I was asked recently why it is that market forces do not push down the wages of the top earners in financial services. The answer, it would seem to me, is that the profitability of the financial services sector is based on privilege, rather than normal economic activity, and it is this that drives hiring behaviour.

In a normal industry, where there is a profitable project, a number of different entrepreneurs have the ability to invest in this area. The act of investing produces a good that a consumer buys. The more of these goods produced, the lower the price that consumers will pay such that the profit making opportunity diminishes and the ability to pay higher wages/expand the business diminishes. This process is good for society since it provides more goods demanded by the public at lower prices. The entrepreneurs are motivated to hire additional people in order to invest in these areas increases profits to themselves. A beautiful system, I’m sure you’ll agree.

However, the profits of the financial service industry are far in excess of where they would be in a true market economy without fractional reserve banking/fiat currency/central banks. Profits within the industry are essentially a product of the net interest margin (difference between interest rates at the short and long end of the curve) and the outstanding liabilities (more credit lent means more profit).

The central bank’s action keeps the net interest margin wide since it buys government debt at the short end of the curve and has an inflationary bias. In addition, the ability of the central bank to continue to bail out the industry should it get into “liquidity” trouble encourages more risky behaviour – both in taking on additional leverage and taking additional duration risk. Hence the product of net interest margin and liabilities is artificially kept high by central bank action. These excess profits are paid for by the rest of society through higher inflation.

Given that the vast majority of the banking sector’s profitability is dependent on privilege, it makes no sense for a firm to hire additional people in order to exploit profit making opportunities – there are no opportunities. The rational response is to hire no one at all, except in the case where hiring defends and extends this privilege. This explains the army of remuneration consultants, the bank-funded pro-central bank economists, the lobbyists, the symbiotic relationship between government and banks particularly evident in the higher echelons of the US government where officials seem to pass between top positions in government and on Wall Street so easily.

Some hiring of people of course is inevitable in order that administrative work is done, and this is also beneficial in defending privilege since the industry can argue to the government, from whence its privilege comes, that it is an importnant provider of jobs. However, the insiders with the top positions are very reluctant to hire additional people since this would not increase their wealth though providing additional goods with demand, but rather dilute their privilege through more heads.