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).

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).