A few years back, two finance professors at the University of Chicago set out to discover who was behind the spectacular rise in the very top incomes in the U.S. Steven Kaplan and Joshua Rauh quickly concluded that for all the outrage about the pay of corporate chief executives and their lieutenants, it didn’t account for more than a sliver of the gains. And highly paid athletes and entertainers were too small in number to have much impact.
The big, big gainers, Kaplan and Rauh found, were on Wall Street. At least 2,500 people at major investment banks made more than $2.5 million a year, they estimated, acknowledging that the actual figure was probably substantially higher. They couldn’t nail down numbers for private-equity firms, hedge funds and other money-management outfits but concluded that their ranks and compensation had grown dramatically. The country’s big law firms, many of them legal remoras attached to Wall Street, accounted for thousands more high earners. Overall, the top 0.1% of the income distribution in the U.S. in 2006–the most recent year for which data are available–was made up of 148,361 taxpayers who took home more than $1.9 million each. This top 0.1% accounted for 11.6% of personal income, according to income-inequality mavens Emmanuel Saez of the University of California, Berkeley, and Thomas Piketty of the Paris School of Economics. Back in 1978, the top 0.1% claimed only 2.7% of income. Rising pay on Wall Street was the biggest single contributor to the shift. “This was all market-oriented,” says Kaplan. “Part of the reason you saw such a big increase in pay over time was just an increase in scale.” The sums of money managed and size of transactions arranged by Wall Street grew exponentially, starting in the 1980s. So did profits and pay. You can argue that CEO compensation is a rigged game, but on Wall Street, lavish pay packages have never been restricted to the top of the executive ladder. Top-performing investment bankers and traders were paid big sums because otherwise they might jump ship to a rival bank or a hedge fund. And nobody was forcing rich people and pension funds to entrust their money to high-fee private-equity firms and hedge funds. Now, though, the scads of lushly paid Wall Streeters have driven the financial sector into a ditch, and taxpayers around the world are spending trillions of dollars to fix the problem. This chain of events has, understandably, focused big-time scrutiny on financial-sector compensation. President Barack Obama plans to limit cash pay to $500,000 for the top five executives of firms that take more aid from the government, and the stimulus legislation he signed into law on Feb. 17 sharply restricts bonuses for the 25 highest-paid employees of any company that has taken bailout money. While Wall Street is unhappy about these measures, its bosses agree that they must do a better job of linking pay to long-term profitability rather than short-term jackpots. None of this gets to the core of the issue. What distinguished Wall Street pay in recent years was less its short-term nature than its staggering generosity. This remunerative largesse extended far beyond the top five or even top 25 executives at big firms. Shortly before its merger with Bank of America at the beginning of this year, Merrill Lynch paid bonuses of at least $1 million to 700 employees–after the firm’s worst year ever, when it racked up losses of $27 billion. Whether you think this is a problem depends on whether you agree with Kaplan and Rauh’s assessment of the forces behind rising Wall Street pay. If it was all a market phenomenon, it will now correct itself, as the financial sector’s employee ranks and paychecks shrink to reflect the smaller pool of assets it has to play with. Overall income inequality is likely to drop sharply as well, Kaplan says. But what if Wall Street’s pay practices helped cause the mess we’re in, and what if they don’t correct themselves The bonuses granted by Merrill and other money-losing firms seem to indicate an unwillingness to adapt to changed circumstances. Yet government attempts to dictate compensation at financial institutions are likely to bring about unintended and probably unpleasant consequences. The solution could lie instead in restricting certain financial behaviors or just hiking tax rates on the highest incomes. The bottom line is that Wall Street is uniquely risky–but that doesn’t mean the risk takers have to be uniquely compensated to match. Read “How To Know When The Economy is Turning Up.”
See 25 people to blame for the financial crisis.