the origins of profit, part 1

I guess the set of things I tend to go back to thinking about over the span of a given year or two tends to remain relatively narrow. I keep going back to thinking about value and profit, two things which I have posted about several times within the past 2 years.

Most recently this came up again as a friend commented on Facebook to say something about the preferred capital gains tax rate, and how it didn't bother him that certain rich people, such as Mitt Romney or Warren Buffet, pay lower tax rates (because they only pay capital gains) than the middle class. He then went on a rant about how the people who pay only capital gains tax and not regular income tax tend to be the most productive and are contributing a lot to the economy, creating jobs, etc.

I responded by saying that I viewed capital gains as a kind of unearned income, similar to someone who wins the lottery, and therefore if we really wanted the tax code to be perfectly fair, capital gains should be taxed at 100%, not 15%. It's not the kind of income that you have to do any work to get, instead it's just a way to get paid for already being rich and doing nothing. He countered by saying that I was implying thinking was not a type of work, and I assured him that I did indeed consider thinking to be work, but I didn't think most capital gains required thinking to achieve--rather, they just require capital.

This got me thinking again about the origins of profit, and whether what I said at the spur of the moment on FB is really true, or if it's more complicated, or if I'm just dead wrong there, and there is a good reason why capital gains could really be considered to be "earned" in the sense that wages are. (Mind you, I did add a comment that despite not considering capital gains or lottery winnings to be earned income, I do think it is fine for someone to legally keep their winnings, minus taxes. I also acknowledge that making everything perfectly "fair" may have large negative consequences on the growth of the economy, and that if given the choice between the two I may prefer economic growth to fairness.)

Let's start with a definition of "fairness". It's surely a loaded and contentious term, but for my purposes here I think "exchanging value for value" will suffice. In other words, if you can demonstrate that somehow, a person who reports a capital gain on their tax forms gave up something of equal value to the thing they received, then I'd agree that this was a "fair" transaction. If not, surely it was unfair (although perhaps still justifiably legal).

On the face of it, the whole idea of a capital gain seems to violate this principle trivially. By definition, a capital gain is when you buy something at a lower price and then sell it at a higher price. So if there is any real "value" associated with the thing that was traded, it's hard to see how both of these transactions could simultaneously be fair. Of course, this goes back to my related subject of frequent thought this year, the connection (or lack thereof) between fact and value. For someone who believes in objective value, two different exchange values for the same good seems like a direct and immediate proof that there was some unfairness somewhere. For someone like myself who believes in subjective foundational values, the connection is less direct, but it still seems like there is something unfair going on here. Of course, one of the main important shifts from classical economics to neoclassical economics was a shift from thinking about objective value to subjective value, and classical economists like Marx who believed in objective value tended to be a lot more sympathetic to the idea that corporate profits were unfair and unjust, whereas later neoclassical economists tended to hand wave them away because of subjectivity. If all value is subjective, then there really isn't any such thing as "fair" in the first place, which is purely a normative judgement unconnected to any economic facts. Does that mean my intuitions are naive and if I really followed through on the consequences of my subjectivist foundations for value that I'd come to agree with the neoclassical economists? The purpose of writing this post is to explore that.

Continued in part 2...

the origins of profit, part 2

As I mentioned in part 1, it seems trivially true on the surface of it that if you buy something for a lower price and sell it for a higher price (a capital gain) that you've received more value than you've given, and hence that you haven't really "earned" the extra value you wind up with.

But there is a bit more to it than that. First, there is the question of whether between the buying and the selling, you've done something to add more value to it. And second, there is the question of time. If there was a long time which elapsed between when you bought it and when you sold it, perhaps it doesn't make sense to just directly compare the two prices, some adjustment is needed. I'll address these 2 points in order.

On the question of adding value to it in between the transactions, I think this is what my college friend was getting at by saying that perhaps I'm not considering thinking to be work. He's imagining that there is some thinking done that increased the value of the commodity and therefore, "added value" to it. For example, if an entrepreneur starts a business with some of his own capital, and hires a bunch of workers, and then after he's paid all of his workers he finds that his total costs were less than his revenues, perhaps the extra "profit" that he keeps has to do with the thought that went into organizing the business and managing the employees.

But really this is not a pure example of capital gains, because the entrepreneur in question is acting both as CEO and as investor at the same time. He's supplying both the capital and the management skills necessary to run the company. In a corporation, you can see a more pure example of why this should be split into two different things, where the investors supply the capital and the CEO is treated simply as another hired employee. Yes, the CEO must do a lot of real work to run the company, and yes he has to be compensated for that. But the investors don't do any work, they just supply the money. And yet often, there is still profit left over to give to the investors in the form of dividends. It's this profit that goes down on their tax forms as "capital gains" and it's this profit that I tend to think of as unearned, not the CEO's salary (inflated though it may be in present day).

This brings us to point 2, time. Perhaps the analogy to make here to see why capital gains might be fair is one between dividends and interest. Perhaps the added value the investors are supplying has to do with the fact that the value of the money they use to buy the stock is greater than the value of the money later when they sell the stock. If taken as a literal statement, the previous sentence would only be true if the "real" profit was 0 while the "nominal" profit was non-zero, in other words, the apparent profit was only due to inflation. Obviously, that's not true in most cases. Investors would not be happy, and indeed would not even bother investing, if their real profits were zero. But then, maybe the value the investor is adding is the use of his money for some period of time, so that his compensation in dividends is analogous to the interest that a lender of money is paid on a loan. This is the most deep and interesting part of the whole thing, which would lead into another discussion on whether the whole idea of getting paid interest on a loan is similarly unfair. (And interestingly, there is something called "Islamic banking" which is banking where it's illegal to charge interest on a loan because it's considered unfair and "usary" according to Islam. There were similar laws in
early Christian civilizations, but this ideal soon gave way to the more pragmatic practice of allowing bankers to charge interest.) Unfortunately, I don't feel I understand this one quite well enough to say much about it, so I'm going to skip over it for now. Let's assume for the sake of argument that charging interest on a loan is indeed fair, and that the Koran is a book of lies. I think we can skip over it by again separating out two different parts of the investor's returns, one due to the interest they would have earned if they'd left the money in a bank, and one due to the additional profit they received by choosing to instead invest it in a company.

Interestingly, when I looked this up on Wikipedia, I found that economists and accountants use two different definitions of profit. So the answer may turn out that capital gains are either partially earned or unearned depending on which definition you're using. Accountants tend to consider profit to be simply revenues minus costs, in other words the amount that is actually paid to the investor. Makes sense, but the economists do something similar to what I was suggesting in the previous paragraph and include in the costs one more type of cost which is "opportunity cost". By choosing to invest the money there rather than somewhere else, the investor is giving up the interest or dividends he or she might have earned on the money somewhere else. So the pure profit, or "economic profit"--as economists call it if the word "profit" itself is ambiguous--refers to how much extra money the investor made relative to a typical investment they could have made elsewhere.

And from looking at various Wikipedia pages, I get the sense that it is relatively well accepted that economic profits in a particular market are due to markets deviating from pure competitive equilibrium. In other words, they are always due to some kind of barrier to entry that makes it difficult for new businesses to break into the same market and compete with the existing firms. If it were easy to compete, then somebody would come into the market and undercut the huge profits of the existing firms, gradually driving the profits back down to the equilibrium "normal profit" level. The bottom line is that if anybody is making an economic profit (also called "abnormal profit" sometimes) then they are doing it because they have some privileged position that allows them to exclude others from competing, not because they are receiving the "fair market value" of the goods they are producing. So then the question becomes, what is this normal profit and does it differ from the interest that you'd receive on a risk-free asset like a longterm government bond plus a risk premium? If it doesn't differ, then I think we've come to an answer, namely that normal profits are fair if and only if charging interest on loans is fair, and abnormal profits are always unfair. (If it does differ, then the question is what else is entering the equation here?)

You pay capital gains tax not just on economic profits but on any profits including "normal" profits. So my conclusion is that capital gains are somewhere between partially earned and completely unearned, depending on whether you feel that charging interest on a loan is earned or unearned income. And I do have more to say about that, but as I said interest is something that's a lot more deep and mysterious and therefore my thoughts and beliefs on it are not as well formed or complete.

the origins of profit, part 3

Ok, I guess it's hard for me to say "this is the most deep and interesting part of it" and then just skip it and refuse to say more. So I'll bite. What is interest really and is it fair? Or is it usary? I get the sense that this is something which is very deep and has been debated for ages, and is in some sense at the very heart of capitalism.

But before I say something about interest, let me make one more comment about capital gains. Based on my previous post, you might think that, if you believe interest is fair and therefore normal profits are fair, then maybe most capital gains involve normal profits, and are therefore fair. I'd have to look this up to be sure, but I wanted to point out that I *think* the case is exactly the opposite. Most profit levels are abnormal, not normal. Normal would be the break-even point where a business was just on the edge of going out of business. If they slip below the normal profit level then they're not going to find any more investors because the investors will shift into companies making abnormal profits. Also, consider the fact that the long term yield of investing in the DJIA is consistently much higher than the yield on bonds, and yet if the companies that compose the Dow were only making normal profits, you would expect the only difference to be a small risk premium accounting for the possibility that the entire stock market collapses. This doesn't seem to be the case at all, from what I can tell.

Moving on to interest, what is it? Interest can be broken down into a sum of several things. One is inflation, which is interesting in itself but not terribly relevant here. Another is a risk premium which depends on how likely it is that the borrower will default on the loan. Another is a liquidity premium which depends on how easy it is to immediately demand your money in the form of cash (for example, you will get a higher interest rate on a money market than a checking account because it's harder to get the money back immediately, and an even higher rate on a CD where it's almost impossible to get the money back ahead of time). And then left over after all of those factors in the sum is just a raw number which seems to indicate something like the compensation for a person "not using" their money, and instead letting someone else use it for a while.

If you make an analogy to rent, then this leftover factor seems to make sense. If you're not using your house, you can rent it out to someone else for a while and they will make regular payments. So why not do the same for your money? But two things should be mentioned here. First, even rent was considered by many classical economists, including Adam Smith I believe, to be "unearned income". And in light of more modern economics, it seems only fair to the extent that the person has legitimately acquired the house through their own blood sweat and tears. If instead they simply inherited the estate (whether house, land, or money) from their ancestors, as tends to happen within many rich families from one generation to the next, then it's not true that they did anything to earn it although perhaps their ancestors did. And if you trace the ancestory back far enough, you may find that the land was acquired by conquering some other people, or that the wealth was built up through slavery or other unfair practices.

But even assuming that all of the ancestors at some point legitimately built up the wealth or the land from their own labor power, and assuming modern neoclassical economics (at least at the micro level), it still seems like there might be something a bit different about money than land. If I own a house, then there is some tangible good that I could otherwise be getting real use out of, raising a family in it perhaps or starting a clothing factory. But if I own money, all I have is a number in my bank account, or at best a physical piece of paper. It's not anything anyone can use directly, its only use is supposed to be as a placeholder for value. It's supposed to be something that I can trade for something with actual value that I can use. Money is not something tangible, it's more like a right or an agreement. Money is a legal document that gives me the right to have power over other people or over my environment. It's something that grants someone more freedom. When I then take that and use it to convince someone else to give me even more money, but I don't have to give up the original money in the end... what just happened other than using your power over someone else to extort them into giving you even more power?

Marx criticized capitalists for reifying money into something tangible and I think there's both something insightful about that but also something that seems shortsighted. I want to say that there shouldn't be much of a difference between tangible assets and intangible assets, as society becomes more and more virtualized. The lines between physical and virtual are disappearing, and for the most part that seems like a good thing, not a bad thing. But there's also something naggingly right about the basic point. Is it fair or is it not fair to use your money to get even more money from someone else and keep all of the original money? And once you have more than the basic amount of money required to live a comfortable life, are you actually giving up anything by investing the rest of it to get even more of it? It seems like a no-brainer that you would.

Then there is the awkward and bizarre issue that if interest is really some sort of compensation for giving up something, then there ought to be a relatively straightforward way of determining what the "fair" interest rate is to charge. And yet, interest rates are not really determined by the free market, they are simply set by the Federal Reserve. What rate they get set to depends on what the people in charge want the economy to do, not on any measure of fairness... if the fairness of capital gains depends on the fairness of interest rates but the interest rates are not set based on fairness, where does that leave us?

Continued in part 4...

the origins of profit, part 4

So, our hunt for the origins of profit has led us to the question of where interest rates come from... and one answer to that question is that they are simply dictated by the Federal Reserve. But it's not quite that simple because even if they are adjusted in the short term to boost the economy or to ward off inflation, maybe in the long run they try to set them to some kind of objectively determined rate that depends on economic growth. And maybe if they didn't set them approximately right, the whole economy would break down? We're getting into territory where I don't have enough knowledge to say much and I suspect asking different economists would give you very different answers depending on what school of thought they subscribe to. Nevertheless, I will continue along my train of thought, making the best guesses I can.

Interest rates are closely connected to the amount of money in circulation. And by money I don't mean the M1 supply (physical money) but all of the money in the economy, most of which is created by commercial banks through fractional reserve banking and the practice of lending out money that then gets deposited in another bank and then lent out again, multiplying the base currency by the "money multiplier" that's determined by the reserve requirement. The bigger the money supply is, the lower the "price" to borrow money is, ie the lower the interest rates. The smaller the money supply is, the higher the interest rates. This is how the Fed controls interest rates. Yes, they directly set the rates that they charge commercial banks for loans through the discount window, but the main way they achieve a targeted interest rate is by buying or selling government securities on the open market, pumping new money directly into the economy or extracting it out. So if you were to make some kind of objective assessment about what the interest rates "should" be it would have to depend on how big the money supply is, but that's what's controlled directly by the Fed.

Now let's return to the concept of "normal profit" for a moment. We've already seen that abnormal profits are unearned and simply due to someone being in a pre-existing position of privelege compared to someone else. But can normal profits be justified? They are typically justified by today's neoclassical economists by the concept of "opportunity cost". But if you think about it, this is somewhat of a circular justification. Let's assume company A returns a normal profit to their investors, that is 0 economic profit. If you ask what value it was that the investor added to the final goods the company produced and sold to its customers, the answer is supposedly "the investor could have used the money to invest in company B which also would have yielded a normal profit--the value added was that the investor gave up the right to invest in company B". But then if you ask what the value added was from an investor who did invest in company B, the answer is that the investor could have invested in company A which returns a similar profit. It all seems like a circular justification aside from the size of the money supply, which is set by government policy. If the money supply is large then interest rates are low and the bar for a "normal profit" correspondingly gets set lower, therefore more money is invested and more business ventures happen. If the money supply is small then the interest rates are high and the bar for a normal profit gets higher, so less business ventures happen and more people are laid off. Hence there is a constant struggle between wealthy investors who want profits to be as high as possible and therefore interest rates as high as possible, and employees who don't want to get laid off who want interest rates to be as low as possible which makes for more business ventures and less unemployment but thinner profit margins. Whoever can lobby the government more easily for their side of the story ends up winning out, and the interest rates get set somewhere in between.

I think the only other part of this whole thing I had intended to mention originally which I haven't yet is the idea of "economies of scale". I wrote an entry in April 2010 about the origins of profit and said that I thought "it takes money to make money" is a central principle behind it. You can see that with interest rates as well--if you have money, you get paid more on a regular basis for having it, even if it is just sitting in the bank.

I likened the principle of "it takes money to make money" to a group of bullies ganging up to have more leverage against smaller cliques on the playground. But defenders of capitalism would call the same thing "economies of scale". Sometimes it is cheaper to produce something when you are producing a whole lot of them than if you are just producing one. And this sounds reasonable, until you realize the connection between this and the idea of "barriers to entry" and the deviations from the perfectly competitive market we mentioned earlier. The more economies-of-scale come into play, the bigger the barrier to entry for other firms and hence the higher the profit margin. If anybody can produce each item at the same cost then the market is highly competitive. But the more it takes a huge amount of capital to get started, the closer the market becomes to a monopoly and the further it gets from the capitalist's ideal of free competition. So an economy of scale makes the capital the investors can raise more valuable, but only because it pushes the market further from free and more towards monopoly. So it's not clear that this is in the end any different from what I described initially, where pooling money together allows you to make more money in the same way that a group of people are stronger than an individual and therefore can more easily team up on smaller groups or individuals, having more bargaining power to get their way.

Bottom line is, our system of fractional reserve banking makes profits possible and economic growth possible, but maybe the Koran has it right in terms of fairness, and neither profits nor interest are really fair in any sense other than "might makes right". Which after all, is the basis for evolution. Is it really a surprise that capitalism, based on social Darwinism, has to rely on a similar justification? The fundamental paradox of capitalism seems to be that, if the market were free then there would be no economic profits, and yet the only thing that can convince people to start businesses and drive growth is economic profits. So capitalism necessarily involves coercion, and there is no such thing as a truly free or fair market where value is exchanged for value.