The Wall Street Journal-20080117-CAPITAL- A Source of Our Bubble Trouble
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CAPITAL: A Source of Our Bubble Trouble
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.
Finance has had a remarkable run. It has been one of the fastest- growing industries in the U.S. (and Britain), and has attracted an increasing share of the country's, and the world's, talent. Today, roughly $1 in every $13 of employee compensation in the U.S. goes to those working in finance.
The value added by finance -- a measure for calculating the industry's contribution to the economy -- rose to 4.4% of gross domestic product in 1977 from 2.3% in 1947, says Thomas Philippon, a finance professor at New York University's Stern School of Business. Its work force grew commensurately, with employees that were only slightly more educated than the typical American worker, and their compensation grew at roughly the same pace as that of other workers.
After 1980, finance kept growing, reaching 7.7% of GDP by 2005. But the nature of the industry's work and work force changed. "From the 1980s onward, the financial sector grows by increasing the value added and compensation of its employees faster than in the rest of the economy," Mr. Philippon says. Workers in finance are increasingly highly skilled and educated.
In short, there are fewer bank tellers and back-office clerks and more M.B.A.s, Ph.D.s and even M.D.s on Wall Street. In the 1960s and 1970s, graduates of Harvard University were much more likely to be lawyers, doctors and academics than to head for Wall Street. "Today, we see a huge shift of talent from elite schools toward finance," says Harvard economist Lawrence Katz, who, with colleague Claudia Goldin, recently surveyed 6,500 Harvard graduates from selected classes between 1969 and 1992.
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. A survey of the Class of '07 last spring by the campus newspaper, the Harvard Crimson, found more than one-fifth of the men -- and about one-tenth of the women -- who took jobs, as opposed to going to graduate school or other pursuits, headed to investment banks.
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. "Wall Street and legal professionals have contributed at least as much as, and probably more than, top executives of nonfinancial public companies to the widening of the income distribution," writes Stephen Kaplan of the University of Chicago's Graduate School of Business. The top 25 hedge-fund managers combined earned more than CEOs of the Standard & Poor's 500 companies combined in 2004, he calculates.
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.
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Corrections & Amplifications
Graduates of Harvard University who go into finance earn 195% more than Harvard grads in other careers, or nearly triple the pay. Yesterday's Capital column incorrectly said they earn 195% of the pay of those who work elsewhere. In addition, the first name of Steven Kaplan of the University of Chicago's Graduate School of Business was misspelled as Stephen in the column.
(WSJ Jan. 18, 2008)
