SOMETHING IS NOT ROTTEN IN THE STATE OF DENMARK

But the winner-take-all explanation for the rise in inequality cannot be the whole story either.

The reason is that, like skill-biased technological progress, the explanation ought to apply to Denmark just as much as the United States.

A part of the answer is finance. The US and UK dominate the “high end” of finance—the investment banks, junk bonds, hedge funds, mortgage-backed securities, private equity, quants, etc.—and this is where many of the astronomical earnings have shown up in recent years. Two finance professors at Harvard Business School (of all places) estimate that investors who use financial market intermediaries pay 1.3 percent of their total investment to their fund manager every year, which over the thirty-year horizon of an investor saving for retirement amounts to handing the manager a third of the assets initially invested.⁴⁶ A chunk of change, but nothing compared to those who manage the hedge funds, private equity funds, and venture capital funds that epitomize high-end finance, where, at least until recently, you had to pay the managers between 3 percent and 5 percent of the amount invested every year. Given that the amount invested is growing steadily, it is no wonder some of these managers are becoming very, very rich.

Financial sector employees are now paid 50–60 percent more than other workers with comparable skills. This was not true in the 1950s, 1960s, or 1970s.⁴⁷ This rise in earnings is a big piece of the overall shift in top incomes. In the UK, which is the most finance-dominated large economy, between 1998 and 2007, employees in the financial sector, who represented only about one-fifth of those in the top 1 percent, swallowed 60 percent of the rise in earnings in this group.⁴⁸ In the United States, from 1979 to 2005, the share of top incomes going to finance professionals almost doubled.⁴⁹ In France, where finance still mostly means banking and insurance, the change in inequality was much smaller in absolute terms. Between 1996 and 2007, the share of national income going to the richest one-tenth of one percent of the population went up from 1.2 percent to 2 percent (it then went down during the financial crisis, but had recovered partly by 2014⁵⁰), but about half of that increase, it is estimated, is due to increasing earnings in finance.⁵¹

The superstar narrative does not fit finance very well. Finance is not a team sport. It is an industry marked, supposedly, by individual geniuses, people who can spot the particular irrationalities currently infecting the markets or identify the next Google or Facebook before anybody else. But it is hard to see how that explains why an ordinary manager in the financial sector is nonetheless paid extraordinary fees, year after year. In fact, most years, actively managed funds do not do any better than “passive funds” that simply replicate the stock market index. In fact, the average US mutual funds underperform the US stock market⁵²—they seem to have borrowed the language of individual talent but not the talent itself. A large part of the premiums paid to financial sector employees are almost surely pure rents; that is, rewards not for talent or hard work but for nothing more than having lucked out in landing that particular job.⁵³

These rents, much like the rents from government jobs in poor countries discussed in chapter 5, distort the entire functioning of the labor market. As the 2008 global crisis unfolded, caused in large part by a combination of irresponsibility and incompetence on the part of the masters of finance, a study reported that 28 percent of Harvard college graduates of recent cohorts opted for jobs in finance.⁵⁴ That ratio was 6 percent in 1969 and 1973.⁵⁵ The reason to be concerned about this is that if some job pays a premium unrelated to its usefulness, like the fund managers earning a fat fee for doing nothing, or the many talented MIT engineers and scientists hired to write software that allows stock trading at millisecond frequencies, then talented people are lost to firms that might do something more socially useful.

There is another problem. The salaries and bonuses of CEOs of the larger corporations are set by board of directors compensation committees, and these committees use the salaries of CEOs at comparable firms as a benchmark. This creates a contagion; if one company (say, in finance) starts to pay its CEO more, others not necessarily in finance feel they have to as well, to keep getting the best. Their CEOs feel undervalued compared to CEOs they play golf with. Consultants who help the CEOs compile a list of what happens in “comparable” firms are very skilled at selecting a sample of particularly high salaries; the high finance salaries tend to infect the rest of the economy as well. The practice of using salary comparisons to negotiate increased compensation has spread far beyond the largest firms, and even beyond the for-profit sector.

This is not helped by the fact that CEOs, everywhere and not just in finance, try very hard to pack boards of directors with people they feel they can control (or people who are only interested in getting paid their director’s fees). The result is that CEOs are often rewarded for pure luck; when the stock market valuation of the firm goes up, even if it is due to pure chance (e.g., world crude oil prices went up, the exchange rate moved in the firm’s favor), their salary increases. The one exception, which in some ways proves the rule, is that CEOs of companies where there is a single large shareholder who sits on the board (and is vigilant because it is his own money on the line) get paid significantly less for luck than for genuinely productive management.⁵⁶

Stock options probably contributed to the skyrocketing CEO salaries, by normalizing the idea that CEO pay was directly linked to shareholder value and nothing else.

One solution to the puzzle posed by Denmark might be that finance is much more dominant in the UK and the US than in continental Europe,⁵⁷ and perhaps a more attractive option for those countries’ elite graduates. Relatedly, stock options (and stock market–linked compensation more generally) are much more likely to get used in the Anglo-Saxon world, where more people are familiar with the stock market and where most reasonable-sized companies are traded.