Wednesday, April 29, 2009

Why Bankers Will Continue to Make Just as Much as They Used To

I can understand the brouhaha over banker pay. Bankers make a lot of money. And the seeming unwillingness of the banks to lie low on the compensation front for even a quarter or two makes me wince.

Case in point, this New York Times article: After Off Year, Wall Street Pay Is Bouncing Back

Even as the industry’s compensation has been put in the spotlight for being so high at a time when many banks have received taxpayer help, six of the biggest banks set aside over $36 billion in the first quarter to pay their employees, according to a review of financial statements... If that pace continues all year, the money set aside for compensation suggests that workers at many banks will see their pay — much of it in bonuses — recover from the lows of last year.

Yes, bankers will get paid as much this year as they did before the financial services meltdown.

Another number in the article jumped out at me: "Historically, investment banks have paid workers about 50 cents for every dollar of revenue." This is surprisingly similar to the amount paid to employees of ad agencies and other marketing services firms. It is also surprisingly similar to the amount paid to consultants and lawyers (adjusting for the implied equity-ownership pay in partnerships.)

The headcount-expense/revenue ratio in professional services firms is so universal because the economics of salaries and revenue are linked. We (and the mass media) tend to think of firm revenue being set in one supply and demand market and eexpenses being set in another and firms forming only in that uncommon circumstance where the revenue is enough to support the expenses. This may well be true for companies that make widgets: whether or not the widgets are made is a consequence of whether or not they can be made for less than they sell for.

But in a professional services firm, this is not how it works. The demand for the firm's product is also the demand for the underlying labor, so these demand curves are linked in a simple fashion. The supply curves, obviously, are also linked. Because of this--and the industry dynamic it creates--professional services salaries are the amount left from firm revenue after rent, technology and returns to equity-providers are paid*. Since these other amounts are generally within a small range of percentage of firm revenue, the amount paid to employees will be as well.

If you think bankers make too much money, focusing on how much they are paid will get you nowhere. If they are not paid 50% of firm revenue, they will go to another bank that will pay them that much. If no bank will pay them that much, they will go start a new bank. If that sort of compensation is outlawed at any bank present or future, they will start a bank where they are the equity owners and get paid that much. The money has to go somewhere, and it's not going to go to the providers of capital because the providers of capital to professional services companies have no negotiating leverage.

Taxes would work. In most of the business world, it seems that the highly compensated are paid on a de facto post-tax basis, so if taxes are raised, compensation is raised to correct for it. But this can't be true under my theory of professional services firms. So that's one way.

But I believe that outsize salaries are the result of a market failure, so why screw around with taxes when we should be addressing the market failure itself? I'm no expert here, so I'm not going to expound in detail my pet theories of why banking services cost so much. But in general I think that financial services regulations are far too oriented around who is allowed to provide certain services and how they are licensed when they should be oriented around actually protecting people who need protection. These two things are supposed to be the same, in principle, but they have not turned out that way.

I know it's easier to get the average person incensed over someone's pay than to get them to think about reforming a market--especially a market the average person could care less about--but I guarantee that no matter what the government does, no amount of bluster over how much bankers make will change their pre-tax compensation a single iota unless they focus on why revenue per employee is so high.


* Yes, I don't believe payments to owners in professional services firms are the residual profits. And why should they be, when the employees can leave and set up shop across the street with almost no need for equity capital? In the implicit negotiation over distribution of revenue, the employees have all the bargaining power. The equity will be paid a fair return, but will not receive any structural increases in revenue. On the other hand, the equity will continue to bear the majority of the variability in profits. This view, while not the standard economic view, has the advantage of being supported by reality. (It also accounts for why non-partner-owned professional services firms tend to conglomerate, but that's another post.)

Sunday, April 12, 2009

There's lots of bad economic news, so much that not much of it breaks through the clutter for me anymore, but this did:

Tufts accepts 26 percent of pool, suspends need-blind admissions:

The admissions office ... stopped practicing a need-blind admissions policy toward the tail end of the process, a decision that affected five percent of applicants, Dean of Undergraduate Admissions Lee Coffin said.

Admissions officers were able to first read every application in a need-blind manner, during which they did not consider an applicant's ability to pay. But with more families requesting larger amounts of aid due to the recession, officers suspended need-blind practices for the final 850 applications -- of 15,038 total -- when potential financial aid ran out.

"We read every application need-blind, conducted committee need-blind, and then we ran the numbers and realized that we just couldn't do it, that we had gone as deeply as we could go," Coffin said.
I bet this is a problem a lot of colleges and universities are facing this year and may face the next few years. This is where the government funding should be going; investing in education for young people is the best possible use of our economy's surplus.

Read Romer in Post-Scarcity Prophet:
When you're thinking about the future, you never really know what we're going to discover, but I think there's a reason to set for ourselves an ambition of trying to raise the rate of growth by half a percent per year.

... If we can make the choices that increase the rate of growth or real income per person to 2.3 percent per year, in 50 years we can get extra income per person equal to what in 1984 it had taken us all of human history to achieve.

One policy innovation, for example, that would boost the growth rate would be to subsidize universities to train more undergraduate and graduate students in science and engineering.
Subsidizing education is as close to free for our society as anything we know of. I haven't run the numbers, but I suspect that the break even on this investment (in a steady state) is shorter than anything else we can think of.

Two asides.

1. I don't agree with Romer on all of this, especially the idea that only science and engineering should be subsidized. Romer is focused on technological discovery as a driver of growth, but in my observation, ideas are discovered by people from all disciplines. Romer makes this point, although seemingly unintentionally, in his EconTalk podcast:
Research grants to universities are not the best way to develop all different types of ideas. Imagine that all music that we could listen to was produced by academic departments of music on college campuses. If you've ever listened to what music people write when they do research, it's pretty unlistenable stuff. The pure university research path isn't the way I want to get the music I listen to or the books I read. But, on the other hand, if you have the kind of things like open source, there is a kind of democratic element where people in open source have to cater to--or lots of things on the web that are free--they're catering to not just a narrow group of peers, but a wider audience. And that creates incentives for people to create things that are valuable for large numbers not just small elites.
If we want better music, give tuition subsidies to lots of music students rather than grants to a few music professors. This seems rather obvious in the arts, but it's almost certainly more true in other academic departments. The idea that "physics advances funeral by funeral" is a by-product of the current university system.

I also don't think that anyone, government included, know where we should focus our research to create ideas. Romer says "we never really know what we're going to discover..." and this is true not just within science, but within knowledge as a whole.

2. For my friends who conflate economics and finance: growth is not evil. The point of creating more income in a society is not to have more rich folk or to consume more stuff. Growth in income, although measured in dollars, is the ability to create more value, not more money or more things. We create additional value primarily by a better arrangement of materials, not the greater use of materials. So, a laptop today is more valuable than a mainframe computer of thirty years ago even though it uses less resources and costs quite a bit less. (There is a somewhat involved argument about why this creates a more even distribution of income, but that's pretty OT.) That growth often means more use of resources and more inequality is a bad outcome, but--IMHO--is not caused by growth itself but by the inefficient tuning of the institutions that encourage growth.

Growth is society becoming more productive. This additional productivity doesn't just mean that more people have gigantic flat-screen televisions (although certainly many people will use their excess production this way) but that we have better health outcomes, less incentive to fight over resources, more personal freedom and, hopefully, even the ability to increase the percentage of the pie that goes to people who currently have less.