Is there a “misallocation” of human capital to finance?
Maybe – but I see no evidence.
Nicholas Kristof has an article in which he urges young people not to reject Wall Street as a career choice, since banking isn’t fundamentally bad: allocation of a scare resource (capital) and stuff. And then he starts with a list of caveats, which includes this revealing line:
Granted, young people haven’t been pouring into finance in recent years out of eagerness to reform this rigged system but to milk it. In 2007, on the eve of the financial crisis, 47 percent of Harvard’s graduating class headed for consulting firms and the financial sector — a huge misallocation of human capital. However well-meaning these new graduates are initially, they often end up caught up in the scramble at the trough.
This “misallocation of human capital” is a truly fascinating meme that I’ve seen crop up over and over. With so many people agreeing that there is a waste, you’d think they have some kind of model or data or something in mind when they say things like that.
Not only is there no scholarly, academic, peer reviewed support for the idea that we’re misallocating human resources to finance – there’s little literature on the misallocation of workers anywhere.
To understand this, you have to understand what ‘misallocation’ means: it means that there are alternative uses for resources, that will produce more benefits than the current project to which they have been put to use. For example, when we build (say) a house when prices are “high”, we’re diverting labour, steel, cement etc which could have been used in road construction. But if the benefits produced by the house exceed the benefits produced by the road, it’s worth it. How do you know how much benefits a house is producing? You look at the price that people are willing to pay for it. If you spotted the tautology*, congrats! You’re half on your way to understanding bubbles.
People purchase a house as an investment – they’re willing to pay so much because they think prices will increase (or at least be as high) in the future. There are sometimes good fundamental reasons to believe this: you’re living in a country with soaring population growth or income growth or the city that you’re living in is rapidly becoming some kind of urban center for X. But sometimes (no points for thinking of examples) the only reason to believe that prices will be high in the future is that other people believe it – and they’re willing to pay a lot, which drives up prices and confirms your view that it’ll be worth more soon. Assets (be they houses, dot-com stocks or tulip bulbs) become overvalued, which sends false signals about their worth, resulting in a misallocation of resources towards their production. When these signals end, the bubble bursts and asset prices collapse.
Now, that’s misallocation by the market. The other type is when the government allocates resources badly. This type or arrangement – unlike a bubble – can go on forever, slowly bleeding the economy but not ending until there is some kind of crisis. Example: Italy’s government jobs.
Now, these are the main sources of misallocation** in an economy. Here’s my question: do any of the people who assert that there are too many workers in finance refer to either of these pathways? Nope. Never. Even the economists do not mention, even off-the-cuff, what implicit model they’re using.
But let’s look at these in turn, anyway. Is there a finance bubble? Note that this is not the same as “a bubble in the financial market” – almost all bubbles show up in one form or another in the financial market. The question is – are the financial institutions overvalued unsustainably – and will at some point naturally shrink in the future, causing resources to be reallocated to the “real” economy? There’s no sign of this. The closest thing I can think of is Goldman Sachs cutting bonuses a few days ago– but that’s too recent to make sense of and it may just be the case that GS was “overvalued”.
Or is it a government distortion? In the absence of the bailouts, these companies would have collapsed and shrunk. But the bailout of financial companies in the US actually turned a profit rather than cost $400 billion. Almost all banks eventually returned the money that was lent to them, which means that it wasn’t so much a bailout as the government acting as a super-bank: lending banks the money they needed to whether the storm. It’s entirely possible , of course, that the finance industry represents this kind of distortion – and it’s healthy to declare that resources are being misallocated because of this “heads I win, tails the taxpayer loses” dynamic – and I’m predisposed to believe it. My problem is that no-one is making this argument. No one is testing this hypothesis. The free market theoretically allocates resources efficiently and there’s usually a good theoretical reason to explain failures. Here, however, no-one connects the dots while declaring that the financial sector is sucking away talented young people from the “real economy”. These declarations seem to be driven by an instinctive belief in the the “too big”-ness of the financial sector, rather than a deeply thought out, data driven case that can be tested.
* Why are people paying so much for houses? Because they produce a lot of benefits. How do you know they are beneficial? Look at how much people are willing to pay for them!