Monday, November 24, 2014

The Best, Brightest, and Least Productive?

NEW HAVEN – Are too many of our most talented people choosing careers in finance – and, more specifically, in trading, speculating, and other allegedly “unproductive” activities?

In the United States, 7.4% of total compensation of employees in 2012 went to people working in the finance and insurance industries. Whether or not that percentage is too high, the real issue is that the share is even higher among the most educated and accomplished people, whose activities may be economically and socially useless, if not harmful.

In a survey of elite US universities, Catherine Rampell found that in 2006, just before the financial crisis, 25% of graduating seniors at Harvard University, 24% at Yale, and a whopping 46% at Princeton were starting their careers in financial services. Those percentages have fallen somewhat since, but this might be only a temporary effect of the crisis.

According to a study by Thomas Philippon and Ariell Reshef, much of the increase in financial activity has taken place in the more speculative fields, at the expense of traditional finance. From 1950 to 2006, credit intermediation (lending, including traditional banking) declined relative to “other finance” (including securities, commodities, venture capital, private equity, hedge funds, trusts, and other investment activities like investment banking). Moreover, wages in “other finance” skyrocketed relative to those in credit intermediation.

We surely need some people in trading and speculation. But how do we know whether we have too many?

To some people, the question is a moral one. Trading against others is regarded as an inherently selfish pursuit, even if it might have indirect societal benefits. But, as economists like to point out, traders and speculators provide a useful service. They sort through information about businesses and (at least some of the time) try to judge their real worth. They are thus helping to allocate society’s resources to the best uses – that is, to the most promising businesses.

But these people’s activities also impose costs on the rest of us. Indeed, a 2011 paper by Patrick Bolton, Tano Santos, and José Scheinkman argues that a significant amount of speculation and deal-making is pure rent-seeking. In other words, it is wasteful activity that achieves nothing more than enabling the collection of rents on items that might otherwise be free.

The classic example of rent-seeking is that of a feudal lord who installs a chain across a river that flows through his land and then hires a collector to charge passing boats a fee (or rent of the section of the river for a few minutes) to lower the chain. There is nothing productive about the chain or the collector. The lord has made no improvements to the river and is helping nobody in any way, directly or indirectly, except himself. All he is doing is finding a way to make money from something that used to be free. If enough lords along the river follow suit, its use may be severely curtailed.

Those in “other finance” often engage in similar behavior. They skim the best business deals, creating a “negative externality” on those who are not party to them. If the bad assets that they reject – for example, the subprime mortgage securities that fueled the 2008 financial crisis – are created anyway and foisted on less knowledgeable investors, financiers contribute no more to society than a lord who installs a chain across a river.

In a forthcoming paper, Patrick Bolton extends this view to look at bankers and at the Glass-Steagall Act, which forbade commercial banks from engaging in a wide variety of activities classified as “investment banking.” Ever since the Gramm-Leach-Bliley Act of 1999 repealed Glass-Steagall, bankers have acted increasingly like feudal lords. The Dodd-Frank Act of 2010 introduced a measure somewhat similar to the Glass-Steagall prohibition by imposing the Volcker Rule, which bars proprietary trading by commercial banks, but much more could be done.

To many observers, Glass-Steagall made no sense. Why shouldn’t banks be allowed to engage in any business they want, at least as long as we have regulators to ensure that the banks’ activities do not jeopardize the entire financial infrastructure?

In fact, the main advantages of the original Glass-Steagall Act may have been more sociological than technical, changing the business culture and environment in subtle ways. By keeping the deal-making business separate, banks may have focused more on their traditional core business.

Bolton and his colleagues seem to be right in many respects, though economic research has not yet permitted us to estimate the value to society of so many of our best and brightest making their careers in the currently popular kinds of “other finance.” Speculative activities have plusses and minuses, much that is good and some that is bad, and these are very difficult to quantify. We need to be very careful about regulations that impinge on such activities, but we should not shy away from making regulations once we have clarity.

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    1. CommentedMark Taylor

      This reminds me of a friend of mine. Currently at Cambridge, as close to a bona fide genius as I know of. Initially, he was going to go into bio-chemistry. In other words do something that was worthy of his talents. But no, now he is going to go into the City. What a waste of a first rate mind.

    2. CommentedDina Strange

      Jean, this is like saying, a fox should create the rules for its own hunting in the chicken hoop. Let me know how that will work.

    3. Commentedjean nutson

      Banks have the right to engage in other businesses for as long as they adhere to the rules of ethical corporate conducts ,moreover the duty of regulatory authorities is not to ensure banks and other corporate bodies do not violate corporate rules but to set the rules and to issue out punitive measures when they violate them,it is the responsibility of the banks themselves to ensure their activities do not cause any mayhem to the financial structure.

    4. CommentedClaudio Migliore

      My problem with this article starts at the end of the second line, first paragraph. Why say "alleged"?
      Since I did not write the article, I can safely say I do not think the mentioned activities are unproductive, but shouldn't Mr. Shiller take a stand on this issue?
      If he did, he might be forced to go beyond generalizations and distinguish creative financier from snake oil salesman, just as a traffic-optimizer waterway owner is not the same as a highway robber.

      If one could go into the details, the patter that emerges is one where the societal disease is not the existence of individual parasites, but the fact that society demands absolute safety, governments sell it (or the illusion thereof) and then attempts to mask first, and then distribute, the blame and the cost around when the bubbles burst.
      Does too much intellectual horsepower go into finance? Does to much go into Hollywood? The weapons industry? Either you think the market is in charge and always right in some way or you think there are other metrics to make decisions. The latter case is fraught with risks.

    5. CommentedChee-Heong Quah

      The problem is not with the finance, but with government-backed finance. Remove government from the equation and you'll get a pure market-driven balanced finance.

    6. CommentedRoger McKinney

      Bright people go into finance because that's where the best pay is. To go into other careers would be irrational. Careers in finance pay the best because of the Fed's inflationary policies. Businesses in finance get new money first, before prices have risen. That allows them to buy assets, such as stocks, before they increase in value and then sell them at a profit. This is no mystery. It's basic monetary theory.

    7. CommentedDouglas Costello

      I suppose people will even bet (speculate) on which raindrop gets to the bottom of the pane first. Not productive but entertaining if bored.

      Why are the Best, Brightest going in for these activities the same as all the others in the industry. Greed. They aren't concerned with productivity or economic growth it is how many deals can they do and how much can they slice off for themselves. At the risk of sounding like a vehement socialist financing is not rocket science but they have made it so and then they get creative so you can bet each way and still win while your customer always looses.

    8. Commentedsande cohen

      Isn't it time to retire the phrase "best and brightest" and replace it with something like "well-positioned and opportunist"? I taught at the #1 ranked art school in the U.S. whose President, Harvard educated, had been denied tenure for lack of publication before landing at our door. In a few years, he played the speculative-derivative game-version of academia, raising the image or sign-value of the institution by building an art venue for showcasing. We started calling mfa readings "showcasings." Because the bookstore was a 30k per year money loser, that was cut. The speculators, Mr. Schiller, harm everything they touch. It doesn't matter whether this is cloaked in the silliness of free-trade or the progressive silliness that art will set you free, make you a better person. 1.2 trillion in student loans tell a truth about this predatory system.

    9. CommentedMukesh Adenwala

      Happy New Year to all. A claim has been made in the article that speculation is socially useful and maybe even harmful for the society. In the traditional sense, that is, as it has been so far, always the case; it produces nothing but excitement, often at the cost of others.
      The question to ask is: Should this be the necessary outcome? On this New Year Day let me take a flight of fancy for I am not capable of much else.
      At some future date the economic crisis once again strike the developed nations. Loans in large numbers were granted for production of personalised objects on 3D printers. Loans were also granted, once again in large numbers to parlours offering `experience on demand’ through virtual reality machines. All such loans were securitised and a superstructure of exotic varieties of derivatives was built upon such loans. It seems that objects produced do not have much market and cannot be sold and there are not enough consumers wanting that tailor made experience and pay for it. Banks and financial institutions have incurred huge losses and large scale nationalisation appears to be the only viable outcome, else the world economy would fold under the weight of losses on account of bad loans and the derivatives that do not have market value anymore.
      At the recommendation of one Mr. Robert Healer, government declares two policies. First, by statute the strike date for derivatives is extended by a period of two years. Next the government institutes an agency. The agency takes over the objects produced by 3D printers and assigns a notional value to each object depending on the cost of production. The agency then institutes a lottery and declares that once the lottery subscriptions for any object reaches 10% over its declared notional value, a lucky draw would be held and the object would be given to the lucky winner. Companies engaged in selling customised experiences are hired by the agency to provide `learning’ experience to the younger generation. The extra 10% over the notional value of objects is transferred to experience generating companies so that they can repay their loans too. Within a period of 2-3 years, nearly all the loans are repaid.
      Now the derivatives, prices of which were based on the value of loans are traded and the markets thereof are also cleared to a large extent. Overall losses to the individuals as well as the governments are now within `affordable’ range and the business confidence returns to normal and business as usual is back.

    10. CommentedGregory Warren

      As a former C.F.O. for a large foreign bank, my experiences with Wall Street greed, and the resulting vacuum of ethics, is quite substantial through 40 years of working on Wall Street.. Prior to the costly, dumb, and ineffective Dodd-Frank Bill, the Wall Street community were kept in forced compliance by Glass-Steagall; the very fear of an S.E.C. examination emanated from Glass-Steagall. Firewalls were in place, and the greedy Wall Street " entrepreneurs" did not have access to their Banks Balance sheet.
      Too bad the public must pay, and I was tutored by a old pro from Dominick & Dominick who taught me the meaning of
      " Scotch Weeks". Between fictitious trades of derivatives, and broker-dealers complaining of " not being able to compete with larger banks", it is all one big farce to line the pockets of Wall Street. Morals, ethics, and the sorry state of our Country is evidence to the growing greed factor that induces theft or fraud.
      In summary, we measure the cost of losses to the U.S. taxpayer versus the value of continuing non-disclosure of trades, and so many other devious transactions; I have concluded that the S.E.C. has lost it's once mighty power to control the "Executives of Wall Street", who indeed manipulated Congress into dismissing Glass-Steagall, as outdated. Smart and greedy executives, and the man that dares tell the truth is called at once a fool and fanatic. ( Plato )

    11. CommentedWayne Davidson

      Ivy league schools and their cohort confer graduates with a set of moral standards that consistently conflict with the principles of morality. The intentionality of the rent extractors is cultural and their moral codes are institutionalized.

    12. CommentedStephen Brown

      Has there ever been a study examining whether the high personal cost of education is a cause for entering these more "unproductive" areas of finance? -A similar article on this topic suggests only 5% of these graduates intend to stay in Finance beyond 10 years, so are these graduates' finance ambitions caused simply by a desire to pay off debt quickly, and if so would some sort of education subsidy paid off with a graduate tax result in more people going straight into a "productive" field they actually want to be in?

    13. CommentedProcyon Mukherjee

      The gist of what trading and speculating is all about, "helping to allocate society’s resources to the best uses – that is, to the most promising businesses", leaves a sobering thought that the current reach for yield, that sucks every penny out of the monetary system to buy-sell the same asset several times in the day, must be a sacred duty performed for the best use, in fact the only use, of collecting the trading services fees and other transaction fees.

      The world would be supremely better "allocated" if such exchange is linked by law with a mandatory tax, that is directed to better use, like providing safe drinking water, sanitation, primary education, basic health services or even just toilets in remote corners of this world.

    14. CommentedTom Shillock

      America has always been based on the hope of personal economic betterment from the Pilgrims onward. The distinction between “rent-seeking” and other forms of financial corruption on the one hand and honest industry on the other has always been socially considered a continuum. Indeed, people who become rich through corruption especially if they get away with it fascinate us, they become legendary because we envy them. The spirit of American is fundamentally selfishness, we call it individualism.

    15. CommentedEdwin Hamilton

      In my Comment (second one) here
      this URL
      does NOT link. Can you fix, please -- thank you.

    16. CommentedScott Wolfel

      Rent seeking?

      "[T]he 16 big banks that, according to a 2010 Citigroup Inc. (C) report cited by Deloitte LLP, earn about $55 billion a year from derivatives." (Link below.) Most of this is not from proprietary trading, but from market making as a result of the opacity of the market., so the problm goes far beyond the repeal of Glass-Steagall.

      They are not just "rejecting" bad assets, they're creating them for huge profits and, of course, huge bonuses.

      Elite Universities, and no doubt Professor Shiller (whose work I love), are training the "best and brightest" who get their pick of the elite highest paying jobs.

      As a result of financial deregulation, and now toothless and misguided reregulation as well as the massive run up of debt in the debt supercycle , financial incentives have been misaligned and the "best and brightest" as well as the "worst and dumbest" can get incredibly wealthy creating and trading financial instruments that add little or no economic value (ie: rent seeking.)

      The larger problem may be that, like Feudal Lords, we can no longer cross that economic river without them. 5 years ago, the financial crisis morphed into an economic crisis after the financial Emperors allowed Lehman Brothers to fail, as an "object lesson" like Bo Xilai in China. Global credit markets quickly seized, we bailed out the financial industry, as we had to to avert Depression, and the rent seeking was turbocharged. There were no penalties for excessive risk taking, except for Lehman, and rent seeking has moved to new heights.

      Since the financial crisis, we've had consistently negative net capital investment in America, meaning that our productive capacity is declining, yet the financial economy, and the owners and traders of financial assets, is again booming thanks to "financial engineering" by the Federal Reserve. Our economy has been financialized and the Lords of Finance collect their rents, paying tribute to the Lords on the Potomac.

      Excellent article below on the gutting of derivatives regulations can serve as the next chapter of the excellent Frontline documentary "The Warning." Professor Shiller's students will no doubt agree with him in class, and write brilliant papers on "rent seeking," and will be wealthy derivatives traders and creaters in a couple of years.

    17. CommentedStylized Fact

      Well, it could be worse, those people could be working for Google.

    18. CommentedEdwin Hamilton

      The status quo structure is highly dependent on severely deceiving the people, I believe -- hopefully this will NOT last. Please see here:
      "Exceptionalism" will be the USA showing these track records to its citizens.
      The Public Be Suckered, here:

    19. CommentedG. A. Pakela

      The percentage of total compensation that you site is less than the the 8.4% that the financial sector represents as a percentage of the U.S. GDP. As far as what your students are doing with their lives, can you blame them for seeking to go into the most lucrative field in order to get the quickest payour for their huge investment in time and money to get that Ivy League or equivalent degree?

      And if as you state, finance represents unproductive rent seeking, why are individuals willing to part with their money in order to pay for financial services? We live in a free society and no one is putting a gun to our collective heads to pay for financial and insurances services unless we believe that we need them.

      I don't know that you can characterize the financial sector as "rent seekers" who put up barriers. The alternative to speculators, for instance is cartels made up of physical producers as was the case in the oil industry when oil companies known as the "seven sisters" dominated global petroleum industry from the 1940s to the 1970s. In fact, this is what banks are accused of doing and they are rightly being investigated for their behavior.

      The bottom line of what you are saying is that the market does not assign compensation to fields that yield the highest value to society. However, the alternative is to have academics, politicians and regulators decide who should receive what compensation.

        CommentedDavid Kelland

        But the politicians have created the status quo by creating the FDIC and the bankers have leveraged themselves up so much that if a few of them failed in a disorderly manner, millions of people might be thrown out of work. Surely, that is not a free market that rewards "better" enterprises. Even conservatives can agree that monopolies should be broken apart. They should also agree that having four banks that can hold the American economy hostage in a crisis is not a good situation for taxpayers. Socialized risk and privatized gain.

        CommentedAylin Yardimci

        "And if as you state, finance represents unproductive rent seeking, why are individuals willing to part with their money in order to pay for financial services?" How exactly does demand for a particular service render that service objectively productive?

        Commentedjuan carlos

        "We live in a free society"... the perfect excuse for everything.