Lambert here with a spoiler alert: Rents.
Steven McIntosh, Reader in Economics, University of Sheffield. Originally published at VoxEU.
Individuals who work in the finance sector enjoy a significant wage advantage. This wage premium has received increasing attention from researchers following the financial crisis, with focus being put onto wages at the top of the distribution in general, and finance sector wages in particular (see Bell and Van Reenen 2010, 2013 for discussion in the UK context). Policymakers have also targeted this wage premium, with the recent implementation of the Capital Requirements Directive capping bankers’ bonuses at a maximum of one year of salary from 2014. In this article, we document the finance sector pay premium, and then investigate possible reasons for its existence (see Lindley and McIntosh 2014 for a fuller discussion of our analysis).
Our focus is the UK, and we define the finance sector as any firms involved in financial transactions. We are therefore considering banks and insurance companies, as well as the ‘City’ firms of fund managers, stockbrokers etc., who come to mind when mention is made of the ‘finance’ sector.
The New Earnings Survey is the best source of wage information in the UK, covering as it does 1% of all workers in the country. The measure of wages used from the New Earnings Survey is annual earnings, which therefore includes annual bonus payments – an important consideration when analysing the finance sector. Holding constant gender, age, and region of residence, finance sector workers are found to earn 48% more on average than non-finance sector workers. Part of this difference will be due to the characteristics of workers who tend to work in finance, be they more motivated, driven etc. Because the New Earnings Survey is a longitudinal dataset that observes the same individuals over time, we can control for any such characteristics even when they are not measured – as long as they remain constant over time – by looking at the change in wages for individuals who move into, or out of, the finance sector, and whose fixed unobserved characteristics will not have changed. The results suggest a 37% change in wages, on average, when individuals move between the non-finance and finance sectors. Thus, much of the finance sector premium remains even after controlling for such unobserved differences across workers.
The Robustness of the Finance-Sector Wage Premium
Another potential reason for the finance sector wage premium is that finance contains occupations that are typically better paid on average, whichever sector they are in. We again looked at those individuals moving into and out of the finance sector, but this time restricted the sample only to those doing a job with the same title in both the finance and non-finance sectors, focusing on generic job titles such as ‘function manager’, ‘ICT professional’, ‘secretarial’, ‘customer service’ etc. The results reveal that the same people doing the same job earn around 20% more when doing that job in the finance sector rather than the non-finance sector. This premium is observed to be remarkably similar whatever job title is considered – whether it is a typically high-paid or low-paid job. This suggests that the pay premium is ubiquitous across all individuals working in the finance sector. This idea is further supported by looking at the wage premium at various points of the wage distribution. Although the finance sector pay premium is observed to be the largest between high earners in the finance and non-finance sectors – at the top end of the wage distribution – it is certainly the case that it is also observed throughout the full distribution.
We can consider the different sub-sectors of finance. As perhaps expected, the premium is highest in the sub-sectors most associated with the ‘City’, such as fund management (55% estimated premium in the specification observing the same individuals moving across sectors), security dealing (49%), pension funding (47%), and security broking (45%). However, a significant premium is observed in all sub-sectors, again hinting at its ubiquity.
Explaining the Finance-Sector Wage Premium
How can we explain the high and rising wage premium available to all finance sector workers? Using a selection of data sets, we considered various hypotheses.
Rent sharing – the idea here is that the finance sector produces larger rents (surplus profits) than most sectors, which are then shared with the workforce.
The fact that the finance sector pay premium is received by all workers – regardless of their position in the wage distribution or the job they do – is consistent with a common factor such as profits being important, but is more difficult to explain with individual-level characteristics, which would need to be common to all workers in the sector. We provide further evidence for rent sharing by using EU KLEMS data to regress real gross value added (value of output minus value of input materials, as a measure of rents) against a set of sector indicators and other control variables. Observed rents in the finance sector are amongst the highest of all sectors (together with sectors involved in petroleum, energy, tobacco, and real estate, which all also produce excess profits of their own for various reasons). Furthermore, when we estimate individual-level wage equations, including a measure of sectoral rents, we observe such rents to be more strongly associated with wages in some of the sub-sectors of finance than in most other sectors. For example, on average in the non-finance sector, a 1% increase in rents is associated with a 0.15% increase in annual wages. In the fund management and security broking sub-sectors of finance, however, this figure is 0.9% and 0.63% respectively. There is therefore a strong association between rents and earnings, particularly in the investment-related jobs associated with the ‘City’.
Is the finance sector more skill intensive? The reason for the high finance sector wage premium could simply be that finance hires, on average, more highly skilled workers who would earn a higher wage wherever they worked.
We investigated this, considering both formal qualifications and childhood literacy and numeracy tests as different indicators of workers’ skills. As expected, the finance sector hires a larger proportion of graduates than the economy as a whole, and in particular, graduates from numerate subject areas such as economics and maths/computing, as well as management, are over-represented in finance. Furthermore, the data suggest a rise in the extent to which graduates are over-represented over time, though the increase is relatively small. This therefore cannot be the full story behind the rising pay premium. In addition, controlling for qualifications still leaves a significant finance pay premium when looking at wage differences across sectors within qualification groups.
We measured cognitive skills by looking at the childhood tests scores of individuals who go on to work in the finance sector when they are adults, compared to the non-finance sector. We consider two cohorts of individuals: one born in 1958 (the National Child Development Study) and the other born in 1970 (the British Cohort Study). Again as expected, finance sector workers have higher average scores on childhood numeracy tests than non-finance workers. However, there is no evidence that this gap is widening, it being around 0.4 standard deviations for both cohorts. For literacy scores, the 1970 cohort do see a higher finance–non-finance gap than the 1958 cohort, though most of this improvement in the literacy scores of future finance workers is amongst the least well qualified. Finally, controlling for cognitive test scores has little effect on reducing the estimated finance premium. Thus, while it is true that individuals working in the finance sector are more skilled than average workers, there is little evidence that this is responsible for much of the finance wage premium, and no evidence it can explain the rising premium.
Rather than the characteristics of the individuals working in the finance sector, it might be the nature of the jobs that they do that explains the high and rising wage premium.
In particular, the theory of task-biased technological change argues that new ICT technology has replaced workers doing routine, easily programmed tasks, but is complementary to non-routine analytical tasks (see Autor et al. 2003). We used data from the GB Skills Survey, which asks about the tasks involved in workers’ jobs. Jobs in the finance sector are more likely than non-finance jobs to involve non-routine tasks, such as numeracy, literacy, problem-solving, influencing people, and complex computing tasks, and thus the high demand for labour to carry out such tasks may help to explain the finance sector premium. However, there is no evidence that the non-routine task component of finance sector jobs increased over time between 1997 and 2012, while there is such a trend in the non-finance sector, so that the finance–non-finance gap in non-routine task use has actually fallen over time. Again, therefore, the theory cannot explain the rising finance pay premium over time. In addition, the premium remains statistically significant for skilled workers even after controlling for task content of jobs.
Concluding Remarks
In summary, the available evidence is most consistent with the rent sharing explanation for the finance sector pay premium. For this explanation to work, however, we also need it to explain why the premium is rising. This could be due to a rising opportunity to engage in rent sharing, due to financial deregulation, implicit insurance against risk through bank bailouts, and increasing complexity of financial products creating more asymmetric information, as well as increased incentives to aim for a larger share of rents due to falling top-end marginal tax rates. Whether governments want to enact policies to try to reduce the premium depends on whether they view it as a private sector matter with benign effects on the economy as a whole, or as having a distorting effect on the labour market, attracting the best workers away from potentially more socially useful jobs.
References
Autor, D, F Levy, and R Murnane (2003), “The Skill Content of Recent Technological Change: An Empirical Exploration”, Quarterly Journal of Economics, 118(4): 1279–1334.
Bell, B and J Van Reenen (2010), “Bankers’ Pay and Extreme Wage Inequality in the UK”, LSE Centre for Economic Performance Special Paper 21.
Bell, B and J Van Reenen (2013), “Bankers and Their Bonuses”, LSE Centre for Economic Performance Occasional Paper 35.
Lindley, J and S McIntosh (2014), “Finance Sector Wage Growth and the Role of Human Capital”, Sheffield Economics Research Paper 2014002.
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Whether governments want to enact policies to try to reduce the premium depends on whether they view it as a private sector matter with benign effects on the economy as a whole, or as having a distorting effect on the labour market, attracting the best workers away from potentially more socially useful jobs.
When the authors say “reduce the premium” this is tantamount to say that the rents of the financial sector should be reduced. This is particularly true, if as the authors find, there is a higher share of wage premium in this sector. This is not surprising since the cost of capital in financial activities is much lower than in any other sector. Particularly the Hedge Funds, which I believe don’t have any capital requirement: just attract few investors and then leverage to the infinitum. Almost certainly the policies of BofE, Fed or BCE further lowering the cost of capital for this institutions migth explain most of the widening gap between financial sector wages vs the rest of the economy. Nothing to do with skills of course, not to mention that this didn’t have such noticeable benign effects on the rest of the economy.
A smaller sector with above-average wages is the legal sector. Non-lawyer support staff, such as legal secretaries, office admin and HR, seem to earn more in a law office than in other non-financial sectors.
Part of this is likely rent sharing, as most law offices are partnerships, with annual bonuses representing a portion of compensation for non-partner employees.
Another aspect is that the typical partner wants highly reliable staff, and is willing (and able) to pay up to retain good people, rather than tolerate the higher turnover which goes with holding wages down to market levels.
Both law and finance are ripe for the extraction of economic rents, since both have artificially high-barriers to entry (licensing requirements, for instance) and are–or have been made to be–very complex fields.
Protection from new entrants + informational asymmetries = the ability to charge way more than you’re worth.
How about the ineffectiveness of investors in reigning in the amounts creamed off by management? We’ve heard since 1980 about the sacrosanct obligation of the managers to the stock holders. But here, we see a clear case of management using its position to siphon off a huge share of the profits that could, maybe even legally should, go to the shareholders in the form of dividends. Even from the perspective of orthodox capitalist thinking, this is not the way railroads are supposed to be run. If annual returns to investors rather than share price was the measure of how well a firm was doing, then these abuses would stick out like a sore thumb. What we seem to have in finance is a stunning ability of directors and managers to pocket the earnings at the expense of the shareholders (who we are always told have first claim over workers to profits).
Hyman Minsky wrote: “Any economic unit (essentially anyone who can get credit – Steven) can create money. The problem is getting it accepted.” That’s what these people do – ‘print’ money. They get it “accepted” by passing off the responsibility for their ‘financially-engineered’ debt products to the lender-of-last-resort when they can no longer unload them in the financial markets. Toxic waste is magically transmogrified into debt backed by the full faith and credit of the US government.
Events since 2008 have proved we don’t need the financial sector with its much vaunted “efficiency of capital”. Nor it would seem do we need people to save. If we need a few trillion dollars we can just create it ex nihilo – ‘out of thin air’. It should be clear by now that money is not wealth; it is debt – just like “the product (according to Dr. Michael Hudson) of Wall Street” .
One plausible reason is that the financial sector employees are simply getting paid more for a higher risk of losing jobs. I have no evidence though but its an idea worth investigating. For example, think of a dentist whose services will always be valuable, vs a credit derivatives trader who suddenly found himself useless post 2008.
Healthcare, MIC, Energy, FIRE, and other industries. ALL circle jerk for MOAR extraction (and “share the rent” with execs and pols).
Result: Structural unemployment / “secular stagnation”, inequality, inverted totalitarianism, etc.
Instead of dealing with the underlying problem(s), bogus TINA ‘solutions’ like blowing financial bubbles are proposed by economic ‘experts’ who have sold their soul to the neolibcon, anti-constitutional(*) NWO.
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(*) That’s why, from time to time, I call them ‘quislings’: they shill for oligarchical interests that are undermining our country and our democracy.
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There is an easy solution. Run banking as a public utility and compensate its employees as such. They should be making far less than school teachers and school teachers are being screwed over. There is not a single financial instrument created since banking came into existence that wasn’t involved with extracting rent for doing nothing except fronting capital/treasure/etc, and if it is too difficult to explain how someone’s exorbitantly compensated job is contributing to society it is probably unnecessary, and worse, likely unethical.
easy?
fair enough…
Let me propose here the Pro Sports Compensation Rule – the more your team makes, the higher the salaries for top players. The star of the team can ask for a big multiple of the lowest player.
Applied to corporations, the Rule works like this – as top manager I can ask for more money because my firm makes more [higher revenues]. Furthermore, I’m the star [CEO] so I deserve more because I’m connected to making more revenues. It also doesn’t hurt that I greatly increased my firm’s total revenues by a series of dubious M&As [horizontal or vertical acquisitions] — which will explode a couple of years after I leave.
In other words, the more money you’re shuffling, the bigger the cut you get, especially if you’re the dealer.
However, if you have no connection to money, especially if you are a cost center such as a teacher or counselor, you’re at the mercy of the star – and the Rule falls hard on you. You get paid what the star allows you to have.
In the key sector of finance during the phase of financialization, the aristocracy of labor will be found among the 20% of the populace used as the cadre to administer capitalism. Perrucci and Wysong, in their book, “The New Class Society”, point out this feature of the class system, where the top 20% receive the benefits from the economic arrangements of the existing social order. The idea of an aristocracy of labor has been written about by the historian Hobsbawm in industrial England. In the US, the aristocracy was seen among the railroads. The key engine of vast fortunes was the transportation links of the railroads and the necessary labor to keep the trains running on schedule and for the transit lines to keep labor going to work at the factories during the industrial expansion of America. You can see the vestiges of the forward thinking compensation of railroad workers to this day, on every IRS 1040 the railroad pension right along side Social
Security, predating SSI. The Social Security System was built with the corporate expertise of the railroad magnates. The people necessary for the key sectors of the economy at any given era will rise to the top of income stratification and be certain of security due to their value to the reigning profit making enterprises of the day. As the article above concludes: “….. Thus, while it is true that individuals working in the finance sector are more skilled than average workers, there is little evidence that this is responsible for much of the finance wage premium, and no evidence it can explain the rising premium.
Rather than the characteristics of the individuals working in the finance sector, it might be the nature of the jobs that they do that explains the high and rising wage premium.”
The finance sector is a den of thieves who control the system through the dc stooges, courts and regulators.
Or maybe the finance industry has increased the wages slightly more than the economy average for a number of years?
A small difference in yearly increase repeated over many years can make a big difference. How long would it take to get a 20% wage premium if the yearly increase was 1% more?
Similar to the compound interest phenomenon.
As of why they increase the wages more than average?
Might possibly be due to the ‘profitability’ during the bubble years leading to ability to increase wages more than average. Or maybe they’d rather increase pay for their employees more than economy average instead of having the transaction costs of replacing employees. Like Ford did.
I love the spoiler alert Lambert.
I am surprised not to see a fourth “reason”: Highly organized government-abetted systematic looting and de facto legal immunity.
Well actually, given that most economists derive their living in one form or another by serving as paid apologists and “explainers” for the looters, I’m not surprised at all at the omission.