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Big Banks and Income Disparity

Nobel economist Joseph Stiglitz made some critically important observations in the Sunday New York Times. He pointed out that income disparity is a cause of the maddeningly slow recovery from the effects of the Great Recession, not merely a consequence of it. He drew parallels to the income disparity that predated the Great Depression. In my view he is correct, though there are persuasive opinions to the contrary.

One key to reducing inequality it tackling structural elements of the financial system that contribute to the widening income gap. The economy needs to promote parity, and the financial system as it currently functions is an impediment.

Income disparity is illustrated by the widely known Saez-Piketty graph that garnered so much attention a few years ago:

This graph cries out to be compared with another that depicts wages and education in the financial sector compared with other sectors of the economy:

The academics who compiled the data on financial sector wages and education went to great lengths to determine what was behind this U-shaped data set. They concluded that the regulation of the industry was the most likely cause.

It is obvious that the period before the New Deal regulation of the financial sector and the period of financial deregulation starting in 1980 share high levels of financial sector compensation and income disparity. The period of regulation, between the other two, is characterized by moderate levels of both financial sector wages and education and low income disparity.

This generates some interesting questions. Income disparity undoubtedly has many causes. But the data over so long of a period suggests that wages in the financial sector and income disparity are related. It might be that high financial sector wages contributes to disparity. It might also be that the two share some common causes.

A third chart might be helpful. This depicts the financial sector share of GDP over an even longer period. The U-shape s less pronounced (in part because of scale), but the graph has common features with the data on income disparity and financial sector wages and education.

What this chart shows is that here have been periods of growth in the financial sector in which this growth not coincided with growth in other sectors of the economy. Broadly speaking, over long periods of time these periods have coincided with deregulated marketplaces. This is both curious and troubling. The principal function of the financial sector is to facilitate the deployment of available capital to productive purposes. If it is doing its job well and therefore earning the increased wealth it is experiencing, the other sectors should be growing also, profiting from more efficient deployment of capital.

We can articulate a hypothesis that can be tested. Deregulation of the financial sector leads to large and complex financial markets as financial institutions engage heavily in activities that are extraordinarily profitable. Both the size of the markets and their complexity provide asymmetric advantages to well capitalized, liquid and sophisticated financial institutions. Therefore unconstrained financial institutions will maximize size and complexity. This size and complexity increases the profits of financial institutions and the incomes of financiers. But the economy, as a whole, profits substantially less. In fact this activity by the financial institutions harms productivity as available jobs in the lower pay ranges either provide less income or cease to exist. Therefore deregulation leads to greater size and complexity that leads to higher profitability and incomes in the financial sector and a growing relative share of the financial sector that leads to diminishment of non-financial sector productivity and an increase in income disparity.

My recent paper “Cracks in the Pipeline: Restoring Efficiency to Wall Street and Value to Main Street” makes this case.

Professor Stiglitz most certainly has a point. The persistent disparity of incomes in the United States is explained as a cause of the lingering effects of the Great Recession, but it is a condition that is intolerable. There are a number of remedies; but one that addresses the problem by eliminating a structural cause is an essential component. If the hypothesis suggested above is valid, the business of finance should be purposely shrunk to its core function -- intermediating capital flows from investors to businesses, governments and households who seek investment or loans. There would be no independent reason for a financial sector that profits from other activities. It is not even a question of allowing these profits to create a more robust financial sector. The excess profits derive from activities that are risky, at minimum, in proportion to their revenue potential. We know that from the financial crisis, if nothing else.

So when banks complain that regulations stifle innovation or profit potential or that business may be driven offshore, the answer may well be “so what.” The startling truth may be that the elimination of most of the financial innovations of the last 35 years would be the best job creator ever considered.