Finance & human capital

How much would the global economy lose if the financial sector were to shrink?* This question raises a problem about the role of human capital.
Take the question: why are (some) bankers so well paid? One possibility is that they are highly skilled; they have lots of human capital and a high marginal product.
But if this is the case, they could use those skills elsewhere. Sure, they wouldn’t earn quite as much outside the financial sector - that’s why they work in it. But their skills would be useful, so they’d make a big contribution to the economy. In this case, the losses to the economy if the financial sector shrinks would be second-order. No big deal.
But there’s an obvious objection here. Maybe financial salaries are high because people have huge job-specific human capital. In moving out of finance, they would lose this capital. So there’d be a big resource loss.
Which brings me to my puzzle. How can we tell whether someone is earning good money because they have job-specific human capital, or because they are appropriating organizational capital for themselves? Take three cases:
1. When a bank hires someone from another bank on a high salary, it is often not paying merely for the man’s skills. What they want is his clients, or his knowledge of his ex-employers‘ products or trading systems. The bank is trying to buy organizational capital, not just  human capital.
2. High salaries are a form of efficiency wage. Traders must be bribed not to transfer assets cheaply to potential future employers. They are paid more than their pure marginal product, their human capital would warrant.
3. Many trading strategies work only because the bank can borrow cheaply or deal at next-to-no cost, or exploit inside knowledge of order-flow. Traders working for banks can therefore make more than they would if they traded on their own account.  But this excess is a return to the banks’ capital that they get for themselves, not a return to pure human capital.
Insofar as these mechanisms operate, financial sector workers are paid far more than their pure human capital would warrant. Which means they might not be so employable outside the financial sector. So, ceteris paribus, there would be a larger resource loss from shrinking the financial sector.
What I’m saying here is that there’s a problem for those who want to defend the financial sector.  You can do one of two things:
1. You can defend bankers’ pay on the grounds that it’s a reward for high skills, in which case you shouldn’t worry much about the financial sector shrinking, as these skills would be useful elsewhere.
2. You can argue that shrinking finance would be expensive. But this requires you to ditch the Econ101 just-so stories about people being paid a return to human capital, and to recognize that salaries are a reward to power, not (just) to “skill.“
Is there really a plausible third possibility?
* I frame the question at the global level to avoid the issue of whether a shrinking of UK finance would cause migration of City workers.

Comments

[Mike Woodhouse]

How about arguing that it’s a reward for high banking skills, which are less valuable outside the finance sector?

As a programmer within a bank I have high programming skills that are generally useful, but I'm probably paid more than my "general" value because I have banking domain skills that make me more valuable to my employer. I could certainly write programs in an entirely different industry, but I'd be less valuable there, lacking domain knowledge.

But maybe "knowledge" and "skills" aren't directly equivalent, or maybe I've completely missed the point...

[Luis Enrique]

Hmm. If I wanted to "defend" the finance sector, or at least argue that shrinking it might not be a good thing, the first thing I'd want to do is divide the finance sector up into various functions (retail banking, investment banking, fund management etc.) and ask which bits are going to shrink.

But to tackle your question: are defenders of finance stuck on the horns of your dilemma? If I want to claim bankers have high human capital, must I also accept that the net loss from shrinking finance will be small, as they are reallocated elsewhere? What if I want to claim that bankers are doing something important, and that if they are allocated elsewhere, we will suffer from having less of this important thing done? Isn't that an option 3?

For instance, what if, as a rough approximation, the quality of factor allocation decisions is increasing in the size of the finance sector (with diminishing marginal gains). Or, perhaps more realistically, we would be unable to distinguish between the bits that improve allocation and the bits that don't, so if we were to shrink global finance we would end up shrinking the useful along with the useless.

If skillful bankers are reallocated to other tasks, within an economy that now has inferior factor allocation capabilities, would we not be significantly worse off?

[This doesn't mean I think banking is all human capital with no organizational capital / power ... ]

[Frank the sales forecaster]

Wouldn't abnormally high returns to human capital often mean that an endevour has managed to avoid paying for all of its social costs? It seems to be the case with modern finance that the profits were fattened quite a bit by foisting all the cost of failure off on the rest of us. You could chose to include avoiding recognizing social costs in "power", but often it is just igorance of the actual social costs.

As to your broader question. Housing values are closely tied to proximity to appropriately paying work. I have observed what has happened in several cities that had areas which saw dramatic changes in employment opportunities. On these US based observations it seems unlikely that the lose of extremely high paying jobs would have no effect on local housing, but the effect will be less than the pessimist would expect. If the jobs aren't coming back, the quality of the housing and ammenities will attract other nearly as highly compensated individuals and things will be meh. If the jobs come back then things will be better than meh, but it will take time. Given England's maturing demographic, inbound imigration of knowledge workers is likely a necessity to avoid an over-all secular decline in the field.

[Matthew]

I can't see why a shrinking X sector could ever be bad news for the global economy per se - surely demand = supply? If you said 'is a shrinking manufacturin sector bad for the global economy' what can it mean?

I'm also a little sceptical about Kaletsky's specific points - did more children live with their parents in the 1980s than now, despite only 60% LTV mortages? Weren't house prices relatively cheaper?

[chris]

@ Mike - I wasn't dismissing job-specific human capital, merely questioning its size.
Put it this way. Estimate the gap between your current salary and the best you could get outside finance. Multiply it by the number of workers similar to you who might shift out of finance under Turner-style proposals. What proportion of GDP have you got? How does it compare to the near 10% loss of GDP caused by the financial crisis?
And there's another issue raised here. If job-specific human capital is so important, mightn't it have been a mistake for the government to have expanded university education so much? Mightn't it have been better to encourage more people to find work at 18, and so spend three years gaining those valuable job-specific skills?
Note here that I'm not endorsing (or not) proposals to shrink the City - merely asking how the debate aligns with our ideas about how labour markets function.

[Glenn]

If you look at the employment figures total employment in financial services increased in the UK by only 22,494 1999 to 2007. So while it created a lot of wealth (can debate til cows come home about how much of that wealth is left) its not created that many net new jobs (directly)...

[olique estefan]

Well written post. Nice portrait and Topics Thanks for sharing. keep on posting. waiting for your next post.
regards

[Emma]

Surely the answer is that although the human capital may not be job specific, the marginal product that their human capital allows them to produce is higher in banking, because the marginal value of banking is higher than the other uses to which that human capital could be put, and that banking pay is so high in order to equate the supply and demand of bankers?

Your human capital is only as valuable as the value people place on your product!

You seem to be trying to argue that renumeration is determined by human capital (of various sorts) but you can only measure the value of that capital by the value of the marginal product... unless you buy the labour theory of value.

Salaries are neither a reward to (just) power or (just) “skill“ but to utilise that skill (or power) in the most productive context.

Excuse me if I'm mistaken :)

[Emma]

I guess what I am trying to say is, the value of the human capital is partly driven by the demand side, and you can't tell what the loss would be without knowing the renumeration human capital would garner in the non-finance labour market (that, I think, was your point all along) but that this is not strictly related to the decomposition of human capital you suggested in the post (and cannot be determined a priori), but involves many other factors too!

Apologies.

[Jonathan]

Many bankers receive an obscene level of pay that us "lesser mortals" can only dream about.

[Luis Enrique]

Emma,

that's a good point; in addition, the demand side isn't just about how much people value the product, it's also about market structure. The returns to human capital in a monopoly setting is different to that in a competitive setting, I think. If shrinking finance involved reducing the quantity of rent-capturing bankers, I can't immediately think through the consequences for welfare ... what if the pricing power of the bankers left behind rises?

[Emma]

I was thinking like this: What is the upper bound of pay? (market determined) marginal product, what is the lower bound? labour market conditions - I was assuming the banking market was (relatively) competitive and that drove the market wages of bankers towards the upper bound, if the banking market were less competitive you would expect higher bank profits (or share price) not higher bankers pay (depending on how effective the corporate governance is). So what is keeping banking pay high is not competition for the bankers human capital from the non-bank sector, but from other banks.

The effects of shrinking the banking sector will surely depend on what is the cause. If demand drops off, the "welfare" consequences will be neutral (or positive) as the capital (like the bankers) are redeployed to more valued uses. If the shrinking is caused by regulation reducing the supply of banking, you would surely just increase the market power of remaining banks, and increase the marginal product of remaining bankers. Other regulation I guess will have other effects.

So you have to ask the question why would anyone want to artificially reduce the size of the banking sector? In my eyes, the size of the banking sector isn't the problem, risk is. Banking pay is a sideshow.

(This is ignoring Lord Turner and his social usefullness argument, that the market causes too much demand for banking.)

Apologies again for so much thinking out loud!

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