Complaining about hedge fund managers and their paychecks

Yesterday, the New York Times ran a much-remarked-upon story entitled "Wall Street Winners Get Billion-Dollar Paydays" in which they suggested, by their tone and choice of quotations, that income inequality poses a hidden danger to the economy.

To come up with their story, the Times used an article in a magazine called Institutional Investor's Alpha which estimated hedge-fund managers' paychecks for 2007 by looking at the reported performance of those funds and their stated fee structure and calculating what the Alpha article called "earnings" and the Times story called "the manager's pay."

Whether or not that translates directly to the managers' actual pay for the year, the real question is -- what is the problem?

Plenty, according to the Times and the sources they quote in the story. The story's author notes that, while the top 25 hedge fund managers all made $360 million or more in 2007, "the median American family, by contrast, earned $60,500 last year."

This inequality of income must be a harbinger of disaster, according to the Times. "Since 1913, the United States witnessed only one other year of such unequal wealth distribution — 1928, the year before the stock market crashed," the article says, citing research by a senior fellow at the Economic Policy Institute in Washington (a lobbying group of academics that bills itself as "a nonprofit, non-partisan" think tank but whose articles generally advocate against free-market policies). "Such income inequality is likely to impede economic recovery," the Times quotes the same source as saying.

The Times also quotes famous bond manager Bill Gross, who says that the widening income divide (widening because of the high pay of hedge fund managers) is a cause for worry:

"Like at the end of the Gilded Age and the Roaring Twenties, we are going the other way," Mr. Gross said. "We are clearly in a period of excess, and we have to swing back to the middle or the center cannot hold."

Why "the center cannot hold" is a mystery (it is also, of course, a literary reference to a line from W. H. Auden's poem "The Second Coming," published in 1920 and therefore written during the period that Auden was "a left-wing political poet and prophet"). Why does the ability of any American to make a paycheck of whatever size threaten the prosperity of anyone else?

The anger certain elements feel about the paychecks of others stems from either envy or (if we want to put a more charitable interpretation on it) the persistence of the erroneous zero-sum mentality, which we have discussed in earlier posts such as this one.

A perfect illustration yesterday of zero-sum thinking was radio talk show host Michael Savage, railing about the hedge fund managers' pay and citing the Times article, who said that it was obvious that three billion dollars didn't materialize out of thin air, and that for hedge funds to make that money, someone else had to lose it!

Those hedge fund managers did not coerce anybody to invest in their funds, and they publicized their fees to investors before they invested, so participation was absolutely voluntary. Investors voluntarily weighed the potential value that those hedge fund managers could bring versus the cost of participating in those funds, and those who felt that the value was justified invested and those who did not used their money elsewhere.

The manager with the pay cited prominently in the Times article and by commentators on the article, whose calculated revenues were $3.7 billion, achieved that number by making investment returns in 2007 of 590% and 353% on funds that he managed.

Clearly, such investment returns are considered valuable to some investors, who willingly pay those who can achieve such returns for them. Also obvious is the fact that, if you can return 590% on a sum in the millions or the billions of dollars, you can add more value than if you earn 590% on a smaller amount, such as on one dollar. Generally, when people earn a lot of money in a free society, it is because they add a lot of value in a way that others are willing to pay for (in other words, in a way that others will trade some of the value that they added by their work somewhere else). Of course, this argument concerns earnings that were not achieved through coercion or through fraudulent deception (for example, if the hedge funds held a gun to investors' heads and ordered them to invest with them, or if they said that their fees were going to be one thing and then they deceptively charged something else, but nobody is arguing that this is what happened).

The ability to make money by adding value wherever you most see fit to do so is the mark of a free economy. Not only is it not a threat, but it is vitally necessary. People like Bill Gross who say that rising pay on the upper end means that "the center will not hold" are mistaken: it is when governments come in and remove the ability of citizens to make more by adding more value that things fall apart.

If governments regulate against income inequality, it actually leads in extreme cases to forced labor. If pay were mandated to be equal for all work, and someone who ran a hedge fund or did brain surgery or jumped out of airplanes in the middle of the night into combat situations was mandated to have the same pay as someone who splits peas for a living, then there would be no incentive for searching out ways of adding more value. It would be necessary for the government to force people to do more dangerous, difficult, or unpleasant work, because there would be no reason to sign up for the added risk or difficulty. In fact, this is just what happened in communist countries such as China during the twentieth century.

The zero-sum mentality that is behind all the agitation against the paychecks of hedge fund managers, CEOs, or partners at investment banks is fallacious and ultimately dangerous to freedom.