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February 16, 2007

Risk, Reward and the New Class

Friedrich von Blowhard writes:

Dear Blowhards--

As you know, I am a small businessman. As a result of what I do I spend time talking with investment bankers and bankruptcy lawyers. In the process I have learned a little (okay, very little) about finance. I want to talk about one of the concepts I stumbled across in finance that seems to make a lot of sense. That is the notion of a general and positive correlation between risk and reward. This is a pretty basic concept; the Wikipedia article on risk (which you can read here ) puts it this way:

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

This certainly resonated with my personal experience. As the owner of (and sole investor in) a small business, I had the potential to make more money than I had in a previous career as a salaried employee, but I had to take considerably more risk to get it. And this seems true of small businesses as a class. It appears from reasonably careful studies (such as those quoted in this story) that around half of all small businesses close in the first five years of operation. That implies a roughly a 13% annual failure rate. That number apparently rises to two-thirds in a decade, which would imply that in the second five years the failure rate drops to around 7% annually. Although the story implies, no doubt accurately, that some business closures are not complete crash-and-burns, I know from personal experience that the vast majority of such terminations are fraught with emotional and financial loses.

Pondering the notion that increased risk ought to imply increased reward, I was struck by the notion that society might see a lot more entrepreneurship if it adjusted income taxes for the downside risk associated with a given level of earnings. It seemed unfair to tax a small businessman who earned a $100,000 profit by betting his own money exactly as if he was collecting a $100,000 salary from an employer who was absorbing the associated downside risks. After all, if the skill or luck of a small businessman turns bad, he might make no money at all the next year, or more to the point, he might not just lose his livelihood, but his savings and his house as well. I can remember in my first decade in business the peculiar sensation of being required to personally guarantee the debts of my business, something I do not remember ever being required to do as an employee.

The Risk-Reward Curve and Its Outliers

Playing with this notion, I even constructed a rough risk-reward curve for society as a whole. Well, the axes lacked numbers, but as I recall the same was true of the graphs in my college econ textbook.


After I sketched this out, it dawned on me that there were a number of professions that were way off the general curve. Doctors, lawyers, and accountants, for example, made a lot of money but did not have to put much money at risk to earn it. At least I never remembered seeing a single Going Out of Business Sale: Medical Supplies Cheap sign posted on any doors in the medical buildings I ever visited.


As the years went by, I saw an increasing number of stories in the newspaper about another group that was likewise off the standard risk-reward curve: corporate CEOs. I remember reading an article in the early 1990s on the then-rising trend of rewarding such executives with stock options in order to better align their interests with those of their stockholders. (This approach to compensation really took off in 1993 after the Clinton administration decided that CEO salaries in excess of $1 million would no longer be tax-deductible.)

I noticed a little flaw in the alignment between CEOs and stockholders that stock options were supposed to provide, however. If the stock of the corporation rose, the CEO made a killing, especially relative to the amount he had invested (i.e., nothing.). However, if the stock price fell, he or she did not lose a thing. Heads the CEO won big, tails the ordinary stockholder lost. I thought: why not lend the CEO money to buy stock in his or her corporation? If the purchased stock rose in value the CEO would make a lot, but if the stock lost value the CEO would lose his or her shirt, just like the ordinary shareholder. Then interests would really be aligned.

Oddly, none of the CEOs (or the members of their corporate compensation boards) seemed to find this obvious logic compelling.

And then more recently I started to notice a lot of stories about the stupendous compensation being collected by some hedge fund managers. I also noticed that this compensation seemed to work a lot like that of corporate CEOs, very good in good years, and with no particular downside in bad years. As this story points out, the trader whose ill-considered bet on natural gas prices cost investors in the Amaranth hedge fund some $5 billion last year was eventually sacked in disgrace. However, it probably softened the blow as the ex-trader sat at home watching TV and drinking beer in his underwear to remember that in 2005 he had earned $80 million.

To a small businessman bankrolling his own business, this sounds like going to Vegas with a group of rather simple-minded people who have agreed to make good your losses, but who have generously agreed to allow you to keep a big piece of any winnings. Yowsa!

So How Are Risk-Averse Professionals and Managers Doing?

Over time, I kept track of what was going on with the members of my pet risk-averse group of professionals and corporate/financial managers. I discovered that academics had given this group had a name, either The New Middle Class or, for brevity, The New Class. I also noticed that this group seemed to keep getting a better and better deal from our society. Doctors, of course, are big wheels in healthcare (and generally rake in around 20 cents on every additional healthcare dollar spent); as everyone knows, the healthcare sector has expanded over the past 40 years from a puny 5% of the 1965 economy to over 15% of the much, much larger economy 2007 economy. (If you have been deceived by the hype that managed care has crushed doctor earnings, you might check out this summary of what doctors earn.)

According to the American Lawyer, it appears that the largest law firms have been increasing their billings at a clip of roughly 10% a year in an economy that is not growing at remotely that rate. According to this story, average partner compensation at these firms was almost $1 million annually as far back as 2004, a number that has no doubt since been exceeded.

As for CEOs of public companies, this story in the Christian Science Monitor points out that while in 1980 CEO compensation was a measly 41 times the pay of the average worker, in 2003 CEOs were taking home 500 times the pay of the average worker. Again, I am not aware that the last 4 years have seen this trend reverse itself.

And as for hedge funds, according to this story from Reuters, assets managed by hedge funds increased 29% in 2006, hitting $1.43 trillion dollars. (BTW, this number almost certainly includes some of your pension fund money, whether you know it or not.) Since hedge fund managers are paid (among other ways) on a percentage of assets under their management, well, they are obviously doing even better than they were in 2005.

But no doubt my group of highly rewarded yet risk-free experts and managers, the best and the brightest of our society, use their great brains to realize remarkable results for the rest of us, right? I mean, without the genius of the current crop of admittedly highly compensated CEOs, public company profits and shareholder returns would be in the toilet, right?

Well, maybe not. I happened to read a 2005 paper by Ian Dew-Becker and Robert J. Gordon of Northwestern University, Where did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income. (You can peruse this paper here). In it I saw some data that suggests that our highly compensated CEOs are not doing as well by their shareholders as their more poorly compensated predecessors 50 years ago did:

[I]t is immediately clear from Figure 3 that the share of before-tax corporate profits declined from about 13 percent of domestic income in 1950 to about 11 percent in [the first quarter of 2005.] These profit shares place some perspective on recent debates about whether productivity gains have gone disproportionately to [shareholders. In fact,] there has been a long-term decline in the profit share. [emphasis added]

And as for the results that investors have realized at the hands of hedge-fund managers, well, here is what The Economist had to say in the November 18th-24th 2006 edition (I was unable to find a copy of this online, at least for free):

The trouble is that hedge-fund managers are not producing the kind of bonanza they used to in the days when George Soros, the man who famously broke the Bank of England on Black Wednesday in 1992, dominated the sector. In the 1990s, their compound annual return was 18.3%; since 2000, it has been just 7.5%...This creates a problem for investors. In a period of low inflation, the fees charged by hedge-fund managers absorb a large proportion of nominal academic reckons the hedge-fund take can be as much as 40% of portfolio returns. That makes it hard to see how the process can be worthwhile for the client. Of course, this system is extremely good news for the managers themselves. Hedge-fund titans regularly top the list of the great earners [of the world], thanks to the performance fees that kick in when they do well.

And as for the social outcomes being offered up by lawyers and accountants, well, all I have got to say on this topic can be conveyed briefly by referring to some of my earlier posts on Enron, and tobacco litigation. (I will defer my comments on the state of U.S. healthcare to another time.)

What's the Impact of All This Reward & No Risk for The New Class on Everyone Else?

Pondering on all this, one day I was struck by a strange thought. If this new class has been steadily increasing its share of the rewards of the U.S. economy while refusing to absorb any of the risks, what impacts has this had on, well, everybody else? How are those outside the golden circle of the New Class faring?

The data of Mssrs. Dew-Becker and Gordon in the paper referred to above suggest that the New Class has not been very good at sharing with the other children in the sandbox:

Our most surprising result is that over the entire period 1966-2001, as well as over 1997-2001, only the top 10 percent of the income distribution enjoyed a growth rate of real wage and salary income equal to or above the average rate of economy-wide productivity growth. Growing inequality is not just a matter of the rich having more capital income; the increasing skewness in wage and salary income is what drives our results.[emphasis added]

Dean Baker summarizes the impact of the New Class on the rest of the economy (in a piece you can read here):

The country has seen a sharp growth in inequality over the last quarter century, as most workers have seen almost no increase in their wages even though productivity has increased by more than 70 percent...While there was a redistribution from wages to profits in the 80s and 90s, the upward redistribution that has kept most workers from benefitting over the last decade has been entirely from workers at the middle and bottom to workers at the top. In other words, the reason that autoworkers, teachers, and dishwashers are falling behind is that doctors, lawyers, CEOs and college presidents are walking away with so much of the pie.

BTW, the upward redistribution from wages to profits in the 80s and 90s that Mr. Baker refers to was as we have seen above was modest and temporary; remember that the long term rewards to capital appear actually to have trended downward over the past 50 years. (I'll be getting back to that important point in a future post).

Well, if the rest of society has done poorly on the reward front, how is it doing on the risk side of the equation? While bankruptcy data is by no means a perfect measure of such things, I think that it is at least suggestive. Elizabeth Warren, a Harvard Law School professor comments in her 2002 paper: Financial Collapse and Class Status: Who Goes Bankrupt? (which you can read here) certainly suggests that downside risk remains alive and well in the U.S.:

From 1991 to 2001, the number of households filing for bankruptcy in the United States rose by 66 per cent. This jump was all the more remarkable because it occurred during a long-running economic boom that yielded record profits on Wall Street, low unemployment, and negligible inflation.

According to Ms. Warren, the risk of financial collapse has not only risen, but is by no means concentrated at the very bottom of the pile:

These data [on occupation, education, and home ownership] make it clear that the sharp rise in bankruptcy filings cannot be attributed to a large number of chronically poor debtors (people with no skills and no prospects) who end up in financial collapse. The data presented here make it clear that, whatever their current economic circumstances, the families in bankruptcy share many of the same educational, occupational, and home buying experiences as other middle-class Americans. [Emphasis added]

But that does not mean the risk is distributed equally; oh, no:

[T]he proportion of workers who are sales clerks and construction workers is about the same in bankruptcy as it is in the general population...There remains a pronounced divergence at the very top, with doctors, lawyers and aeronautical engineers markedly under-represented in bankruptcy [relative to their numbers in society]. [Emphasis added]

Yep, those risk-averse New Classers definitely know something the rest of us do not. But what is it? How do they so successfully defy the risk-reward curve? How do they float above the rest of us earth-bound types?

I will be poking into that topic in my next post.



posted by Friedrich at February 16, 2007


I don't think you're quite right about lawyers. I'm a self-employed lawyer, and at least in my observation, lawyers take on a lot of risk. Yes, on average we are well-compensated, but lawyers often put a lot of their own resources on the line in hopes of big returns. If you've ever seen the movie version of A Civil Action, there's a scene where Schlictmann's (is that his name?) office is basically cleaned out after he loses a big lawsuit. That sort of thing happens. I've got cases that are anything but a sure thing, but I enjoy working on them, and I have put a not-insignificant amount of my personal money on the line in litigating them.

Now, when it comes to the more transactional sorts of law, with monied clients paying handsome bills, you're more correct -- there's not a lot of risk there. But for many lawyers, there is a great deal of risk.

Posted by: James on February 16, 2007 9:18 PM

Well, as an investor who got burned all I can say is that between New Class Hedge Fund Managers (shark attacks) and New Class Corporate CEO's (golden umbrellas) and New Class Investment Bankers and their New Class Analists (conflict of interest, anyone?) and New Class Brokers (preferred treatment for preferred clients) the odds are severely stacked against "the little guy," on Wall Street.
Then again, maybe I was just stupid. \o/

Posted by: ricpic on February 16, 2007 10:19 PM

A great piece, and I'm not disagreeing at all on the basics. I think that James is right about lawyers, though. An MD is guaranteed a high upper middle class level or above. (I happen to know of one who's happy to live at a middle middle-class level, and I feel like selling tickets for people to go see her -- a living fossil). But passing the bar isn't a guarantee -- I know a fair number of ex-lawyers, and some of them aren't doing well in their new trade either.

I'd also note that long-term risk is increasing for labor. A GM-type worker with benefits and a guaranteed job is increasingly atypical. More and more people are contractors, temps, and day labor. In fact, some contractors (in janitorial for example) are fake entrepreneurs, earning $8 / hr., controlling no capital, and dependent on a single employer.

Even before recent changes, the risk/return equation worked against entry-level business. Someone with limited financing can lose it all on one hand, whereas someone with deep pockets can play 20 hands, lose ten, and come out way ahead. (I'm assuming he wins the big ones, of course).

My brother is a startup (restaurant), and I wonder whether his marriage would survive failure. He's done everything right, gets great reviews, and his business is booming, but he's got high-interest loans and he's having trouble refinancing. Right now he's working for the lenders, and a downturn would kill him. (Someone with deep pockets would be home free by now, because he wouldn't have the debt, and someone with very deep pockets could do ten restaurants and win with half of them)

One word sums up a lot of this: finance. Investors, creditors, and money managers are the winners. Business managers win too, but a lot of them are pramarily in finance (Enron, to my knowledge, contributed nothing to power production, oil exploration, or anything technical).

There's more to it, of course. Some business managers revolutionize business practice (Walton), and some introduce technical changes (Gates). But a tremendous amount of the big money is purely finance.

Posted by: John Emerson on February 17, 2007 8:29 AM

Check out what Ron Paul has to say about transparency at the Fed...

Posted by: Charlton Griffin on February 17, 2007 9:27 AM

I like this New Class idea and theory. It seems to explain a lot. Hmmmm. More later.

Posted by: Michael Blowhard on February 17, 2007 9:41 AM

Very interesting piece. I too like this New Class concept and distinction.

The superficial rejoinder to your idea about taxing low risk high income at a higher rate than higher risk large returns is that it’s already done though our lower rates of tax on capital gains. The really big payoffs from entrepreneurial activity (even when we’re not talking at the centi-million dollar and above level), come from such activities as taking your company public, or as is usually available at a lower level, selling it to a larger one. Those gains are capital gains.

But the rejoinder is how much risk is involved in the capital gains multi millions that CEO regularly receive though stock options? At most it’s the risk of zero super bonus if the stock does poorly, versus a huge upside if it does well. But CEOs and other highest tier executives nearly always get some sort of fat package even if their company does poorly, just not AS fat. It does seem to me we should take care to close loopholes which allow those sort of pay packages to get converted into capital gains.

What’s truly behind this phenomenon it seems to me is the massively increased leverage which globalization gives to those who manage to be at the top in areas that benefit greatly from global markets. The most popular actors make double digit millions per picture while highly skilled and beautiful or charismatic actions of only slightly overall appeal (or sometimes just not quite the right breaks are the crucial times – promising script becomes a flop etc.) paid only fairly well, or maybe not well at all. What I’m saying is that the relationship between being at the very top and being damn close to as good is exponential in income results.

The same is true of the CEO of GE or Exxon-Mobil.

As well at lot of things turn out to be sham and hustle and salesmanship. Sometimes knowingly that and sometimes as a product of wishful thinking and taking the long main chance. Hedge fund managers sometimes do dazzling presentations based on past industry returns and perhaps impressive seeming new algorithems and then who knows? It might not work out well. For the investors.

I too think there’s something obscene about the income those in the most leveraged positions at large global corporations and in finance are increasingly garnering – just because they’re SLIGHTLY better on average than runners up, with a whole lot of gaming the system and fakery going on. The trouble is it’s hard to come up with effective governmental ways of ameliorating this unfairness (it feels like that to most of us at the gut level) without killing the high level entrepreneurial goose lying the eggs. There’s an awful lot of free riding on that goose, I agree.

Posted by: dougjnn on February 17, 2007 11:58 AM

Physicians were an example used eons ago in sociology courses where the topic was financial reward. I think the sociologist who posited the following was Otis Dudley Duncan, but I'm dealing with a 40-ish year-old factoid and might be mistaken.

Anyhow, the conceptual nub is that jobs that many people are capable of doing (ie, where there's a lot of potential competition) tend to be less well rewarded than tasks rerquiring rare skills, much specialized training, etc.

A physician has had a long period of training where his income was small or nil. He has to have a more than simply above-avrage intelligence (though super-high smarts aren't a requirement). And he has to have the stomach for dealing with a lot of unpleasant things -- blood, guts, body wastes, etc. Plus, his failures are often in the form of the death of a patient; dealing with that requires a temperment not all of us have.

Morever, a physican's "product" is something hightly prized in most/all societies. When one is truly ill, cost of cure becomes a small consideration to many people.

This is why physicians fall where they do on your x-y diagram. While financial risks are comparatively small, a lot of other legitimate factors are built into the earnings.

I'm not saying that physicians are fairly paid -- that's a case-by-case matter. But, in general, their higher-than-average pay zone can be justified.

Posted by: Donald Pittenger on February 17, 2007 1:46 PM

It's interesting to compare doctors and lawyers, in terms of compensation and what income they can reasonably expect to make.

Physicians, as has been noted by John Emerson above, are virtually guaranteed a high upper-middle class income --- I'd say that in most specialties, they are safe in assuming they can be making $300,000 or $400,000 a year a few years out of their residencies. But this level of income is largely assured by a network of insurance and government programs that reflect the value that society places on medical care. Of the average doctor's $400,000 income, most of that money is being paid by insurance companies or government health care program, not directly from patients' pockets.

Lawyers, on the other hand, toil in a field where the U.S. society does not ensure substantially free access to legal services. If a middle-class person has a legal problem, they have to come up with the fee themselves. I have a lot of prospective clients who come to me about real legal problems, but have to turn away because they can't afford even a modest ($1500-$2000) retainer. Many lawyers don't have the comfort of billing insurance companies for their services. We have to scrap for every dollar we make, in negotiations and haggling either with our clients, or with our opponents, and it's rarely guaranteed.

In a sense, you could say that medicine has a kind of huge "income safety net" for its practitioners. Lawyers don't.

Posted by: James on February 17, 2007 2:36 PM

I believe that medical schools have also limited admissions in fear of an oversupply of doctors (bringing down remuneration).

Doctors are sliding downward, though, above all in autonomy and working conditions but also in income, because of increasing control of the profession by HMOs and insurance companies. Job satisfaction is less, and my guess is that talented greedy people go into finance or business administration nowadays instead of medicine. (It's all scuttlebutt, but I did work at a treaching hospital / research university for 25 years).

MD remuneration with 2+ years of experience ranges from $150,000 mean for family practice up to $320,000 for anesthesiologists: Link Given that these are means, half the family practice people would make less than $150,000. My guess is that only doctors taking a lot of non-paying patients would make less than $100,000, though.

Posted by: John Emerson on February 17, 2007 4:00 PM

"This level of income is largely insurance and government programs...not directly from patients' pockets"

Don't you think people put their health above legal wrangling? Also, who's paying the taxes and health insurance premiums?

Lawyers, on the other had, "toil" (toil, toil, I tell you!). They don't "work' like the rest of us, they "toil". They have to "scrape for every dollar that they make". Wow, that's quite display of self-pity.

You'd think with all that insecurity and hand to mouth existence, lawyering would be a lot less attractive as a profession. But there seems to be no shortage of law students lining up in schools all over the country. I wonder why that is? I guess there's probably more to a profession than money, eh? But you're the one that wanted the brass ring. Kind of hard to sympathize, even with the Oliver Twist-like life of toiling, haggling, and scraping. After all, you make life so easy for the rest of us.

Here's a nice little summary of the situation:

"The ones that handle all the money are the ones that make all the money."

Look around a bit and see if that's not true. Nobody competes to keep on competing. They compete to win. Most of us are born into a form of servitude from which we will never escape. Getting a proper perspective on work is a bit easier when you understand that. I don't think risk should necessarily be rewarded per se. Performance should. And you don't have to go it alone to perform well. You might have to to make more money. But the two are not the same thing.

Posted by: BIOH on February 17, 2007 4:27 PM

I hear a bit too much heavy breathing about higher income workers taking gains from lower income workers. "The rich get richer, the poor get poorer". My comments:

1. If the redistribution was real and most went to upper income earners, why do I see so many "blue coller" workers driving $60,000 cars? And wearing iPods, buying big screen TV's? (All anecdotal, for sure, but....)

2. Wage and salary gain/loss data for the past 30 years cannot be rationally analyzed without including ALL benefits provided by the company - health care, 401k contributions, etc. My mom makes an extra 4% a year due to company match to her 401k. Nobody had a 401k 30 years ago, much fewer had them 10 years ago.
3. Hedge fund performance declines in the past few years could be indicative of the poor performance of the stock market as a whole. Comparing 7.5% average returns in today's markets to double that of 10 years ago in a vacuum may not tell the whole story. Also, there could be a flood of managers into hedge fund managing now, which could also mean a watering down of performance as more mediocre (or inexperienced) managers enter the field.

4. Any time someone talks about someone making "too much money" it makes me nervous. The market dictates what people are paid. Being a doctor means dealing with ever more complex systems, ever more risk of lawsuits, longer training and ever more mountains of information to learn. If they make $300,000 a year, does that fit reasonably within this risk/return matrix?

5. I would point out the obvious here about CEO compensation, but then again I work for a public company and receive a fairly large chunk of my compensation in the form of stock options and grants, so it may just be obvious to me. CEO compensation started to go up precisely BECAUSE CEO pay became tied to share price. Granting share options is a cheaper way of paying a CEO because it doesn't impact the cash flow of the company except in the tax hit. It may dilute the dividends available to existing shareholders, but not that much (image 100,000 shares granted into a pool of 50 million shares). Because these are less of an impact on the company as a whole, it's easier for companies to get carried away with it.

6. Public companies are not "owned" by the public in the sense that they have strong management say, unless a single entity or person owns a large number of shares. One of my earlier mentors once told me "public companies are not for the benefit of the shareholders, employees or the Board of Directors. They are run for the benefit of the executive team", which is true. Shareholders make decisions among many public companies in terms of share growth, dividend payout/growth or both. If the executive management can pay out enough of the bottom line in the form of dividends to entice people and firms to invest, but keep millions for themselves (and still manage the company towards growth and profitability), then they make large bank for themselves. It's the market at work.

It's no different than owners of a private company - they keep costs down and profits up so they can make money. If paying less gets them employees that can still do a job adequately, why pay more just to pay more?

7. No discussion here about skill sets either. I work in a highly specialized field, one that takes years to learn. Not many people have the skill sets or talents to do what i do well (not a boast, but simply a statement to make a point). I have an MBA, work for a public company, and management investments above $100m each. In the risk/reward analyses here, does that mean I'm overpaid because I don't have my own money in the pot? Or is there a greater risk for me because I have long term compensation (partially stock options) in the mix? How many people are out there with the skills and experience to do what I do? Not many, if judged by the number of headhunters that call me weekly.

Hope I didn't ramble on too much.....

Love the site - keep up the good work!

Posted by: Dave on February 17, 2007 4:50 PM

With respect James, you’re talking about the low end of the legal profession, or lower half anyway. In income. I’m not saying that everyone there is at the lower half among lawyers of intelligence or capabilities. There can be a variety of reasons for working in that lesser compensated sector including personal convictions, preference for a smaller community lifestyle, somewhat less demanding hours often enough, and so on. I’m speaking as someone who began and spent a number of years at a top and large Wall Street law firm before moving over to investment banking. I’ve got a good knowledge of what it’s like at sizeable firms in other cities as well – my work took me all across the country and continued to after I became an investment banker and continued to work extensively with lawyers.

What is the case is that a great many lawyers work incredibly hard and very long hours for their outsized pay. This is true in successful class action lawsuit firms as well as the corporate variety (although usually somewhat less so, or only episodically so.) So often do doctors but that mostly ends or can end with a still very hansom income after residency and especially internship is over. Most professions have lots of workaholics by choice but there isn’t much choice about it for most lawyers who become successful for at least the first 10 years of their careers, and often much longer than that, first 15 or more. I’m talking 80 hours a week hard, sometimes more like even 100, almost certainly 60 and up all the time - and that isn’t playing around on the internet time. That's churning out paper time, relieved by client meetings or courtroom appearances which are a lark in comparison. Through the junior partner level typically at any sizeable and well compensated firm, though there are of course wide differences. The big New York firms are indeed especially brutal in this regard.

It’s also true that the legal profession is far less selective at it’s lower end than medicine is. The graduates of the top 10 law schools may well have a higher IQ on average than the graduates of the top 10 med schools, though both are damn high (aside from a good number of the AA slots fillers). I’d strongly wager that the average IQ of the bottom 10% of US law schools have much lower IQs than that bottom tier of US med schools. I think the same holds true, more or less, for those who make it past the state bar exams. They really aren’t all that tough, they just involve a bunch of subjects you never studied in law school and have a specific one state only set of rules to learn (unlike top law schools which generalize on this) so you have to take a cram course. All this means there’s a pretty big supply of lawyers for the lower tier slots in the legal profession.

Posted by: dougjnn on February 17, 2007 4:54 PM

To some extent, the rise in bankruptcy filings over the past couple decades can be attributed to the increased availability of easy credit.

Posted by: Peter on February 17, 2007 5:08 PM

Out here in the boonies, things are a little different. In Great Falls, Montana, one of the two biggest cities in Montana and still less than 100,000 people, there is currently a food-fight among physicians over financial advantage (the hospital was a monopoly and some doctors started a specialty hospital -- no emergency, no welfare, just high-end surgery) that has driven out many of our best doctors. Anyway, doctoring now is in large part a matter of matching the test result to the right prescription and monitoring the results. They can barely remember the names of the patients.

We are getting an increasing number of marginal doctors floating through -- people who are personally not charming, not good managers, unable to fit into a group. And an increasing number of dubious lawyers -- one was caught watching porn, another was sentencing people to jail for not keeping up with their bills (debtor's prison, anyone?), etc. They are tempted to dabble in art schemes, they try to save the family ranch and fail, they get drunk and maudlin in bars. Not a pretty sight.

I'm inclined to think that the biggest risk is to these people's integrity.

Prairie Mary

Posted by: Mary Scriver on February 17, 2007 6:33 PM

"Why do I see so many "blue coller" workers driving $60,000 cars? And wearing iPods, buying big screen TV's? (All anecdotal, for sure, but....)"

Ipods cost $200. If a genuinely blue collar worker is driving a $60,000 car, I'd be willing to bet that he was single, with a pretty good chance of doing business with the repo man pretty soon.

Dave really ignored a lot of the key points friedrich specifically made here, and seemed to be repeating what he always says in this kind of argument.

Posted by: John Emerson on February 17, 2007 8:32 PM

Prairie Mary-

See my last comment in my immediately previous comment above.

The low end of the legal profession is not all that selective. The low end of the medical one, much more so, due to more strict cutoffs. This is partly diluted by SOME of the foreign educated doctors we import (e.g. Caribbean med school educated whites -- look out and pass unless you have compelling other info -- and some Indian ones). There still are licensing requirements but those generally aren't as restrictive as med school admission ones, IQ wise. Of course some smart med students like some other smart people all over the place end up squandering their brains, etc.

Posted by: dougjnn on February 17, 2007 9:00 PM

John Emerson said--

Ipods cost $200. If a genuinely blue collar worker is driving a $60,000 car, I'd be willing to bet that he was single, with a pretty good chance of doing business with the repo man pretty soon.

Or possibly living with his parents, or with three room mates in relative squalor. He figures the car first to attract the chick. He figures he'll maneuver to her place for the first few shackups, to get her hooked, then start talking about his future change plans.

Not saying this is likely to work so well all of the time. Just saying it could well be part of what's in the head of that 60K car buying blue collar worker guy.

Posted by: dougjnn on February 17, 2007 9:04 PM

Thank you very much for this.

Posted by: Steve Sailer on February 17, 2007 9:29 PM

You'd think with all that insecurity and hand to mouth existence, lawyering would be a lot less attractive as a profession. But there seems to be no shortage of law students lining up in schools all over the country. I wonder why that is?

Many people just sort of stumble into law school. If you're a college student heading toward graduation with an unmarketable BA degree, with no prospects whatsoever for even a semi-decent job after graduation, law school starts to look like a fairly reasonable alternative. It beats flipping burgers.
What makes law school a feasible alternative for people in this situation is that it's actually pretty easy - no math, no science, hardly any computers, mostly essay tests - in short, nothing to scare off a technophobic BA holder. One even could say that law school is basically a natural extension of liberal arts college. Law schools usually don't have much in the line of required undergraduate coursework, so they're suitable for most liberal arts graduates.

Posted by: Peter on February 17, 2007 9:49 PM

dougjnn, I think I'm talking about the "lower" 80% of the legal profession. The big law firms with lucrative corporate practices actually employ a comparatively small percentage of working attorneys. So, while those law firms get a lot of attention, they're not the reality for most lawyers.

Posted by: James on February 17, 2007 10:15 PM

Where do college professors fall on that chart? A tenured professor has about as much security as possible - and the income is good. Instapundit linked to a study which showed the _base_ salary for a full professor of law at some major schools ran from $200K to $300K. I suppose that's an outlier, as most could make big bux in practice.

But even outside the golden halls of law school, professors do real good. The average salary for U of Illinois professors (including associates and assistants) is over $90K.

In 2004-05, the AAUP reported the average salary for a full professor at a PhD-granting private non-church school was $127K, with over $30K in additional compensation.

By comparison: the median family income in 2004 was $46K; the average annual wage was $39K.

Posted by: Rich Rostrom on February 17, 2007 11:34 PM

which showed the _base_ salary for a full professor of law at some major schools ran from $200K to $300K. I suppose that's an outlier, as most could make big bux in practice

Yeah, big bux at the cost of vastly harder and vastly more grinding, less interesting work most of the time. There's a sense of being at turning points of power sometimes in big time private sector law that's pretty exciting (major takeover battles for example which is what I did), and when you reach the mid and senior level partner stage when your're almost exclusively overseeing other lawyer's work and taking most of the credit with clients, and making judgment calls left and right and pretty much only (or if a litigator making the star turns in court) that's pretty darn good. But the dues to get there are pretty enormous. I'm not sure I can think of anywhere they're higher. Though admittedly the rewards can be great.

In retrospect the life of a law prof seems pretty good to me. If one can find the right woman to go with, or thinks one can when embarking. Which is so often near the crux of it all, isn't it?

Posted by: dougjnn on February 18, 2007 12:23 AM

Most faculty never reach full professor, and most colleges don't grant PhDs. So you're talking about the very elite of the professoriate. College faculty at lesser places do pretty well, but Illinois for example is pretty high on the totem pole,even it's though far below MIT.

Posted by: John Emerson on February 18, 2007 12:38 AM


Where do college professors fall on that chart? A tenured professor has about as much security as possible - and the income is good.

I'll raise you one.

I sometimes think that most humanities departments should simply be eliminated or at least stripped nearly naked.

This is coming from someone who grew up with and long had a deep belief in the classical British rooted tradition of liberal arts education.

I still do in part but I've come to think that the area not only currently is, but is inherently subject to ideologically highly biased takeover (PoMo currently of course). Subjectivity big time. What's the defense against those who don't share a Greco-British predilection for moderation and balance?

As well, just how much is the creation of fine, powerful and durably affecting literature helped by the proliferation of English majors and doctorates, whether or not they're spouting PoMo nonsense? I suspect somewhere between very little and it's a negative influence. And so on with the rest of the graduate level modern language departments, which are not about teaching fluency to non native speakers. What good are they? Is it all more or less mastubatory? Is it just an excuse for our daughters and delicate sons to be able read novels more or less for fun in college and get a degree?

Most "studies" departments, whether they be in African-American, Gender, Liberation, or some Gay/Lesbian themed studies are largely garbage, conducted at a notably lower level of intellectual standard and with notably less openness to challenging ideas (to their professor's worldview). In other words they're heavily about political indoctrination and mutual ideological support.

History must of course remain, with reform. Cultural anthropology? Oh that's supposed to be a social science, isn't it? Yeah right. Talk about reigning and unchallengeable dogmas (if you want to get anywhere). Physical or paleo or genetic anthropology are entirely different, and wholly respectable, stories.

It's a mess in the softer side of elite higher academe these days. A real mess.

The hard and hardish sciences remain good. Thankfully.

Posted by: dougjnn on February 18, 2007 12:59 AM

Another way to measure risk is in terms of income volatility - the probability of an income swing of x% from year to year. You can look at all changes, just decreases, vary the income, look at it as a function of initial income, etc. I don't recall the numbers for the top 20%, but income volatility for the bottom 80% has significantly increased over the past 20 years or so.

I'm fairly surprised to see aeronautical engineers mentionned in the last quote. They make a quite nice upper-middle-class income, but I don't think many make more than 120K, which is rather different than docs and lawyers. Am I wrong about that?

Posted by: ptm on February 18, 2007 2:47 AM

"How do they so successfully defy the risk-reward curve? "

There's some reason to believe that in many cases (doctors, corporate execs) it's largely because they have a ton of control over their own compensation. Compensation committee's, the AMA, etc. It's no surprise they think their peers are worth more money, and the circle goes upwards.

Posted by: ptm on February 18, 2007 2:49 AM

wow, I wish I was making what you guys thought I was making..... :)

The other trend I've noticed is how many of my fellows/residents make choices based soley on the amount of their loans. Makes sense.

But, yes, that's a main reason people choose medicine. It's relatively safe in most cases, unless you are 1990s-2000s eras CV surgeon....funny how technology and new procedures can affect a job.

Posted by: MD on February 18, 2007 9:40 AM

Actually academic trends demonstrate the intersection of risk/reward plus supply/demand.

The gaps between research unis and smaller teaching colleges are large in both compensation and conditions. The differences in pay between stars and regular full profs can be 200-400%. The differences between bschool, law school, engineering, or econ profs and the humanities can be very large. And especially in the humanities, the share of tenure track jobs is shrinking as more colleges hire untenured adjuncts with very low pay (say $25-30K per year) and limited benefits.

Moreover, as with elite law firms, most of the top 100-200 colleges hire people with Phds from about 30 schools at most, with the top 10 departments accounting for half the PhDs at the top 50-100 departments. Entering classes in technical fields are weeded out at a high rate, and most PhDs from the top 50 programs will never get a tenured professorship in their lives -- at least not at a research university with better than a 2-2 teaching load.

So I'd say that the odds of a smart kid graduating from say, Illinois or Texas with a BA are much better of going to a top law school and landing at a well-paying law job by 40 (>$200K per year) than of getting into a top PhD program and ever getting to be a tenured full professor at a top 50 department in any field earning $100K per year (in today's dollars). If he doesn't go to a top Law school, he still has a shot at building up a lucrative private practice in the hinterlands. If he doesn't get into a top 25 PhD program, he is probably hosed for life as an academic while having to spend more years in grad school than any lawyer or doctor.

Posted by: wala on February 18, 2007 11:34 AM

I had to come back and add this: I deal with the system a fair amount as a doc and as a patient with MS. And I have no clue what to do about medicine. Not a damn clue. I'm pretty sure the wonks, bureacrats. doc-careerists and the-never-practiced-but-have-MPH's will take care of it just, well, we'll see.

Posted by: MD on February 18, 2007 11:36 AM

Take a look at this article by a Michigan State professor which examines the questions “Is it fair that CEOs make hundreds of times more than the lowest level employee?” and “Are CEOs worth what they are paid?” Some highlights:

I suggest that what we are really paying CEOs to do is take risks! As an investor holding a diversified portfolio of company stocks, I want each company to take risks. If they do, conventional financial wisdom suggests that my portfolio risk declines and I will benefit since the winners should compensate for the losers.

However, the pressure to take risks puts CEOs in a precarious position. If they take risks that ultimately don’t pan out (and many won’t in a dynamic and competitive global economy), the CEO is likely to suffer considerable losses to their compensation, their reputation and even future earning potential (are people eager to hire former Home Depot CEO Nardelli or former Sunbeam CEO Al Dunlap?). Only in hindsight do we know which bets were dumb.

Hence, what we observe more than anything in the design of CEO pay packages are features that protect CEO compensation from adverse consequences arising from bets that don’t pay off, and from factors outside their control (e.g., economic down-turns). The first test of CEO worth, therefore, is not whether the CEO’s bets paid off in the short-term with annual increases to firm performance (the performance model of CEO pay), but whether the CEO made the bet in the first place! CEO compensation must be structured to encourage risk-taking in the form of entrepreneurship. We can reward good bets, but we first must get the bets made!

Posted by: Carter Adler on February 18, 2007 12:38 PM

dougjnn, sounds like your view of humanities in academia is based entirely on insights gleaned from the National Review and David Horowitz, and no first-hand experience.

Posted by: James on February 18, 2007 12:44 PM

1) One thing to remember about traditional economic theory of risk and reward is that there has always been the concept of "pure economic rent"---people whose compensation is off the risk-reward chart due to being able to do or sell something that few others can. The owner of the patent on Nutra Sweet, for example, or an NBA player, or, yes, a doctor. Technically, the "risk" falls into the "getting there"---getting into and through medical school, or actually being able to play basketball the way Magic Johnson could. Johnson didn't get paid "by the point." He had a contract which had to be paid off even if he flopped in the next season. He'd made it to the NBA.

2) 22 million small businesses in the United States in 2003. 737 thousand active doctors in 2000. 6600 total hedge funds...clearly more people "get" to owning businesses than arrive at graduation day from med school, or as a quarterback in the NFL.

3) Therefore I think your best example is corporate CEO's. There is no question that they do not take personal risk in any direct relationship to the capital they get paid, period. And failure is no great penalty---golden parachutes fully corrupt the risk-reward quotient. It's the best argument against widely-held corporations. CEO's too often (still) have their Boards in their pockets, and therefore are able to negotiate utterly irrational deals for themselves in "market" terms.

4) Sarbannes Oxley has nixed your suggestion about lending CEO's money to buy stock in their company. Conseco, Tyco and other scandalous failures have been traced in part to just that. The loans are secured with the stock they bought, which gives senior execs every reason in the world to then cook the books to inflate the stock price so that their loans don't get "called." Hence, "accounting fraud." Much more damaging to the "little investor."

Posted by: annette on February 18, 2007 6:36 PM

Lawyers and docs and accountants have one thing going for them: a state monopoly on a given profession. In other words, you have to get a license.

Doctors however do a much better job of defending their profession by limiting the supply of MDs. JDs, on the other hand, are a dime a dozen because the ABA will accredit any fly-by-night Hollywood Upstairs Law School that comes down the pike. There's a JD glut and it's a pretty tough racket if you didn't go to Ivy League or its near-equivalent.

Nursing is interesting. It too has a license but only requires 2 years in school. You can get a degree at a community college. I don't know why more people don't do it.

I have a friend who is a nurse and she can make 6 figures if she's willing to work crazy shifts. Employers are begging her to work: calling her up looking to recruit her, spamming her with junk mail, all sorts of things. Must be nice.

Posted by: Brian on February 18, 2007 10:44 PM

"We are getting an increasing number of marginal doctors floating through -- people who are personally not charming, not good managers, unable to fit into a group."

Can they tell pneumonia from heart failure? The employer may be more worried about the doctor's social skills, but as a patient I'm more worried about his or her clinical acumen...

As for academia, a PhD is a scam for the degree recipient in most cases. You're better off with a government job and a library card if you're passionate about learning.

Posted by: SFG on February 18, 2007 10:44 PM

I think academia as well as journalism, fashion, and all the other 'interesting' jobs falls into the lower right hand quadrant--plenty of risk, no reward.

Posted by: SFG on February 18, 2007 10:45 PM

People who own their own businesses already have the ability to create a lower tax rate than salaried workers. Business owners can shelter substantial amounts of income from taxation in the form of non-cash benefits and deductible business expenses that have a substantial element of personal reward.

Posted by: Grant on February 19, 2007 12:37 AM

I think it's being overlooked that borrowing to pay for a medical degree is just another kind of risk taking. A med student who flunks out is just as much stuck with debt or loss of savings as someone who's business fails.

Posted by: Jay on February 19, 2007 12:55 AM

The big money in medicine is not in one-on-one patient care. It's investments in clinics, deals with pharm companies, owning labs to which one can steer one's own tests, etc. The doc doesn't have to charm patients -- just boards and partners.

Prairie Mary

Posted by: Mary Scriver on February 19, 2007 4:26 AM

FvB: Thanks for the very interesting thought piece. Two comments:

1) A lot of entrepreneurship occurs under the aegis of large, public companies. These companies are constantly rolling out new products and tweaking existing products is a full-time endeavor for each and every corporation in the US. Maybe your attempts at entrepreneurship would have been more comfortable if they had occurred while you were a line manager at a corporation?

2) You need to include training time and weeding out of prospects in the compensation picture. The MD training process is relentless and costly and last for over a decade in many cases. And candidates are constantly either leaving or being forcibly ejected. Same goes for lawyers.

Still you are raising very valid points. The discussion needs to be refined a bit.

Posted by: jult52 on February 19, 2007 9:01 AM

"Nursing is interesting. It too has a license but only requires 2 years in school. You can get a degree at a community college. I don't know why more people don't do it."

Many people would like to get a degree in nursing but there is a shortage of teachers in the field. Instead of dealing with this problem (raising salaries in this particular area of education, perhaps?) the medical field wants to import many H-1B's mainly from third-world countries. Not good for either the US or the third-world countries.

Posted by: D Flinchum on February 19, 2007 3:56 PM

Wow, great post. I especially liked how it moved beyond traditional left/right dualisms. You should check out Jacob Hacker's book, "The Great Risk Shift", which has some relevant stuff.

If we really wanted a tax system that did not overburden people with highly unstable incomes (e.g. freelancers who have a "big" year followed by several lean years), we should tax wealth instead of income. That way someone who had gone into debt, invested, and taken a lot of risk to earn, say, a $500,000 jackpot, wouldn't be too penalized. Really, we tax income because it is supposed to be a proxy for wealth, but it is a highly imperfect proxy and becomes worse the more variance there is in income.

Posted by: MQ on February 19, 2007 6:46 PM

We do seem to have a system set up to actively discourage entrepeneurship. Between health insurance being dependent on employment and the way our tax system is set up, it's obvious the government wants us all to be good little employees of big corporations so we can be tax farmed with as little trouble as possible.

However, big corporations don't want employees anymore. Too expensive. They want us all to be contractors and temps. So, interesting tensions afoot.

I tend to think corporations are going to figure out some way to offload healthcare onto the government. I don't think taxes are ever going to be fixed. Marginal tweaking perhaps, but a sprawling sclerotic fading empire like ours isn't going to do anything too imaginative.

Posted by: Brian on February 19, 2007 10:17 PM

MQ: "If we really wanted a tax system that did not overburden people with highly unstable incomes (e.g. freelancers who have a "big" year followed by several lean years), we should tax wealth instead of income."

I realize you weren't necessarily advocating taxing wealth but it is a terrible, terrible idea for many, many ideas. It would discourage saving, encourage spending and make many contemporary financial trends in the US worse. I also don't see how taxing wealth would help entrepreneurs with small businesses in most cases - how would they cough up the cash to pay these taxes? Anyway, a half-baked idea.

Posted by: jult52 on February 20, 2007 8:51 AM

Entrepreneurs would cough up the cash to pay a wealth tax out of their, ummm, wealth.

Anyway, you're right that it's a half baked idea, but that doesn't mean it couldn't work with more time in the oven. The biggest problem is the savings disincentive, which is to some extent unavoidable, but it could be greatly reduced by pairing the wealth tax with a consumption tax.

Posted by: MQ on February 22, 2007 3:02 AM

It is all of a piece, isn't it?

From the Oligarchs in the FSU (Former Soviet Union) to the New Class here in the First World to the emerging elite in (still theoretically communist) China and various other Third World countries, capital/wealth is being concentrated at the very top.

In the developed world, especially the US, the sum of having been dominant for so long, many of the un-intended (?) consequences of globalization and the consolidation of capital is that the middle is being hollowed out and the underclass is expanding.

Global corporations, internationally through the World Trade Organization, the IMF, the World Bank, etc., and on the national level here and in many countries through lobbyists, financial support for candidates, hiring past and future elected officials or in some other countries through paramilitary death squads and so on, have structured a complex system that exists solely to further the concentration of capital/wealth.

One way they do so is by defining "risk" purely in terms of "capital." In a global sense we might talk about the "risk" posed by war, pollution, hunger, or climate change. In a national sense we might talk about "risk" in terms of the ramifications of immigration or terrorism. In a personal sense "risk" means losing your house or health, strain on family, etc. In the "pure" world of corporate capitalism these are only considered as "risks' in terms of how they might alter the profitability of the corporation.

A legal framework has been created that grants corporations the status of an individual. A corporate "individual" is further defined in ways that would make an actual flesh and blood human be considered (at the very least) a sociopath. Namely, corporate "responsibility" is virtually exclusively defined as increasing the capital/wealth of shareholder/owners.

Let me move this from the lofty heights of global economic theory and practice to personal observations and the anecdotal. The average citizen sees taxes go down for the extremely wealthy and for corporations; they see fewer services from government and get fewer benefits from employers (assuming they are employed). Spun by pundits and blinded by self-interest, average citizens are divided along all sorts of essentially false dichotomies, fighting over table scraps.

Posted by: Chris White on February 22, 2007 3:38 PM

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