The Economy is Broken, Rent-Seeking Broke it

The Economy is Broken, Rent-Seeking Broke it

Image for postPhoto by Nathan Dumlao on Unsplash

We have an economy where wealthy people make money just by having money, not by creating value. We live in an economic system where it is more profitable to invest in lobbying government for favorable regulations and policies than it is to create a valuable, useful product. In fact, in this economy many useless activities are more profitable than innovation, seeking new markets, and creating value, useless things like collusion with competitors and betting on stock performance rather than investing in stocks directly(derivatives). We have an economy where exorbitant sums of money are being made without the contribution of anything of value from those who benefit. In this economic system, less and less real money is in the money supply and it is being replaced by borrowed money. What appears as a student loan, mortgage, and consumer debt in accounts of the many show up as real dollars in the accounts of the few (the top 10%). It seems every bank on the planet is reporting growing debt to GDP ratios. Why are we on this crash course? Because of unrestrained rent-seeking in nearly every aspect of our economy.

A different type of rent:

Economic Rents are different than the common use of the word ?rent.? An Economic Rent is very simply described as ?unearned income? or, in other words, ?above market return.? It is receiving wealth without generating wealth. It is making money without creating anything of value. It is asset appreciation above what market fundamentals can explain. It can also be considered making money without risking anything or making money where the risk does not match the reward.

Adam Smith knew about it.

Capital, Labor, and Rents were three concepts Adam Smith discussed a lot and to great depth. It?s funny how today all we seem to hear people talk about are Capital and Labor. This may be by design, as both the Neoclassical Economists and the Neo-Liberal Economists equated Land with Capital, thereby hiding the oldest known form of Rent-seeking. This form of rent-seeking was detailed by Adam Smith in the Wealth of Nations:

?As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was in common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land ?.?

? Adam Smith: The Wealth of Nations

No risk? a lot of reward?

Again in the Wealth of Nations, Adam Smith discusses Economic Rents and the Rentier Class (Rent-Seekers) in an example of a factory. First you have a landowner who rents the land to the capitalist who hires the labour to make a product. Everyone makes money on the deal. The landlord (rentier) makes money on the rent, the capitalist on the profit, and the labor on the wages. The thing is, both the capitalist and the labor have something to lose in the agreement, they assume some risk. The capitalist can lose money and the laborer can lose their job. Their return is proportional to the demand for the product they create. The rentier?s land value is not tied to the value of what is produced on the land, therefore the rentier makes money without having any skin in the game.

Image for postRent-Seeking is the reason many more people are being left behind today. Photo by D A V I D S O N L U N A on Unsplash

Poker = Economy

I like poker as an analogy for the current state of the economy. Outcomes in poker are a great microcosm of the financial outcomes that people and companies experience in our economy. Every outcome is a result of a balance between luck and skill. For a good outcome, a person can have 3 combinations of luck and skill: high skill and minimal luck, moderate levels of both skill and luck (50/50 chance of good outcome), or low skill and a lot of luck. Bad outcomes also come with 3 combinations of skill and luck: High Skill and bad luck, relatively even skill and luck, or bad skill and bad luck. The word ?luck? in this case represents things beyond our control or factors that are too complex for anyone to predict. Skill is the value of our decisions, good or bad. Luck is environmental variables beyond our control.

Read Thinking in Bets to see how poker can teach us a lot about life.

Back to poker. Imagine you have a poker room with two type of tables: the limited bet, small-stakes tables and a single no-limit, high-stakes table. There are 90 players at the small-stakes tables and 10 high-stakes players. The high stakes table is in its own room separate from the other tables. For every pot at all tables, the house (card room owner) takes a percentage of all the money in the pot. This percentage of the pot, called the ?rake?, is collected to cover the house?s costs, which are associated with providing a safe and stable place to play poker. The rake pays for the building, tables, chairs, staff, food, drinks, bookkeeping, advertising to attract players, and all other services needed to put on this game of poker in a safe, fun, in-demand, and luxurious environment. Can you guess who each character is analogous to in our economy?

  • The low-stakes players are you and me, the 90% at the bottom.
  • The high-stakes players are the other 10%.
  • The house/host/casino is the government.

Low-stakes players try to out-skill and out-luck each other in the hopes of winning enough money off their neighbors to make it to the high stakes table. The high-stakes players move large sums of money between each other, but they start to get a little upset at having a little bit skimmed off of every pot by the house. They figure their presence alone brings in everyone else, since people are eager to make it to their table and win a portion of their money. Since the house makes more money off the pots at this table, the card room prioritizes keeping these players happy. Leveraging their position by threatening to leave, the high-stakes players suggest a solution that benefits themselves and the house, a proposition the house eagerly accepts.

In the proposition, the rake is increased at all low-stakes tables even though the current rake is directly equivalent to the value being created by the house. The excess rake is then split between the house and the high-stakes players, covering more than the rake from their table, thereby growing their pot every hand. In other words, there is more money coming into every high-stakes pot from the house than what is leaving each pot through the rake.

This is already an unhealthy, unsustainable state of affairs for the 90% of players. The total amount of money they?re playing with is slowly shrinking. They keep playing for the slim chance they might win enough money off their neighbor to make it to the high-stakes table. A tall order considering they are playing with sums 10,000 times smaller than what the high-stakes players are playing with and the money available to them keeps shrinking. The low-stakes players have 50 dollar pots instead of $500,000 pots. Eventually at this rate all the money will be at the high stakes table. It?s a one-way street. Every few minutes a low-stake player has to leave the casino because they lose all their money. Remember, poker is game of skill and luck, some of the players who lose are highly skilled players. The high-stakes players are a smart bunch; they have a solution for this too. They agree to let players at the 90% of tables borrow money. There is a mark-up on this loaned money and it is collected on top of the rake. There is also interest on this borrowing. The other 90% take the deal because they know they need to stay in the game if they will ever have a chance of making it to that high-stakes table. This borrowing also allows them to play with more money than before, increasing the pot sizes at the low-stakes tables and allowing for a slightly higher limit to bets.

So now we have 90% percent of players in this casino playing with less and less real money, with regular top-ups of money that really belong to the high-stakes players. This is a common form of rent-seeking. The top 10% uses their position to pressure the government to establish policy that increases their wealth passively. Rent-seeking is essentially making money for nothing.

Economic Rents should be a part of any discussion of the economy.

Our economy is healthy if a person must create something of value to make money or grow their wealth. Our current economy seems to reward people for already having money, not generating wealth. Neglecting Economic Rents in an analysis of the economy is a major oversight that leads to extremely flawed solutions to economic problems. Economic rents are a market distortion. They are the most dangerous economic distortion of the past 50 years. The problem were exacerbated in the 1980s.

Gorvernments seem to ignore economic rents.

Governments are often blind to rent-seeking in the economy. They do things like focusing on job creation without focusing on the types of jobs being created. They help create jobs that facilitate rent-seeking. The jobs being created today are putting downward pressure on wages. Corporations are flooding the job market with cheap jobs, devaluing all existing jobs. This artificially created downward pressure on wages is an economic rent. This is why high minimum wages work; they set a minimum price that corporations have to pay to buy our work. This is a rent-busting measure.

In other cases, governments enact policy that favors large corporations at the expense of smaller more innovative ones, which reduces competition and innovation. This is another Economic Rent and it is often a by-product of the lobby efforts of large, powerful companies. Lobbying is a very common form of Rent-Seeking. These companies invest in changing the rules of the game in their favor, instead of investing in new markets or products. If policy changes, they increase their profits without increasing their contribution of value to the economy.

Not all profit is rent, but all rent is profit.

A lot of people consider all profit equal, but profit that is above market value is Economic Rent. It?s profit without creating value. Too much Rent will eventually grind an economy to a halt. It?s like friction in an engine. If a person doesn?t keep their car engine lubricated, it will seize. Economic Rent is an economic inefficiency.

There are many forms of rent-seeking.

It?s not just landowners who can be rent-seekers. In the 20th Century new types of rent-seekers emerged. Unions have been called rent-seekers from time to time, but I believe this is very rare and with today?s weak and disorganized labour, this form of rent-seeking has virtually disappeared. Unions are a misdirection brought up mainly by the more common and harmful group of rent-seekers, rentier corporations. So many of today?s corporations are Monopolies or Oligopolies and invest heavily in Lobbyists. It?s typically the largest companies and the wealthiest segments of the population that are involved in rent-seeking to a scale that hurts the economy. Rent-seeking by labour is not currently at a scale that threatens our economy. Rent-seeking will always be present in business, but the scale of the rent-seeking is often proportional to the size of the rent-seeker?s wealth.

Investing is full of different types of rent-seeking. Investing in actual assets like stock aren?t rent-seeking unless some form of insider trading is taking place. Investing in futures or derivatives has taken many forms throughout history. In 1998 OTC stock derivatives were introduced in the United States. Here again, we have another example of rent-seeking. Investing in an IPO (Initial Public Offering) is a great way to make your money work for you and it produces value. The money a person invests can be used by a company to create value and contribute to the GDP. Derivatives on the other hand, are essentially a bet on how particular stocks will perform. You can bet that a stock will do poorly and make money if you?re right or it can go the other way around. The exchange/bank holds the money while everyone waits to see what the stock will do and who will win the bet. Investing in OTC derivatives does not fuel the production of value, it only stands to make money on top of money. Derivatives can get more complicated than that, but the simple fact that you aren?t putting your money into the creation of value or wealth means they are a form of economic ineffeciency, of rent-seeking. Look at the performance of the economy since OTC derivatives were introduced and you?ll see two things: poor performance of the overall economy and accelerating increases to wealth inequality.

For a useful history of futures/derivatives, check out this site.

Other forms of rent-seeking are suppressive in nature. Efforts and dollars spent to keep wages low are rent-seeking. Bringing in cheap foreign labour because a company does not want to pay market value for local talent is rent-seeking. Corporations building barriers to entry for potential competitors are a form of rent-seeking. This last example includes lobbying government to change policy and introduce regulations that impact newcomers to the market more significantly than established players (incumbents). Or it can be price cutting to take temporary loss in order to push a smaller, newer company out of business. Salaries above market value are economic rents. As are income taxes that are too high, this is a form of government rent-seeking which is present in developing countries.

In conclusion:

One of the greatest problems facing our cities and citizens these days are issues of affordability. There?s a lot of finger pointing about it. There?s a lot of spinning tires amongst policy makers and governments. If we truly want healthy economies and affordability in our cities, we must address rent-seeking head on.

EXTRA NOTE ABOUT UBI: While I haven?t picked a side on the topic of Universal Basic Income (UBI), UBI presents an interesting thought exercise. Going back to the poker analogy:

If the house starts using some of the rake at the high-stakes table to put real money on the low-stakes tables played at by the 90%, the sustainability of the entire game would increase dramatically. Real dollars would be added to the pots on 90% of the tables. Or the money could be added directly to the 20% of players with the smallest stacks to get them back into the game, eventually making everyone richer. Ultimately there?s a gravity for money to naturally make its way to the high-stakes table. The money?s going to keep flowing to the top, but it?ll be real money in this scenario. And with every pass through the low-stakes table, it might bring a new high-stakes player with it. Every iteration gives more opportunity for the most skilled among the 90% to make their way up. No one would ever need to leave the game.

Food for thought.

Notes from the Author:

This article has received a lot of very good comments. A few comments have brought up derivatives and I?d like to clarify my position and language regarding them. I think there are more economically efficient ways to provide the type of ?insurance? OTC derivatives provide. I will be detailing solutions to this issue in future pieces.

Also, this is not an original concept, I?m only adding my voice to the chorus. I highly encourage further research on Rent-Seeking to anyone who found this article interesting. This introduction should help readers better understand the work of academics and specialists.

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