Boring banks support economic growth; risk-loving banks drive the economy off a cliff

Paul Krugman calls our attention to the sexily titled (as only economists can) Wages and Human Capital in the U.S. Financial Industry: 1909-2006. Its authors, Thomas Philippon and Ariell Reshef, find:

From 1909 to 1933 the financial sector was a high skill, high wage industry. A dramatic shift occurred during the 1930s: the financial sector rapidly lost its high human capital and its wage premium relative to the rest of the private sector. The decline continued at a more moderate pace from 1950 to 1980. By that time, wages in the financial sector were similar, on average, to wages in the rest of the economy. From 1980 onward, another dramatic shift occurred. The financial sector became once again a high skill, high wage industry. Strikingly, by the end of the sample relative wages and relative education levels went back almost exactly to their pre-1930s levels.

In other words, pre-1930 financial jobs and post-1980 financial jobs were complicated and very well paid. From 1930 through 1980, banking was boring and finance jobs didn’t pay particularly well. (The authors calculate that financial industry wages are currently 40% too high relative to what similar workers earn in other industries.)

Why? The authors say the pre-1930 and post-1980 financial industries share another characteristic: minimal regulation. The complexity of financial industry jobs and the high pay during low-regulation eras reflects creative scheming to make money in ways not permitted from 1930 through 1980:

Our investigation of the causes of this pattern reveals a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial sector in the wake of the Depression era regulations, and started flowing back precisely when these regulations were removed. This link holds both for finance as a whole, as well as for subsectors within finance. Along with our relative complexity indices, this suggests that regulation inhibits the ability to exploit the creativity and innovation of educated and skilled workers. Deregulation unleashes creativity and innovation and increases demand for skilled workers.

This begs the question: “Do we prefer unregulated banks that engage in complex, creative schemes to maximize their wealth or regulated, boring banks?” The question answers itself.

The pre-1930 and post-1980 eras both culminated in massive bank failures and triggered prolonged global economic downturns: “The Great Depression” and the current “Great Recession.” (Admittedly, the U.S. government has not allowed/forced megabanks into bankruptcy/reorganization, but the banks have certainly failed… Otherwise, they wouldn’t need multi-trillion-dollar bailouts.)

Conversely, the simple, well-regulated financial system that reigned from 1933 through 1980 coincided with tremendous economic growth in America and the world.

That’s why Paul Krugman is calling for strong regulation that will make banking boring again and take the huge profits (and its corollary: risk taking) out of banking. Krugman correctly views banking as an industry that should support the rest of the economy, not drive the economy… to the point of occasionally driving it off a cliff:

Policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

One final finding of the paper is the difficulty of enforcing financial regulations in a low-regulation era. Because deregulation drives up both financial industry pay and the level of financial innovation/complexity, the government’s ability to attract skilled regulators falls exactly when it most needs skilled regulators:

Following the crisis of 1930-1933 and 2007-2008, regulators have been blamed for lax oversight. In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly-skilled financial workers, because they could not compete with private sector wages.

Posted by James on Friday, April 10, 2009