Forbes published its annual list of the richest Americans last week. If you're like me, this is fun reading. I like seeing who's doing well and how they made it.
Something from the list caught my attention this year: The sheer number of those who made their fortunes from finance.
Fully one-fifth of those on this year's Forbes list come from the financial industry, including hedge fund managers, private equity tycoons, and bankers. One-fifth. For perspective, I dug up the 1985 edition of the Forbes Richest Americans list. Back then, four people, or less than 1%, of America's richest hailed from the finance world.
This meteoric rise in financial-sector wealth isn't restricted to billionaires and financial entrepreneurs. Since the mid-1980s, there's been a surge in average compensation for finance employees that outstrips every other industry (More on why here):
Source: Bureau of Economic Analysis, author's calculations.
In 1959, the average finance employee made 7% more than the average worker from other industries. By 2006, finance workers out-earned their non-finance peers by 57%.
And for what?
This rise would be well and good if the average finance worker added more value to society than everyone else. And Wall Street has convinced some of us that they indeed do. Comedian Jon Stewart once sarcastically called this the Big Bank Theory.
But think about it. Does the financial industry really add anything to society? Some parts, yes. Basic banking. Brokerage services. Financial advisors. Some investment banking. These are all vital elements of the economy. They help businesses grow and people achieve goals.
But nearly every financier from the Forbes list traffics in a different business entirely. They aren't helpers or advisors. They rarely even finance other people's creations. They simply trade the financing of other people's creations back and forth -- they're paper pushers. Traders. Hedge fund managers. Private equity executives. They don't create anything. They have no patents. They build no factories. Most employ very few people. They're several steps removed from anything relevant -- and yet they out-earn nearly every other industry. Insanity is too kind a word. It's just sad.
A good example of this comes from an old New York Times article describing the life of Avis Rent-a-Car, a company whose ownership has bounced between several dozen financiers over the years:
Modern capitalism has two parts: there's business, and there's finance. Business is renting you a car at the airport. Finance is something else. More and more of the news labeled "business" these days is actually about finance, and much of it is mystifying. Even if you can understand -- just barely -- how it works, you still wonder what the point is and why people who do it need to get paid so much. And you strongly suspect that the swirl of financial activity around Avis for the past six decades has had little or nothing to do with the business of renting cars.
The article then ridicules The Wall Street Journal, which takes a modern finance view of Avis' future:
The Journal warned, "If a buyout or acquisition deal doesn't materialize for Avis, stock and bond investors will have to focus on the fundamentals of its car-rental business." Goodness! Anything but that!
Getting what you pay for
To some degree, there's nothing wrong with this kind of speculative finance. It's capitalism. It's always been around -- just more so today.
The danger is in the incentives. It's now far more lucrative to finance stuff than it is to make stuff, and it's even more lucrative to trade the financing of the stuff.
The result is entirely predictable: Brainpower floods into high finance like gnats to a bright light. Fifty years ago, 4% of Harvard's graduating class went into finance. Today it's about a quarter. At Princeton's School of Engineering, financial engineering is the most popular undergraduate major. What is financial engineering, you ask? It involves derivatives, leverage, Ferraris, bankruptcies, and invariably a bailout. Nothing you'd be proud of.
Two decades ago, Michael Lewis' phenomenal book Liar's Poker laid out Wall Street's utter swamp of a culture. Lewis once wrote that the goal of his book was to convince college students that abandoning their childhood dreams to make a fortune on Wall Street is a terrible idea. Instead, he writes, "Six months after Liar's Poker was published, I was knee-deep in letters from students ... who wanted to know if I had any other secrets to share about Wall Street. They'd read my book as a how-to manual." Morals do funny things when you wave a seven-figure bonus in someone's face.
Berkshire Hathaway's (NYSE: BRK-A ) (NYSE: BRK-B ) Charlie Munger (himself a financier) put it a little more eloquently: "Ever more of the nation's ethical young brainpower is attracted into lucrative money management and its attendant modern frictions, as distinguished from work providing much more value to others."
That's really it. The tragedy of the Big Bank Theory isn't what current financiers are doing. It's what the next generation of our best and brightest won't be doing -- engineering buildings, discovering new medicines, designing computers. Useful things. Things where making the cover of Forbes earns you the respect, not the astonishment, of others.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.