Feb. 17 (Bloomberg) -- For two centuries, Wall Street survived wars, depressions, bank panics and terrorist attacks. Now Wall Street as we know it is dead. Gone.
When a healthy and thriving person dies suddenly, a medical examiner may talk to family and friends to see if the deceased had recently changed behavior in some way.
Wall Street did change radically in recent years in one notable way. Twenty or 30 years ago, it was common for the best and the brightest to be doctors or engineers. By the 2000s, they wanted to be investment bankers.
When Wall Street was run by people randomly selected from the population, it was able to survive everything. After the best and brightest took over, it died the first time real-estate prices dropped 20 percent.
Are the two facts related? In other words, did Harvard kill Wall Street?
The suspect certainly had the opportunity. If you walked into any major Wall Street firm a year ago and randomly selected an employee, chances are that person would either be from an Ivy League school like Harvard University, or have an MBA, or both.
The statistics are striking. Back in the 1970s, it was typical for about 5 percent of Harvard graduates to work in the financial sector, according to a recent study by Harvard economists Claudia Goldin and Larry Katz. By the 1990s, that number was 15 percent. It probably climbed since then.
And the proportion of those with MBAs grew as well. Economists Thomas Philippon of New York University and Ariell Reshef of the University of Virginia found that, in 1980, workers in finance earned about the same wages, on average, as workers in other sectors. By 2005, financial-sector workers earned 50 percent more than similar workers in other industries.
Wages and Degrees
Philippon and Reshef went on to explore what caused the surge in wages in the financial sector. They found one of the key reasons was the increasing reliance on highly educated workers with post-graduate degrees.
Their results accord with anecdotal evidence concerning the hiring practice of Wall Street firms. A 2008 report in Fortune said that Goldman Sachs hired about 300 MBAs in 2007 and that, last year, Merrill Lynch and Citigroup were planning to hire 160 and 235 MBAs, respectively.
Is it just a coincidence that so many superstar minds arrived on Wall Street just as it died?
Wall Street is gone because its firms did a terrible job assessing the risks of the positions they took. The models these firms used to evaluate risks failed. But having a failed model brings a firm down only if the firm collectively buys into the model.
To do that, the firm must be run by people who have a great deal of faith in their models, and a great deal of faith in themselves. That’s where Ivy Leaguers and MBAs come in.
Master of Mastery
What do you get from an MBA? One recent study found that MBAs acquire an enormous amount of self-confidence during their graduate education. They learn to believe that they are the best and the brightest.
This narcissism has a real career impact. Psychologists at Ohio State University studied the behavior of 153 MBA students, who were put in groups of four and asked to orchestrate a large financial transaction on behalf of an imaginary company. The psychologists observed that the students who had the strongest narcissistic traits were most likely to emerge as leaders.
According to Amy Brunell, the lead author, the results of the study had large implications for real-world settings, because “narcissistic leaders tend to have volatile and risky decision- making performance and can be ineffective and potentially destructive leaders.”
The Bathroom Test
Guys like John Thain (Harvard Business School, 1979) exemplify this behavior when their sense of entitlement is so grand that they can spend a fortune renovating an office while their firm is going down in flames.
The consequences of Wall Street’s reckless brilliance in many ways parallel modern-day engineering disasters. If you travel through Italy, you can’t help but notice the many Roman bridges that still stretch across that nation’s waterways. How is it that the Romans could build bridges that would last thousands of years, while the ones we build today collapse after a few decades?
The answer is simple. Back then, they did not have the fancy computers required to calculate exactly how strong a bridge must be. So an architect made a bridge very, very strong. Today, engineers can calculate exactly how much steel they need to incorporate into a bridge to bear the expected load. The result is, they are free to make them weaker.
Room for Error
Another result is less wiggle room for design error. Hence, modern bridge’s predilection for collapsing.
The same is true of the financial sector. Back when Wall Street was run by individuals without fancy degrees, they had a proper skepticism toward fancy models and managed their risks with a great deal more humility and caution. Only when failed models became canon did catastrophe strike.
Wall Street didn’t die in spite of being run by our best and brightest. It died because of that fact.
(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He was an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election. The opinions expressed are his own.)