Where the Money Is

— By Kevin Drum

| Tue Jan. 4, 2011 1:53 PM PST

Over at Free Exchange, A.S. asks, "Are the rich making you poor?" Apparently not:

Talented traders and portfolio managers do make an obscene amount of money while other traders just get rich....The winner-takes-all nature of finance explains the income disparity within the industry. But it does not mean a Wall Street fat cat is getting rich at the expense of a more naïve investor whose stock holdings are limited to the mutual fund his 401(k) is in. The only thing that naïve investor is betting on is that the American economy will continue to grow and that companies will be profitable in the long run. Speculators actually can do this naïve investor a service. They can eliminate mispricing, promote efficiency, and provide market liquidity; this can enhance growth in the long run.

Well then, I have to ask yet again: where is this tsunami of money coming from? If financiers receive a greater fraction of national income than they did in the past, somebody else is getting less. That somebody is almost certainly you and me, whose wages haven't kept up with economic growth, thus creating a huge and growing pool of extra money for the financiers to hoover up.

The only other alternative is that the modern financial sector is actually creating wealth that otherwise wouldn't be created. That is, their magic has caused the economy to grow faster, and they're merely reaping the benefits of growth they themselves are responsible for. I imagine this is a popular explanation among Wall Street bankers themselves, but does anyone else buy it? If it were true, surely it would show up in accelerated growth rates starting around 1980. Right?

Are the rich making you poor?

Jan 4th 2011, 16:35 by A.S. | NEW YORK

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MOST adults accept that life is not fair, but the word fairness gets used a lot when we talk about income inequality. Is it right that some have so much material comfort and security, while others have so little? On the other hand, is it fair that talented, hard-working people must give away the fruits of their labour? What’s fair and whether it matters depend on one's personal values. But for policymakers, the important issue to think about is the nature of the income inequality. Are the rich getting richer while the poor and middle class stay the same? Or, are the rich getting rich at the expense of the poor? When the latter is true, the case for intervention is stronger.

According to a recent New York Times article the rich getting richer has made the poor worse off. The argument is that the poor and middle class become discouraged and give up:

Yet the increasingly outsize rewards accruing to the nation’s elite clutch of superstars threaten to gum up this incentive mechanism. If only a very lucky few can aspire to a big reward, most workers are likely to conclude that it is not worth the effort to try. The odds aren’t on their side.

Inequality has been found to turn people off. A recent experiment conducted with workers at the  University of California found that those who earned less than the typical wage for their pay unit and occupation became measurably less satisfied with their jobs, and more likely to look for another one if they found out the pay of their peers. Other experiments have found that winner-take-all games tend to elicit much less player effort — and more cheating — than those in which rewards are distributed more smoothly according to performance.

The logical leap between the two paragraphs is confusing. There’s a world of difference between being frustrated that the guy in the cubical next to you makes more for doing the same job and your feelings about the fact that Kim Kardashian made $6m last year. (Maybe your soul dies a little every time you watch “Keeping up with the Kardashians”, but the show probably does not make you want to give up on life all together.) Also the policy implications of this argument are unclear. It would be a terrible idea to put a limit on how much one person can earn because it makes someone else feel bad.

Tyler Cowen’s excellent essay on income inequality points out that envy and resentment tend to be local and not directed at economic superstars. Mr Cowen points out that as income inequality has increased, Americans (of all income levels) also experienced an increase in living standards, life expectancy and access to cheaper goods. An increase in well-being is probably more important than stagnant income.

But Mr Cowen is concerned that so much of America’s income disparity is the result of compensation in the finance industry. He worries that the current state of finance means the rich do get richer at the expense of others. One way this is true, he argues, derives from the very nature of finance. Extraordinary profits are made by spotting an “incorrect” price and trading on this. But not everyone can get rich this way. There is only so much money to be made in any one arbitrage opportunity. The first person who acts gets the biggest piece of the pie.

There’s a second reason why the financial sector abets income inequality: the “moving first” issue. Let’s say that some news hits the market and that traders interpret this news at different speeds. One trader figures out what the news means in a second, while the other traders require five seconds. Still other traders require an entire day or maybe even a month to figure things out. The early traders earn the extra money. They buy the proper assets early, at the lower prices, and reap most of the gains when the other, later traders pile on. Similarly, if you buy into a successful tech company in the early stages, you are “moving first” in a very effective manner, and you will capture most of the gains if that company hits it big.

The lucky talented traders and portfolio managers do make an obscene amount of money while other traders just get rich. But making money this way consistently is very hard. Sometimes you will be wrong or your timing will be off and you lose money. This is why the average American is not actively trading. Being consistently successful at it takes knowledge, expertise and capital. The winner-takes-all nature of finance explains the income disparity within the industry. But it does not mean a Wall Street fat cat is getting rich at the expense of a more naïve investor whose stock holdings are limited to the mutual fund his 401(k) is in. The only thing that naïve investor is betting on is that the American economy will continue to grow and that companies will be profitable in the long run. Speculators actually can do this naïve investor a service. They can eliminate mispricing, promote efficiency, and provide market liquidity; this can enhance growth in the long run.

Mr Cowen lists another reason why finance sector pay comes at the expense of the poor, which is very worrying and problematic. It stems from the distortions that exist in the industry. Mr Cowen reckons that the large rewards and guarantees of government bail-outs provide too much upside with too little downside. This asymmetry encourages excessive risk taking where the rich get the all the upside (when their bets pay off) and the poor and middle class bear the downside by being more adversely effected by recessions (when the bets go badly).

The solution to this problem is more regulation and credible policies that limit moral hazard. But that’s easier said than done. Regulation is a blunt tool. Rules that seem like a good idea in the abstract often have unintended consequences because banks can always increase profit by avoiding regulations. Regulatory arbitrage often causes distortions in certain markets and more opacity (see Basel I and II).

A good start might be to hire more qualified regulators. This is hard when the government cannot offer the millions the private sector does (again with finance pay being a problem). But this does not mean that putting arbitrary limits on finance sector compensations is a good idea. Firms will merely find a way around the limits or do more business abroad. Making compensation contingent on medium-term firm profitability is not guaranteed to work either. Many bank executives lost a fortune when their company stock at Lehman and Bear became nearly worthless, and this threat did not make them any more prudent. There are no easy answers, but understanding the nature of inequality and the aspects of it that require thoughtful remedies is a good start.