Who gets paid what and why?

There is tremendous public outrage these days against the bonuses and excesses of executives at AIG and financial institutions like it. I feel the same way. It is just the most extreme example of the tremendous disparities in pay between top executives and regular working folks within companies. The injustice of these disparities is all the more keen now because these financial institutions have received billions in taxpayer money from those same regular working folks and the executive continue to receive the same outrageous bonuses!

For me this begs the question of how we got into this situation and what we can do to prevent it from happening again. That’s a big question, of course, but I have a few ideas.

I would like to broaden the question to why certain people and professions earn the pay that they do. There are a number of perfectly reasonable justifications, for example:

• Some professions require long and extensive training. It is reasonable to pay people more who have deferred their earnings to pursue this education in an amount equivalent to the net present value of those deferred earnings
• Some work is less desirable than other work and people must be paid more to do it (e.g. mining, garbage collecting).

But these reasons do not adequately explain why executives at financial institutions were making so much money. Nor does it explain why teachers, police officers, and firemen earn so little in comparison.

I’ve got a couple theories that seem to explain more of the story:

• Barriers to entry/Privilege: The best professions often have significant barriers to entry that prevent the less advantaged or less fortunate from joining them. These barriers could be the normal barriers of socio-economic status, or they can be explicit attempts to constrain supply and thus increase pay (e.g. the time and money requirements to become a real estate agent), or hidden biases and unspoken preferences that are deeply ingrained in society.
• The Proximity to Money Theory: I would propose that the closer you are to money, the more money you earn. For example, if you charge a 1% fee on a financial transaction, that seems reasonable. But if you consider that the transaction is for $50 billion, and that 1% equals $500 million, a lot of money can quickly get siphoned off to those closely involved. As our financial system has been consolidated and globalized, the size of transactions has increased dramatically, which makes it possible for more and more money to be diverted to a relatively small number of people, consolidating wealth. In the past these fees would have gone to local bank officials, etc. and recycled in local economies. Now it goes to a few global officials who spend their days in the high-rises of New York or London and their weekends in Monte Carlo and their private island off the coast of Thailand. 
  
  So it becomes easier to see why executives at financial institutions earn so much: there is no one closer to more money than them! This also helps to explain why teachers earn so little. Education is very far from money in time and space. Children earn no money and have no money of their own, and will not earn much money for 20 or more years. This makes it hard to understand and explain exactly how much value and money teaching creates. Obviously education is an investment in the future and creates tremendous value, but the short term perspective of our society makes it hard to account for it.
• Workplace culture: This is really a corollary to the first theory. People that are very aggressive in pursuing their financial self interest will tend to be drawn to those professions that allow them to make a lot of money quickly. As people tend to gather in professions like investment banking, the culture of those institutions gets tainted with that same greed and aggression. I have heard many stories from friends and colleagues about the caustic, hostile and intense culture in the (formerly) most lucrative financial institutions. Anyone not out to make a lot of money for themselves or with an emphasis on other human values is bound to choose a different profession in exchange for a more pleasant working environment or be forced out. This creates a negative reinforcing cycle that ends up creating extremely aggressive and hostile institutions, both inside and out, over time.
• Rewarding the impression of success and value: There is also an implicit assumption in western culture that the people who make a lot of money are more important and possibly more valuable. This interacts badly with the workplace culture effect described above to result in increasing status for those who are making lots of money by being more greedy and aggressive. This perverse rewarding of values that would normally be quite low on our list of virtues starts to turn the world upside and is really a shame. This draws in talented people to this system of greed who would otherwise be inclined to do work with more social value. Talented and successful people get used to following the path mapped out for them by social rewards. In the same way one might pursue an A+ in school, these people see that pursuing jobs that will earn them a lot of money are the next step in their path of accomplishments. A big paycheck = A+. Then to survive in this culture of greed and aggression they must adapt or be spit out. Some adapt and some are spit out, but the result is that this system of greed attracts and retains those who are most aggressive and most talented, which is a not just a shame but a true tragedy.
  
  (As an aside, I am pretty sure a similarly negative reinforcing cycle is at play with our elected leaders. We do not seem to be electing the people most of us would most want to see at the helm. I will save a discussion of those dynamics for another time.)

So the system of greed that gets created keeps pursuing more and more money and higher and higher returns until outright fraud or ingenious deceptions are required to keep moving forward (e.g. Enron or the collateralized debt obligation industry laced with toxic subprime mortgages). Then the bubble bursts and we end up with the situation we have today.

So what is the alternative? I certainly don’t have the whole story, but I can see at least two key leverage points.

Figure out how to value longer term investments further from money: If we could convincingly evaluate the return on investment of educating our children, for example, we would probably be comfortable paying teachers significantly more. When we could see that the ROI and reward to risk ratio of paying to have a great teacher is on par (or probably better) than investing in a fancy new hedge fund, money will naturally flow in the direction of education and away from these hedge funds, most of which do not create anything of real value anyway. Certainly not enough to justify their returns and fame.

Tax financial transactions to slow the movement of money: I am not the first to propose this idea, but I like it alot. In today’s world, tremendously huge amount of wealth can transferred around the globe in a matter of a few milliseconds. On the other hand, labor and tangible capital move much, much more slowly. This creates dislocations and disinvestment that promotes huge instability. The fickle whims of global investors chasing return can move their money daily and as a result there is no patient capital that will see projects through to completion. This is very destructive and foolish. Especially in an era of Madoff Ponzi schemes and smoke and mirrors hedge funds, money can easily be siphoned off to institutions promising higher returns but who are not able to truly deliver. Real return on investment in the real world takes significant time. Putting a small tax on global financial transactions would slow the movement of wealth and begin to align financial capital flows more closely with labor and tangible capital flows.

Develop a new societal relationship to wealth: Another way to break this cycle is to not equate wealth with social value. It is a very deep assumption that those who have made more money have created an equivalent amount of social value but I believe this is false. More often major wealth is an indication of ruthlessness and greed. Certainly there are a few scattered wonderful people who were at the right place and right time and hit the jackpot (whether it is Powerball or a new startup), but these folks are the exception not the rule. I am sure that a comprehensive scientific study would confirm this belief of mine. Hopefully one day such a study will be done.

Imagine if we had a strongly progressive tax system that asymptotically taxed earnings so that it was impossible to earn more than $1M, for example. We can debate what the right ceiling is, but I would argue for a lower ceiling for reasons I will describe more here.

• Democratizing money and the good life: If no individual could earn more than $1M, this would be more than plenty for any one person. (I believe it is about $40,000 is where happiness starts to be inversely related to income.) Of course, there may be business opportunities or desires to create situations or environments that would require more money than that. But if no one person could do it themselves we would be forced to work together. In an era of the internet and the potential for global cooperation, there is a tremendous opportunity to pool resources to promote mutually beneficial projects that would not have been possible in the past. We can pool resources to develop new communities, to undertake new research, to start new businesses, etc. There are no longer significant inefficiencies associated with this kind of collaboration and in fact it would probably be a good system to reinforce that projects generate real social value rather than be ego driven vanity projects. Vetting by a group would strengthen ideas and project designs.
• Moderating the pace of our economy: Our economy is prone to overheating, creating booms and busts. I think it would be a good rather than bad thing to put a little sand in the gears by limiting how much anyone could make. People often say that such a progressive tax system would be a disincentive to work, innovation and progress. I disagree. I believe it would reintroduce the wisdom that comes from slowing down and taking more time to be thoughtful. To do the right things, not more things. More activity is not intrinsically valuable. Activity can be destructive, and in a world in which our fossil fuel energy stores are being depleted and the environment is at the breaking point with regard to carbon in the atmosphere, pollution and overharvesting, it is probably a good thing to slow down the whole system. This would slow down the overall economy, creating more time for people to spend time with family, friends and to work in their local communities on intrinsically satisfying projects and plans. Also, curbing the green instinct would be socially valuable and a secondary benefit to slowing the economy.

Thoughts? Comments? Reactions? I’d love to hear what you think.