A Stitch in Haste

I was saving this recent Dilbert strip for a future Sidebar Sidetrack, but I'm going to post it now instead:


(Click to enlarge.)
Armed with that:

Just why investment bankers and traders out-earn, say, doctors or computer engineers is a question I've never heard convincingly answered. Are they smarter? Unlikely. Do they contribute more to the economy? Questionable. True, Wall Street often performs a vital function. It channels savings into productive investments. It helps provide access to capital and credit. In 2006, U.S. companies raised nearly $4 trillion through new stocks and bonds. Many financial innovations, including mortgage-backed securities, have benefited individuals and companies.

But Wall Street also frequently misallocates capital and credit. The "tech bubble" of the late 1990s was one episode. Now we have subprime mortgages. Why? Well, the herd mentality of financial crazes has a long history. But compensation practices skewed so heavily toward bonuses based on annual profits make matters worse.

Apparently Robert Samuelson, like Paul Krugman, isn't really an economist but just plays one on TV. Nevertheless, he knows full well what drives Wall Street salaries: supply and demand, just like any other market. He can barely go two sentences without explaining his own concocted paradox: In a sector that creates $4 trillion of new financial products (let alone the secondary markets) every year, is an annual bonus that reflects a fraction of a fraction of a percent of that enormity really such an outrage?

Typically we see this sophomoric, flunk-the-final screeching in the context of celebrity salaries: Does Alex Rodriguez "deserve" $275 million? Did Bon Jovi really "contribute" $67 million of value to society in 2006? Should Johnny Depp ($92 million in 2006) out-earn a computer engineer?

The answer to all those questions is: Yes, if that's what the free market concludes. Rodriguez' compensation package, for example, is not a single financially "obscene" transaction, but the aggregation of perhaps a million de minimis transactions or more: ticket sales, endorsements, broadcasting rights, media stories, etc. All of which, bit by bit, aggregate into a voluntary* arrangement that — by definition — is correct, justified and entirely moral. (*Ignoring side issues such as baseball's antitrust exemption, FCC licenses to television and radio stations, taxpayer subsidies to stadiums, and other ancillary considerations.)

And remember that, despite being the most heavily regulated industry in the universe, finance is an entirely voluntary domain. No one is forced to buy a stock or bond (or, it bears repeating, a subprime mortgage via a fraudulent application). Can the "noble" politicians who refuse, for example, to consider even the most modest Social Security reform say the same about their "vital function"? And the fact that we don't let supply and demand work its wonders in medical salaries the way we do on Wall Street is precisely why we are running out of doctors. Go figure.

If Samuelson thinks that Rodriguez is overpaid (or, more proximately, that a Yankees ticket is overpriced), then he is free not to enter into that transaction. If he thinks that Johnny Depp is "exploiting" moviegoers, then he is free to protest by staying home. And if he doesn't like the subprime market, then he can opt not to borrow through it. Beyond that, he has no standing to complain — and neither does any politician, bureaucrat or other malcontent. Move along folks, no externalities to see here...

Meanwhile, Samuelson claims that "Wall Street also frequently misallocates capital and credit." Misallocates — by what standard? If I go to a movie that I end up disliking, did I "misallocate my capital"? Would I be "crazed" to ever go to a movie again after seeing a bad one? Of course not. Bad outcomes do not automatically prove bad decisions. "It made sense at the time" is not always a rationalization.

Finally, remember my parable in this post: Wall Street specifically, and the free market generally, are not required to prove that they are perfect. They merely need to prove that they are better than the only available alternative: command-and-control statism by people who think exactly like Samuelson (or worse).

That would be an investment guaranteed to prove worthless.

More thoughts at EconLog, Rolling Doughnut.