Wednesday, January 13, 2010

Wall Street Pay

This is another reductionist exercise. I don’t care what people on Wall Street make. But I am interested on why they make so much, and I want to apply a reductionist analysis. They are obviously doing something for which the demand exceeds the supply. What is that thing, and why the imbalance?

My starting point for almost all inquiries into new phenomena is “What’s changed?” Why is there so much money available and so much money paid, relative to the past? These questions assume that Wall Street pay is in fact higher than it used to be. I’m going to take that as a given. If I’m wrong, then never mind.

I have already identified one component of the problem: the trade deficit causes money that would ordinarily flow through Main Street to flow through Wall Street instead. I should take this opportunity to add a second point, which is that personal savings in this country has come more and more to mean pension accounts of some sort, and most of that money, too, flows through Wall Street and not Main Street. All of the money wants securities, so the securities industry is where the money goes. That’s why there’s so much money available for Wall Streeters to siphon off for themselves.

But why are money managers and traders paid so much? Why aren’t there thousands of them chomping at the bit to work for a nice six-figure paycheck? Why eight, nine or ten(!) figures? I’m thinking it’s the law of diminishing returns.

Remember The Bell Curve – Herrnstein and Murray’s book that everyone thinks was about race but wasn’t? The Bell Curve was about the skewing of rewards in our society toward the brainy end of the spectrum. For whatever reason, it appeared to the authors that we were developing a bimodal income distribution, with a big and growing divide between the manual labor class and the intellectual labor class. The divide was especially ominous because the entry of women into the workforce was reducing social mobility. Doctors marry doctors now, not nurses; lawyers marry lawyers, not secretaries. Remember when there were secretaries? Remember when smart women were teachers? But I digress…

Anyway, the world is paying more and more for smarts, and the reason, I submit, is that the law of diminishing returns applies to intellectual projects. Consider legislation. How hard is it to come up with a law against murder? Over time, just about all of the obviously necessary and easily constructed legislation has been constructed and enacted. But there is always an ongoing battle between the law and those who would avoid it (not evade it, which is a matter of policing, not legislating). So legislators need to be smarter. But they aren't getting smarter, because we'er not smart enough to raise their pay enough to attract smarter people. Read any good laws lately?

Here’s Jules Verne on two characters in From the Earth to the Moon:

“Now if Barbicane was a great founder of shot, Nicholl was a great forger of plates; the one cast night and day at Baltimore, the other forged day and night at Philadelphia. As soon as ever Barbicane invented a new shot, Nicholl invented a new plate…. Which of these two inventors had the advantage over the other it was difficult to decide from the results obtained. By last accounts, however, it would seem that the armor-plate would in the end have to give way to the shot; nevertheless, there were competent judges who had their doubts on the point.”

The weaponers vs. the armorers. The eternal struggle between problem and solution. The better the solution, the trickier the next problem. But just how smart were Messrs. Barbicane and Nicholl, or, more to the point, how smart were the people they hired to do their R&D? And how much did they pay them? How much would they have to pay them? And wouldn’t the price rise as the task got harder, as the ability to think up the next solution became rarer and rarer?

And what else could those very bright people be doing? The world is their oyster. Why gun-making or plate-making? Why banking? Why software? Some people, of course, work at what they like, and money isn’t everything. But money biases decisions:

The graduate with a science degree asks," Why does it work?"
The graduate with an engineering degree asks, "How does it work?"
The graduate with an accounting degree asks, "How much will it cost?"
The graduate with an arts degree asks, "Do you want fries with that?"

And Wall Street has the clearest path to riches for the very bright. Because the amount of money there is growing rapidly, and because the benefit of a small advantage is measurable in dollars, and because only a few people can create even small advantages now that the easier questions have long since been answered.

The easy questions are those relating to the allocation of capital. Howard Dean recently said in an interview that his family worked on Wall Street for generations, but that they were in the business of capital allocation (that’s what Warren Buffett says he does for a living, too), and now Wall Streeters are in the business of financial engineering. Dr. Dean sees financial engineering as unproductive, as compared to capital allocation, which he, rightly, considers a very important function in a capitalist system.

Dr. Dean is right and he is wrong. Many money managers do get paid to allocate capital, to keep it flowing from weaker industries to stronger ones. But there is also a lot of money to be made by exploiting tiny market-inefficiencies that are, in the scheme of things, too small to matter, but nevertheless, with the right technology, can add up to handsome profits for socially useless effort. The brains are being used not to detect inefficiencies, but to detect them milliseconds more quickly than others. As if that really matters to the allocation of capital. That, I think, is why people are so pissed off at Wall Street. You can make a lot of money there doing nothing that needs doing. Not only is it a waste of the money you make, it’s a waste of the talent you employ.

Most people who think Wall Streeters are overpaid cannot articulate why they are overpaid, because they don’t know what they do. But that’s the point. The contribution these financial engineers make to the general economy doesn’t seem to be worth the compensation. It can’t be, or there would be some tangible evidence. It’s not just that financial service companies deal in intangibles. People seem not to resent venture capitalists. They don’t even resent mutual fund managers, who really do allocate capital. No, it’s the ones who just appear to be fixing unimportant anomalies that get their goat.

Of course, there is always a baby in the bathwater. There is something harder than the allocation of capital that is also an essential function of Wall Street: the transmogrification of capital. Investment bankers used to match up risk-takers with risk-creators. Now they match up risk-avoiders with risk-creators. That’s a very much more difficult thing to do.

It started with ERISA, the Employee Retirement Security Act of 1974. That law required that all defined benefit pension plans be funded and that virtually all retirement plans of all kinds be prudently invested. By fiat, a major portion of the capital of the United States was being told what level of risk it could take. But that did nothing to change the kind of risk that entrepreneurs were creating. The capital structure of American business had to be reshaped so that the demand for capital matched the capital available, not only in amount, but in style, where the style was changing rapidly from risk-taking to hyper-risk-averse.

A review of the 1970’s and 1980’s will reveal, I think, capital structures divided into two parts: (i) as much low-risk, senior paper as could be generated, and (ii) a high-risk common stock element. And the LBO was born – leveraged buy-outs, where the (relatively) careful money took the debt and risk takers remaining in the economy – the rich getting richer – took the risk. Of course, the risk was nowhere near as great as the price it could command with so much of the money tied up in “prudent” investments. So there was lots of money to be made by the common shareholders, and so lots of money available to pay the investment bankers who created the debt. Junk bonds were everywhere, and the paychecks were fat, indeed.

In the last decade, the sovereign wealth funds of our trading partners have augmented the pension funds, taking even more risk capital out of the system and also preferring to buy as much safe paper as possible. As the law of diminishing returns teaches, the more prudent capital there is to invest, the harder it gets to find prudent investments. Really, really smart people were needed, people who could demand a lot of money for putting together really complex deals. And they could get a lot of money because the investors were more concerned with safety than return.

This sort of financial engineering is really quite valuable to the economy, because the idea of “allocating capital” per se begs the question of how risk tolerance, and if there is a big mismatch between the risks being created and risks investors will take, financial engineering is the only solution. ERISA and the trade deficit created the need for that engineering, and the more money flows into those capital pools, the more money there is to be made allocating it, and the harder it gets to do so. The natural result is that the people who are ready, willing, and, above all, able, to perform these feats stand to earn enormous amounts of money.

But that's just the baby. There’s still that nasty bathwater of useless trading and the corruption that attends so rich a pot. This post has run on too long already, though, so…

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