Finance & human capital
How much would the global economy lose if the financial sector were to shrink?* This question raises a problem about the role of human capital. Take the question: why are (some) bankers so well paid? One possibility is that they are highly skilled; they have lots of human capital and a high marginal product. But if this is the case, they could use those skills elsewhere. Sure, they wouldn’t earn quite as much outside the financial sector - that’s why they work in it. But their skills would be useful, so they’d make a big contribution to the economy. In this case, the losses to the economy if the financial sector shrinks would be second-order. No big deal.But there’s an obvious objection here. Maybe financial salaries are high because people have huge job-specific human capital. In moving out of finance, they would lose this capital. So there’d be a big resource loss. Which brings me to my puzzle. How can we tell whether someone is earning good money because they have job-specific human capital, or because they are appropriating organizational capital for themselves? Take three cases:1. When a bank hires someone from another bank on a high salary, it is often not paying merely for the man’s skills. What they want is his clients, or his knowledge of his ex-employers‘ products or trading systems. The bank is trying to buy organizational capital, not just human capital.2. High salaries are a form of efficiency wage. Traders must be bribed not to transfer assets cheaply to potential future employers. They are paid more than their pure marginal product, their human capital would warrant.3. Many trading strategies work only because the bank can borrow cheaply or deal at next-to-no cost, or exploit inside knowledge of order-flow. Traders working for banks can therefore make more than they would if they traded on their own account. But this excess is a return to the banks’ capital that they get for themselves, not a return to pure human capital.Insofar as these mechanisms operate, financial sector workers are paid far more than their pure human capital would warrant. Which means they might not be so employable outside the financial sector. So, ceteris paribus, there would be a larger resource loss from shrinking the financial sector. What I’m saying here is that there’s a problem for those who want to defend the financial sector. You can do one of two things:1. You can defend bankers’ pay on the grounds that it’s a reward for high skills, in which case you shouldn’t worry much about the financial sector shrinking, as these skills would be useful elsewhere.2. You can argue that shrinking finance would be expensive. But this requires you to ditch the Econ101 just-so stories about people being paid a return to human capital, and to recognize that salaries are a reward to power, not (just) to “skill.“Is there really a plausible third possibility?* I frame the question at the global level to avoid the issue of whether a shrinking of UK finance would cause migration of City workers.