The Paradox of Profits: Part 1

This is the first of three essays on the topic of profits. The paradox is that while the profits that accrue to any given individual may be unjust, the profit system itself is necessary in order to have a modern, progressive society. There is no simple way for us to enjoy the benefits of the system while overcoming all of the instances of injustice.

This essay will discuss the ways that individual profits can be unjust. The next essay will discuss the merits of the profit system. The third essay will discuss the challenge of reconciling these two propositions.

Note that I have a Ph.D in economics and I am an economic conservative. I assume that the typical reader here is neither of those. Let us approach this topic with a goal of learning from one another, not putting one another down.

Although economists have technical terms such as “economic rent” or “return on investment” that pertain to profits, I want to use a definition that comes closer to ordinary usage. Let us think of profit as income that accrues to investors, business founders, and high-salaried employees, particularly top executives.

Another term that we need to understand is “just” or “unjust.” I want to use an approach based on common intuition. As a thought experiment, imagine subjecting an individual’s income to a courtroom trial, in which the jury gets to decide whether that person’s profits are justly earned or not. The jury can take note of a physician’s arduous path through medical school and long hours of work but also will look into over-billing or unwillingness to take patients on Medicare. When I think about unjust profits, I think of instances where, if I were on the hypothetical jury, I would vote to disapprove of someone’s profits.

Economic conservatives often claim that profits are the just reward for hard work, sacrifice, and risk-taking. But my own view is that this is only partially true.

The Millionaire Next Door, written by Thomas J. Stanley and William D. Danko and published in 1998, describes the sort of people whose profits most of us would approve. Many of them operate small, family-owned firms. Think of a business that you would find in a strip mall, such as a restaurant, a convenience store, a hair salon, or a martial arts studio. Owners of these sorts of businesses put in long hours, deal with many kinds of adversity, and face substantial risk.

Another characteristic of next-door millionaires is that they postpone gratification. Today, if at age 30 you have an annual income of $70,000, you might be able to choose a lifestyle in which you save $10,000 or one in which you save nothing. Households that choose to live well within their means today stand a good chance of accumulating a million dollars by the time that they retire. Households that instead save very little will end up with very tiny nest eggs.

If this were the whole story about profits, then our hypothetical jury would approve most cases. But that is not the whole story, as I can illustrate using two personal experiences.

In the late 1980s and 1990s, I worked for the Federal Home Loan Mortgage Corporation. I like to say, “I worked Freddie Mac before it became famous.” In the latter part of the 1990s, I founded an Internet business, which we sold in 1999. I like to say that “If you get a chance to sell an Internet business in 1999, take it.”

For many years, Freddie Mac gave its shareholders generous dividends and nice appreciation of its stock price. With a traditional private company, these shareholder profits would be reward for supplying the firm with necessary capital with which to expand. However, in the case of Freddie Mac, the ability to expand came from the U.S. government, which sponsored the creation of the enterprise and was widely viewed (correctly, as it turned out) as willing to bail out Freddie Mac’ bondholders if necessary. I do not think that our hypothetical jury would have readily approved the profits that were earned by Freddie shareholders in the 1990s and early 2000s.

In 2003, long after I had left the firm, Freddie Mac’s board replaced top management with a new management team. This team did two things differently. One is that these executives awarded themselves much higher compensation packages, with the CEO taking more than $10 million in a year where the business was falling apart. The other change they made was to adopt riskier business practices that by 2008 had wrecked the company and arguably the entire economy. As a former employee wrote,

In addition to a $200,000 increase in base salary, [the CEO] would receive “a special extension bonus” of $3.5 million, an additional equity grant of $800,000 in restricted stock, another equity grant for 2008 valued at $9.4 million, of which $8.8 million was guaranteed, plus a “special cash performance award” of up to $6 million, “depending on the number and strategic value of the performance milestones that have been achieved.”

Employees were livid. The company’s finances were in tatters.

(see Susan Wharton Gates, Days of Slaughter: Inside the Fall of Freddie Mac and Why It Could Happen Again)

I do not think that our hypothetical jury would have approved, at least in hindsight, the profits taken by the new management team.

As to the Internet business that I founded, it was bought by one of the dotcom bubble enterprises, for a combination of cash and stock. Not surprisingly, the stock soon crashed (and we were locked out of selling it), but I point out that “the cash retained its value.”

In effect, my partners and I received a gift from the hapless fools who purchased stock in our acquirer. A hypothetical jury might give us credit for spending several years working extremely long hours without knowing whether any of our effort would pay off. Also, we made some good decisions that helped to make our business an attractive acquisition — as well as some bad decisions that I could laugh about when it was all over. But I don’t think that the jury would have approved of everything that we took away from our adventure.

My general point here is that not every profit is well deserved. Some people, like the management team that took over Freddie Mac in 2003, have enjoyed nice profits when they deserved instead to be punished. And some people, like me, benefit from luck and timing.

The bottom line, in my view, is that while the “millionaire next door” model of hard work, delayed gratification, and risk-taking has some truth to it, that model is not the whole story. I think that it is reasonable to say that, using the hypothetical jury as our mental model, there are plenty of cases in which profits are unjust.

But that is not the end of the story. I hope you will tune in for the other two essays in this series.