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High Income Inequality: A Financial Sector Perspective

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Modern Money

Dr. Sylvia Maxfield, Dean, Providence College School of Business

In the past three decades the income inequality gap has exploded across the United States. We typically view rising inequality through the lens of class; focusing on the growing disparity between the top 5% or 1% of the population and the bottom 10% or quartile. But looking at income inequality from this vantage point misses a critical dimension: there are serious gaps between economic sectors and in particular, the financial sector of the economy has grown disproportionately wealthy compared to other sectors. This gap not only has profound consequences for the distribution of income but also has negative effects on the overall growth and development of the U.S. economy.

Beginning in 1980, financial sector deregulation began in earnest, encouraging investment in financial sector expansion and attracting a greater percentage of college and high-school graduates. This shift to the financial services sector has contributed both to the growing inequality of wages between workers in the “real” economy – which produces goods and non-financial services and drives most of the employment growth — and the “financial” economy – which has higher wages and is siphoning off talent from the real economy. To put this into perspective, the relative wage in finance versus the private sector in 1980 was 1.03 and since then has increased by .65 to 1.68 in 2005.

Another indicator of disproportionate financial economic growth affecting the income inequality gap is the correlation of strong financial sectors and vast income gaps by cities. According to the latest U.S. Census Bureau data, overall, big cities remain more unequal places by income than the rest of the country. Not surprisingly, the data finds that the most unequal cities (those with the largest income gaps) are those with the strongest financial sectors.

The sharp relative income gains of the financial sector are not only a source of income inequality. The relative strength of the financial sector should help bring resources to other sectors and support their growth, but this isn’t always so. Ideally, the financial economy should be the “handmaiden” to the real economy, facilitating capital investment in companies and helping finance innovation, product development and expansion. Financial market innovation that facilitates new products and processes for the financial sector itself, such as credit default swaps or selling insurance for credit products, boost bank profits and salaries but are far removed from the traditional bank function of channeling savings into non-financial sector investment.

For all the money being lavished on the financial sector in salaries that are two-thirds higher than the average private sector job, society seems to be getting very little in the way of return. A recent paper by Thomas Philippon at NYU finds that the financial sector is no better at transferring funds from savers to borrowers – its core function – than it was 100 years ago, resulting in an annual misallocation of some $280 billion in the U.S. economy.

Markets are the best way for societies to allocate resources but, because markets are prone to flaws, they require oversight so that they promote overall economic well-being. Different sectors of the economy are more prone to market failures than others. Finance is high on this list. When the financial sector becomes a large growth engine, for example, as in the years leading up to the Great Depression, society becomes more vulnerable to the negative effects of flawed markets, including the consequences of speculative bubbles such as occurred in housing finance in the US prior to 2007.

A fascinating piece of analysis shows that financial sector wages relative to private non-farm sector wages peaked in 1929 and the ratio was 1.65 in 1933. They then decreased by 0.57 to 1.08 in 1960,not coincidentally following decades of extraordinary growth and expansion of the middle class in America, and further decreased by 0.05 to 1.03 in 1980. However since 1980 relative financial sector wages have rocketed , increasing to levels well above 1929 by 2001. Currently wages in finance are 68% higher than wages in rest of private sector.

The U.S. has an employment and wage gap because the U.S. economy is still trying to find a way out of a growth model heavily fueled by expansion of the financial sector post-1980, where wages were extraordinarily high compared to the rest of the economy. The debate we should be having is about policy levers for rebuilding the U.S. economy that encourage investment necessary to create sufficient jobs to achieve a mutually reinforcing virtuous cycle of moderate growth.

Sylvia Maxfield, Ph.D., is Dean of the School of Business at Providence College and former vice president and senior sovereign credit analyst at the Wall Street firm of Lehman Brothers.