The recent global debate over the pay of bankers has raised issues that are basic to economic theory, and to moral and political philosophy, simultaneously. One question concerns what level of pay is necessary in order to attract people to do a certain job, and to do it effectively. Another question concerns what level of pay would be appropriate, fair, or just to pay people to do that job. Both are entailed in the current debate on the pay of bankers (particularly investment bankers).

The G-20, and more recently the European Parliament, as well as individual countries (especially Germany, France and the UK) have promoted the institution of new norms to govern the pay of bankers, requiring for example that their pay should be spread over a number of years, or be provided in part in the form of shares or other instruments, the return of which will depend on the success of the bankers’ strategies over a longer period than previously.

There are incentive-based arguments for these reforms, which suggest that altering pay packages in such a way will reduce the propensity of bankers to engage in inappropriate risk-taking (socializing risk while privatizing benefits). However, there are also, implicit in the political discussion, concerns about fairness.  Financial sector rewards have been unusually large relative to those prevailing in other sectors of the economy, even for people with otherwise apparently comparable qualifications.

The spokespersons of the banking industry claim that very high rewards for bankers are necessary in order to attract them to do the work which is required.  Implicit here is the idea that the skills which are required to perform this work are based in naturally occurring talents which are sparsely distributed, are costly to acquire or are greatly onerous and unpleasant to employ. For one or another of these reasons, in the absence of suitably high rewards, individual banking firms are likely to lose the workers they need to function — if the rewards they offer are not sufficiently high.  By extension, such firms are likely to shrink or go bankrupt, or to be forced to move to other more permissive jurisdictions, if they wish to avoid such a fate. Countries introducing legislation forcing the industry to dampen wages may similarly experience a painful and perverse outcome, losing revenues and employment and the economic benefit of financial intermediation services.  Is this a reasonable portrait of the likely consequences of the proposed reforms to the banking industry?

In the labor market described by standard economics textbooks, workers are a homogeneous and interchangeable ‘factor of production’ which competes on wages to be employed.  Similarly, there is intense wage-based competition by profit-maximizing firms, within a given industry as well as across different industries, to attract workers. In such an environment, workers are paid what they are because that is what is necessary to attract them, and because it is profitable to do so at that wage (in view of their incremental contribution to output).  A wage ceiling which makes it impossible for a specific firm or industry to attract workers will (if there are no reasons to assign social valuations to the goods produced which are lower, or to the inputs used which are higher, than the market prices for them) create a ‘wedge’ which obstructs efficient decisions and reduce the economic output of the society.  This is the conceptual picture which defenders of current compensation practices in the banking industry have in mind.

The standard portrait does not seem to provide a persuasive portrait of wage determination in the global banking industry for a number of reasons. First, wage differentials have been and remain very large, between the financial industry and other industries, including many which appear to employ persons with broadly comparable skills (such as MBAs from prestigious business schools). Second, wage differentials are so large that it seems highly unlikely that they are needed on the observed scale to bring about participation or to elicit effort.   Other industries also involve long work hours and employ highly talented and educated persons. Indeed, many such industries appear to employ skills (e.g. engineering) which require even more specialized training and arguably involve greater rarity than the “generalist” pool from which finance professionals have been heavily drawn.

There are other ways of thinking about wage determination which may be pertinent to the case of the banking industry.  The financial industry appears to benefit from large “rents”, or supernormal returns. These may result from barriers to entry based on the need for large initial pools of capital, the hoarding of specialized knowledge generated from past experience or position of centrality in the market, and other factors.   In such an industry, wages will typically include a component of rent sharing.   The sharing of the spoils in order to maintain an internal “moral economy” which is conducive to success reflects the desirability to the firm of avoiding the disruptions to production which result from employee turnover or non-cooperation.  In large partnership-based firms such as Goldman Sachs, the workers, or at least the elite among them, are prominently and explicitly among the rentiers.

In an industry in which rent sharing is present, individual firms may well face the necessity to compete fiercely for specialized workers with other firms in the industry. Competition within an industry and the presence of rent sharing in an industry are entirely possible to reconcile. It can be true at one and the same time that global investment banks compete fiercely for available workers, and that those workers are collectively paid more than they need to be in order to bring about their participation in the industry and to encourage them to work effectively. It follows that an individual firm may have great difficulty in introducing wage restraints in such an industry, but the industry as a whole may be able to do so without loss to its productive capabilities. It is for exactly this reason that recent moves to bring about wage restraint in the financial industry, as an object of national and indeed global public policy, may be justified.

Global investment banking is an industry in which pure shareholders often (as in the case of Goldman Sachs) play a smaller role in decision-making than the elite worker-proprietors who run the banks and whose wages account for its primary costs.   It is hardly surprising that the bankers who are the primary beneficiaries of this system should vociferously claim that wage restraints will destroy their ability to “create value”.  It is an empirical question how far relative wages can be lowered without causing a reallocation of workers from banking to other industries.  A coordinated lowering of relative wages need not, moreover, have any substantial impact on the competitiveness of individual firms or the viability of specific geographical locations of the industry (especially if, in light of the globalized nature of the banking industry, such restraints are globally coordinated). The goal of such a policy, once the fever pitch has been lowered, is to turn banking into an “ordinary” industry.

Insofar as the financial sector has grown “too large”, or its products are in part socially harmful, public policies which incrementally direct valuable resources from it toward other sectors may create rather than destroy social value. However, there are more direct and effective means than wage restraints of establishing a healthier relationship between the financial and the real economy.  There is a respectable case for wage restraint, but if it is conceived of as mere ‘leveling down’ it attacks the symptom rather than the cause.  Changing the qualitative structure of bankers’ incentives so that they avoid certain actions and engage in others is more promising.  There is, however, no substitute for addressing the true root cause: supernormal returns to financial speculation.  Far better to lower the spigot than to skim the froth.

The economic crisis in Greece, which has roiled all of Europe, has been presented by the mainstream media as arising from the mismanagement of economic resources.  In fact, the real roots of the crisis and others like it are in the malfunctioning of political institutions.

Politics, according to the famous formulation of Harold Lasswell, is about who gets what, when and how.  Although all political institutions produce an answer to these questions, well-functioning ones must produce answers that are, at a minimum, not manifestly irrational (for instance, in the sense that they are worse for nearly everyone than those which some alternative would have brought about) nor manifestly unjust  (for instance, in the sense that they systematically favor the already advantaged over the already disadvantaged).  However, many political institutions fail to satisfy one or both of these criteria.

One of the most common forms of such irrationality is that the public finances become hostage to a collective action problem involving different influential actors in the society, who treat the public fisc as a common pool resource, seeking to draw the maximum from it while contributing the minimum to it.  This collective action problem is not a necessary consequence of the plurality of actors and their interests, although that plurality is a necessary condition for its occurrence.  In fact, the crisis of the public exchequer is a reflection of the weakness of the state in relation to the society as a whole.

A weak state is very often, as a matter of description, the ineffective slave of many masters and the ineffective master of many slaves.  It is neither the effective slave of some nor the effective master of all.    The immediate consequence of this condition is that the weak state can neither effectively raise resources nor effectively spend them.  It raises too little to pay for what it spends.  It does not raise money where it should and it spends on the wrong things.

When this condition becomes deep-seated, it leads to a self-reproducing cycle, in which the weakness of the state contributes to its weakness.  The chronic fiscal deficits to which this political situation gives rise can be readily tolerated if the national economy is able to generate an increase in national income sufficient to counterbalance the increase in the national debt.  If not, the state must either attempt to overcome its weakness in relation to the society (even if initially through measures which reveal that weakness, such as the inflation tax) or face the consequence of its weakness, in the form of fiscal crisis. Fiscal crisis in turn implies the necessity of defaulting on debt wholly or partially, or raising revenue and lowering expenditure abruptly.  The former may provide a salve (especially if the situation is not so serious that fresh borrowing is needed even to maintain current expenditure) but risks punishment from creditors in the form of higher costs of borrowing and no guarantee that the drama will not be repeated.   The latter restores fiscal probity at the cost of generating severe adverse consequences for human beings, and for public investment in national development, while also providing no guarantee that the drama will not be repeated.

From the perspective of the accountant, there are only two routes out of this dilemma.  The first is to turn a relatively stagnant economy into a more dynamic one that is capable of growing enough to afford the cost of the broken relationship between state and society.  The second is to establish a new relationship between state and society in which the state is both more effective master and more effective slave of the social interests.  In practice, these two routes are not independent but are more often than not deeply intertwined.  The national economy is relatively stagnant in part because the state cannot act effectively to invest and to create the conditions of sustainable growth.  The repair of the relation between state and society is the sine qua non of sustainable growth and development.

What of Greece? Greece has had a rate of economic growth that has been respectable and may have sustainably accumulated debt were it not for the change of mood in the global market.  To this extent, Greece is not fully responsible for its situation.  Nonetheless, it has suffered a collapse of confidence because it was vulnerable to one.   Its national economy is unable credibly to promise the extent of future dynamism necessary to reassure its creditors (in part because fiscal constraint will undermine the public investment necessary for future growth and development).  The creditors would in turn not have been able to demand that reassurance had Greece not pursued a leveraged path.

Now that the crisis has struck, its golden chains to the Euro prevent Greece from pursuing the low road tactic of nominal exchange rate depreciation as a means of spurring growth.  The alternative low road tactic of real exchange rate depreciation (the lowering of real wages and costs) is available to it, but is socially painful in the extreme, and unlikely to be an ultimate solution.  Default may also not provide a salve even in the short run, due to the dependence of the Greek economy on borrowing to finance current consumption (i.e. its primary fiscal deficit).  Nor does it provide assurance in the long run, as the fundamental weakness of state in relation to society make it difficult to exclude recurrent crises or their endemic equivalent of chronic fiscal constraint, even if Greece continues to grow moderately.

Greece, like every country before it that has been in such a situation, has no alternative but to reform the relation between state and society, regardless of what desirable reforms may take place to the international economic system.  A functioning state must be capable of taxing and must be capable of saying no.  It must make sound investments and must productively organize economic life. However, none of this suffices for political institutions to be well functioning. Throughout the world there is a choice between a more democratic and socially inclusive route to the emergence of a capable state (which in turn serves the ends of democracy and social inclusion) and a more authoritarian and non-inclusive route (which serves the few).  Only one of these roads is desirable. Finding it is the work of politics.

Who produces the knowledge some believe we have about development? And who consumes it? Plentiful experiential evidence suggests that ideas about development are largely produced in the developed countries, and crucially, legitimated in them. They are also often peddled in Southern countries by Northern institutions, where to varying degrees they receive ‘take up’.

Without the legitimization provided by Northern institutions (whether universities, aid organizations or think tanks) those ideas that are produced in the South fail to capture broader attention, and can even fail to enjoy much influence in their home countries. Moreover, there is reason to believe that the ideas which gain prominence are not necessarily the ‘best’ but rather those which happen to be selected through the prevailing selection mechanisms, involving (sometimes subtly and sometimes grossly) politicized institutions and biased media.

Development has flourished as an institutionalized discourse and as a set of practices for 60 years.  However, ideas about development continue disproportionately to be produced in certain places, and authority is largely bestowed upon them in those same places.  The fads which serially sweep the world of development theorists and practitioners (for instance, currently the idea that randomized trials are necessary to evaluate the effectiveness of development interventions or that ‘aid’ is counterproductive) invariably emanate from the North. This fact about the flow of ideas draws little attention.  That inattention seems at first surprising, but the studied disregard of the obvious is not altogether unexpected in a field characterized by enthusiastic use of euphemisms (among the least bewildering of which are ‘technical cooperation’ and ‘capacity building’).

An empirical study of who produces the reigning ideas in development studies (and by extension in development policy), and to what extent these ideas gain currency because of where they are produced and who first favor them, cries out to be done.  (A recent article by a group of World Bank researchers gives some measure of a related but distinct problem – the disproportionate attention paid in economics journals to the North.)  However, the empirical researchers littering elite academic and policy institutions who are busily attempting  to identify with statistical precision the effects of the latest micro-intervention are not very interested in this.

What are the barriers to a more equitable world pattern of ideas production, legitimization and dissemination? As importantly, what effects would we expect that a more equitable pattern would have?

The current, and sadly entrenched, inequalities in ideas production have their origins in international differences in the resources devoted to research (whether ‘basic’ or applied), weaknesses in the academic and policy institutions in the South, even in those countries which are now gaining in importance, and path-dependent reasons for the lock-in of the position at the global commanding heights of ideas production arrogated by Northern metropolitan centers.

Invigoration of Southern academic and policy institutions can be aided by material resources but often requires other contributions.  The interpersonally interdependent ‘team based’ nature of much intellectual production makes it hard to establish or revive intellectual institutions without careful and extended nurturing.   The subordination of these institutions to political establishments, national or international (often abetted by a financing model in which projects and consultancies are made essential to the survival of both institutions and individuals) has corrupted or destroyed once flourishing educational and research institutions (of which it is not hard to provide a long list) or made for unfertile soil. There is of course some shared responsibility here.

Some years ago the World Bank helped to establish the Global Development Network as an ostensibly independent initiative to foster research on development in the South.  In fact, the Bank was unwilling to un-tether the apron strings, maintaining a subservient organization in perpetual tutelage to the Bank’s ideas as to what constitutes good research. The same is true of various donor driven research initiatives in specific regions (such as Sub-Saharan Africa).   The real solution is to create independent regional research funds with permanent endowments or with financing tied to transparent formulae which are independent of donor whims.  These research funds can in turn seed independent institutions which have the power to question, criticize, produce and legitimate ideas through bona fide intellectual scrutiny.  Competition in the production and dissemination of ideas can turn development economists from ‘yes men in the halls of political economy’ (to borrow George Stigler’s memorable phrase) to real servants of society.