4 4 Forget about hard work and the merit system and honesty
and all that crap, and get to where the Money River is.
When I cofounded Working Assets (now known as Credo) in 1983, we organized as a private corporation. Our corporate charter was our license to enter the American marketplace, with its 300 million consumers and all the legal, financial, and physical infrastructure Americans have built over generations. It also gave us the right to maximize financial gain for ourselves. We paid a pittance for these privileges and at no extra cost got limited liability and perpetual life. The entire package came with a timeless guarantee that our physical, intellectual, and financial property would be protected by the full authority of America’s state and federal governments.
“Not a bad deal, starting a corporation,” I mused at the time. “Sure, we may fail, and I may lose my investment, but if we win, we win big. And boy, is America behind us!”
Ten years later, when our annual sales passed $100 million, my partners and I realized that our closely held company would be worth millions more if we took it public. Thus, in addition to all the gifts America had already given us, we could pluck several extra million dollars out of thin air simply by floating a stock offering. Having just read Kurt Vonnegut’s novel God Bless You, Mr. Rosewater, about a wealthy heir and the crafty lawyer who advises him, I thought I was getting close to the Money River.
In the end, the company’s founders chose to remain closely held and forgo the “liquidity premium” we would have reaped had we sold our stock to strangers, figuring we were doing well enough, thank you, and would be happier (if poorer) outside the speculative vortex. I never regretted the choice. But that peek at the Money River piqued my interest.
Something had always mystified me about how fortunes are made in America. Clearly, the route to riches requires hard work and talent, but the magnitude of most fortunes wildly exceeds any reasonable compensation for either of these. Somewhere inside our economy lurks a magnifying machine that transforms legitimate rewards into grotesque riches. Hidden multipliers and takings are involved, and I wanted to locate them, if not profit from them. In other words, I wanted to find the Money River.
I had a few hunches where the river might lie. One came from my experience as a homeowner. If you bought a house for, say, $300,000 and sold it later for $400,000, you would pocket the difference. This is called a capital gain, and it would come not from anything you did, but because more people wanted to live in your neighborhood. That’s a function of many things—population growth, schools, public transportation, and so on—that have nothing whatsoever to do with your labor or talent. They’re societal phenomena or government provisions.
These societal gifts, moreover, are multiplied by financial leverage. You didn’t actually pay $300,000 for the house when you bought it. You paid, say, $30,000 of your own money and borrowed the rest. Then, over the years, you paid down the mortgage to, say, $200,000. When you sold the house for $400,000, you paid off the mortgage and kept $200,000. So, for an initial investment of $30,000, you walked away with a net gain of $170,000. That’s a 467 percent return for buying and selling a piece of property. A century ago, the American economist Thorstein Veblen called it “something for nothing.”1
A similar sort of leverage kicks in when founders of a private company go public. This might be called equity leverage (as opposed to debt leverage), and its effect can be even more spectacular. Equity leverage works by incorporating anticipated future earnings into present asset prices, thereby enabling stock sellers to get a lump sum now for a potential stream of future profits that may or may not materialize. If a company is expected to grow, this leverage can be huge—and it’s on top of the liquidity premium that accrues simply from enlarging the universe of potential stock buyers. It’s what enables people like Mark Zuckerberg, founder of Facebook, to become billionaires before they’re thirty.
And that’s not all. Large chunks of many fortunes come from sources less visible than these. Consider the nest egg of another youthful billionaire, Bill Gates. According to Forbes magazine, Gates in 2013 was the richest man in America and second-richest man in the world, with a net worth of $72 billion.2 Virtually all of that comes from stock he received or bought cheaply as Microsoft’s cofounder. And from whence (besides equity leverage and the liquidity premium) does the value of that stock arise?
Here we move beyond multipliers into the realm of takings. Microsoft wrote the code for its most profitable products, the Windows operating system and the Office applications, and marketed them ferociously. But it didn’t really invent them; it copied or adapted them from other software. What’s more, there’s no lack of good alternatives in the market. The reasons why people pay hundreds of dollars, over and over, for unexceptional products that cost just a few dollars to reproduce include the following:
• Everyone uses Microsoft programs, so if you want to be compatible, you have to use them, too.
• Your computer manufacturer preinstalled them and included them in the price of your computer.
• You can’t borrow them from friends because they’re copyrighted.
Thus, a sizable portion of Microsoft’s stock value—arguably the lion’s share—comes from system properties such as the network effect, market power, and copyright protection, a gift for which our government charges nothing. On top of this, Microsoft benefits from decades of public investment in schools, semiconductors, and the Internet; centuries of scientific progress; and unstinting generosity from nature (think of the fuels and atmosphere required to power the Internet). When you add it all up, you can’t help but conclude that a large portion of Gates’s fortune wasn’t earned by him but rather was taken by him from wealth that rightfully belongs to everyone.
How much of what we call private wealth is taken in ways like these and systemically magnified rather than genuinely earned by its recipient? If you asked Warren Buffett, the second-richest American after Gates, he’d say, “A very significant percentage.”3 If you asked Nobel economist Herbert Simon, he’d be somewhat more precise. “If we’re very generous with ourselves, I suppose we might claim we ‘earned’ as much as one-fifth of our income. The rest is patrimony associated with being a member of an enormously productive social system.”4
The more one thinks about these things, the more one sees that behind all large fortunes lies a plethora of undeserved rewards. It is this that constitutes the Money River, and the highly limited access to it accounts for our highly skewed distribution of wealth.
THE LONDON UNDERGROUND ABOUNDS with warnings to “mind the gap,” referring to the space between station platforms and train doors. In our larger society, similar warnings could be issued about the gaps between rich and poor and between humans and nature. These gaps must be not only minded but also narrowed. The persistent question is how to do this, and I contend that rent is a useful and indeed necessary tool.
But before we get to that, we must first become familiar with rent. The term was first used by classical economists, including Adam Smith, to describe money paid to landowners. It was one of three income streams in the early years of capitalism, the others being wages paid to labor and interest paid to capital.
In Smith’s view, landlords benefited from land’s unique ability to enrich its owners “independent of any plan or project of their own.”5 This ability arises from the fact that the supply of good land is limited, while the demand for it steadily rises. The effect of landowners’ collection of rent, he concluded, isn’t to increase society’s wealth, but to take money away from labor and capital.
Thus, land rent is an extractor of wealth rather than a contributor to it.
A century later, a widely read American economist named Henry George (his magnum opus, Progress and Poverty, sold over two million copies) enlarged Smith’s insight substantially.6 At a time when Karl Marx was blaming capitalists for expropriating surplus value from workers, George blamed landowners for expropriating rent from everyone. Such rent extraction operated like “an immense wedge being forced, not underneath society, but through society. Those who are above the point of separation are elevated, but those who are below are crushed down.” George’s proposed remedy was a steep tax on land that would recapture for society most of landowners’ parasitic gains. But unlike Paine, who would have returned recaptured rent to everyone, George would have left it in government’s hands.
In the twentieth century, the concept of rent was expanded to include monopoly profits, the extra income a company reaps by quashing competition and raising prices. Smith had previously written about this form of wealth extraction, but he didn’t call it rent. “The interest of any particular branch of trade or manufactures is always to widen the market and to narrow the competition. … To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can only serve to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.”7
Figure 4.1: ADAM SMITH’S “ABSURD TAX”
It’s important to recognize that the tax Smith spoke of isn’t the kind we pay to government; it’s the kind we pay, much less visibly, to businesses. That’s because prices in capitalism are driven by four factors: supply, demand, market power, and political power. The first two determine what might be called fair market value; the last two determine what is now called rent. Actual prices charged are the sum of fair market value and rent. Another way to say this is that rent is the extra money people pay above what they’d pay in truly competitive markets.
The contemporary concept of rent also includes income from privileges granted by government—import quotas, mining rights, subsidies, tax loopholes, and so on. Many economists use the term rent seeking to describe the multiple ways in which special interests manipulate government to enrich themselves at the expense of others. If you’re wondering why Washington, DC, and its environs have grown so prosperous in recent decades, it’s not because government itself has become gargantuan, it’s because rent seeking has.
In short, rent is income received not because of anything a person or business produces but because of rights or power a person or business possesses. It consists of takings from the larger whole rather than additions to it. It redistributes wealth within an economy but doesn’t add any. As British economist John Kay put it in the Financial Times, “When the appropriation of the wealth of others is illegal, it’s called theft or fraud. When it’s legal, it’s called rent.”8
BECAUSE RENT ISN’T LISTED SEPARATELY on any price tag or corporate income statement, we don’t know exactly how much of it there is, but it’s likely there’s quite a lot. Consider, for example, health care in America, about one-sixth of our economy. There are many reasons why the United States spends 80 percent more per capita on health care than does Canada, while achieving no better results, but one of the biggest is that Canada has wrung huge amounts of rent out of its health-care system and we haven’t.9 Every Canadian is covered by nonprofit rather than profit-maximizing health insurance, and pharmaceutical prices are tightly controlled.
By contrast, in the United States, drug companies overcharge because of patents, Medicare is barred from bargaining for lower drug prices, and private insurers add many costs and inefficiencies.10 Not even major reforms won by President Obama in 2010 are likely to change this. Indeed, by expanding coverage, they may actually increase the rent extracted by health-related companies.
Or consider our financial sector. Commercial banks, the kind that take deposits and make loans, receive an immensely valuable gift from the federal government: the right to create money. They’re allowed to do this through what’s called fractional reserve banking, which lets them lend, with interest, about ten times more than they have on deposit.11 This gift alone is worth billions.
Then there are commercial banks’ cousins, investment banks, which are in the business of trading securities. They can’t mint money the way commercial banks do, but they have tricks of their own. For one, they charge hefty fees for taking private companies public, thus seizing part of the liquidity premium that public trading creates. For another, they make lofty sums by creating, and then manipulating, hyper-complex financial “products” that are, in effect, bets on bets. This pumps up the casino economy and extracts capital that could otherwise benefit the real economy.
For many decades, the Glass-Steagall Act of 1933 prevented a single company from being both a commercial and an investment bank. The law’s reasoning was that since commercial banks are federally insured, they shouldn’t engage in the riskier activities of investment banks. In the 1980s and ’90s, however, banking regulations were trimmed, and New Deal laws, including Glass-Steagall, were repealed. By the time the housing bubble burst in 2008, financial companies were reaping about a third of all corporate profits, an astounding proportion that doesn’t reflect the huge bonuses they paid their top employees (such bonuses reduced their profits by $18 billion in 2008).12 Even more amazing, by 2010, less than two years after the biggest taxpayer-funded bailout in history, the banks’ profits and bonuses were back to pre-crash levels.13
We could wander through other major industries—energy, telecommunications, broadcasting, agriculture—and find similar extractions of rent. What percentage of our economy, then, consists of rent? This is a question you’d think economists would explore, but few do. To my knowledge, the only prominent economist who has even raised it is Joseph Stiglitz, a Nobel laureate at Columbia University, and he hasn’t answered it quantitatively.
The amount of rent in the US economy, Stiglitz says, is “hard to quantify [but] clearly enormous.” Moreover, “to a significant degree,” it “redistributes money from those at the bottom to those at the top.” Further, it not only adds no value to the economy but “distorts resource allocation and makes the economy weaker.”14 And finally: “There’s no begrudging the wealth accrued by those who have transformed our economy—the inventors of the computer, the pioneers of biotechnology. But, for the most part, these are not the people at the top of our economic pyramid. Rather, to a too large extent, it’s people who have excelled at rent seeking in one form or another.”
EIGHTY YEARS AGO, JOHN MAYNARD KEYNES looked forward to what he called “the euthanasia of the rentier.” That day would come when the supply of capital was so large, relative to the demand for it, that the return to capital “would have to cover little more than [its] exhaustion by wastage and obsolescence together with some margin to cover risk and the exercise of skill and judgment.” At that point, Keynes opined, “the intelligence and determination and executive skill of the financier will be harnessed to the service of the community on reasonable terms of reward.”15
Alas, it was not to be. In seeming defiance of the laws of supply and demand, the rentier class, rather than disappearing, has ascended to new heights. How this happened is a long story, the essence of which is that, with the help of a compliant political class, the captains of finance built an enormous casino in which, thanks to leverage and legerdemain, unnaturally high returns can still be won.
A modest poker parlor for the rich would be one thing, but the magnitude of this floating casino is staggering. Consider these numbers:
• The global value of financial derivatives in 2012 was $687 trillion.16 That compares to a total world GDP of $72 trillion.
• The total value of foreign exchange transactions in 2010 was $1.5 quadrillion (a quadrillion is 1,000 trillion). Of that amount, only 1.5 percent was used to pay for real goods. The rest was currency speculation.17
I focus on this bloated casino because it’s both a problem and an opportunity. The problem is that it extracts billions from our real economy and leads to bubbles, crashes, and extreme inequality. The opportunity—if we seize it—lies in the possibility to redirect some of these extractions to real people and businesses.