The best & the brightest capturing their value-add

By Razib Khan | October 15, 2009 7:09 pm

In the interminable debate on Wall Street compensation Ryan Avent makes an important point:

Officials in Washington scrutinising the pay packages of TARP recipients are primarily focused on the incentive effects of those pay structures–whether financial pay packages are inducing financial employees to take excessive risks. But the bigger incentive problem may be–almost certainly is–the drain of talent from other fields, into finance. If there were more evidence that this drain was producing significant net benefits for the economy, than there would be less cause to worry. To an increasing number of people, it looks as though the financial sector is recruiting the nation’s best brains and putting them to work endangering the global economy.

Let’s table whether financial engineers are really endangering the global economy.

phillipsgr01.pngSince 1800 the world economy has produced a radical increase in wealth which is qualitatively different from what came before. The chart to the left has the y-axis as the log of per capita income. Something happened in 1800. In the popular imagination we call it the Industrial Revolution, though economic historians argue whether we should bracket out the phenomenon in this manner. No matter, a change did occur. In fact, many changes occurred. Modern finance emerged during this period, as did our contemporary legal and political structures. The corporation matured with the groundbreaking example of the VOC. Ideologues campaigned in favor of free trade, surplus population emigrated to the New World, and the vast spaces and resources of North America served to free up Europe’s labor and capital for its workshops instead of extracting more for the sake of primary production.
All of these changes are important on the margins. But the biggest change, the biggest driver of productivity growth and therefore wealth, has been innovation, in particular technological innovation. The greatness of technological innovation is that its effects spillover and accrue to all of society, as all boats rise with the tsunami of productivity growth. There are a few technologists who become fabulously wealthy, but it can be argued (rightly I believe) that these technologists do not in fact capture the vast majority of the wealth which they generate indirectly to themselves. In other words, the productivity growth fueled by computers which leads to a wealthier population is only marginally reflected in the value of technology firms themselves or incomes of their employees. Imagine if Johannes Gutenberg captured all the economic growth and controlled the totality of the societal ferment which the printing press generated.
In contrast intelligent people who go into finance, or medicine or law, make a contribution to society, but they capture a much greater portion of the value which they add economically in compensation. The total value may be less, but if they capture a much larger fraction then rationally on an individual scale society’s loss is their benefit. Who does society admire, the surgeon who saves lives, or the technologists who toil away to produce tools and instruments which allows thousands of surgeons to save lives? Who has greater cachet on the marriage market, a doctor who is pulling in $200,000 a year, or an engineer at Intel pulling in the same money? How does a family whose breadwinner is a post-doc bringing in $50,000 a year working on cutting edge basic research feel in relation to a colleague who went to Wall Street after grad school and is pulling in $500,000 a year?
The command economies of the Eastern Bloc failed to create the incentives which resulted in technological innovation, their forte was copying. But the reality is across the history very few economies have been able to lay the cultural seedbed for innovation. At his talk at the Singularity Summit Peter Thiel argued that in fact the amount of innovation occurring in our culture has decreased. Why? There are many reasons. But I do wonder if price and social signals to our best and the brightest are part of the reason why innovation is not occurring at the same clip. As a friend who is an engineer at Intel communicated to me nerd with an M.D. is a “catch,” a nerd with a doctorate from MIT is a nerd. We live in a world where all the glory goes to those who fish, not those who produce better hooks & lines for the fishermen.
H/T Matthew Yglesias.

CATEGORIZED UNDER: Culture, Economics
  • bob

    The chart also shows that amazing mid 20th century spike. It appears the growth rate now is closer to the late 19th century rate.

  • Tom Rees

    So the question is why the market is so skewed. If innovation is engine of growth (and it is), why aren’t the innovators better rewarded? This is particularly acute in ‘blue skies’ academic research.
    I think part of the answer lies in the difficulty of producing a metric that links innovation to wealth, and also in the lag between innovation and implementation (the two are related, of course).
    In finance, it’s easy. They work on short time horizons (too short, many people think now), and return on investment is immediately quantifiable and visible.
    For technology, each advance is a product of many individual efforts, and the ‘profit’ to society might be a long way downstream (and so difficult to connect to an individual).
    Another way to look at it is that investment in innovation is a gamble, and it’s the financiers that reap the rewards of the gamble (and of course they spread-bet the risk and are not penalised for long-term failure).

  • Katharine

    Odd. Also, depressing. These are people who apparently have not realized that money is simply money, that knowledge is more important, and that frankly, there’s more to life than money. As long as you can feed your face and have somewhere adequate to live, it’s a little absurd to pile on what amount to merely extraneous ‘markers of social status’ (more like gilded junk!), and somehow it makes them look, in my opinion, as if they’re trying to compensate and failing miserably for an actual lack of brainpower.
    How does this trend among Americans compare to trends from other countries, e.g. China, India, etc.

  • mdb

    Government guaranteed job and great pay, who wouldn’t work for the financial industry if they could?
    Do not overlook the role government played in this mess. If the companies were allowed to fail, smart people would be running away from finance very quickly. Instead Goldman Sachs is paying massive bonuses with taxpayer provided AIG insurance money.

  • John Emerson

    As I remember, quants are usually people who got math PhDs and then had to figure out what to do with them. A lot of science fields are like that — physics and above all, astronomy. In almost every academic area there are fewer cademic job openings than new PhDs.
    In other words, finance isn’t robbing the world of mathematicians, but the world is failing to provide math work for the mathematicians it has.
    Math and physics whizzes of the second rank have been dropping down into easier fields forever, with mixed results.

  • razib

    a lot of them are physics phds. and i’m not offering academics as a opportunity cost as industry. so yes, *industry* isn’t providing them work.

  • dev

    I think you’re getting closer to the heart of the problem, but are not quite there yet in my opinion. My thoughts:
    First, to a large degree contemporary society accords prestige in accordance with a person’s wealth, no matter how it’s acquired. While there may be greater prestige in certain circles from being a doctor than an engineer, I suspect this is more from greater awareness of doctors as a profession (see: prime-time TV shows) than from social attitudes about desirable vs. undesirable professions.
    So to attain social prestige seek great wealth in whatever way you can, and the most straightforward way to obtain great wealth is to put yourself into a position within the economic system where lots of money flows through and you can capture a disproportionately large fraction of that money for yourself. Hence, for example, the attractiveness in times past (or in present-day less developed countries) of being a crony of the king or similar ruling autocrat and running the tax system or being granted royal monopolies. Hence also the attractiveness of working for certain kinds of financial institutions (e.g., hedge funds, investment banks) today where vast sums flow through firms with relatively few employees.
    The problem for technologists is that (as you note) they can’t capture value in such a disproportionate way, because (in my opinion) the very success of most technologies depends on their being broadly adopted and creating value for others than their inventors. Aggressive attempts to circumvent this (e.g., through truly draconian policies around intellectual property) would likely strangle technology adoption in the cradle.
    This imbalance in potential rewards flows out of the structure of modern economies, and not from social attitudes and norms. Thus the likely most effective ways to fix it (assuming you think it’s something that needs fixing) are either to lower the potential rewards of being in certain high-leverage positions within the economy (e.g., by strictly regulating certain types of financial transactions) or to bring the people in those positions under full democratic control (e.g., by nationalizing certain types of economic institutions). Whichever approach governments might take, I think it can be justified given the fact that at present government (and hence taxpayers) are in effect guaranteeing that people in such positions can make bets in which they are fully rewarded if they win but for the most part protected from the consequences if they lose.

  • Allan Niemerg

    mdb has identified a big part of the problem: government involvement. As long as the banking industry is allowed to socialize the risk and privatize the reward, why shouldn’t we expect risky behavior?
    And I suspect that in many instances quants weren’t being used to hedge risk as much as they were used to give the APPEARANCE of having hedged risk to prospective purchasers of all the risky products being sold. Their presence allowed all the market participants to believe that something was “truly different” this time.
    And one final note on innovation: There doesn’t seem to be any real evidence that innovation has slowed in any way. Productivity, the best test of innovation, has actually grown faster during the current downturn. Every year we learn to make more and better with fewer resources and less work. The fads and fashions of the nation’s “best brains” is a sideshow to that reality.

  • razib

    . Productivity, the best test of innovation, has actually grown faster during the current downturn.
    doesn’t productivity always grow during downturns? the best workers don’t get fired, so the work force shrinks and increases in median productivity.

  • John Emerson

    I believe that when the stock market crashed, past productivity was retroactively reduced. Certainly in construction and real estate, but there were a lot of spinoffs and downstream effects, and what we’re talking about is the influence of finance on productivity, so every decline counts since finance influences everything.


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About Razib Khan

I have degrees in biology and biochemistry, a passion for genetics, history, and philosophy, and shrimp is my favorite food. In relation to nationality I'm a American Northwesterner, in politics I'm a reactionary, and as for religion I have none (I'm an atheist). If you want to know more, see the links at


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