Thursday, 9 April 2009

Supply & Demand or Comparable Worth on Wall Street?

At a recent dinner party, a friend's wife remarked that she was grossly overpaid in the financial services industry. "Why do you say that?," I inquired. "Because so many well-educated people do more useful jobs than I do for less money," was her reply. When I reminded her of supply and demand, she agreed that these basic principles of economics should govern the determination of wages but that she still believed she was overpaid. Overpaid or not, she certainly appeared confused.

I was reminded of this conversation as I was reading Steven Pearlstein's column in yesterday's Washington Post.

Pearlstein's view is that overall pay on Wall Street " to be ridiculously out of line with that of similarly skilled and equally successful people in other industries." Of course, implicit in that statement is the view that pay for similarly skilled and equally successful people should be in line across industries. Like my recent dinner companion, Pearlstein appears to believe that wages should not be determined in a competitive market for labor governed by the principles of supply and demand.

Pearlstein goes on to list the pernicious effects of high pay. "No matter how it is structured, pay at such astronomical levels has a tendency to swell heads, inflate egos and tempt people to take undue risks of all sorts, ethical as well as financial."

Let's ignore Pearlstein's remarks about swollen head and inflated egos, since even if they tend to produce great bores, they would seem to pose no risk to the financial system. But what about Pearlstein's claims that high pay tempts people to take undue risks?

Well for every Ken Lay and Bernie Ebbers who exhibit risky behavior, there appear to be a Warren Buffet and Bill Gates, models of prudent behavior. And plenty of people with low pay have been tempted to take undue risks, as the subprime mortgage saga reminds us. As a purely empirical matter, I'm not aware of any correlation between pay and the adoption of risky behavior.

What do the critics of market-based compensation suggest for Wall Street? As it happens, Pearlstein appears no more able to offer a suitable alternative than was my dinner companion.

"The answer to that problem isn't for Congress to use the tax code to effectively legislate pay caps for Wall Street. In the current climate, however, the only way to beat back such bad ideas is to find some other ways of stopping and reversing the Wall Street arms race on pay."

At least Pearlstein recognizes that legislating pay caps is a bad idea. But he still believes there's an imperative to find some approach that would result in lower pay on Wall Street.

Pearlstein is no doubt aware of the hundreds of thousands of layoffs on Wall Street and in the City of London. And he must be aware that average pay in the financial services industry is now running significantly lower than it has in years. In other words, the principles of supply and demand are already resulting in the wage declines that Pearlstein advocates. Yet Pearlstein still feels the need for some other method to cap pay on Wall Street, presumably on a sustained basis.

I suspect Pearlstein's objections to the determination of wages via supply and demand is that these economic principles allowed Wall Street pay to get "ridiculously out of line with that of similarly skilled and equally successful people in other industries." But if pay on Wall Street was "ridiculously out of line" with pay in other sectors, it was not the result of pernicious Wall Street traders undermining the political process to forestall needed regulation, as Pearlstein claims. Rather, it was the result of prices adjusting to bring labor supply in line with labor demand on Wall Street.

If Pearlstein someday finds a better way to determine wages in the labor market, we'll look forward to the day when the allocation of resources is consistent with similar wages for equally-successful people with similar skills. But until then, and notwithstanding the current recession, Pearlstein's angst is a small price to pay for a system that has worked so well in so many countries for so many years.

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