Sunday, November 28, 2010

How Many Investment Bankers Does it Take to Make a Functioning Economy?

I saw an interesting article in the New Yorker about the debatable social utility of the finance world. The article has a lot of resonance.

To be clear, any advanced economy has a need for a financial sector. Banks lend capital to businesses that then develop goods and bring them to the marketplace. If the business does well, then jobs will be created, and these new workers will spend part of their earnings, which will lead to a virtuous cycle of more jobs and more consumer spending. Good financial institutions are no doubt good at picking up on the fundamentals of a good company and directing capital efficiently to those who are most likely to produce results.

Moreover, the financial sector can perform a valuable service when it manages investments prudently. Many non-wealthy individuals such as policemen, firefighters, and teachers have pensions that are invested in part with hedge funds or Wall Street firms. If these firms can get a positive return on the investments, they are insuring a decent quality of living for many working and middle class professionals.

The problem, as this article demonstrates, is the way the financial industry has functioned in recent years. Traders are often rewarded on a quarterly or annual basis for bets that may in the long run lose money for their clients. The article provides a good discussion on rampant rent seeking in finance, when firms use their resources to obtain an economic gain from others without providing any tangible benefits back to society through wealth creation.

Over the past decade or so, many of the nation’s brightest students from its most prestigious universities have sought jobs in finance. Even when the financial industry is actually useful, it may not make sense to have our best minds in it. Instead, they could be doctors finding a cure for cancer, entrepreneurs building the next Apple or Facebook, or educators building quality schools for the next generation. But why would young people spend several years working in those careers before breaking through when they could make a huge salary in finance upon graduation?

Shouldn’t a meritocratic economic system reward those who create the most value? If that isn’t the case, it should at least reward those who bring in the most money or create the most wealth. And while there is good reason to doubt that those in finance create the most wealth for society, it is a fact that they make much more than those in other professions that also require industriousness, intelligence, and ambition. The article notes:

From the end of the Second World War until 1980 or thereabouts, people working in finance earned about the same, on average and taking account of their qualifications, as people in other industries. By 2006, wages in the financial sector were about sixty per cent higher than wages elsewhere. And in the richest segment of the financial industry—on Wall Street, that is—compensation has gone up even more dramatically…

In other words, during a period in which American companies have created iPhones, Home Depot, and Lipitor, the best place to work has been in an industry that doesn’t design, build, or sell a single tangible thing.

Is that a healthy trend? As we think about ways to insure economic recovery, I’m sure that is a question we will continue to answer in coming years.

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