Deregulation and its trail of destruction

When I was a child growing up in England in the 1960s, my mother's dream for me was that I would become a bank clerk, with ambitions to be a bank manager, the epitome of all that was best in the world, safe, reliable, honest, looking after people's hard-earned savings, helping business and the world to grow. A bank manager could countersign your passport application, that's how trusted he was.

What would she say now looking at the damage that bankers have wrought, when, to quote Paul Krugman, "finance turned into the monster that ate the world"? How could these pillars of respectability in the community have turned into such greedy monsters?

Part of the answer comes in a just published academic study which examines the nexus between high education, high salaries and deregulation of financial markets.

The authors' conclusion is that deregulation played the key role in attracting highly educated graduates away from manufacturing and other occupations and into finance. Such was the lure that by the late 1990s rents accounted for 30 to 50 per cent of the wage differentials between financial and other occupations.

The particular value of the study by economists Thomas Philippon and Ariell Reshef into "Wages and human capital in the US financial industry, 1909-2006" is that it covers a long time period and shows the striking similarities between the period immediately before the Depression and today. In fact, the paper might usefully be subtitled, "When will they ever learn?"

The authors discovered that the pre-Depression period and the 1980s onward had several things in common - in that financial jobs were relatively skill intensive, complex and highly paid. But in the in-between period, from the time of the Depression until 1980, a time of heavy regulation, financial jobs were not well-paid relative to other non-farm jobs.

They also discovered that, "The relative skill intensity and relative wages of the financial sector exhibit a U-shaped pattern from 1909 to 2006. 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."

The key is deregulation, aided by non-financial corporate activities, particularly initial public offerings and credit risk. Perhaps surprisingly, computers and information technology, according to the authors, played a more limited role in the spurt in financial skills and salaries. The findings reinforce those of other authors, who have also found that bright graduates are attracted to deregulation like moths to the flame, and noted, for example, a brain drain of managers from mutual funds to less regulated hedge funds in the 1990s.

Using the long time frame, the authors were also able to show that economic crises, periods of high unemployment, bank failures and long bear markets had no predictive power for relative wages and skills employed in finance. Regulation, or deregulation, is the key.

With the advantage of hindsight, lawmakers and academics have been quick to blame the financial regulators for their lax oversight of the industry. The two authors comment that regulators did not have the skilled staff to understand what was happening or keep up with the rapidly changing financial markets, and could hardly match the astronomical private sector pay.

The study also points to some of the awkward questions and implications for policymakers. If deregulation is the driving force for the financial industry, and regulators cannot keep up, the other side of the coin would be that tighter regulations will lead to an outflow of talent from finance. On the other hand, has it been a good thing for the economy that so many of the brightest brains chose finance over other careers?

My mother had her model bank manager, who was the father of my best friend, a Royal Air Force officer, but a navigator not a wild flyboy. He was as buttoned down and buttoned up as you can imagine. His idea of daring was a striped shirt, and he was difficult to talk to about politics, pop music or philosophy. But as to his reliability and trustworthiness with money, you could bet the bank on him.

http://www.scmp.com/portal/site/SCMP/menuitem.2af62ecb329d3d7733492d9253...