Financial Sector Employees Are Overpaid

In a recent paper, NYU's Thomas Philippon estimated the size of the financial sector. The model he used was surprisingly accurate from 1920's through the 1990's. But as this chart from his paper shows, something happened in the late 1990's that threw off the model.

Here are Philippon's possible explanations for the discrepancy:

Up to the 1990s, the model seems able to predict most of the changes in the size of the financial sector. The model falls short in the more recent decade. Since the model forces all the demand for financial services to come from domestic firms, the discrepancy could reflect the globalization of the finance industry. There could also be an increase in financial services provided to U.S. households. Alternatively, it could be that the financial sector is too large and should be reduced.

In another new paper (this one is more preliminary than the first), Philippon and University of Virginia's Ariell Reshef try to explain why bankers, traders, and other financial sector employees get paid so much.

It first turns out that these workers didn't always used to be so richly rewarded:

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and it wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward, another shift occurred. The financial sector became a high-skill high-wage industry again. Even more strikingly, relative wages and relative education relative to the private sector went back almost exactly to their levels of the 1930s.

What accounted for much of this change? Deregulation of course.

We find a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial industry in the wake of the depression era regulations, and started flowing back precisely when these regulations were removed.

During the recent surge in wages for financial sector workers, Philippon and Ariell find that technology played a relatively small part in explaining higher pay:

Computers and information technology also played a role, but, contrary to common wisdom, they cannot account for the overall picture for the simply because the financial industry of the late 1920s looked remarkably like the one of the late 1990s.

The researchers also looked into the role of risk: finance sector employees are more likely to lose their jobs than average. How much does that account for the rise in pay? About six percent of it.

The duo next create a model of finance sector wages and come to a very interesting conclusion:

We find that in 1920-1940 and in 1990-2005 employees in finance are overpaid.

Why is this the case? Some economists have argued that the flow of highly-skilled workers into fields like law and finance may not be desirable because even though the private returns are higher in these jobs (i.e. they pay more), social returns in some other less-well-paying jobs are higher.

Here is a chart showing the predicted and actual wages in the financial sector:

It implies that workers in finance are overpaid by 40 percent.

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