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Correction to This Article
A previous version of this column erroneously stated that the average bonus at Goldman Sachs was nearly $600,000 in 2009. That figure is for average pay.

A Wall Street pay puzzle

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Monday, January 18, 2010

Why does Wall Street make the big bucks? A nation with 10 percent unemployment is understandably puzzled and outraged when the very people at the center of the financial crisis seem to be the first to recover and are pulling down fabulous pay packages. At Goldman Sachs, the average pay for 2009 has been estimated at nearly $600,000; at J.P. Morgan Chase's investment bank, it's been reckoned at slightly below $400,000. These averages conceal multimillion-dollar bonuses for top traders and investment bankers; underlings get smaller sums. Are Wall Street's leaders that much smarter and more industrious than everyone else?

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By their own admission, they're not. Testifying last week to a congressionally created commission, Wall Street chief executives conceded that their errors directly contributed to the crisis. Wall Street money moguls may be bright and diligent, but they're not unique. It's where they work -- not who they are -- that's so enriching. A study of Harvard graduates found that those who went into finance "earned three times the income of other graduates with the same grade point average, demographics and college major," reports Harvard economist Lawrence Katz, the study's co-author.

Is it possible that what Wall Street does is three times more valuable to society than other well-paid occupations? That's hard to believe. It's not that Wall Street is just the vast casino of popular imagination. It helps allocate capital, which -- done well -- promotes a vibrant economy. In 2007, Wall Street firms enabled businesses to raise $2.7 trillion from the sale of stocks, bonds and other securities. But Wall Street sometimes misallocates capital, as the 1990s "tech bubble" and today's crisis painfully remind. The huge social costs (high unemployment, lost income) refute the notion that Wall Street consistently creates exceptional economic value that justifies exceptional compensation.

The explanation for Wall Street's high pay lies elsewhere. Most of us are paid based on what we produce or, more realistically, what our employers produce. By contrast, Wall Street compensation levels are tied to the nation's overall wealth. Investment banks, hedge funds, private equity firms and many other financial institutions trade stocks, bonds and other securities for their own profit. They also advise mutual funds, pension funds, endowments and wealthy individuals on how to invest and trade.

There's a big difference between annual production and national wealth. In 2007, the year before the crisis, annual production (gross domestic product) equaled almost $14 trillion. In the same year, household wealth was $77 trillion (5.5 times production); that covered the value of homes, vehicles, stocks, bonds and the like. Eliminating nonfinancial assets (mainly homes) cut wealth to about $50 trillion (3.5 times). Deducting household debts from financial wealth pushed net worth to $35 trillion (2.5 times income).

People who are trying to protect or expand existing wealth are playing for much higher money stakes than even hardworking and highly skilled producers. That's the main reason they're paid more. Similar percentage changes in production and wealth translate into much larger gains or losses in wealth -- up to five times as much based on the crude math above. Many lawyers enjoy the same envious position of being paid on the basis of wealth enhancement or protection. They're involved in high-stakes mergers and acquisitions, estate planning, divorces and tax planning. On average, partners in the top 25 law firms earned $1.3 million to $4 million in 2008, reports the American Lawyer magazine.

All this provides context to today's pay controversies. Wall Street may be greedy -- who isn't? -- but the explanation for its high compensation is its economic base (wealth, not production). That's why it's so hard to control or regulate. Since the 1960s, the industry has changed dramatically. Then, revenue came mainly from commissions on buying stocks and bonds for others. In 1966, commissions were 62 percent of revenue. Now, firms mostly make and manage investments for themselves and others. In 2007, commissions provided only 8 percent of revenue.

The transformation has made Wall Street a greater source of potential economic instability. Some compensation packages exacerbated the crisis by offering big bonuses if big risks paid off. Because government provided a safety net for the whole system, it's justified in taxing the industry -- as President Obama proposed last week -- to cover the costs, as Douglas Elliott, a former investment banker now at the Brookings Institution, correctly argues.

A larger issue is: How much should society concentrate on existing wealth as opposed to creating new wealth? Wall Street's lavish pay packages may attract too many of America's best and brightest. "It's bad for the rest of the economy," says economist Thomas Philippon of New York University, a student of the financial sector. "We also need smart brains outside finance." If that somehow happens, the crisis may yet have a silver lining.

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