February 19, 2009 — Immediately after the financial industry was deregulated in the mid-1980s, Wall Street paychecks began a steady rise. By 2006, those on Wall Street were earning 30 to 50 percent more than workers with comparable skills in other industries, according to research by a University of Virginia economist and a colleague.

"In that sense, financiers are overpaid," conclude Ariell Reshef of U.Va. and Thomas Philippon of New York University in their recently released National Bureau of Economic Research working paper, "Wages and Human Capital in the U.S. Financial Industry, 1909-2006."

The 100-year review finds that financial industry pay correlates strikingly with both the relative amount of industry regulation and the relative education and skill levels of workers.

In two periods of relatively little financial industry regulation —from the 1900s to 1933, and from the mid-1980s to 2006 — the industry drew highly educated workers to high-skill jobs, and paid significantly more than other industries did for similar workers.

The industry was first significantly regulated in 1933, in the wake of the 1929 stock market crash. A dramatic shift in the workforce occurred during the 1930s and 1940s as education and pay levels fell sharply, ending up roughly in line with the rest of the private sector by the 1950s. Things remained that way until the 1980s deregulation.

"We find a very tight link between deregulation and human capital in the financial sector," notes the paper. "Highly skilled labor left the financial industry in the wake of the Depression era regulations, and started flowing back precisely when these regulations were removed."

Following the 1980s deregulation, the education and skill levels of Wall Street workers increased sharply, as did wages, returning to levels very similar to those observed in the 1930s.

Reshef and Philippon find that several commonly cited factors had little impact on the recent skyrocketing of wages. Some have suggested that financiers are paid a "risk premium" because they are more likely than average to lose their jobs, but that only accounts for about 6 percent of the Wall Street wage premium, the study authors calculated.

Finance wages also bear little correlation with simple macroeconomic explanations, including the average price/earning ratio of stocks, the size of the stock market relative to the nation's economy, or the intensity of international trade.

Computers and information technology undoubtedly played a role in the rise of education and skill levels in recent years, but clearly weren't a factor in the very similar run-up in wage and education levels seen in the 1906 to 1930s period, note the authors. "The fact that relative wages and education in finance were just as high in the 1920s as in the 1990s rules out technology — in particular information technology — as the main driving force."

What was similar in those two periods, argue the authors, was an increase in risky debt instruments (such as junk bonds) used to finance companies with high growth potential, often in new industries. In the 1900s, the new and transformative industries included electricity and railroads. In recent years, information technology has generated similarly sweeping business opportunities and repercussions.

Skilled analysis is required to value and capitalize such emerging industries, note the authors. The complex challenges of valuing the companies being spun out of the Internet boom, and of capitalizing them with initial public offerings of stock, drove demand for smart, skilled workers.

But Wall Street paychecks rose faster than what these skilled and educated workers would have earned in other industries.

Reshef said that the '80s saw an ideology, led by former Federal Reserve chairman Alan Greenspan, that markets can regulate themselves. Greenspan now admits his mistake, he noted.

"It's very clear that the deregulation era started in the 1980s, and when we look at the data that's exactly when we find that the excesses started to increase," Reshef said. "Better regulation could have prevented this situation. The data speak to that effect."

By 2006, finance industry paychecks were 30 to 50 percent fatter than those in other sectors. "Those levels of wages are unsustainable" and "can be expected to disappear," Reshef noted, but whether they are "overpaid" is hard to say. "The real question is, 'Are they paid more than their social benefit?'"

Unfortunately, no good studies exist on the "value added" by finance workers, Reshef said, but he and Philippon plan to further investigate that issue.

The study offers two major lessons to the current discussion of changes to finance industry regulations. "First, tighter regulation is likely to lead to an outflow of human capital out of the financial industry," Reshef said.

Second, regulators' salaries must be competitive with private-sector wages.

"Following the crises of 1930-1933 and 2007-2008, regulators have been blamed for lax oversight," the paper notes. "In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly skilled financial workers."