Does Finance Deserve Its Earnings?

Many economists (even some relatively free market economists) have begun to question the high returns flowing to the financial industry in recent years.  It’s not that people don’t understand that finance is important, or that it plays a critical role in our economy, but rather the claim is that finance is much more generously rewarded than in the past, and that those extra earnings are at least partly unmerited.

Today I’d like to defend finance.  Not the role it played in the housing debacle (in that specific case I agree with the critics.)  Instead I’ll try to show that even in the absence of policies such as Too Big To Fail, you would expect the share of income going to finance to be rising sharply, as compared to earlier decades.

Let’s start with a simple economy that produces lots of wheat and a little bit of iron.  The income distribution in society mostly reflects differences in productivity in farming.  Stronger farmers can produce somewhat more than weaker farmers, but not a lot more.  Hence income is distributed fairly equally.

Suppose productivity in the mining industry mostly depends on skill at noticing iron deposits.  Let’s also assume that this skill is distributed very unequally–some people are much better at spotting iron deposits than others.  The next assumption is crucial.  Once iron is found, it can be mined very easily.  The hard part is finding the iron in the first place.  In that sort of economy, income will become less and less equally distributed as iron becomes a larger and larger share of GDP.

In the 1950s and 1960s it wasn’t that hard to figure out where capital needed to be allocated.  Capital was allocated to produce steel, and the steel was used to produce cars and washing machines.  Capital was allocated to the production of aluminum, and the aluminum was used to make airplanes. The most productive members of society were those who made things, and Michigan was near the top in per capita income.

Today the most productive members of society are not those who produce things, they are those who discover the things that need to be produced.  Once you have the blueprint, it is easy to produce many types of software and pharmaceuticals.  The big money goes to those who figure out the blueprint, but also to those who allocate capital to the guy who has the idea for a Google, or Facebook, or Twitter.  In contrast, the technicians who actually implement the vision often earn modest salaries.  Thus companies are “discovered” in much the same way as an iron deposit is discovered by a skilled geologist.

And then there’s globalization, which means decisions about allocating capital can vastly improve productivity even in the old-line industries that were dominant in the 1960s, when the rest of the world hardly mattered.  Finance is not that important in an agricultural economy or even in an economy where the mass production of goods can be done with almost military precision.  It becomes extremely important in an economy where it is not at all clear what should be produced, or on what continent that production should take place.

I’m not sure if I’m saying anything new—this analysis is sort of related to the ”economics of superstars.” But if it is well-understood, why do people seem so perplexed by the fact that finance earns much bigger incomes than in the 1960s?  Finance now plays a much more important role than in the 1960s.

Perhaps people are drawing the wrong conclusions from the housing fiasco.  Finance made a serious mistake in allocating so much capital to housing, but that’s not what caused the recession.  In a country with 100 million houses, the damage from adding two million a year for a couple years instead of one million a year for a couple years is modest.  The reason we have a severe recession is because of tight money, not too many houses.  Otherwise we would have had a severe recession in 2006-08, when housing construction collapsed, rather than 2008-09, when we actually had a big downturn.  And of course much of the sub-prime mortgage fiasco had nothing to do with housing construction, it was refinancing.

As long as we have an economy that is increasingly dominated by “idea companies,” where the idea is really, really hard to discover and really easy to implement once discovered, finance will earn huge gains.  In my model economy the iron spotters were highly productive and the iron miners had a relatively low marginal productivity.

Right now, those who develop new ideas are being highly rewarded.  More importantly, those who spot good ideas developed by others, and allocate capital to implement those ideas, are also highly rewarded.  Get used to finance earning obscene profits, it isn’t going away.  But if it makes you feel any better, they are producing something of great value (except when they screw up and allocate money to sub-prime mortgage borrowers.)

Some might point to the fact that finance also earned high incomes in the years right before the Great Depression.  And yet we obviously did not yet have high tech economy.   But those high incomes merely reflected the extraordinary bull market.  Today finance earns large incomes even during years where stock prices are not soaring.  In others posts I’ve argued that income is a pretty meaningless metric, as it is distorted by the mixing wage income and capital gains.  Whenever stock prices soar income will temporarily look much less equal.  But our recent move toward greater inequality is not just driven by stock gains during bull markets; it’s a secular trend that isn’t going away anytime soon.

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