A reasonable, if not naïve, question then becomes: aren’t the financial regulators supposed to prevent this?  Sure, but they’ve been outgunned by lobbyists and seemingly captured by the finance industry, and these factors too are major contributors to rents.

Anyway, I stumbled on this figure below, from a very insightful paper by Philippon and Reshef.  The figure plots an index of financial deregulation against relative pay in the industry (an increase in the deregulation index implies looser regulation).

phil_dereg

Source: Philippon, Reshef (2009).

I was struck by how tight the fit is between deregulation and pay in finance relative to the economy-wide average.  But does this really imply rents are afoot?  Perhaps it just shows that when you un-cuff Adam Smith’s invisible hand, you unleash efficiencies that plodding regulators were formerly blocking (note clever use of “afoot” and a “hand”—full-body economics here, folks).

Not so fast.  First, there’s the fact that the sector helped to tank the economy, so let’s factor in negative externalities.  Second, there’s a growing body of work relating the growth in the finance sector to price distortions (overpriced financial intermediation), unproductive rent-seeking, and of course, systemic risk.

Call me dark, but what I see here is a toxic relationship between deregulation, underpriced risk, and exorbitant, inefficient pay scales that contributes to the growth of inequality, not to mention the shampoo economy (bubble, bust, repeat).

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8 comments in reply to "A Striking Picture of Pay and Deregulation in Finance"

  1. Rima Regas says:

    Spot on, Jared. That figure illustrates perfectly the general rule we all know. Without rules and a code of ethics to live and operate by, we have chaos. It’s true of everything.


  2. Tom in MN says:

    And GDP growth was highest in the 50′s and 60′s when there was the most regulation. I suspect these rents are part of what is holding down growth, just as the fees they collect off the top hold down individual investment gains.


  3. dilbert dogbert says:

    Viewed from the “seeker’s” side it looks like very efficient rent seeking.


  4. Noni Mausa says:

    “Little Boy Blue
    Come blow your horn
    The sheeps in the meadow
    The cows in the corn…”

    But, isn’t it good for sheep to be in the meadow, and don’t cows like corn?

    Oh yes, if you asked the cows or the sheep. But sheep in the meadow nibble the grass to its roots, destroying the meadow and any hay intended for the winter. And cows in the corn trample what they don’t eat, and then die of bloat, (a horrible way to go, by the way.) There are very good reasons why that kid has a trumpet, and why those fields have strong fences.

    Noni


  5. Edward Lambert says:

    It is great to see more models being developed to show the disease of inequality.


  6. Bob Wyman says:

    Computer and information technology dramatically increase the scale of assets that can be managed by any single finance professional. Finance compensation is typically tied to scale, not skill, thus, as their software systems get better, the top finance professionals get richer — without needing to work either harder or smarter. Even though some financial fees are reduced as technology improves, as long as technology increases the scale of a finance professional’s work at a rate greater than their fees drop, the professional will make more money — without needing to work either harder or smarter…

    Finance is a business in which “network effects” appear regularly. e.g. People use large banks or brokers because there are scale-related benefits to doing so. Technology, not just “skill or hard work,” enables the large institutions to grow larger and expand their ability to exploit network effects. The result is that a finance professional’s income becomes largely determined not by how hard or smart they work, but rather by where they work.

    There is a great deal of rent going on here…


  7. Richard H. Serlin says:

    And, as these people get more and more astronomical money, they have more ability to pervert government to their will. More progressive taxation really can start a virtuous circle, and has in the past. I had a post on this in Mark Thoma’s links:

    http://economistsview.typepad.com/economistsview/2011/09/links-for-2011-09-10.html


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