Over the weekend Floyd Norris pointed to this chart of financial industry compensation to explain why Wall Street pay may whither. The idea is that during unsustainable banking booms, compensation for investment banking grows. But after the booms, compensation reverts to a more normalized level.
Why does compensation spike like this? Over at FT Alphaville, they point out that the study that produced this graph–“Wages and Human Capital in the U.S. Financial Industry, 1909-2006” by Thomas Philippon and Ariell Reshef–argues that it isn’t just irrational exuberance that grows pay. It is an increased demand for a highly skilled workforce in times of increasing financial complexity that drives up compensation.
The authors argue that the wage increases are related to greater skill requirements: in both the 1930s and the 1980s, there was a higher demand in financial services for employees that could handle complex transactions involving credit risk, for example. In support of that, the authors map metrics for the average educational attainment of financial services employees over the excess wage results and show that there is a fairly good relationship between the two.
So here’s our question: hasn’t this turned out to be a bad idea? The employees paid huge bonuses because they “could handle complex transactions involving credit risk” turned out to have not actually been able to do anything of the sort. Our financial system now lies in ruins in part because of the fatal conceit that mathematically skilled financial professionals could properly evaluate risk.
Let’s put it another way. While the sample set is small, this graph should produce a tradable result. It creates a clear indicator of financial bubbles. The next time you see compensation spiking in the financial industry, it’s probably safe to conclude we’re in a financial bubble. Short the banks, if there are any publicly traded banks around at that time.
To put it yet another way, on the basis of historical trends, bankers were not overpaid. They were paid more because things got more complex, which just follows the historical trend. What was actually happening was that financial complexity was over-valued, leaving the illusion of great wealth creation and artificially inflating demand for bankers with education and skills that suggested they could deal with the complexity.