[Noah Smith] The Riddle of the Wall Street Brain Drain

Nowadays, if you’re a smart college graduate, Silicon Valley and its tech-startup scene is the hot place to be. But 10 years ago, it seemed like everyone with a brain and big ambitions wanted to go to Wall Street. The worlds of investment banking and trading were a golden ladder to the good life.

Why did so many smart kids go into finance -- and why do so many still do so? One fairly obvious reason is that finance pays a lot of money. Maybe that‘s both cause and effect -- talent could be drawn to the sector because of the high salaries, or the salaries could reflect the talent level.

This flow of smart people to finance inevitably spurs talk of a brain drain that leaves other industries begging for skilled workers. Some of this is because Wall Street doesn’t really have the greatest reputation among an awful lot of people. Even before the 2008 crash, there was a widespread notion that finance doesn’t contribute much to society. “I create nothing. I own,” declared Gordon Gekko, the fictional buyout specialist in the 1987 movie “Wall Street.” The stereotype is that finance is a parasitical activity, an artifact of a legal system that allows smart people to suck up what economists call rents from the rest of society by shuffling ownership of productive enterprises from person to person.

If that’s what finance is, then it’s an absolute tragedy when the finest minds go into the industry. If the smartest people waste their time trying to trick each other -- and the rest of the country -- out of money and exploiting holes in the legal system, it means they’re not working on creating products that will benefit society. Would we rather have Harvard graduates creating new solar cells and self-driving cars, or new kinds of opaque, exploding mortgage-backed bonds?

Of course, this popular impression of Wall Street goes way too far. In reality, finance is absolutely essential to the functioning of a modern, productive economy, which needs to borrow many billions of dollars every day just to function. Corporations must issue bonds and sell stock to finance investment, startups need to do initial public offerings to raise the capital to grow, people need mortgages to buy houses and everyone needs a retirement-savings account. Without finance, the US and most other countries would be much poorer.

But with that said, is it true that many of the brightest minds are being wasted? New research from economists Michael Bohm, Daniel Metzger, and Per Stromberg has some evidence from Sweden. Their finding: The finance industry, at least in Sweden, hasn’t been nearly as big a brain drain as people think.

Bohm et al. take advantage of the fact that Sweden’s universal-military service requirement means that everyone gets an IQ test. Using IQ as their measure of natural talent, the authors look at how the flow of smarts to the finance industry changed during the great boom of the 1990s and 2000s. Here is what they report:

Despite finance wages having increased dramatically in Sweden during the period 1991-2010, particularly at the top of the wage distribution, we do not find any … increase of talent in the financial sector. Both average talent in finance and the fraction of top talented workers going into finance remain roughly constant.

If you’re worried about financial brain drain, this is good news. Although the US might be a different story, it’s notable that skyrocketing wages in the finance industry failed to lure a higher fraction of smart people into Sweden’s industry. That implies that finance’s wage premium in that country wasn’t due to an increase in the talent level. In fact, some economists who study the US have also found that human capital doesn’t explain the rise in pay.

However, this is bad news for those concerned that finance is a drag on the economy. If extra-high finance industry wages aren’t due to a higher concentration of talent, then there must be some other reason Wall Street generates such a flood of riches.

One possibility is the shift in developed nations toward services -- rich countries simply might be specializing in providing financial services to poorer countries that rely on things like manufacturing and mining. Another possibility is that the information technology boom that accelerated in the 1990s required a larger financial sector. But a third possibility is that the industry’s critics are right, and that Wall Street collects huge undeserved rents from the rest of the economy. Even without a brain drain, there might be some serious waste going on.

By Noah Smith

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion. –Ed. 

Bloomberg