The Financial Crisis and Human Capital Allocation

Here's an excellent article by Fareed Zakaria on why the financial crisis also presents a huge opportunity to clean up some of the problems of the political, financial, and economic system of the last decade(s) and how the new administration has (available) the brain power to effect this change:

Volcker has also argued that the highly complex financial system was not nearly as stable as people believed and that far-reaching efforts were needed to regulate and stabilize it. Now these issues will get attention at the highest level. The fear on Wall Street is that a Democratic administration would overregulate. But look at who is advising Barack Obama—Buffett, Volcker, former Treasury secretaries Robert Rubin and Larry Summers. It is more likely that what will come from their efforts will be a better-regulated financial system that, while producing less-extravagant profits, will be more stable and secure.

What I personally find really interesting is his succinct summary of something I have heard over and over in the last few weeks - How the inflated financial industry caused a misallocation of talent into the financial sector:

The financial industry itself is likely to shrink, and that's not a bad thing, either. It has ballooned dramatically in size. Curry points out that "30 percent of S&P 500 profits last year were earned by financial firms, and U.S. consumers were spending $800 billion more than they earned every year. As a result, most of our top math Ph.D.s were being pulled into nonproductive financial engineering instead of biotech research and fuel technology. Capital expenditures went into retail construction instead of critical infrastructure." The crisis will stop the misallocation of human and financial resources and redirect them in more-productive ways. If some of the smart people now on Wall Street end up building better models of energy usage and efficiency, that would be a net gain for the economy.

Esther Duflo recently wrote about this for VoxEU and two years ago I read an excellent paper on the incentives for productive and unproductive economic behavior by William Baumol that I cannot recommend strongly enough:

[The] allocation between productive activities such as innovation and largely unproductive activities such as rent seeking and organized crime. This allocation is heavily influenced by the relative payoffs society offers to such activities. This implies that policy can influence the allocation of entrepreneurship more effectively than it can influence its supply.