Great Problems: An Epidemic of Rent-seeking

In a healthy society, people acquire wealth by making stuff people want. Farmers till plots to provide for their nutritional wants. Workers assemble motorcycles for consumers who pay money because they find the motor bikes valuable. Perhaps the worker serves a philanthropic organization and earns a salary by serving the official goal of the organization. Or perhaps the worker earns money by creating crafts that others in the community value.

A society structured as the above has two great benefits. First, incentives are aligned to produce more output. A person can only acquire wealth by producing wealth. Thus the production of wealth is encouraged, as man's natural greed is channeled towards productive ends. Second, humans are innately goal seeking creatures. It makes us fundamentally happy to strive towards a goal - whether that goal be winning a football game, learning a new song on the piano, leveling up in Warcraft, or producing a product that people want.

In a dysfunctional society, people acquire wealth via corruption, rent-seeking, and theft. Perhaps they steal it at the point of a sword. Perhaps they acquire wealth through outright corruption. Perhaps they acquire wealth through holding a position in a completely dysfunctional management structure that requires internal politicking and Kabuki make work rather than actual performance.

As Adam Smith wrote, "there is a great deal of ruin in a nation" Corruption has always existed in America. But in the past decades it seems as if the dominant paradigm has shifted, so now more and more income comes via dysfunctional rent-seeking rather the net creation of new wealth. 1

A most severe case of runaway rent-seeking was described by the historian Rostovtvzeff, who wrote of the late Roman empire:

The reforms of Diocletian and Constantine, by implementing a policy of systematic spoliation to the profit of the State, made all productive activity impossible. The reason is, not that there were no more large fortunes: on the contrary, their build-up was made easier. But the foundation of their build-up was now no longer creative energy, or the discovery and bring into use the new sources of wealth, or the improvement and development of husbandry, industry and commerce. It was, on the contrary, the cunning exploitation of a privileged position in the State, used to despoil people and State alike. The officials, great and small, got rich by way of fraud and corruption.

The problem in America is not quite this bad - yet. But it is bad, and getting worse.

The "rent-seeking" economy has several variations:

Rent-Seeking Variation #1: Groups and individuals exploit a dysfunctional political system to get insanely rich.

Exhibit A is Wall St's strategy of developing "financial innovations" that produce immense profits in the short term by creating systematic risk in the longer term. When the long term arrives and the systemic threat blows up, the government bails out the banks and the firms survive to play again in the next cycle.

Wall St. abounds with other examples. If the political-economic structure was rebuilt according to Heltonian guidelines, I suspect that the financial sector would be under 5% of GDP, rather than approaching 20% of GDP.

Wall Street hedge funds rarely make their fortunes by placing sound long term bets about the proper allocation of resources. In reality, they make money by skimming off the top as trillions of dollars slosh around due to the endemic instability in the financial system (instability that would be fixed with sensible reform). In a well ordered financial system, the stock market would be flat and predictable 2. Interest rates would never change, housing, equities and bonds would trade at unchanging ratios based on long term cash flow predictions. The only way to make money would be to actually predict the performance of particular companies. There would be no IPO "bounce", no stock bubbles, no real estate bubbles. 401Ks would be invested in low expense ratio, future cash-flow weighted index funds, not in market cap weighted funds. The era of being forced to invest in a Fidelity plan with a 1% expense ratio that churns 150% of its stocks each year would be over.

High Frequency Traders make money not by adding liquidity or playing market maker (in fact they remove liquidity), but by gaming design flaws in the SEC regulated stock market (essentially they get to peek into the order book and front run the market, a sensible black box auction system would remove this source of gamesmanship). 3

Beyond Wall St. there are thousands of more run-of-the-mill cases of corruption. Washington D.C. is one of the wealthiest metropolitan areas in the country due to number the government contractors, lobbyists, and consultants finding ways to get a piece of the government pie.

A more petty example of corrupt riches is the wealth of professionals who are protected from competition by licensing laws. I am not opposed to some sort of occupational licensing. But standards should be set to reflect actual job requirements, not to create artificial barriers to entry. Professions such as podiatrists or orthodontists have hard caps on how many people can enter their profession each year. Only 280 orthodontists may graduate a year. The supply limitation allows them to earn 50% more than dentists ($350k for a 35 hour work week). The number of medical school seats in the U.S. remained flat from 1980 to 2006, despite a 37% increase in the population. The artificial supply constraints allow doctors to extort high wages from middle class Americans.

Variation #2: Bureaucracies and pseudo-bureaucracies (grant funded NGO's, subsidized university system) that thrive not in proportion to meeting their stated goals of working for the public benefit, but due to politicking, unionized voting blocks, or - in the worst cases - actually creating problems and thus needing more funding in order to fix the crisis.

Typical government workers do not earn exorbitant wages, so it may seem unseemly to target them for criticism. But the income they do earn is rarely linked to producing stuff people want. For example, teachers do not earn money based on how well they inspire and educate children. Their aggregate salaries are determined based on the political clout of the unions, and individual salaries are based purely on seniority.

A professor at an architecture school or law school does not earn a six figure salary due to providing such superior mentoring and teaching. They earn their money because they are the legal gate keepers to entering licensed occupations.

Police officers who earn time and a half overtime for drinking coffee at construction sites, do not earn six figures salaries for providing such valuable traffic management skills. They earn their salaries because the police unions lobbied for laws mandating their employment.

Variation #3: Corporations with dysfunctional management structures that maintain their position only through economic rents, monopoly, or cozy relations with government, and thus have no discipline in working to create products that people want, but rather direct all effort towards internal politicking.

The rise of the mega-federal-state resulted in a dramatic increase in the size of corporations. It is always easier for a huge top down government in Washington D.C. to interact with and regulate a few corporations rather than hundreds of corporations. Economies of scale are generally greatly overrated, but one area where economies of scales really exist is in government lobbying - bigger corporations can afford lobbyists to write the laws that serve their interests.

If you look at the origin of most mega-corporations, you will see a link with government. IBM hit it big when it won the original contract for providing the counting machines that processed FDR's new Social Security program. General Motors, Boeing, Honeywell, and Anheuser-Busch all leapt past competitors thanks to World War II contracts. Chase and Bank of America have grown massive due to too-big-to-fail policies. Citigroup has been bailed out multiple times over its 175 year history, and grows bigger each time. Fidelity and State St. grow huge managing government pensions and from exploiting 401k regulations. TV broadcast companies and telecoms gained a market oligopoly due to the methods of auctioning off spectrum rights.

The U.S. government appointed several 'Nationally Recognized Credit Rating Organizations'. These three main agencies for many years dictated top-down control on the price of capital for American businesses. Naturally, big corporations are highly favored. If you are Starbucks, you get extremely cheap credit. Note also that thanks to government control of the interest rate, the interest rate has generally been lower than the rate of monetary inflation. Thus these favored, highly rated corporations essentially get free money. Starbucks uses that cheap credit to buy up the choice real estate. It's coffee sucks, but that doesn't matter, few local operators can out bid subsidized Starbucks for a hot corner location.

Not every inefficient-mega-corporation owes its dominance solely to federal assistance. There is such a thing as natural monopoly - cable TV is an example. Barriers to entry are so high that in most cities little market competition exists. I live in the Comcast Imperium. The prices keep rising, the customer service is notoriously awful, and broadband speeds remain behind other developed countries.

Credit cards are another natural oligopoly due to network effects - you need to use the credit card that stores accept, stores need to use the credit card that everyone has. As a result, Visa and Mastercard get to exact a 1-2% tax on transactions across the country.

Ever wonder why glasses at Lenscrafter costs $300? Luxotica owns every single major brand - and has purchased many of the chain lens stores. This gives it enormous power to set prices. If a local store sells discount frames, Luxotica will threaten to pull all of its products from the store, ruining the shop.

My region has among the highest medical costs in the world. One reason is because the major hospitals banded together for the purposes of price collusion. When insurers refused to give into the hospitals demands for increased reimbursements, the hospitals dropped the insurer. Enrollees rebelled, the bargaining power of the combined hospital network was too great, and the insurers had to give in.

These oligopolistic mega-corporations present an enormous problem. They make money not primarily from producing awesome products, but rather by manipulating regulatory procedures, long standing relationships, and rent-seeking. As a result, there is a lack of internal pressure focusing the organization on producing great products. Instead the main activity of people in the organization is towards personal enrichment and empire building. Furthermore, these organizations are fundamentally too large for effective management. The end game is a nation of Dilberts.

Variation #4: Productive enterprises are blocked and stymied by misguided regulation.

For centuries the price of energy dropped. Inventors developed ways to replace wood with coal, whale oil with crude oil. But since 1970 this progression has stopped. The natural successor energy source - nuclear - has been halted. Nuclear power has dangers, but the fear of these problems was so great that development in solving safety problems was basically halted 4.

Much debate has spewed forth about the fact that rises in the costs of living have nearly outstripped the rise in median income. One reason for this great stagnation, is that cheap products have been outlawed forcing people to buy expensive products. The Chevrolet Spark costs around $7,000 U.S. dollars new in Chile, but it's not street legal at that price and specifications in the U.S.

Want to open a cheap walk in health clinic? You can't fight city hall. Want to open up a doctor owned specialty clinics where you can perform cheaper surgery in a safe environment? The big hospitals will gang up to shut you down. Want to start a doctor run health network? The insurance companies will lobby to ban you. Want to start an insurance company that offers lower premiums because it takes advantage of scientific evidence to only cover treatments that look promising? Tough cookies - regulations explicitly state what you have to cover.

Want to start an architectural grad school that costs $5k a year instead of $40k? You'll never get accredited. Look at the accreditation standards, notice how many of the standards are subjective matters of having enough resources and qualified faculty (aka Ph-D's). Then notice that the people doing the accreditation are backed by the power of the existing architectural schools. A true low cost competitor has zero chance of gaining accreditation.

The growing problem of trivial patents and patent trolls further stymies productive enterprises. Innumerable Patents are granted for trivial technology, thus resulting in any other firm discovering the same technique having to either stop its innovations or lawyer up.

Variation #5: Seville Disease has wiped out the manufacturing base

The American manufacturing base was once the envy of the world. Cities from San Jose to Detroit, from St. Louis to New Haven, hummed with the work of clock makers, furniture crafters, car makers, and chip fabricators. Now hundreds of thousands of factories have folded. The blight first hit makers of toys and trinkets. But now production of high tech goods such as circuit boards, memory chips, and LCD displays have packed up and gone over seas. My dad worked at Bell Labs for three decades designing telecommunications equipment. As he winded down his last few years, he trained a Chinese team to take his place, rather than training Americans.

A recent Forbes article states:

The U.S. has lost or is on the verge of losing its ability to develop and manufacture a slew of high-tech products. Amazon?s Kindle 2 couldn?t be made in the U.S., even if Amazon wanted to: * The flex circuit connectors are made in China because the US supplier base migrated to Asia. * The electrophoretic display is made in Taiwan because the expertise developed from producting flat-panel LCDs migrated to Asia with semiconductor manufacturing. * The highly polished injection-molded case is made in China because the U.S. supplier base eroded as the manufacture of toys, consumer electronics and computers migrated to China. * The wireless card is made in South Korea because that country became a center for making mobile phone components and handsets. * The controller board is made in China because U.S. companies long ago transferred manufacture of printed circuit boards to Asia. * The Lithium polymer battery is made in China because battery development and manufacturing migrated to China along with the development and manufacture of consumer electronics and notebook computers.

America's problem is the same problem that afflicted the 16th century Spain. When America established its hegemony and set up the world currency system, her leaders installed the U.S. dollar as the reserve currency for the world. America took advantage of this position to export dollars and import goods, rather than to manufacture goods herself. With demand for the dollar as reserve currency pushing up the price of the dollar, local manufacturers lost their ability to compete. Furthermore, China in the past decades has enacted an overt policy of keeping its currency undervalued to encourage exports. This is a violation of trade agreements and should enable the U.S. to take counter measures. But the political leadership has been asleep at the wheel.

Thus instead of Americans earning money via creating manufactured goods that people want, the American government prints money, gives the money to politically favored corporations, bureaucrats, and workers, who then export the dollars in return for cheap HDTV's. 5

Variation #6: The Internet Monopoly Gold Rush

Every day, tens of millions of people log into Facebook and derive pleasure from stalking crushes, commenting on photos, organizing events, and posting funny status messages. The enablement of this pleasure requires the work of hundreds of thousands of people. There are the engineers that designed the chips in the home computer, the technicians maintaining network switches that route the internet, the open source hackers that wrote the operating system that Facebook runs on, the assemblers in China who put together the server boxes and laptops needed to run Facebook, the laborers who laid the fiber wire for the internet backbone.

The labor of all of these was required to make the pleasure of Facebook happen. The vast majority of the people involved make a normal, decent working wage. Some - particularly the factory assemblers - make a less than decent wage. One person - Mark Zuckerberg - has made a sum equivalent to the yearly wages of 400,000 Americans.

Why did Mark Zuckerberg make so much compared to everyone else? He does not personally write the code of 400,000 others, or personally design operating systems and build servers. If he retired tomorrow, Facebook would still function normally. He he never existed, some other social network would surely reign supreme instead.

Mark Zuckerberg is rich because he was able to capture ownership a natural monopoly opportunity.

Linus and the other contributors to Linux created an enormous amount of utility by creating Linux. But they did not capture this value because they open sourced it - all the value ended up as consumer surplus.

My dad was an ordinary electrical engineer at Bell Labs who helped design the routers and multiplexers which made the early internet possible. He never got rich because a) he had little bargaining power so he only got an employees salary and not a share of profits b) by the time he did get stock options there was fierce competition in the space and profits went to zero.

The assemblers in China makes so little because they must compete with hundreds of millions of other potential workers who can easily replace them. They have no monopoly, no bargaining power.

In the early 2000's, the advancement of technology and the internet created an opportunity for a large scale, online, social network. This opportunity was a natural monopoly due to both the network effects involved and due to the natural returns to scale of software 6. The market opportunity existed outside the brain of any one person. The opportunity existed like the precence of a river and the invention of turbines creates a market opportunity for an electic dam, or the existence of a mountain and the invention of TNT creates an opportunity for a railway tunnel. Even more fortuitously for Zuckerberg, this market opportunity could be captured with very little up front capital outlay. All it took was to be among the fastest and the best. Thus Zuckerberg wrote the first version himself, and was able to capture a critical mass of users without giving up significant ownership.

When Zuckerberg captured the social network, he became the toll taker over a large swath of the internet. Many things are required to get the pleasure of sharing photos with friends, but Zuckerberg owns the one point which is a natural monopoly, and thus can earn enormous rents.

Now credit must be given where credit is due - Zuckerberg captured this natural monopoly because he outplayed the other competitors. While MySpace and Friendster crashed under load, Facebook scaled remarkably well. The product was solid with good enough design and well managed.

So what is the problem?

Problem number one is that thanks to mechanization, the bargaining power of ordinary labor has fallen. More and more income is being captured by those who hold rent-seeking positions - such as possessing a scarce skill, joining a guild, or capturing a natural monopoly. From a utilitarian standpoint this is undesirable as the median person faces more financial stress and a stagnant income. (See also my essay on economic classes )

Problem number two is that the economic system does not create incentives to produce the products or technology that generate the most utility. The economic system produces the incentive to create products where the entrepreneur can capture as much of the consumer surplus/utility created as possible. Even better is if the entrepreneur can create a monopoly platform where the entrepreneur can take a toll on the value created by others (see for example Google and Facebook). The best and brightest are pulled into creating social networks, games, and socially enabled fantasy football. Much less incentive exists to develop risky, ground breaking technologies, because in those situations there is a low probability that the initial ground breakers will capture the value of any ultimate success.

As a startup entrepreneur I include myself in this category, I create software sold to marketing folk, if my software did not exist, little meaningful utility to the world would be lost. Yet I make three or four times as much money as my roommates who work in research labs trying to cure breast cancer and stop aging. 7

Variation #7: The Marketing and Sales Treadmill

In the modern world, natural resources are the limiting factor of production. It takes only a tiny percentage of the population to farm the arable land, mine iron ore, cut down and process the timber, and extract the oil. A somewhat larger percent converts those resources into the necessities of life - bread, vehicles, homes, roads, bridges, clothing, furniture, stocked grocery aisles, appliances, etc. The worker entering the economy has a problem. They must find a source of income so they can access resources and manufactured goods. But there are no unexploited resources and no surplus jobs to be had processing those resources. They need a job, but their labor is surplus and unnecessary.

What is this worker to do? One possibility is that he starts creating luxuries. He might design iphones, code for Facebook, open a yuppie coffeeshop, start a hand carved furniture business, or brew craft beer.

A second possibility is that he manages to finagle his way into one of the rent-seeking cartels or guilds, as mentioned above.

But perhaps the most common path is that our prospective worker enters the sales and marketing business. It is quite astounding the portion of the economy dedicated to sales and marketing. Even engineering focused companies like Facebook have more sales people than engineers. The basic problem is that there is a surplus of basic goods in the world, but each person still needs some money to get access to those goods. So everyone's energy is focused on imagining some gimmick - a six bladed razor, a beer can that turns blue when its cold, a funny talking gecko - that gives someone a reason to give you money when there is no real differentiation based on product value.

The sales and marketing economy is zero sum. Each business must work harder and harder at new tag lines, gizmos, tricks, and jingles. And when sales guys at the other company work harder, you must work harder too.

Past writers who imagined the future thought that as machines saved our time, we would have more time for leisure. That has not happened. Instead, since no one is self-sufficient, we must work in sales and marketing to convince someone with money to trade cash for our trinket, so that we can have purchasing power to access the natural bounty of the land. Average work hours declined for a century - and then started curving back upwards as the everyone switched the zero sum battle of sales and marketing. The future is here, and it is the sales desk at Dunder Mifflin.

  1. Hat tip to the blogger formerly known as Half Sigma, now known as LotB for his theories of value transference. While his ideas are similiar to well known concepts in economics such as "rent-seeking" and "capturing of the consumer surplus", Half Sigma extended value transference to more situations. For instance, he includes startup entrepreneurs capturing winner take all markets, executives capturing control of corporate bureaucracies, and marketers who succeed by creating goods that compete along startus hierarchies. I was initially skeptical that those examples constituted value transference, but I now think that they are at least partial value transference. For this essay, I have eschewed the word "value" because the word means different things to different people. Some people use it to mean "utility", others use it to mean "price", and others use it to mean some sort of ideal "fair price". You then get in all sorts of fights between people using different definitions. Instead I'll use the word utility for value. If you see the word "value" in the essay, take it to mean "utility". 

  2. Individual stocks would still be very highly variable. But the variability would average out over 5,000 companies. The great swings in the stock market are caused by changes in monetary inflation and interest rates - a few percentage points change can dramatically affect the relative desirability of equities versus other investments. 

  3. See for instance this interview with a former high frequency trader. While some HFT's can make money through the legitimate case of market making, most of their "risk free" money is made by variations of gaining an information advantage over the retail trader. Strategies include analyzing the ordering patterns of certain platforms and exploiting time differences between markets. But the most egregious tactic is blatant front running - making fake orders to gain information only to cancel them, for the sole purpose of discovering the reservation price of slower participants. A sane stock market would use black box acutions to create a fair playing field for all traders. At the very least the stock market should impose penalities for canceling orders. Instead the rules allowed the little guy to get fleeced. 

  4. In the wake of Fukushima, advocating for nuclear power is not the most popular of positions. But one must really think of the long term cost and benefits. Little is more important to quality of life than energy. Our food system is based on converting oil into food. Better cheaper energy can be used to desalinize sea water and irrigate the dessert. It can be used to run factories and water systems to raise standards of livings around the world. We are so paranoid about mistakes from nuclear power that we cut off all development. Over time, many of the dangers could have been greatly mitigated. For instance, could a Fukushima happen with the small Hyperion reactors that are buried deep in the ground? Unfortunately these reactors have been stymied for decades because of regulations preventing their development.  

  5. Technically the government prints treasury bills, but as I have pointed out before, this is really no different than printing money. 

  6. Software has very natural returns to scale, because all engineering costs and up front. The marginal cost of serving one more customer is very low. Thus the best software gets more customers, and more money for investment in engineering, making it even better, making it more popular, etc. The cycle ends up in monopoly or near-monopoly.  

  7. In defense, I am very good at creating marketing software and our company has been quite successful. As far as I can glean, my roommates have not made much progress in their noble pursuits.