By Jonathan B. Wight

Via Krugman we learn that Mankiw comes to the defense of the beleaguered mega-millionaires in finance, who have been getting a bad press: 

“Those who work in banking, venture capital and other financial firms are in charge of allocating the economy’s investment resources…. It makes sense that a nation would allocate many of its most talented and thus highly compensated individuals to the task.”

 It is very true that investment bankers and venture capitalists play a vital part of our dynamic adjustment to a changing world.  They should be amply rewarded for the risks they actually incur with their own money.  

In 1979 the share of income going to the top 0.1 percent of individuals was 2.83%, of which financial professionals garnered 0.34%.  By 2005 the share of income going to the top 0.1 percent had risen to 7.34%, of which financial professionals garnered 1.45%--an increase of more than 300%.  Hence, the share of income in the top 0.1 percent going to financial professionals rose from 12% to 20%. 

But Mankiw’s version of events implies that the extra income going to the financial sector over the past thirty years was somehow the result of greater productivity.  Of course, it likely was not.  It was likely a redistribution of the gains of economic activity. After 1980 a lot of smart people figured out how to rig the financial system so that the rewards of risk-taking were privatized while the added risks were socialized (through bailouts of financial companies “too big to fail”).  The major investment banks put their own people in the Treasury and other agencies.  

Between 1950 and 1980 the U.S. had a “Plain Chevy” financial system that was solid, safe, and reliable: it got you where you needed to go without any big accidents or breakdowns. Financial markets were heavily regulated to prevent risk from spreading uncontrollably.  Financial reserves  and low leverage gave financial managers the incentive to use care.  The economy grew faster during the 1950s and 1960s, evidence that our economy was not being held back by capital allocation.

After 1980 we succumbed to the notion that “greed was good,” and that avarice would lead financial markets to regulate themselves.  The result was a “Ferrari” financial system filled with fast products, faster computers, and greater risks.  The economy itself did not grow noticeably faster because of these slick innovations. 

Of course, not all else is being held constant so it is difficult to say how fast the economy would have grown without these financial changes.  But the initial presumption that innovation always leads to productivity growth needs to be questioned. 

A better highway system can get more people to work faster and lead to overall productivity growth.  But allowing  people to race Ferraris on those highways can lead to pile-ups and innocent people hurt, as happened in the great crash of 2008. 

To my mind the increase in rewards to financial professionals over the period 1979 to 2005 can hardly be justified by economic performance, at least not at the aggregate level.   We rewarded financial professionals for shifting risk onto the public sector, something Adam Smith strongly discouraged through his plan for financial regulations in The Wealth of Nations.