My review of Thomas Piketty’s book, which appears in the current issue of TAC, has been on-line for the past week. Please do check it out if you haven’t already. I’m particularly interested to hear from knowledgable readers of the book whether I am right about the importance of the tail-off in demographic growth in the developed world to the predictions Piketty makes for future growth and inequality. Piketty alludes to the subject a number of times, but never really focuses on it.
There were a few points I made in the review that I couldn’t elaborate on adequately because of space (and because they would be too tangential to the main topic). This probably won’t be the last post I write to pick up on one of those threads – in this case, the question of extreme levels of executive pay.
One of the much-noted oddities of Piketty’s analysis is that his macro thesis is that our future will be one of “patrimonial capitalism” where inheritance matters more than did for much of the 20th century, whereas his data demonstrate that, particularly in the U.S., the growth in inequality over the past three decades has been driven substantially by growth in wage income at the top. This is due in part to the huge pay packages earned by top-performers in finance, but only in part; there just aren’t enough people in finance to dominate the trend. Rather, Piketty asserts, most of the extreme pay packages are in the corporate sector, and accrue to people he dubs “super-managers.” This is a problem for his thesis, because while class origin may be a very important leg up in becoming a “super-manager,” these positions are not actually inherited.
How much this micro-disparity matters to the macro thesis depends on your theory of why pay packages at the top have risen so dramatically. Piketty argues that it reflects self-dealing on the part of the managers, who are able to cow insufficiently independent boards into over-paying them – and he argues in favor of that proposition through a variety of demonstrations that pay appears not to be well-linked to productivity. But this is not an uncontested position. Scott Sumner, in a post that largely deals with another interesting topic to which I may return – ethnicity and productivity – suspects higher productivity really is the driver, and links to a paper that argues that because pay has increased dramatically at the top of a variety of different professions – finance, law, executives of public corporations, executives of private corporations, and athletics – these increases are reflective of a kind of structural change in the economy to “winner-take-all” dynamics, possibly driven by technology.
But what do we mean by “productivity” in this context?
A hedge fund manager earns huge fees for managing capital. Assume, for the sake of argument, that the business is ruthlessly meritocratic: returns are strictly a function of how much money the manager makes for investors in a given year. Now, assume that hedge fund-managers as a category make a lot more money than other comparable finance professionals. What you’d expect, in that case, is a migration of talent from the rest of finance towards hedge fund management – and, as a consequence, some erosion of hedge fund returns and/or hedge fund fees as competition both for investment opportunities and for investor dollars increased.
But another thing you’d expect to happen is for other finance professionals to see their pay increase – because banks and brokerages would need to pay more to prevent their employees from defecting to hedge funds. You’d also expect to see banks and brokerages trying to get into the hedge fund game themselves, chasing those higher returns – which, in turn, would require competing head-to-head with hedge funds for talent. And that would, once again, put upward pressure on finance packages generally.
Now, if we assume that finance is a normal industry, then all of the above should be unproblematic. Talent should migrate to higher-margin activity, and the rest of the industry should adjust. If finance as a whole is more lucrative than other industries, then, similarly, there should be an adjustment as talent pours into finance, and finance would represent a larger fraction of employment and of the economy.
But finance isn’t like other industries. Finance is just a mechanism for allocating resources efficiently. It doesn’t “produce” any goods or services that anybody wants for their own sake. It’s more comparable to law or accounting than to industries like health care, computer software, automobile manufacturing, retailing or education. If finance is growing as a percentage of the economy, that’s prima facie a problem, not a neutral fact.
One way it might be a problem is that pay scales in finance inevitably affect pay scales in other industries, for the same reason that pay scales for one activity within finance inevitably affect other parts of finance. If a trader can make much more money at a hedge fund than at a traditional bank or broker, then she’ll leave unless the bank or brokerage finds a way to raise her pay so she will stay. If traders make much more money than traditional bankers, people will start to leave traditional banking unless pay scales increase to encourage them to stay. So, similarly, if finance is an obviously more-lucrative route than other aspects of business, then pay scales for non-finance executives will have to rise to keep talent from flowing into finance.
This is what I meant when I said the following in my review: “I suspect this income escalator is driven secondarily by self-dealing, but primarily by competition for talent with a fantastically remunerative financial sector.” [Note: there is a typo in the review where “with” was replaced with “within,” which, obviously, changes the meaning.] If the financial sector becomes incredibly lucrative, it will draw more and more talent to it, which will depress pay scales in finance (relative to what they would otherwise have been) but which will also raise pay scales for executives in other areas who have (or had, earlier in their careers) the requisite skills to choose to move into finance. Financialization may, therefore, be one important driver of increasing inequality generally between executives and other salaried employees.
Is financialization another species of rent-seeking, though? I suspect it is – but this analysis would still hold even if it isn’t. Finance could grow as a percentage of national income if a large percentage of financial services are, effectively, being exported – if we’re capturing a larger and larger percentage of the world’s demand for financial services. If that were true, then the rise of finance would not be evidence of some kind of corruption in the heart of the American economy. But it would still drive inequality in other sectors of the economy in ways unrelated to productivity, as described above.
I should stress, I’m not sure I’m right about this by any means – I’m really just speculating. But finance loomed so large in the change in the American economy since 1980, and the internal dynamics of finance are sufficiently different from many other industries, that I think it’s always worth raising questions about whether financialization is implicated, even if, on its face, the phenomenon in question looks much broader-based.