Are you hurting the economy by going into finance?

Finance has become a magnet for the brightest graduates in STEM, and a recent research shows that this has grave consequences – such as a 6.6% cumulative loss in labor productivity growth...

Today’s email is a guest piece from Sungho Park, a junior in Princeton’s economics department who plans on pursuing a PhD in Finance or Economics after graduation.

At Princeton and other elite universities across the country, it is not uncommon for the “dream job” of an undergraduate to be working as an investment banking analyst or management consultant. The “greater financial industry” centered around NYC, along with the tech & entrepreneurship community centered around Silicon Valley, have risen to become two of the strongest magnets attracting elite university graduates. In comparison, engineering, government, academia, and legacy business corporations have lost their appeal significantly. 

A recent economics paper from Sciences Po titled “Finance and the Misallocation of Scientific, Engineering and Mathematical Talent” by Giovanni Marin and Francesco Vona (2017) provides quantitative basis to illustrate the costs incurred by this trend, which might be on your mind and has also been brought up by some of our recent guests, such as Professors Alan Blinder (former Vice Chair of Federal Reserve) and Robert Frank (a pioneer in behavioral economics). 

The loss in productivity due to STEM talents going to finance

Marin and Vona argue that, as we see in the Ivy League, the US financial sector has become a “magnet” for the brightest graduates, particularly in STEM (science, technology, engineering and mathematical fields). In fact, the “share of STEM talents grew significantly faster in finance than in other key STEM sectors such as high-tech, and this divergent pattern has been more evident for STEM than for general skills and more pronounced for investment banking.” This trend did not reverse after the 2008 financial crisis. 

There is also a “persistent wage premium” for STEM graduates working in finance, meaning that a STEM graduate would be much better compensated in finance than in STEM itself. 

Marin and Vona simulated a counterfactual model –– namely asking “what would have happened had students not gone into finance?” In the model, they fixed the level of STEM graduates going into finance to the level in 1990 and reallocated the excess of STEM workers to non-finance sectors. They calculated that finance attracted around 261,000 workers as of 2014, who would’ve otherwise worked in STEM. 

The researchers then calculated that the cumulative labor productivity growth in the whole real economy of the US over the period 1990-2014 was 34.35%, while the cumulative labor productivity growth in manufacturing over the period 1980-2007 was 135.42%. The share of STEM workers was 6.6% and 9.84% for the whole real economy and the manufacturing sector, respectively. 

Based on the data above, they eventually arrived at the conclusion that the brain drain of STEM talents into finance has been associated with a cumulative loss of labor productivity growth of 6.6% in the manufacturing sectors. 

The manufacturing sectors can be interpreted as anything that “makes a tangible product,” which can include pharmaceuticals, hardware and other engineering roles and related research positions. For example, if a mechanical engineer major ends up working for Goldman as a quant trader instead of for Tesla as an engineer, this would count as a loss for the manufacturing sector. 

Theoretical explanation for talent misallocation 

Why would it be a problem for a STEM graduate to work in finance and not in engineering? The problem lies in the fact that manufacturing is a tradable sector, and finance tends towards being a non-tradable sector. 

• A tradable sector is any industry sector that provides goods & services that can be traded across borders either across states or countries. And manufacturing is one of the most “tradable” sectors of the economy (Piton 2017). 

• A non-tradable sector is exactly the opposite –– the goods cannot be traded across borders. Hence, the consumption is exclusively local. For instance, restaurants serve people locally, construction is done locally, etc. These jobs would be considered non-tradable, as opposed to jobs in manufacturing wherein the product can be exported across borders. 

More tradable sectors have been noted to have a higher average productivity than less tradable sectors (Benigno and Fornaro [2013], Reis [2013]).  As tradable sectors are inherently more productive for the economy, investments into these sectors are inherently more fruitful. However, if an increasing proportion of human or financial capital go into non-tradable industries, which are inherently less productive, it can reduce the effectiveness of the investments and furthermore cause a slowdown in the economy. 

Investments of capital and resources from tradable sectors to less/non-tradable sectors, in theory, could cause a misallocation of resources from a productive to less productive sector –– hence decreasing the productivity of the economy, leaving it more prone to downturn during an exogenous shock, such as COVID-19. Hence, should more talent go into finance as opposed to manufacturing or more tradable industries, it could in fact hurt the economy. 

The world needs finance, but finance might not need you

Of course, there is no clear way to regulate our talents from going into the financial sector –– even “free-market” measures such as levying a tax on these employment choices can have unintended negative consequences. Perhaps only changes in social norm and what is seen as culturally desirable could alter this trend of financialization of our STEM talents, which we’ll soon discuss in our upcoming podcast interview with Rob Henderson. 

Regardless of the other criticisms of the financial industry, the best and brightest of our talents heading to finance at disproportionate levels can harm the macroeconomy, and it is definitely a trend that deserves greater reflection by the American society today. 

When asked about their choice of going into finance, many of our friends often respond with: “the world needs finance.” But it seems that the question should not be whether the world needs finance, but whether finance needs you, especially when you’re a STEM talent.

Nobody is arguing that the world should abandon finance, but that doesn’t mean your choices to go into finance don’t have consequences.

Note: While there is disagreement on whether finance is a tradable or non-tradable sector (like Zuegner [2013] considers “finance and real estate” to be a non-tradable sector), we can ignore the nuances for now and see it as at least a much less tradable sector than manufacturing. 

You may reach Sungho at sungho@princeton.edu.

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