Good Reading -- January 2011
I recently received some (probably deserved) criticism that the content here has been too much of the same "I really love value investing/Graham-and-Dodd/Buffett/Klarman/etc." and not enough other stuff. So on that note, and since there happened to be a lot of good stuff recently that doesn't necessarily fall into the usual value investing category, here is an extra large edition chock full of good, more diversified reading.
Facts and Figures
(additional facts & figures chart attached)
"Over the next two decades there will be a 30 percent decline in the number of Chinese between the ages of 15 and 29 — 100 million fewer workers." (Source, and a great article on this topic, is here.)
39.5% of the corn crop in the United States in 2010 went to make ethanol.
In the two years (eight fiscal quarters) since Lehman failed in 2008, Bank of America, JP Morgan, Citigroup, Goldman Sachs and Morgan Stanley have acheived their best-ever aggregate investment-banking and trading revenue.
85% of corporate income taxes are paid by the top 0.5% of companies; corporate tax receipts as a % of GDP and as a % of federal tax receipts has fallen from nearly 4% and 25%, respectively, 40-50 years ago to ~2% and ~10% presently; the average effective tax rate for all publicly traded firms in 2009 was 16.5% vs. a statutory rate of 35%
"2010 in figures: what it all adds up to" (free registration required) -- the FT's year-end compilation of facts and figures. Please note the ever-important caveat: "even when numbers are calculated in good faith and pored over by experts, they can deceive."
"From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007."
Between 1998 and 2006, only 1.4 million first-time homebuyers purchased their hoems with subprime loans. That represented about 9% of all subprime lending during that time; the remaining 91% of subprime loans were for refinancings (and most of those were cash-out refinancings) or vacation homes or "investment" properties.
At the end of 2000, before the subprime/Alt-A mortgage wave really cranked up, the official homeownership rate stood at 67.4%. Its all-time peak, reached four years later, was 69%.
The Economist's charts of the year for 2010 (link only).
"Inside the Secret World of Trader Joe's" -- an interesting profile of a great business (and one in a bad industry to boot).
"Solitude and Leadership" -- an interesting take that is somewhat similar to the "sit-on-your-a** and read all day" Charlie Munger school of investing.
"Who Wants a 30-Year Mortgage?" -- good article from Bethany McLean about the uniquely American passion for the 30-year mortgage and the problems it creates.
"In Investing, It's When You Start and When You Finish" (chart also attached) -- really interesting graphic to support the hard, cold facts. Important for all investors to understand.
"If you invested money at the end of 1930 and withdrew it in 1950, the stock market would have returned about 2 percent a year after inflation and taxes"
"After accounting for dividends, inflation, taxes and fees, $10,000 invested at the end of 1961 would have shrunk to $6,600 by 1981. From the end of 1979 to 1999, $10,000 would have grown to $48,000."
"Market returns are more volatile than most people realize,” Mr. Easterling said, “even over periods as long as 20 years.” Indeed, the best 20 years were '48-'68 at 8.4% p.a., followed by '79-'99 at 6.2%. But the worst 20 years of '61-'81 produced -2.0% per year.
"Lloyd Blankfein's Secret Facebook Page" -- this is one of the funniest things I've read in a while. (NSFW language)
"In Defense of the 'Old Always'" -- the latest from James Montier.
"The Demographic Future: What Population Growth -- and Decline -- Means for the Global Economy" -- an excellent article with massive implications. Make this one a top priority.
"Have You Ever Tried to Sell a Diamond?" -- this article is from 1982, but sadly it all still applies. I vividly remember reading for the first time about the amazing, semi-fraudulent charade that is the global diamond market as run by the DeBeers cartel when I had a case about it in business school, which was just before I started engagement ring shopping...anyway, all bitterness about overpaying for a small chunk of artificially priced carbon aside, this is a classic business tale of marketing and psychology.
"2000 vs. 2010" -- some interesting facts and figures (with the caveat that the entries under "Environment" are extremely subjective, at best).
"Economic Optimism? Yes, I'll Take That Bet" -- interesting column about energy and commodity prices, peak oil, Malthusians, and/or rational optimism. Speaking of, the recent book The Rational Optimist is a good read. There are some major holes, and I'd take issue with certain parts of it, but its a very worthwhile perspective to consider.
"The Road to Business Success: A Talk to Young Men" -- interesting lecture from Andrew Carnegie given to students in 1885.
"The Inequality That Matters" -- some very useful and important thoughts on income inequality in the U.S. I really, really liked this article (even and especially the part about hedge fund managers and the incentives in investment management). "In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good." One of the best articles I've read in a long time. (Another good article from the same author: "Too Few Regulations? No, Just Ineffective Ones")
"Trader Pay Tops Brain Surgeons' and Shows Gap Weathers Crisis" -- I agree that Wall Street and finance jobs are still considerably overcompensated.
Economic Optimism? Yes, I’ll Take That Bet
By JOHN TIERNEY
Five years ago, Matthew R. Simmons and I bet $5,000. It was a wager about the future of energy supplies — a Malthusian pessimist versus a Cornucopian optimist — and now the day of reckoning is nigh: Jan. 1, 2011.
The bet was occasioned by a cover article in August 2005 in The New York Times Magazine titled “The Breaking Point.” It featured predictions of soaring oil prices from Mr. Simmons, who was a member of the Council on Foreign Relations, the head of a Houston investment bank specializing in the energy industry, and the author of “Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy.”
I called Mr. Simmons to discuss a bet. To his credit — and unlike some other Malthusians — he was eager to back his predictions with cash. He expected the price of oil, then about $65 a barrel, to more than triple in the next five years, even after adjusting for inflation. He offered to bet $5,000 that the average price of oil over the course of 2010 would be at least $200 a barrel in 2005 dollars.
I took him up on it, not because I knew much about Saudi oil production or the other “peak oil” arguments that global production was headed downward. I was just following a rule learned from a mentor and a friend, the economist Julian L. Simon.
As the leader of the Cornucopians, the optimists who believed there would always be abundant supplies of energy and other resources, Julian figured that betting was the best way to make his argument. Optimism, he found, didn’t make for cover stories and front-page headlines.
No matter how many cheery long-term statistics he produced, he couldn’t get as much attention as the gloomy Malthusians like Paul Ehrlich, the best-selling ecologist. Their forecasts of energy crises and resource shortages seemed not only newsier but also more intuitively correct. In a finite world with a growing population, wasn’t it logical to expect resources to become scarcer and more expensive?
As an alternative to arguing, Julian offered to bet that the price of any natural resource chosen by a Malthusian wouldn’t rise in the future. Dr. Ehrlich accepted and formed a consortium with two colleagues at Berkeley, John P. Holdren and John Harte, who were supposed to be experts in natural resources. In 1980, they picked five metals and bet that the prices would rise during the next 10 years.
By 1990, the prices were lower, and the Malthusians paid up, although they didn’t seem to suffer any professional consequences. Dr. Ehrlich and Dr. Holdren both won MacArthur “genius awards” (Julian never did). Dr. Holdren went on to lead the American Association for the Advancement of Science, and today he serves as President Obama’s science adviser.
Julian, who died in 1998, never managed to persuade Dr. Ehrlich or Dr. Holdren or other prominent doomsayers to take his bets again.
When I found a new bettor in 2005, the first person I told was Julian’s widow, Rita Simon, a public affairs professor at American University. She was so happy to see Julian’s tradition continue that she wanted to share the bet with me, so we each ended up each putting $2,500 against Mr. Simmons’s $5,000.
Just as Mr. Simmons predicted, oil prices did soar well beyond $65. With the global economy booming in the summer of 2008, the price of a barrel of oil reached $145. American foreign-policy experts called for policies to secure access to this increasingly scarce resource; environmentalists advocated crash programs to reduce dependence on fossil fuels; companies producing power from wind and other alternative energies rushed to expand capacity.
When the global recession hit in the fall of 2008, the price plummeted below $50, but at the end of that year Mr. Simmons was quoted in The Baltimore Sun sounding confident. When Jay Hancock, a Sun financial columnist, asked if he was having any second thoughts about the wager, Mr. Simmons replied: “God, no. We bet on the average price in 2010. That’s an eternity from now.”
The past year the price has rebounded, but the average for 2010 has been just under $80, which is the equivalent of about $71 in 2005 dollars — a little higher than the $65 at the time of our bet, but far below the $200 threshold set by Mr. Simmons.
What lesson do we draw from this? I’d hoped to let Mr. Simmons give his view, but I’m very sorry to report that he died in August, at the age of 67. The colleagues handling his affairs reviewed the numbers last week and declared that Mr. Simmons’s $5,000 should be awarded to me and to Rita Simon on Jan. 1, but Mr. Simmons still had his defenders.
One of his friends and fellow peak-oil theorists, Steve Andrews, said that while Mr. Simmons had made “a bet too far,” he was still correct in foreseeing more expensive oil. “The era of cheap oil has ended,” Mr. Andrews said, and predicted problems ahead as production levels off.
It’s true that the real price of oil is slightly higher now than it was in 2005, and it’s always possible that oil prices will spike again in the future. But the overall energy situation today looks a lot like a Cornucopian feast, as my colleagues Matt Wald andCliff Krauss have recently reported. Giant new oil fields have been discovered off the coasts of Africa and Brazil. The new oil sands projects in Canada now supply more oil to the United States than Saudi Arabia does. Oil production in the United States increased last year, and the Department of Energy projects further increases over the next two decades.
The really good news is the discovery of vast quantities of natural gas. It’s now selling for less than half of what it was five years ago. There’s so much available that the Energy Department is predicting low prices for gas and electricity for the next quarter-century. Lobbyists for wind farms, once again, have been telling Washington that the “sustainable energy” industry can’t sustain itself without further subsidies.
As gas replaces dirtier fossil fuels, the rise in greenhouse gas emissions will be tempered, according to the Department of Energy. It projects that no new coal power plants will be built, and that the level of carbon dioxide emissions in the United States will remain below the rate of 2005 for the next 15 years even if no new restrictions are imposed.
Maybe something unexpected will change these happy trends, but for now I’d say that Julian Simon’s advice remains as good as ever. You can always make news with doomsday predictions, but you can usually make money betting against them.
Andrew Carnegie, "THE ROAD TO BUSINESS SUCCESS: A TALK TO YOUNG MEN" From an address to Students of the Curry Commercial College, Pittsburg, June 23, 1885.
It is well that young men should begin at the beginning and occupy the most subordinate positions. Many of the leading business men of Pittsburg had a serious responsibility thrust upon them at the very threshold of their career. They were introduced to the broom, and spent the first hours of their business lives sweeping out the office. I notice we have janitors and janitresses now in offices, and our young men unfortunately miss that salutary branch of a business education. But if by chance the professional sweeper is absent any morning the boy who has the genius of the future partner in him will not hesitate to try his hand at the broom. The other day a fond fashionable mother in Michigan asked a young man whether he had ever seen a young lady sweep in a room so grandly as her Priscilla. He said no, he never had, and the mother was gratified beyond measure, but then said he, after a pause, "What I should like to see her do is sweep out a room." It does not hurt the newest comer to sweep out the office if necessary. I was one of those sweepers myself, and who do you suppose were my fellow sweepers? David McCargo, now superintendent of the Alleghany Valley Railroad; Robert Pitcairn, Superintendent of the Pennsylvania Railroad, and Mr. Moreland, City Attorney. We all took turns, two each morning did the sweeping; and now I remember Davie was so proud of his clean white shirt bosom that he used to spread over it an old silk bandana handkerchief which he kept for the purpose, and we other boys thought he was putting on airs. So he was. None of us had a silk handkerchief.
Assuming that you have all obtained employment and are fairly started, my advice to you is "aim high." I would not give a fig for the young man who does not already see himself the partner or the head of an important firm. Do not rest content for a moment in your thoughts as head clerk, or foreman, or general manager in any concern, no matter how extensive. Say each to yourself. "My place is at the top." Be king in your dreams. Make your vow that you will reach that position, with untarnished reputation, and make no other vow to distract your attention, except the very commendable one that when you are a member of the firm or before that, if you have been promoted two or three times, you will form another partnership with the loveliest of her sex--a partnership to which our new partnership act has no application. The liability there is never limited.
Let me indicate two or three conditions essential to success. Do not be afraid that I am going to moralize, or inflict a homily upon you. I speak upon the subject only from the view of a man of the world, desirous of aiding you to become successful business men. You all know that there is no genuine, praiseworthy success in life if you are not honest, truthful, fair-dealing. I assume you are and will remain all these, and also that you are determined to live pure, respectable lives, free from pernicious or equivocal associations with one sex or the other. There is no creditable future for you else. Otherwise your learning and your advantages not only go for naught, but serve to accentuate your failure and your disgrace. I hope you will not take it amiss if I warn you against three of the gravest dangers which will beset you in your upward path.
The first and most seductive, and the destroyer of most young men, is the drinking of liquor. I am no temperance lecturer in disguise, but a man who knows and tells you what observation has proved to him, and I say to you that you are more likely to fail in your career from acquiring the habit of drinking liquor than from any, or all, the other temptations likely to assail you. You may yield to almost any other temptation and reform--may brace up, and if not recover lost ground, at least remain in the race and secure and maintain a respectable position. But from the insane thirst for liquor escape is almost impossible. I have known but few exceptions to this rule. First, then, you must not drink liquor to excess. Better if you do not touch it at all--much better; but if this be too hard a rule for you then take your stand firmly here. Resolve never to touch it except at meals. A glass at dinner will not hinder your advance in life or lower your tone; but I implore you hold it inconsistent with the dignity and self-respect of gentlemen, with what is due from yourselves to yourselves, being the men you are, and especially the men you are determined to become, to drink a glass of liquor at a bar. Be far too much of the gentleman ever to enter a barroom. You do not pursue your careers in safety unless you stand firmly upon this ground. Adhere to it and you have escaped danger from the deadliest of your foes.
The next greatest danger to a young business man in this community I believe to be that of speculation. When I was a telegraph operator here we had no Exchanges in the City, but the men or firms who speculated upon the Eastern Exchanges were necessarily known to the operators. They could be counted on the fingers of one hand. These men were not our citizens of first repute: they were regarded with suspicion. I have lived to see all of these speculators irreparably ruined men, bankrupt in money and bankrupt in character. There is scarcely an instance of a man who has made a fortune by speculation and kept it. Gamesters die poor, and there is certainly not an instance of a speculator who has lived a life creditable to himself, or advantageous to the community. The man who grasps the morning paper to see first how his speculative ventures upon the Exchanges are likely to result, unfits himself for the calm consideration and proper solution of business problems, with which he has to deal later in the day, and saps the sources of that persistent and concentrated energy upon which depend the permanent success, and often the very safety, of his main business.
The speculator and the business man tread diverging lines. The former depends upon the sudden turn of fortune's wheel; he is a millionnaire to-day, a bankrupt to-morrow. But the man of business knows that only by years of patient, unremitting attention to affairs can he earn his reward, which is the result, not of chance, but of well-devised means for the attainment of ends. During all these years his is the cheering thought that, by no possibility can he benefit himself without carrying prosperity to others. The speculator on the other hand had better never have lived so far as the good of others or the good of the community is concerned. Hundreds of young men were tempted in this city not long since to gamble in oil, and many were ruined; all were injured whether they lost or won. You may be, nay, you are certain to be similarly tempted; but when so tempted I hope you will remember this advice. Say to the tempter who asks you to risk your small savings, that if ever you decide to speculate you are determined to go to a regular and well-conducted house where they cheat fair. You can get fair play and about an equal chance upon the red and black in such a place; upon the Exchange you have neither. You might as well try your luck with the three-card-monte man. There is another point involved in speculation. Nothing is more essential to young business men than untarnished credit, credit begotten of confidence in their prudence, principles and stability of character. Well, believe me, nothing kills credit sooner in any Bank Board than the knowledge that either firms or men engage in speculation. It matters not a whit whether gains or losses be the temporary result of these operations. The moment a man is known to speculate, his credit is impaired, and soon thereafter it is gone. How can a man be credited whose resources may be swept away in one hour by a panic among gamesters? Who can tell how he stands among them? except that this is certain: he has given due notice that he may stand to lose all, so that those who credit him have themselves to blame. Resolve to be business men, but speculators never.
The third and last danger against which I shall warn you is one which has wrecked many a fair craft which started well and gave promise of a prosperous voyage. It is the perilous habit of indorsing--all the more dangerous, inasmuch as it assails one generally in the garb of friendship. It appeals to your generous instincts, and you say, "How can I refuse to lend my name only, to assist a friend?" It is because there is so much that is true and commendable in that view that the practice is so dangerous. Let me endeavor to put you upon safe honourable grounds in regard to it. I would say to you to make it a rule now, never indorse: but this is too much like never taste wine, or never smoke, or any other of the "nevers." They generally result in exceptions. You will as business men now and then probably become security for friends. Now, here is the line at which regard for the success of friends should cease and regard for your own honour begins.
If you owe anything, all your capital and all your effects are a solemn trust in your hands to be held inviolate for the security of those who have trusted you. Nothing can be done by you with honour which jeopardizes these first claims upon you. When a man in debt indorses for another, it is not his own credit or his own capital he risks, it is that of his own creditors. He violates a trust. Mark you then, never indorse until you have cash means not required for your own debts, and never indorse beyond those means. Before you indorse at all, consider indorsements as gifts, and ask yourselves whether you wish to make the gift to your friend and whether the money is really yours to give and not a trust for your creditors.
You are not safe, gentlemen, unless you stand firmly upon this as the only ground which an honest business man can occupy.
I beseech you avoid liquor, speculation and indorsement. Do not fail in either, for liquor and speculation are the Scylla and Charybdis of the young man's business sea, and indorsement his rock ahead.
Assuming you are safe in regard to these your gravest dangers, the question now is how to rise from the subordinate position we have imagined you in, through the successive grades to the position for which you are, in my opinion, and, I trust, in your own, evidently intended. I can give you the secret. It lies mainly in this. Instead of the question, "What must I do for my employer?" substitute "What can I do?" Faithful and conscientious discharge of the duties assigned you is all very well, but the verdict in such cases generally is that you perform your present duties so well that you had better continue performing them. Now, young gentlemen, this will not do. It will not do for the coming partners. There must be something beyond this. We make Clerks, Bookkeepers, Treasurers, Bank Tellers of this class, and there they remain to the end of the chapter. The rising man must do something exceptional, and beyond the range of his special department. HE MUST ATTRACT ATTENTION. A shipping clerk, he may do so by discovering in an invoice an error with which he has nothing to do, and which has escaped the attention of the proper party. If a weighing clerk, he may save for the firm by doubting the adjustment of the scales and having them corrected, even if this be the province of the master mechanic. If a messenger boy, even he can lay the seed of promotion by going beyond the letter of his instructions in order to secure the desired reply. There is no service so low and simple, neither any so high, in which the young man of ability and willing disposition cannot readily and almost daily prove himself capable of greater trust and usefulness, and, what is equally important, show his invincible determination to rise.
Some day, in your own department, you will be directed to do or say something which you know will prove disadvantageous to the interest of the firm. Here is your chance. Stand up like a man and say so. Say it boldly, and give your reasons, and thus prove to your employer that, while his thoughts have been engaged upon other matters, you have been studying during hours when perhaps he thought you asleep, how to advance his interests. You may be right or you may be wrong, but in either case you have gained the first condition of success. You have attracted attention. Your employer has found that he has not a mere hireling in his service, but a man; not one who is content to give so many hours of work for so many dollars in return, but one who devotes his spare hours and constant thoughts to the business. Such an employee must perforce be thought of, and thought of kindly and well. It will not be long before his advice is asked in his special branch, and if the advice given be sound, it will soon be asked and taken upon questions of broader bearing. This means partnership; if not with present employers then with others. Your foot, in such a case, is upon the ladder; the amount of climbing done depends entirely upon yourself.
One false axiom you will often hear, which I wish to guard you against: "Obey orders if you break owners." Don't you do it. This is no rule for you to follow. Always break orders to save owners. There never was a great character who did not sometimes smash the routine regulations and make new ones for himself. The rule is only suitable for such as have no aspirations, and you have not forgotten that you are destined to be owners and to make orders and break orders. Do not hesitate to do it whenever you are sure the interests of your employer will be thereby promoted and when you are so sure of the result that you are willing to take the responsibility. You will never be a partner unless you know the business of your department far better than the owners possibly can. When called to account for your independent action, show him the result of your genius, and tell him that you knew that it would be so; show him how mistaken the orders were. Boss your boss just as soon as you can; try it on early. There is nothing he will like so well if he is the right kind of boss; if he is not, he is not the man for you to remain with--leave him whenever you can, even at a present sacrifice, and find one capable of discerning genius. Our young partners in the Carnegie firm have won their spurs by showing that we did not know half as well what was wanted as they did. Some of them have acted upon occasion with me as if they owned the firm and I was but some airy New Yorker presuming to advise upon what I knew very little about. Well, they are not interfered with much now. They were the true bosses--the very men we were looking for.
There is one sure mark of the coming partner, the future millionnaire; his revenues always exceed his expenditures. He begins to save early, almost as soon as he begins to earn. No matter how little it may be possible to save, save that little. Invest it securely, not necessarily in bonds, but in anything which you have good reason to believe will be profitable, but no gambling with it, remember. A rare chance will soon present itself for investment. The little you have saved will prove the basis for an amount of credit utterly surprising to you. Capitalists trust the saving young man. For every hundred dollars you can produce as the result of hard-won savings, Midas, in search of a partner, will lend or credit a thousand; for every thousand, fifty thousand. It is not capital that your seniors require, it is the man who has proved that he has the business habits which create capital, and to create it in the best of all possible ways, as far as self-discipline is concerned, is, by adjusting his habits to his means. Gentlemen, it is the first hundred dollars saved which tells. Begin at once to lay up something. The bee predominates in the future millionnaire.
Of course there are better, higher aims than saving. As an end, the acquisition of wealth is ignoble in the extreme; I assume that you save and long for wealth only as a means of enabling you the better to do some good in your day and generation. Make a note of this essential rule: Expenditure always within income.
You may grow impatient, or become discouraged when year by year you float on in subordinate positions. There is no doubt that it is becoming harder and harder as business gravitates more and more to immense concerns, for a young man without capital to get a start for himself, and in this city especially, where large capital is essential, it is unusually difficult. Still, let me tell you for your encouragement, that there is no country in the world, where able and energetic young men can so readily rise as this, nor any city where there is more room at the top. It has been impossible to meet the demand for capable, first-class bookkeepers (mark the adjectives) the supply has never been equal to the demand. Young men give all kinds of reasons why in their cases failure was clearly attributable to exceptional circumstances which render success impossible. Some never had a chance, according to their own story. This is simply nonsense. No young man ever lived who had not a chance, and a splendid chance, too, if he ever was employed at all. He is assayed in the mind of his immediate superior, from the day he begins work, and, after a time, if he has merit, he is assayed in the council chamber of the firm. His ability, honesty, habits, associations, temper, disposition, all these are weighed and analysed. The young man who never had a chance is the same young man who has been canvassed over and over again by his superiors, and found destitute of necessary qualifications, or is deemed unworthy of closer relations with the firm, owing to some objectionable act, habit, or association, of which he thought his employers ignorant.
Another class of young men attribute their failure to employers having relations or favourites whom they advanced unfairly. They also insist that their employers disliked brighter intelligences than their own, and were disposed to discourage aspiring genius, and delighted in keeping young men down. There is nothing in this. On the contrary, there is no one suffering so much for lack of the right man in the right place, nor so anxious to find him as the owner. There is not a firm in Pittsburg to-day which is not in the constant search for business ability, and every one of them will tell you that there is no article in the market at all times so scarce. There is always a boom in brains, cultivate that crop, for if you grow any amount of that commodity, here is your best market and you cannot overstock it, and the more brains you have to sell, the higher price you can exact. They are not quite so sure a crop as wild oats, which never fail to produce a bountiful harvest, but they have the advantage over these in always finding a market. Do not hesitate to engage in any legitimate business, for there is no business in America, I do not care what, which will not yield a fair profit if it receive the unremitting, exclusive attention, and all the capital of capable and industrious men. Every business will have its season of depression--years always come during which the manufacturers and merchants of the city are severely tried--years when mills must be run, not for profit, but at a loss, that the organization and men may be kept together and employed, and the concern may keep its products in the market. But on the other hand, every legitimate business producing or dealing in an article which man requires is bound in time to be fairly profitable, if properly conducted.
And here is the prime condition of success, the great secret: concentrate your energy, thought, and capital exclusively upon the business in which you are engaged. Having begun in one line, resolve to fight it out on that line, to lead in it; adopt every improvement, have the best machinery, and know the most about it.
The concerns which fail are those which have scattered their capital, which means that they have scattered their brains also. They have investments in this, or that, or the other, here, there and everywhere. "Don't put all your eggs in one basket" is all wrong. I tell you "put all your eggs in one basket, and then watch that basket." Look round you and take notice; men who do that do not often fail. It is easy to watch and carry the one basket. It is trying to carry too many baskets that breaks most eggs in this country. He who carries three baskets must put one on his head, which is apt to tumble and trip him up. One fault of the American business man is lack of concentration.
To summarize what I have said: Aim for the highest; never enter a bar-room; do not touch liquor, or if at all only at meals; never speculate; never indorse beyond your surplus cash fund; make the firm's interest yours; break orders always to save owners; concentrate; put all your eggs in one basket, and watch that basket; expenditure always within revenue; lastly, be not impatient, for, as Emerson says, "no one can cheat you out of ultimate success but yourselves." I congratulate poor young men upon being born to that ancient and honourable degree which renders it necessary that they should devote themselves to hard work. A basketful of bonds is the heaviest basket a young man ever had to carry. He generally gets to staggering under it. We have in this city creditable instances of such young men, who have pressed to the front rank of our best and most useful citizens. These deserve great credit. But the vast majority of the sons of rich men are unable to resist the temptations to which wealth subjects them, and sink to unworthy lives. I would almost as soon leave a young man a curse, as burden him with the almighty dollar. It is not from this class you have rivalry to fear. The partner's sons will not trouble you much, but look out that some boys poorer, much poorer than yourselves, whose parents cannot afford to give them the advantages of a course in this institute, advantages which should give you a decided lead in the race--look out that such boys do not challenge you at the post and pass you at the grand stand. Look out for the boy who has to plunge into work direct from the common school and who begins by sweeping out the office. He is the probable dark horse that you had better watch.
Source: Andrew Carnegie, The Empire of Business (New York: Doubleday, Page & Co., 1902), pp. 3-18. Paragraph numbers have been added, and the original pagination appears in brackets. Some typographical errors have been corrected.
The Inequality That Matters Tyler Cowen
Does growing wealth and income inequality in the United States presage the downfall of the American republic? Will we evolve into a new Gilded Age plutocracy, irrevocably split between the competing interests of rich and poor? Or is growing inequality a mere bump in the road, a statistical blip along the path to greater wealth for virtually every American? Or is income inequality partially desirable, reflecting the greater productivity of society’s stars?
There is plenty of speculation on these possibilities, but a lot of it has been aimed at elevating one political agenda over another rather than elevating our understanding. As a result, there’s more confusion about this issue than just about any other in contemporary American political discourse. The reality is that most of the worries about income inequality are bogus, but some are probably better grounded and even more serious than even many of their heralds realize. If our economic churn is bound to throw off political sparks, whether alarums about plutocracy or something else, we owe it to ourselves to seek out an accurate picture of what is really going on. Let’s start with the subset of worries about inequality that are significantly overblown.
In terms of immediate political stability, there is less to the income inequality issue than meets the eye. Most analyses of income inequality neglect two major points. First, the inequality of personal well-being is sharply down over the past hundred years and perhaps over the past twenty years as well. Bill Gates is much, much richer than I am, yet it is not obvious that he is much happier if, indeed, he is happier at all. I have access to penicillin, air travel, good cheap food, the Internet and virtually all of the technical innovations that Gates does. Like the vast majority of Americans, I have access to some important new pharmaceuticals, such as statins to protect against heart disease. To be sure, Gates receives the very best care from the world’s top doctors, but our health outcomes are in the same ballpark. I don’t have a private jet or take luxury vacations, and—I think it is fair to say—my house is much smaller than his. I can’t meet with the world’s elite on demand. Still, by broad historical standards, what I share with Bill Gates is far more significant than what I don’t share with him.
Compare these circumstances to those of 1911, a century ago. Even in the wealthier countries, the average person had little formal education, worked six days a week or more, often at hard physical labor, never took vacations, and could not access most of the world’s culture. The living standards of Carnegie and Rockefeller towered above those of typical Americans, not just in terms of money but also in terms of comfort. Most people today may not articulate this truth to themselves in so many words, but they sense it keenly enough. So when average people read about or see income inequality, they don’t feel the moral outrage that radiates from the more passionate egalitarian quarters of society. Instead, they think their lives are pretty good and that they either earned through hard work or lucked into a healthy share of the American dream. (The persistently unemployed, of course, are a different matter, and I will return to them later.) It is pretty easy to convince a lot of Americans that unemployment and poverty are social problems because discrete examples of both are visible on the evening news, or maybe even in or at the periphery of one’s own life. It’s much harder to get those same people worked up about generalized measures of inequality.
This is why, for example, large numbers of Americans oppose the idea of an estate tax even though the current form of the tax, slated to return in 2011, is very unlikely to affect them or their estates. In narrowly self-interested terms, that view may be irrational, but most Americans are unwilling to frame national issues in terms of rich versus poor. There’s a great deal of hostility toward various government bailouts, but the idea of “undeserving” recipients is the key factor in those feelings. Resentment against Wall Street gamesters hasn’t spilled over much into resentment against the wealthy more generally. The bailout for General Motors’ labor unions wasn’t so popular either—again, obviously not because of any bias against the wealthy but because a basic sense of fairness was violated. As of November 2010, congressional Democrats are of a mixed mind as to whether the Bush tax cuts should expire for those whose annual income exceeds $250,000; that is in large part because their constituents bear no animus toward rich people, only toward undeservedly rich people.
A neglected observation, too, is that envy is usually local. At least in the United States, most economic resentment is not directed toward billionaires or high-roller financiers—not even corrupt ones. It’s directed at the guy down the hall who got a bigger raise. It’s directed at the husband of your wife’s sister, because the brand of beer he stocks costs $3 a case more than yours, and so on. That’s another reason why a lot of people aren’t so bothered by income or wealth inequality at the macro level. Most of us don’t compare ourselves to billionaires. Gore Vidal put it honestly: “Whenever a friend succeeds, a little something in me dies.”
Occasionally the cynic in me wonders why so many relatively well-off intellectuals lead the egalitarian charge against the privileges of the wealthy. One group has the status currency of money and the other has the status currency of intellect, so might they be competing for overall social regard? The high status of the wealthy in America, or for that matter the high status of celebrities, seems to bother our intellectual class most. That class composes a very small group, however, so the upshot is that growing income inequality won’t necessarily have major political implications at the macro level.
What Matters, What Doesn’t
All that said, income inequality does matter—for both politics and the economy. To see how, we must distinguish between inequality itself and what causes it. But first let’s review the trends in more detail.
The numbers are clear: Income inequality has been rising in the United States, especially at the very top. The data show a big difference between two quite separate issues, namely income growth at the very top of the distribution and greater inequality throughout the distribution. The first trend is much more pronounced than the second, although the two are often confused.
When it comes to the first trend, the share of pre-tax income earned by the richest 1 percent of earners has increased from about 8 percent in 1974 to more than 18 percent in 2007. Furthermore, the richest 0.01 percent (the 15,000 or so richest families) had a share of less than 1 percent in 1974 but more than 6 percent of national income in 2007. As noted, those figures are from pre-tax income, so don’t look to the George W. Bush tax cuts to explain the pattern. Furthermore, these gains have been sustained and have evolved over many years, rather than coming in one or two small bursts between 1974 and today.1
These numbers have been challenged on the grounds that, since various tax reforms have kicked in, individuals now receive their incomes in different and harder to measure ways, namely through corporate forms, stock options and fringe benefits. Caution is in order, but the overall trend seems robust. Similar broad patterns are indicated by different sources, such as studies of executive compensation. Anecdotal observation suggests extreme and unprecedented returns earned by investment bankers, fired CEOs, J.K. Rowling and Tiger Woods.
At the same time, wage growth for the median earner has slowed since 1973. But that slower wage growth has afflicted large numbers of Americans, and it is conceptually distinct from the higher relative share of top income earners. For instance, if you take the 1979–2005 period, the average incomes of the bottom fifth of households increased only 6 percent while the incomes of the middle quintile rose by 21 percent. That’s a widening of the spread of incomes, but it’s not so drastic compared to the explosive gains at the very top.
The broader change in income distribution, the one occurring beneath the very top earners, can be deconstructed in a manner that makes nearly all of it look harmless. For instance, there is usually greater inequality of income among both older people and the more highly educated, if only because there is more time and more room for fortunes to vary. Since America is becoming both older and more highly educated, our measured income inequality will increase pretty much by demographic fiat. Economist Thomas Lemieux at the University of British Columbia estimates that these demographic effects explain three-quarters of the observed rise in income inequality for men, and even more for women.2
Attacking the problem from a different angle, other economists are challenging whether there is much growth in inequality at all below the super-rich. For instance, real incomes are measured using a common price index, yet poorer people are more likely to shop at discount outlets like Wal-Mart, which have seen big price drops over the past twenty years.3 Once we take this behavior into account, it is unclear whether the real income gaps between the poor and middle class have been widening much at all. Robert J. Gordon, an economist from Northwestern University who is hardly known as a right-wing apologist, wrote in a recent paper that “there was no increase of inequality after 1993 in the bottom 99 percent of the population”, and that whatever overall change there was “can be entirely explained by the behavior of income in the top 1 percent.”4
And so we come again to the gains of the top earners, clearly the big story told by the data. It’s worth noting that over this same period of time, inequality of work hours increased too. The top earners worked a lot more and most other Americans worked somewhat less. That’s another reason why high earners don’t occasion more resentment: Many people understand how hard they have to work to get there. It also seems that most of the income gains of the top earners were related to performance pay—bonuses, in other words—and not wildly out-of-whack yearly salaries.5
It is also the case that any society with a lot of “threshold earners” is likely to experience growing income inequality. A threshold earner is someone who seeks to earn a certain amount of money and no more. If wages go up, that person will respond by seeking less work or by working less hard or less often. That person simply wants to “get by” in terms of absolute earning power in order to experience other gains in the form of leisure—whether spending time with friends and family, walking in the woods and so on. Luck aside, that person’s income will never rise much above the threshold.
It’s not obvious what causes the percentage of threshold earners to rise or fall, but it seems reasonable to suppose that the more single-occupancy households there are, the more threshold earners there will be, since a major incentive for earning money is to use it to take care of other people with whom one lives. For a variety of reasons, single-occupancy households in the United States are at an all-time high. There are also a growing number of late odyssey years graduate students who try to cover their own expenses but otherwise devote their time to study. If the percentage of threshold earners rises for whatever reasons, however, the aggregate gap between them and the more financially ambitious will widen. There is nothing morally or practically wrong with an increase in inequality from a source such as that.
The funny thing is this: For years, many cultural critics in and of the United States have been telling us that Americans should behave more like threshold earners. We should be less harried, more interested in nurturing friendships, and more interested in the non-commercial sphere of life. That may well be good advice. Many studies suggest that above a certain level more money brings only marginal increments of happiness. What isn’t so widely advertised is that those same critics have basically been telling us, without realizing it, that we should be acting in such a manner as to increase measured income inequality. Not only is high inequality an inevitable concomitant of human diversity, but growing income inequality may be, too, if lots of us take the kind of advice that will make us happier.
Lonely at the Top?
Why is the top 1 percent doing so well?
The use of micro-data now makes it possible to trace some high earners by income and thus construct a partial picture of what is going on among the upper echelons of the distribution. Steven N. Kaplan and Joshua Rauh have recently provided a detailed estimation of particular American incomes.6 Their data do not comprise the entire U.S. population, but from partial financial records they find a very strong role for the financial sector in driving the trend toward income concentration at the top. For instance, for 2004, nonfinancial executives of publicly traded companies accounted for less than 6 percent of the top 0.01 percent income bracket. In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning more than $100 million a year was nine times higher than the public company executives earning that amount. The authors also relate that they shared their estimates with a former U.S. Secretary of the Treasury, one who also has a Wall Street background. He thought their estimates of earnings in the financial sector were, if anything, understated.
Many of the other high earners are also connected to finance. After Wall Street, Kaplan and Rauh identify the legal sector as a contributor to the growing spread in earnings at the top. Yet many high-earning lawyers are doing financial deals, so a lot of the income generated through legal activity is rooted in finance. Other lawyers are defending corporations against lawsuits, filing lawsuits or helping corporations deal with complex regulations. The returns to these activities are an artifact of the growing complexity of the law and government growth rather than a tale of markets per se. Finance aside, there isn’t much of a story of market failure here, even if we don’t find the results aesthetically appealing.
When it comes to professional athletes and celebrities, there isn’t much of a mystery as to what has happened. Tiger Woods earns much more, even adjusting for inflation, than Arnold Palmer ever did. J.K. Rowling, the first billionaire author, earns much more than did Charles Dickens. These high incomes come, on balance, from the greater reach of modern communications and marketing. Kids all over the world read about Harry Potter. There is more purchasing power to spend on children’s books and, indeed, on culture and celebrities more generally. For high-earning celebrities, hardly anyone finds these earnings so morally objectionable as to suggest that they be politically actionable. Cultural critics can complain that good schoolteachers earn too little, and they may be right, but that does not make celebrities into political targets. They’re too popular. It’s also pretty clear that most of them work hard to earn their money, by persuading fans to buy or otherwise support their product. Most of these individuals do not come from elite or extremely privileged backgrounds, either. They worked their way to the top, and even if Rowling is not an author for the ages, her books tapped into the spirit of their time in a special way. We may or may not wish to tax the wealthy, including wealthy celebrities, at higher rates, but there is no need to “cure” the structural causes of higher celebrity incomes.
If we are looking for objectionable problems in the top 1 percent of income earners, much of it boils down to finance and activities related to financial markets. And to be sure, the high incomes in finance should give us all pause.
The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.
To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.
Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.
To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks.
Moreover, smart shareholders will acquiesce to or even encourage these gambles. They gain on the upside, while the downside, past the point of bankruptcy, is borne by the firm’s creditors. And will the bondholders object? Well, they might have a difficult time monitoring the internal trading operations of financial institutions. Of course, the firm’s trading book cannot be open to competitors, and that means it cannot be open to bondholders (or even most shareholders) either. So what, exactly, will they have in hand to object to?
Perhaps more important, government bailouts minimize the damage to creditors on the downside. Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis. The U.S. government guaranteed these loans, either explicitly or implicitly.
Guaranteeing the debt also encourages equity holders to take more risk. While current bailouts have not in general maintained equity values, and while share prices have often fallen to near zero following the bust of a major bank, the bailouts still give the bank a lifeline. Instead of the bank being destroyed, sometimes those equity prices do climb back out of the hole. This is true of the major surviving banks in the United States, and even AIG is paying back its bailout. For better or worse, we’re handing out free options on recovery, and that encourages banks to take more risk in the first place.
In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.
And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. This type of implicit bailout brings high social costs by slowing down economic recovery (the interest rate spreads require tight monetary policy) and by redistributing income from the Treasury to the major banks.
The more one studies financial theory, the more one realizes how many different ways there are to construct a “going short on volatility” investment position. To an outsider, even to seasoned bank regulators, the net position of a bank or hedge fund may well be impossible to discern. It’s not easy to unpack a balance sheet with hundreds of billions of dollars on it and with numerous hedged, offsetting, leveraged, or off-balance-sheet positions. Those who pack it usually know what’s inside, but not always. In some cases, traders may not even know they are going short on volatility. They just do what they have seen others do. Their peers who try such strategies very often have Jaguars and homes in the Hamptons. What’s not to like?
The upshot of all this for our purposes is that the “going short on volatility” strategy increases income inequality. In normal years the financial sector is flush with cash and high earnings. In implosion years a lot of the losses are borne by other sectors of society. In other words, financial crisis begets income inequality. Despite being conceptually distinct phenomena, the political economy of income inequality is, in part, the political economy of finance. Simon Johnson tabulates the numbers nicely:
From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.7
If you’re wondering, right before the Great Depression of the 1930s, bank profits and finance-related earnings were also especially high.8
There’s a second reason why the financial sector abets income inequality: the “moving first” issue. Let’s say that some news hits the market and that traders interpret this news at different speeds. One trader figures out what the news means in a second, while the other traders require five seconds. Still other traders require an entire day or maybe even a month to figure things out. The early traders earn the extra money. They buy the proper assets early, at the lower prices, and reap most of the gains when the other, later traders pile on. Similarly, if you buy into a successful tech company in the early stages, you are “moving first” in a very effective manner, and you will capture most of the gains if that company hits it big.
The moving-first phenomenon sums to a “winner-take-all” market. Only some relatively small number of traders, sometimes just one trader, can be first. Those who are first will make far more than those who are fourth or fifth. This difference will persist, even if those who are fourth come pretty close to competing with those who are first. In this context, first is first and it doesn’t matter much whether those who come in fourth pile on a month, a minute or a fraction of a second later. Those who bought (or sold, as the case may be) first have captured and locked in most of the available gains. Since gains are concentrated among the early winners, and the closeness of the runner-ups doesn’t so much matter for income distribution, asset-market trading thus encourages the ongoing concentration of wealth. Many investors make lots of mistakes and lose their money, but each year brings a new bunch of projects that can turn the early investors and traders into very wealthy individuals.
These two features of the problem—“going short on volatility” and “getting there first”—are related. Let’s say that Goldman Sachs regularly secures a lot of the best and quickest trades, whether because of its quality analysis, inside connections or high-frequency trading apparatus (it has all three). It builds up a treasure chest of profits and continues to hire very sharp traders and to receive valuable information. Those profits allow it to make “short on volatility” bets faster than anyone else, because if it messes up, it still has a large enough buffer to pad losses. This increases the odds that Goldman will repeatedly pull in spectacular profits.
Still, every now and then Goldman will go bust, or would go bust if not for government bailouts. But the odds are in any given year that it won’t because of the advantages it and other big banks have. It’s as if the major banks have tapped a hole in the social till and they are drinking from it with a straw. In any given year, this practice may seem tolerable—didn’t the bank earn the money fair and square by a series of fairly normal looking trades? Yet over time this situation will corrode productivity, because what the banks do bears almost no resemblance to a process of getting capital into the hands of those who can make most efficient use of it. And it leads to periodic financial explosions. That, in short, is the real problem of income inequality we face today. It’s what causes the inequality at the very top of the earning pyramid that has dangerous implications for the economy as a whole.
A Fix That Fits?
A key lesson to take from all of this is that simply railing against income inequality doesn’t get us very far. We have to find a way to prevent or limit major banks from repeatedly going short on volatility at social expense. No one has figured out how to do that yet.
It remains to be seen whether the new financial regulation bill signed into law this past summer will help. The bill does have positive features. First, it forces banks to put up more of their own capital, and thus shareholders will have more skin in the game, inducing them to curtail their risky investments. Second, it also limits the trading activities of banks, although to a currently undetermined extent (many key decisions were kicked into the hands of future regulators). Third, the new “resolution authority” allows financial regulators to impose selective losses, for instance, to punish bondholders if they wish.
We’ll see if these reforms constrain excess risk-taking in the long run. There are reasons for skepticism. Most of all, the required capital cushions simply aren’t that high, so a big enough bet against unexpected outcomes still will yield more financial upside than downside. Furthermore, high capital reserve requirements insulate bank managers from the pressures of both shareholders and bondholders. That could encourage risk-taking and make the underlying problem worse. Autonomous managers often push for risk-taking rather than constrain it.
What about controlling bank risk-taking directly with tight government oversight? That is not practical. There are more ways for banks to take risks than even knowledgeable regulators can possibly control; it just isn’t that easy to oversee a balance sheet with hundreds of billions of dollars on it, especially when short-term positions are wound down before quarterly inspections. It’s also not clear how well regulators can identify risky assets. Some of the worst excesses of the financial crisis were grounded in mortgage-backed assets—a very traditional function of banks—not exotic derivatives trading strategies. Virtually any asset position can be used to bet long odds, one way or another. It is naive to think that underpaid, undertrained regulators can keep up with financial traders, especially when the latter stand to earn billions by circumventing the intent of regulations while remaining within the letter of the law.
It’s a familiar story, repeated many times in the past. If one recalls the Basel I capital agreements for banks, the view was that we would make banks safer by inducing them to hold a lot of AAA-rated mortgage-backed assets. How well did that work out? So, with no disrespect to the regulators or the sponsors of the recent bill, it is hardly clear that enhanced regulation will solve the basic problem.
For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It’s no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.
Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world.
That’s an underappreciated way to think about our modern, wealthy economy: Smart people have greater reach than ever before, and nothing really can go so wrong for them. As a broad-based portrait of the new world, that sounds pretty good, and usually it is. Just keep in mind that every now and then those smart people will be making—collectively—some pretty big mistakes.
How about a world with no bailouts? Why don’t we simply eliminate the safety net for clueless or unlucky risk-takers so that losses equal gains overall? That’s a good idea in principle, but it is hard to put into practice. Once a financial crisis arrives, politicians will seek to limit the damage, and that means they will bail out major financial institutions. Had we not passed TARP and related policies, the United States probably would have faced unemployment rates of 25 percent of higher, as in the Great Depression. The political consequences would not have been pretty. Bank bailouts may sound quite interventionist, and indeed they are, but in relative terms they probably were the most libertarian policy we had on tap. It meant big one-time expenses, but, for the most part, it kept government out of the real economy (the General Motors bailout aside).
So what will happen next? One worry is that banks are currently undercapitalized and will seek out or create a new bubble within the next few years, again pursuing the upside risk without so much equity to lose. A second perspective is that banks are sufficiently chastened for the time being but that economic turmoil in Europe and China has not yet played itself out, so perhaps we still have seen only the early stages of what will prove to be an even bigger international financial crisis. Adherents of this view often analogize 2009–10 to 1929–32, when many people thought that negative economic shocks had stopped and recovery was underway. In 2006, banks were gambling on the housing market, and maybe today they are, as the result of earlier decisions, gambling on China and Europe staying in one economic piece.
A third view is perhaps most likely. We probably don’t have any solution to the hazards created by our financial sector, not because plutocrats are preventing our political system from adopting appropriate remedies, but because we don’t know what those remedies are. Yet neither is another crisis immediately upon us. The underlying dynamic favors excess risk-taking, but banks at the current moment fear the scrutiny of regulators and the public and so are playing it fairly safe. They are sitting on money rather than lending it out. The biggest risk today is how few parties will take risks, and, in part, the caution of banks is driving our current protracted economic slowdown. According to this view, the long run will bring another financial crisis once moods pick up and external scrutiny weakens, but that day of reckoning is still some ways off.
Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.
Trader Pay Tops Brain Surgeons' and Shows Gap Weathers Crisis
By Danielle Kucera and Christine Harper - Jan 13, 2011
Wall Street traders discouraged by declining bonuses this month can take solace: They still earn much more than brain surgeons and top U.S. generals.
An oil trader with 10 years in the business is likely to earn at least $1 million this year, while a neurosurgeon with similar time on the job makes less than $600,000, recruiters estimated. After a decade of deal-making, merger bankers take home about $2 million, more than 10 times what a similarly seasoned cancer researcher gets (see table below).
The pay gap between finance and other professions widened between the 1980s and 2006, exceeding the record set before the Great Depression, according to a 2009 study by Thomas Philippon, a professor at New York University’s Stern School of Business. After the 2008 financial crisis, Wall Street started paying a larger portion of bonuses in stock and restricted cash. Yet there’s little sign the gap with Main Street is narrowing.
“I don’t think it’s healthy for the economy to be this skewed,” said Stephen Rose, a 63-year-old professor at Georgetown University’s Center on Education and the Workforce. “I believe there’s some sort of connection between value added to the economy and pay. Everyone is losing sight of any fundamentals.”
Tomorrow, JPMorgan Chase & Co. will lead the largest U.S. banks in reporting full-year earnings, disclosing costs to reward employees. In the first nine months of 2010, the New York-based bank allocated $21.55 billion for compensation and benefits, down 1 percent from the same period a year earlier even though the number of employees rose 7 percent.
Traders Getting Less
While pay levels across the financial industry as a whole may show little change this year, recruiters have estimated that 2010 bonuses for fixed-income and equity traders could drop between 20 percent and 30 percent compared with the previous year. Johnson Associates Inc., a compensation consultant, estimated in November that the biggest bonus increases -- as much as 15 percent -- will go to fund managers and people who advise wealthy clients.
In the first three quarters of 2010, eight of Wall Street’s largest banks set aside about $130 billion for compensation and benefits, enough to pay each worker more than $121,000 for nine months of work. That’s up from the same period four years earlier -- before the crisis -- when the lenders set aside a total of $113 billion, or enough to pay an average $114,400 to each worker.
Calculated in dollars, average pay per employee has risen at Bank of America Corp., Citigroup Inc., Credit Suisse Group AG and UBS AG and declined at Deutsche Bank AG, Goldman Sachs Group Inc., JPMorgan and Morgan Stanley since the same period in 2006.
“The bottom line is all the people in investment banking understand that they work harder and are under more stress,” said Jeanne Branthover, a managing director at Wall Street recruitment firm Boyden Global Executive Search. “Many don’t think they’re paid enough.”
A four-star general with more than 34 years in the military makes almost $185,000 a year, according to the Department of Defense’s accounting office. That’s less than half the $498,246 average compensation and benefits package that New York-based Goldman Sachs paid employees for 2009. Any officer, regardless of rank, receives an additional $225 a month in “imminent danger” pay for serving in a war-zone like Iraq or Afghanistan.
To be sure, government and union jobs often come with benefits that aren’t available to all Wall Street employees, such as housing and guaranteed pensions, and traders’ pay can be dwarfed by compensation for top athletes or entertainers.
It’s too early to draw conclusions about whether the gap between Wall Street pay and other industries will narrow the way it did for decades after the Depression, Philippon said in an interview. As long as the disparity remains, people think twice about entering careers outside finance, he said.
“If you look at the very brightest, there is definitely a trend of trying to get a job on Wall Street,” he said.
A cancer researcher with a Ph.D. in biology and 10 years of industry experience typically makes $110,000 to $160,000 a year, said Rick Hennessey, owner and president of Norwood, Massachusetts-based Commonwealth Sciences Inc., who said he has spent 22 years recruiting candidates for jobs in the life sciences.
Because pay levels can rise to $275,000 if scientists choose to take management jobs or specialize in understanding U.S. Food and Drug Administration regulations, Hennessey said he often tries to discourage candidates from getting their Ph.D.
“The Ph.D.s are the ones that are going to be doing some of the most involved research, but it’s a Catch-22,” he said. “I direct them into other areas such as getting an MBA in conjunction with their bachelor’s degree and use that so they can get on the management track.”
Wall Street careers are different from some other professions because they can be short-lived and pay can vary widely depending on an individual’s performance in any given year, said George Stein, managing director at New York-based recruitment firm Commodity Talent LLC.
“If you have a bad year as a trader, you may get no bonus, and that’s happened to many in recent history,” Stein said. “That’s a risk that traders are willing to take that many in other professions would find unpalatable.”
Even for 2008, the year the financial industry received unprecedented support from taxpayers, many Wall Street professionals got bonuses exceeding $1 million, according to data compiled by then-New York Attorney General Andrew Cuomo. At nine U.S. banks, 4,793 employees got such payouts, 311 were granted $5 million or more and 47 people got bonuses of $10 million or more.
At Citigroup, the U.S. lender that received the biggest government bailout, 738 employees of the New York-based company got at least $1 million, according to a report by Cuomo, who is now the state’s governor. At Merrill Lynch, which sold itself at the height of the crisis to Charlotte, North Carolina-based Bank of America, 696 workers collected such amounts.
Last year’s compensation figures from the biggest firms may belie the changes in pay practices that have swept through the industry since the crisis, said John Taft, chairman of the Securities Industry and Financial Markets Association, a lobbying group for banks and brokerages.
“More of an individual’s incentive is deferred, and it’s more at risk than it has ever been,” Taft said in an interview. “It can be taken away completely. Often times it’s tied to stock price.”
Credit Suisse, Switzerland’s second-biggest bank, said Jan. 10 that it will defer payments on 35 percent to 70 percent of any bonuses of 50,000 Swiss francs ($51,722) and higher. Credit Suisse, unlike its larger Swiss rival UBS AG, didn’t take bailout funds from the Swiss government.
The change in payment terms hasn’t quelled public anger after the U.S. government bailed out financial companies. A Bloomberg National Poll last month found that more than 70 percent of Americans wanted big bonuses to be banned for a year at Wall Street firms that took taxpayer money. Another 17 percent supported a 50 percent tax on bonuses exceeding $400,000.
The industry’s pay practices have contributed to increasing income inequality, said Heidi Shierholz, an economist at the Economic Policy Institute in Washington. The people with the best-paying jobs aren’t always the most deserving, she said.
“There’s a lot of luck associated with landing those jobs that have the very high level of compensation,” she said.
The following is a table comparing the annual pay of some Wall Street professionals with compensation for people in other industries or the military, as estimated by recruiters or reported by the government.
Job Description Estimated Pay Source M&A banker with 10 $2 Million Jeanne Branthover, years experience Boyden Global Executive Search Bank oil trader $1 Million George Stein, with 10 years Commodity Talent LLC experience Corporate bond trader $1 Million Jeanne Branthover, with 10 years Boyden Global experience Executive Search Neurosurgeon with 8-17 $571,000 Rob D’Angelo, years experience Olesky Associates Inc. Law firm partner with $600,000 Jeffrey Lowe, 10 Years experience Major Lindsey & Africa Four-star general $185,000 Tom LaRock, Defense with more than Finance and 34 years experience Accounting Services Cancer researcher $110,000 to Rick Hennessey with 10 years $160,000 Commonwealth Sciences experience Inc. Aerospace engineer $100,000 Peter Bohner, with 5 to 10 years Marymont Group experience Architect with 10 $80,000 to Lonny Rossman, years experience $100,000 API Partners LLC