width=118Are financial sector workers paid too much? Not all of them are, of course, for there are poorly paid bank clerks and cleaners who count in this category. But is it possible to justify the enormous rewards earned - or should we say received - by investment bankers, hedge fund managers and private equity partners?

Most people would easily and quickly answer no. Certainly that is what Congressmen in the US, and Members of Parliament in the UK think. They are trying to cook up ways to discipline financial firms, albeit without conspicuous success so far, as demonstrated by the large sums stashed away for employee compensation by Goldman Sachs after its most recent profitable quarter.

But what does it mean to say that financial folk are paid too much? By what measure, and in relation to whom are they overpaid? Like many other people, I tend to believe that anyone paid more than me is prima facie over-rewarded, but I know this is not the most rigorous test I could apply.

Economists have been trying to produce more robust answers to those questions. Thomas Philippon and Ariell Reshef, for the National Bureau of Economic Research, have looked at a hundred years of data in the US, for pay in finance, and in other occupations. Their conclusions are fascinating.

They find that if you control for educational attainment and skills, financial jobs were highly paid until the Great Depression of the 1930s, higher than the quality of the people who held the jobs would imply. Then from the Depression, and the introduction of new and tighter regulation, financial sector pay reverted to the norm, and remained there until around 1990.

But from that date up to 2006 it raced ahead and, on average, employees in financial firms were paid between a third and a half more than similarly qualified counterparts elsewhere. We just don't know yet whether the crisis will cause another reversion to the mean, but some downward adjustment looks likely.

So there is some basis for saying they are overpaid, but why? Philippon and Reshef argue that regulation, or deregulation is a big part of the story. Deregulation increased the opportunities for innovation and trading, and for profit. There is also evidence to support that proposition from the observable fact that rewards in the less regulated parts of the asset management sector- hedge funds etc- are typically higher than in Security and Exchange Commission regulated competitors.

But is this a good enough explanation? As rewards went up, why did new competitors, prepared to undercut, fail to come into the market? In other parts of the economy, where we see excess returns, we usually look for some weakness in competition, or perhaps for the exploitation of insider information, which excludes new entrants. That may be part of the story, but competition for talent and for customers seems intense between investment banks and others, yet they have collectively been extravagantly rewarded at the expense of those customers.

An alternative hypothesis, which seems to fit the facts, recently emerged from the Paul Woolley Centre for the Study of Dysfunctionality in Capital Markets, at the London School of Economics. Researchers there argue that in fragile speculative industries (and finance has certainly been in that category in recent years) it is hard for investors to monitor those who manage their money. They can see short-term returns, but they do not understand very well how those returns are generated.

Managers can demand higher and higher returns in the upturn. But eventually these high returns reduce the payouts to investors (Bernie Madoff may be the reduction ad absurdum of this phenomenon) and slow the growth of the sector. Managers take more risks in search of higher returns to justify their pay, which at some point will lead to risk mispricing, and a crisis. We have seen the last part of this cycle over the last two years.

If this explanation is broadly correct (and it incorporates the deregulation point as well, as you can see) then what can be done about it? Politicians and regulators are exploring a number of options, from higher tax rates, through fines for certain types of bonus arrangements, to variable capital requirements. Higher taxes may be justified for other reasons, but are unlikely to solve the problem described. Regulators have struggled with the problem for years without finding a solution.

The Bank of England has described the way in which remuneration policy can create risks for banks and said that, as a result, it is of increasing interest and concern to supervisors and regulators. But that was written in 1997, and progress since then has been very slow, on both sides of the Atlantic.

Shouldn't shareholders take more of an interest? After all, it is their money which is at stake. They have earned low returns from financial sector investments, indeed those returns have been very strongly negative in the last two years. Shareholders seem to take little interests in pay policy. The arrival of say on pay provisions in the US - whereby boards will need to put their compensation policies to a shareholder vote in future- may focus minds, though the impact of similar provisions in the UK has been modest. Yet without shareholder pressure, all the signs are that the problem will persist.

Howard Davies, Director of the London School of Economics, was the founding Chairman of Britain's Financial Services Authority and is a former Deputy Governor of the Bank of England. Reprinted from Project Syndicate