## Friday, October 10, 2008

### Is there a silver lining?

Not working in the financial industry, it is all too easy to be cavalier about layoffs at Bear Stearn's, Lehman Brother's and the like. People have lost their livelihoods and are suffering real consequences. But when the dust settles, this crisis may have served a function for our economy.

For a long time now, the best and brightest minds have been drawn to Wall Street. Harvard sent 39% of it's workforce-bound seniors to consulting and financial services in 2008, and 47% in 2007. Conversely, 8.7% went into pubic service and 6.6% went into technology-related industries.

Consulting and finance draw a vast pool of talented individuals beyond the traditional economics and finance majors. In particular, graduates in mathematics and the hard sciences (including computer science) are prized for the mathematical modeling skills and computational acuity. For these students, the lure of the financial industry (where the median salary was $65,000 plus bonuses versus$35,000 elsewhere) was too great.

In many ways, workers are like all other resources in the economy. They are scarce and they need to be channeled into various sectors of the economy. And, like other resources, that channeling is accomplished through the price system.

Wages (the price of labor) help us understand the value of different skill sets and job functions, as determined (mostly) by the forces of supply and demand. For example, doctors make more money than Walmart employees largely because there are fewer people with the ability to perform medical services. Usually, the price system does a good job of approximating the "societal value" of skill sets. But sometimes, as we have seen in the recent financial news, prices can get it wrong.

MIT economist Esther Duflo commented recently that a decrease in the demand for financial services workers might not be a bad thing:
What the crisis has made bluntly apparent is that all this intelligence is not employed in a particularly productive way. Admittedly, a financial sector is necessary to act as the intermediary between entrepreneurs and investors. But the sector seems to have taken a quasi-autonomous existence without close connection with the financing requirements of the real economy. Thomas Philippon calculates that the financial sector, which accounts for 8% of GDP in 2006, is probably at least 2% above the size required by this intermediation. Worse, the sub-prime crisis is almost certainly in part linked to the fact the needs of the financial markets (the insatiable demand from banks for the famous “mortgage backed securities”) led to excessive borrowing and a housing bubble. Watching the events of the last few days unfold does make us one want to send some of the finance CEOs back home. More pragmatically, the disappearance of their exorbitant earnings may encourage younger generations to join other industries, where their creative energies would be socially more useful. The financial crisis could plunge us into a severe and prolonged recession. The only silver lining is that it could cause a more realistic allocation of talents.
Dulfo also notes that, "The “Harvard and Beyond” survey, a survey of several cohorts of Harvard graduates conducted by Claudia Goldin and Larry Katz showed that in 2006 those who worked in finance earned almost 3 times more (195%) than others, after controlling for grades in college, standardized scores at entry, choice of major, year of graduation, etc". This is likely to change in the coming years. But in the end, we may have more scientists, engineers and inventors. That could be very good news for all of us.