Hedge Funds and Rent-Seeking

The economist Robert H. Frank, in an article in the New York Times on July 5 entitled "A Career in Hedge Funds and the Price of Overcrowding," argues that the immense incomes of the most successful hedge-fund managers and private-equity entrepreneurs are drawing excessive resources into those activities. I believe that this is possible, but much less certain than Frank suggests.

An English economist named Arnold Plant argued long ago that patent and copyright laws could have the effect of attracting excessive resources into the production of patented or copyrighted products. The reason was that patent and copyright protection, by excluding competition, enables the patentee and the copyright holder to obtain monopoly profits. Equally productive activities in competitive markets would not generate such profits, and therefore resources would flow from them into the monopolized markets until the profits were equalized in the two sectors. From an overall efficiency standpoint resources would be flowing to a less socially valuable use; they would be socially more valuable in the competitive markets.

This problem is real (though it might of course be offset by the role of patent and copyright protection in enabling external benefits to be internalized) and is dramatized by the phenomenon of the "patent race." Suppose that for an investment of $1 million a product having a commercial value of $4 million can be invented and brought to market in three years, but that for an investment of $2 million it can be invented and brought to market in two years and eleven months. The extra month of output would be unlikely to have a value to society equal to or greater than the extra $1 million spent to get it to market a month sooner, yet if that investment would enable the investor to obtain a patent because he was the first to invent, it would yield him a net of $2 million ($4 million minus $2 million). The problem is not that the successful inventor obtains a return in excess of his cost; this is essential to motivate invention because of the risk of failure. The problem is that he may carry his investment beyond the point at which an additional dollar in investment would yield a dollar in additional value to society.

I am skeptical that the situation in the financial management market is the same. No doubt, as Frank argues, there are diminishing returns to financial management because there are only so many underexplored financial opportunities. But suppose, plausibly, that there is enormous uncertainty concerning the design and implementation of investment strategies. The higher the rewards for success, the more people (as Frank emphasizes) will be attracted to a career in financial management, and the likelier therefore that stars will emerge. If these winners create enormous social values, this may "pay" for the losers, who were lured by the prospect of becoming winners from alternative career prospects in which their social product would have been greater.

It is not like a race for buried treasure or to exhaust a coal mine or an oil field, because there is no fixed quantity of financial opportunities. New ones keep opening up all the time.

So it seems that Frank has really posed an empirical question rather than being able to offer (as he thinks he has done) a theoretical answer. One empirical dimension is the actual social value added of star financial managers. Here one might be tempted to distinguish between hedge funds, which invest but do not manage, and private equity firms, which restructure the companies they acquire in order to increase the companies' value. It is easier to see the contribution of restructuring to social value, and harder to see the contribution of trading in securities. But to the extent that hedge funds invest in new enterprises or buy stock or other securities issued by enterprises, they contribute directly to production. And even when just buying securities owned by investors rather than issued by companies to raise capital, hedge funds and other investment companies contribute to a more accurate valuation of securities, which plays a vital role in directing economic resources to their most valuable uses and users. A company whose stock price rises because investors have correctly determined it to be undervalued can raise capital at lower cost and thus attract resources to an activity in which the resources will be worth more than they are worth in their present use.

But there is no economic law that says that the reward of a financial manager is always equal to the contribution that his management makes to the efficiency of the economy. It may be much greater. This is most easily seen by supposing that luck plays a large role in investment success. Then a career in financial management might attract substantial resources (in the form mainly of the opportunity costs of the time of the financial managers) that produced private rather than social value--private value in the form of large rewards that were the product of luck rather than skill. That would support Frank's conclusion.

Frank points to overconfidence bias as a factor in attracting people to the hedge funds and private equity firms irrespective of the social value of such careers. That bias has been well documented, but so has a force that tugs in the opposite direction--risk aversion. Kenneth Arrow long ago argued that because of risk aversion, there is underinvestment in risky but socially productive activities; his example was innovation. Overconfidence bias, to the extent it offsets risk aversion, may actually improve economic efficiency, a possibility that Frank ignores.