Planet Money
11:19 am
Mon May 7, 2012

How An Investor's Gain Can Be Your Loss

In Sunday's New York Times Magazine, Adam Davidson writes about Ed Conard, a friend of Mitt Romney's and a defender of extremely wealthy investors. Conard argues that investors contribute far more to society than their own bank accounts. Dean Baker, an economist at the Center for Economic and Policy Research, disagrees. Baker is quoted in the story; we asked him to elaborate in the following post.

In his new book, Unintended Consequences: Why Everything You've Been Told About the Economy Is Wrong, Mitt Romney's former business partner Ed Conard claims that for each dollar of wealth pulled in by investors, society gets up to $20. I took issue with this claim, saying that the ratio is closer to 5 to 1. However even this lower number caught many by surprise, thinking it to be an endorsement of Conard's view of the economy, albeit in a bit toned down form. It's worth clarifying what is at issue.

First, the 5 to 1 number is simply a reference to the ratio of labor income to capital income (after taxes). For example, in 2011 after-tax corporate profits were just under $1.1 trillion, while labor compensation was over $5 trillion. If we add the corporate tax revenue to the labor income side, the total is more than $5.5 trillion. The take-away from this is that when companies have productive investment and it actually leads to economic growth, then everyone can benefit.

Even when we talk about productive investment, much of the individual investors' gain is at the expense of other investors. For example in the case of Apple, perhaps the country's most innovative company, we would still have smart phones, tablet computers, and downloadable music if Apple never existed. The products just would not be quite as good. Much of Apple's profit would simply show up elsewhere in the tech sector if the company did not exist. While Apple's innovations have clearly benefited society it would be inaccurate to say that the benefit is five times Apple's profits.

However, every investment by a business person doesn't add to the stock of productive capital. The purpose of much investment is simply to gain rents at the expense of others. This is true in every sector, but especially in the financial sector that is the home of Conard and Romney.

To take an extreme case, high-speed trading is a fast growing sector on Wall Street. One of the main ways that high-speed traders make their money is by designing complex computer programs that allow them to detect large stock purchases and to jump in ahead of the purchaser by a fraction of a second. They can make enormous profits this way (the most successful high-speed traders pocket hundreds of millions or even billions of dollars a year), but they are creating no value for the economy. They are just grabbing profits that would have otherwise gone elsewhere.

Private equity firms, like Bain Capital, where Romney and Conard were partners, often engage in similar sorts of rent-seeking behavior. For example, it is standard practice for these firms to fill up the companies they acquire with debt. This offers a big advantage to private equity companies, since the money they pay out in interest to lenders is tax deductible. This can increase profits simply by reducing their tax bill. In this case the private equity company is gaining at the expense of taxpayers.

Private equity firms routinely engage in many other tactics along these lines. These practices can allow private equity companies to garner great profit while creating little or no actual benefit for society. (My colleague Eileen Appelbaum has done some excellent research on this topic.)

There are also cases where a private equity company takes over a failing company and transforms it into a profitable operation. In this case, the gains to society could be considerable.

I don't know enough about Bain Capital to say what portion of its profits came from rent-seeking, which contributes nothing to society, as opposed to innovative management. However it is highly misleading to imply as Conrad does, that $1 in profit to the individual investor corresponds to $20, or even $5, for the larger economy.

In the case of successful investment in productive activity, the gains to society may considerably exceed the profit to the investor. However, this describes a small minority of what passes for investment in today's economy.

Copyright 2012 National Public Radio. To see more, visit http://www.npr.org/.