The Allocation of Talent to Finance: Welfare, Growth, and Employment Effects

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The recent financial turbulence and its macroeconomic repercussions have sparked a discussion about the social benefits of financial trading. At the policy level, the discussion centers around the question of how to contain excessive risk taking by banks in view of explicit safety nets and implicit state guarantees. While the significance of this question cannot be overestimated, there is a different concern, which might be of equal importance for long-term growth and economic welfare, viz., that the financial sector attracts too much talent, which could produce larger social benefits in different occupations. The purpose of the proposed project is to investigate theoretically under which circumstances the allocation of talent to finance is excessive. To do so, we develop a new model, based on the noisy rational expectations equilibrium model of Grossman and Stiglitz (1980), in which agents who specialize in finance promote informational efficiency, but at the cost that they do not contribute to the production of real output. We study the impact of occupational choice on agents' welfare as well as on macroeconomic growth, production sector wages, and employment.