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The Great Wall Street Sucking Sound

By RANA FOROOHAR – Tue Mar 29, 2011

Ever wonder how investment bankers, a breed known in the past more for its social skills and golf handicaps than for its mathematical prowess, ever invented products like those crazily sophisticated, synthetic collateralized debt obligations that brought down the financial system? Well, they didn't. They hired rocket scientists to do that - a whole lot of them. In fact, Wall Street hires more math, engineering and science graduates than the semiconductor industry, Big Pharma or the telecommunications business. As one mathematician-turned-trader friend recently put it to me, why should he work on new high-tech products at Bell Labs when he could make five times as much crafting 12-dimensional models of the stock-buying and -selling behaviors of average Joes for a major global-investment house, which could then turn around and make massive profits by betting against those very patterns?

It's a question that's right at the center of the debate over the U.S.'s economic future. After the financial crisis, the banking industry secured massive bailouts by convincing us all that Wall Street was the grease on the wheels of the real economy. Banks provided the capital to create new businesses, after all, and if they weren't healthy, nobody else could be either. Of course, that position has become harder to defend as lending rates to new businesses have contracted post - financial crisis and economic growth has remained sluggish even as bailout money has ensured that Wall Street would mushroom in size. Amazingly, three years after the crisis, the percentage of the U.S. economy represented by the financial sector remains at historic highs of over 8%. (See how Americans are spending now.)

Now there's even more compelling historical evidence that Wall Street's favorite argument doesn't hold water. A new study from the Kauffman Foundation, a Kansas City, Mo. - based nonprofit that researches and funds entrepreneurship, has found that over the past several decades, the growth in size and importance of the financial sector has run in tandem with lower - not higher - rates of new-business formation. In the 1980s, when Wall Street really took off, the number of new firms created fell, and in the 1990s, it plateaued and has been stagnant ever since. Basically, the facts show the opposite of what Wall Street would have us believe. A number of factors explain that, but one of the most important, argue the study's authors, is that the financial sector is sucking talent and entrepreneurial energy from more socially beneficial sectors of the economy.

You can see it in the graduating classes of the country's top universities. Harvard graduates, for example, enter financial occupations at a far higher rate now than they did in the 1970s. It's a trend that accelerated markedly in the past decade, as the computerization of finance made the profession both more lucrative and more intellectually stimulating (one can now think about the 12th dimension rather than just golf). The proportion of graduates from MIT, for example, who went to Wall Street rose from 18% in 2003 to 25% in 2006. (See the 25 best financial blogs.)

The problem is that these are the types of people most likely to start the sort of dynamic, job-creating new companies that we need. No wonder economists like Nobel laureate Edmund Phelps speculate that the financialization of the U.S. and subsequent dampening of entrepreneurship may be at the heart of our long-term productivity slowdown (average productivity rates have been lower in the decades since the 1970s than in those before).

Whatever the corporate titans lobbying in Washington say, statistics show that it's new companies, not old, that grow the economy. Some 40% of U.S. GDP this year will come from firms that didn't exist in the 1980s. And nearly all the new jobs in the U.S. are created by firms less than five years old. "The political emphasis shouldn't be on making big firms work," says Kauffman Foundation head Carl Schramm, "but on helping new ones take root."

That's worth thinking about carefully, especially as we continue to let bankers off the hook by trimming the already inadequate budgets of the agencies that regulate them and shying away from restructuring the largest financial institutions in ways that would better protect consumers. Bankers will undoubtedly continue to push the story line that they are funding innovation. The question is whether it's the kind that's real or the kind that's synthetic.