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Rapid rise of finance industry produces negative effects for society

The finance sector over the last decades not only sucked up much of the best talent, its rapid growth also fueled the global crisis. And yet it seems like the current malaise might just be a slight hiccup for the sector.

Traders in New York

Finance sector profits have grown exponentially

A good way to gauge the allure of Wall Street after the financial crisis is to look at America's best university.

Despite the continued fallout from the crisis, more Harvard graduates this year will start a career in the financial sector than in any other field, albeit that their numbers have dropped sharply compared to pre-crisis levels.

According to the annual senior survey compiled by the Harvard Crimson daily student newspaper, 22 percent of the Class of 2011 will work in the financial sector and consulting followed by education with 11 percent of graduates. Back in 2007 almost half (47 percent) of all Harvard graduates joined Wall Street firms.

While this marks a drastic decline in Wall Street's appeal for top talent, experts are not convinced it represents a lasting and more general shift away from finance. Instead, they argue that it is more likely that the amazing rise of the finance sector will go on.

"I see the trend more or less continuing with this being just a small bump in the road," Ugo Panizza, the head of the debt and finance analysis unit at the United Nations Conference on Trade and Development in Geneva, told Deutsche Welle.

His colleague Sameer Khatiwada, a research economist at the International Labor Organization in Geneva argues that the financial sector is already "back to business as usual." He points to the fact that profits and payments of the industry are rising again and that financial firms have been paying dividends even during the crisis contrary to non-financial companies.

Growth of an industry

To understand the rise and the current strength of the finance industry one must go back in history.

During the 1920s wages and skills in the financial sector were very high compared to those in other industries. That changed dramatically when stringent regulations where put in place after the 1929 financial crisis.

As documented by New York University economist Thomas Philippon wages and skills in the banking sector remained largely on par with other industries until the 1980s. Then deregulation began and led to increasing gaps in wages and skills sets in the finance sector compared to other sectors. By 2006, the average worker in the finance industry earned about 70 percent more than the average worker in other fields.

But it's not just wages and skills. The finance industry's share of total corporate profits doubled in the past two decades and at its peak in the early 2000s accounted for more than 40 percent of all US corporate profits.

Traders on Black Friday 1929

Tough regulations were put in place after the 1929 crash

After a brief collapse of profits due to the crisis, the industry seems on track again. In the last quarter of 2010 the finance industry already accounted for roughly 30 percent of all operating profits again which as the Wall Street Journal noted is an "amazing share given that the sector accounts for less than 10 percent of the value added in the economy."

From enabler to driver

The rapid evolution of an industry which earlier was considered an essential, but secondary enabler for other sectors into a full-fledged primary industry and economic growth engine has had other detrimental effects on society.

"The growth of finance really distorted incentives for lots of skilled people, especially those with science and engineering skills," says Dane Stengler, director at the Ewing Marion Kauffman Foundation in Kansas City.

Instead of developing new drugs or designing new cars many of the best graduates of top universities now spend their time concocting arcane finance products like CDO2 or mortgage-backed securities.

"There are giant parts of finance that have just become moving money around and making money with very little relation to what you and I would consider as the 'real economy,'" says Stengler.

The hemorrhaging of top talent from the sciences and engineering into finance has not only hurt those particular fields. According to a study Stengler co-authored, it also "had some effect on keeping entrepreneurship rates down, because some subset of those scientists and engineers would otherwise start their own companies."

What's more, the experts emphasize that the evolution of the finance sector from capital provider to driver of the economy has further exacerbated income inequality in the US and elsewhere.

While there is a vague sense among the general public and experts that the finance sector has become too big and has a negative impact on society, proving that hypothesis is not easy.

Too big to do good

"We can start from anecdotal evidence and conclude that this sort of financial system run by supposedly very smart people went basically bust three times in the last 25 years," says Ugo Panizza referring to the Latin-American crisis, the Savings and Loan collapse in the US and the current crisis. "One could take that as evidence that the industry is not so productive after all."

Lehman Brothers headquarters

Three years after the Lehman collapse pay is still good in finance

To seriously test the hypothesis, Panizza and two colleagues conducted a study with the aim of determining whether there exists a threshold beyond which the finance sector is detrimental. "Our results suggest that finance starts having a negative effect on output growth when credit to the private sector reaches 110 percent of GDP." They also concluded that the size of the finance sector exacerbated the global economic crisis.

"I am confident in saying that above a certain threshold too much finance might be bad for you," says Panizza.

To be sure: Panizza as well as the other experts emphasize that finance is necessary and that it has an important function for society, i.e. providing capital to start-ups.

But according to Panizza the finance sector in 12 countries among them the US, Britain, Canada, Germany, Switzerland, Spain, Ireland and Iceland is too big. That doesn't mean that all countries with large financial sectors are in trouble now, but it does mean that all the countries facing problems now (with the exception of Greece) have a finance sector that according to the study is too large.

New strategy

But how then can the runaway growth of the finance industry be reigned back in?

By applying a three-fold strategy, argue the analysts. One, regulate the finance sector and make sure that the economic policies don't favor finance over other industries as has been the practice in the past. Two, peg your pay to productivity. (In the US productivity of the average worker has increased substantially while wages have stagnated.) Three, promote opportunity in other parts of the economy.

While many are skeptical whether Western governments have the political stamina to get a handle on the rise of finance, they will be forced to sooner or later, predicts Khatiwada: "We will have more of these crises if the structure isn't changed."

A helpful hint that different incentives could reverse the trend toward finance is provided by the 2011 Harvard senior survey. When asked whether they would choose a different field if salary were not an issue, half of Harvard seniors who will go into finance answered with yes.

Author: Michael Knigge
Editor: Rob Mudge

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