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Thursday, January 17, 2008

Misdirecting the Flow of Resources

David Wessel says that excessive expected compensation in the financial industry encourages too many talented resources to flow into the industry, resources that could be put to better use elsewhere:

A Source of Our Bubble Trouble, by David Wessel, Capital, WSJ: First came the bursting of the tech-stock bubble, now the bursting of the housing bubble. The bursting of a bubble in finance -- and the pay of those who helped make the tech and housing bubbles possible -- can't be far behind.

And as painful as that will be for the Bentley/Rolls-Royce/Aston Martin/Ferrari dealership near the railroad station in Greenwich, Conn., the nation's hedge-fund capital, it might be good for the overall economy. ...

Workers in finance are increasingly highly skilled and educated. ... About 15% of men who graduated from Harvard around 1990 were working in finance 15 years after graduation, compared with about 5% of those who graduated around 1970. Among Harvard women, the share employed in finance increased to 3.4% from 2.3%. (Wall Street remains a man's world.)

The trend toward finance appears to be accelerating. ... The lure is obvious. It's the money. Comparing graduates with similar SAT scores, grade-point averages, gender, age, occupation and everything else they can measure, Mr. Katz and Ms. Goldin find Harvard grads who work in finance earn 195% of the pay of those who work elsewhere. That's no typo: Going into finance means making nearly three times as much as your classmates with other careers.

In fact, pay on Wall Street and elsewhere in finance -- even more than those huge salaries of chief executives outside finance -- is a major driver of the widening gap between paychecks of the biggest winners in the economy and the rest of us. ... The top 25 hedge-fund managers combined earned more than CEOs of the Standard & Poor's 500 companies combined in 2004...

Modern finance is, truly, as powerful and innovative as modern science. More people own homes -- many of them still making their mortgage payments -- because mortgages were turned into securities sold around the globe. More workers enjoy stable jobs because finance shields their employers from the ups and downs of commodity prices. More genius inventors see dreams realized because of venture capital. More consumers get better, cheaper insurance or fatter retirement checks because of Wall Street wizardry.

But financial innovation is like splitting the atom: Nuclear power offers energy without greenhouse gases, but nuclear weapons can blow up the planet. It all depends on how wisely it is used. Helping promising companies raise capital? Vital to U.S. prosperity. Devising, selling and trading mortgage-backed securities so complex that no one, even those Harvard grads, can fully understand them? Could be a waste of talent and energy.

Yes, the Harvard-trained physician who helps venture capitalists pick among competing cures for cancer may help millions instead of the hundreds of patients he or she might have treated directly. But tens of billions of dollars of losses in new-fangled investments at the largest U.S. financial institutions -- and the belated realization that some of those Ph.D.-wielding, computer-enhanced geniuses were overconfident in the extreme -- strongly suggests some of the brainpower drawn to Wall Street would have been more productively employed elsewhere in the economy.

And it looks like many of those folks will get the chance to find out if that is so. [Video on continuation page]

It's always easy to look at an industry, identify the losers after the fact, and say they would have been better off doing something else. But that doesn't mean the decision to enter the industry was necessarily a bad one, i.e. the ability to identify firms that entered and failed, in and of itself, doesn't prove that resource flows have been distorted. But I don't think it's hard to argue that expected compensation in the industry is excessive and distorts resource flows from other high value areas, though there are those who argue against the idea that hedge fund managers, for example, are paid more than is justified by their contribution.

    Posted by on Thursday, January 17, 2008 at 12:31 AM in Economics, Financial System, Market Failure, Video | Permalink  TrackBack (0)  Comments (24)

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