Now that Paul Volcker's Economic Advisory Board is up and running, I thought it might be worth digging into "Financial Reform: A Framework for Financial Stability," a report put together by the Consultative Group on Economic and Monetary Affairs (a.k.a. "The Group of 30") under the direction of Volcker.
Early on, the report pinpoints two "unique factors" that "worked together to help account for the extent of the current market breakdown."
Highly aggressive and unbalanced compensation practices have strongly encouraged risk taking over prudence. At the same time, highly engineered financial instruments, in their complexity, obscured the risk and uncertainties inherent in those instruments, giving rise to false confidence and heavy use of leverage to enhance profits, as asset prices rose.
Hmm. Now where was it that I was just reading something about compensation in the financial sector? Oh yes --only this morning FreeExchange pointed to a new paper by Tomas Phillipon, of New York University's Stern Business School, and Ariel Resheff, of the University of Virginia, "Wages and Human Capital in the U.S. Financial Industry: 1909-2006."
One of the conclusions of Phillipon and Resheff's paper is that over the last one hundred years, there were two distinct periods in which wages in the finance sector were relatively high with respect to the rest of U.S. economy -- the 1920s, and the period starting around 1980 and running up until right about now. In other words: the first gilded age, and the second, both of which ended in economic chaos.
Phillipon and Resheff argue that deregulation led to increasing financial sector complexity that rewarded high skill with high wages. But as the Volcker paper observes, that complexity did not just reward skill, it obscured risk. So we ended up with highly paid professionals who steered the global economy into the ditch.
Capping their pay at a mere half million a year seems magnanimous, in that light.