A black hole for our best and brightest

The Washington Post:

In sheer dollar terms, it became irrational for almost any qualified American graduate to pass on a Wall Street job. By the mid-2000s, finance workers earned about 50 percent more than they would have in a similar job anywhere else in the economy. There are almost twice as many financial professionals in the top 1 percent of American income earners today as there were in 1979, according to researchers from Williams College, Indiana University and the Treasury Department. Almost 1 in 5 members of the top 0.1 percent work in finance.

You might think finance workers earned all that money because they were selling new and improved financial products that delivered more value — that helped get money more efficiently from investors who had it to entrepreneurs who could put it to profitable use. Research suggests that’s not the case.

A few years ago, Philippon set out to study 130 years of financial-sector performance. He expected to find that performance improved as the industry grew in recent decades.

Philippon tracked the fees that banks and other asset managers take when they move money between investors and borrowers. In theory, the managers should charge less as their technology improves, because they become more efficient and more competitive with one another. (Or, if they charge the same amount, they should generate better returns for investors.)

That’s how it works with, say, your laptop: As the technology improves, you can either buy a better computer for the same price as your last one or you can buy a clone of your last one for less.

In finance, Philippon found, the opposite is true. Financial firms pocket about 2 percent of the money that passes through their hands. That’s basically unchanged from the price of finance in 1920, and it’s actually an increase from the mid-1960s. “It seems that improvements in information technologies over the past 30 years have not necessarily led to a decrease” in the price of financial intermediation, he concluded in the paper.

What that means is that the growth of complex financial products has served primarily to boost income for the firms themselves, Philippon said. A new paper from researchers in the United Kingdom supports his findings. It analyzes decades of data on individual workers and finds no connection between financial professionals’ specific skill sets and why they make so much more money than similarly skilled workers in other industries.

A good observation – that not merely is (over) investment in finance less productive than some other fields but there is a significant opportunity cost in directing the very best new graduates to it.