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Understanding the Plutocrats: Talent vs. Capital, The Illusion of Skill, and the Winner’s Curse

In my spare time, I have been reading Chrystia Freeland’s The Plutocrats. A refreshingly nonjudgmental book, it seeks neither to condemn nor defend the super-rich, but simply to understand them.

The author’s brisk, journalistic prose, with references hidden away at the end by page number, belies the fact that she has done her homework in the economic, sociological, and historical literature. The text is further enriched with material drawn from Freeland’s own interviews with many of the world’s wealthy. The result is both entertaining and full of real insights.

The Working Rich, Then and Now

One of Freeland’s central questions is why today’s super-rich have so much more money than the wealthy of old. She begins by noting that hereditary wealth has little to do with it. Our plutocrats are, by and large, the working rich. They not only show up at the office every day, but work longer hours than most of their subordinates.

Of course, working rich are not a new phenomenon, especially in America, land of the Carnegies and Rockefellers. Still, even the legendary Robber Barons were not all that wealthy by modern standards. Freeland borrows a yardstick proposed by Branko Milanovic that measures a person’s wealth according to the number of fellow citizens whose labor it could purchase. Andrew Carnegie, at his best, could command the labor of 48,000 Americans, and John D. Rockefeller 116,000. By comparison, before his arrest in 2003, Mikhail Khodorkovsky had wealth equivalent to a year’s labor of 250,000 Russians and Carlos Slim, now the world’s wealthiest person, is worth the annual income of 400,000 Mexicans.

Some plutocrats have become rich by feeding off modern states that are themselves richer than those of former times. Freeland devotes a long chapter to rent-seeking, corrupt privatization, and other forms of political parasitism. She traces at least some of the wealth of both Slim and Khodorkovsky to advantageous privatization deals, and notes that writers like Simon Johnson have rated the rent-seeking prowess of American bankers as equal to that of emerging-market oligarchs.

Without belittling political considerations, however, the parts of The Plutocrats that I found most interesting concern sources of super-wealth that arise from within the market system itself.

Talent vs. Capital

One market-based reason the rich are getting richer is what Freeland calls the “Marshall effect.” More than a century ago, the English economist Alfred Marshall observed that the best people in every field, whether opera singers, painters, or managers, get richer when their clients get richer. The “Rosen effect” also helps. As University of Chicago economist Sherwin Rosen notes, today’s technology allows the best people in each field to reach a far wider audience than in the past. For example, Luciano Pavarotti was able to earn far more than did Elizabeth Billington, the most notable opera star of Marshall’s day, because Pavarotti’s voice was recorded on CDs and transmitted on television. But the Marshall effect and the Rosen effect are only the beginning of the story.

Freeland next invokes the “Martin effect,” which she borrows from business consultant Roger Martin. According to Martin, whereas a struggle between capital and labor dominated the economy for much of the nineteenth and twentieth centuries, the new focus is on a war between capital and talent. The results can be seen in many fields, for example, sports stars who extract a larger share of their leagues’ total revenues than in the past. The triumph of talent is most spectacular of all in finance, where the executives of publicly traded financial firms earn more than those of nonfinancial companies, and the top 25 hedge fund managers earn more than all S&P 500 CEOs combined.

Freeland thinks a key explanation for the triumph of talent in the corporate world is the fact that CEOs routinely sit on, and often dominate, the boards that set their own salaries. Economists call this kind of self-dealing an “agency problem.” One piece of evidence for the agency problem is that talent at the top reaps more generous rewards than talent farther down the corporate hierarchy. She cites one study that found a 10 percent increase in a company’s value was associated with a 3 percent increase in pay of the CEO, but only a 0.2 percent increase in the pay of other employees.

The Illusion of Skill

At this point, though, I begin to think that Freeland does not follow her line of analysis far enough. How real is the talent that is winning all those rewards at the expense of the shareholders who supply the firms’ capital? What if the rewards are due not to managers’ real skills, but to the illusion of skill, a concept that Daniel Kahneman uses in his book Thinking Fast and Slow

Kahneman introduces the illusion with a study he and some colleagues made of a group of investment advisers, much of whose pay was based on the performance of the portfolios they chose for their clients each year. When he compared their performance from year to year, he found a correlation of just .01, that is, essentially zero. There was no talent there. What was being rewarded was pure luck.

When the analysts reported these results to the firm’s executives, they brushed them aside and made no changes to their compensation system. Here is how Kahneman explains their failure to react:

The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions—and thereby threaten people’s livelihood and self-esteem—are simply not absorbed. The mind does not digest them.

Later he adds, “The person who acquires more knowledge develops an enhanced illusion of her own skill and becomes unrealistically overconfident.”

A culture with an ingrained faith in skill combined with self-reinforcing illusions helps explain how corporate boards can, year after year, side with “talent” against the shareholders whose capital they are duty-bound to serve.

The Winner’s Curse

Finally, we can add one last factor that has aided the rise of the plutocracy, one that Freeland recognizes implicitly, but not explicitly. It stems from a link that she notes between the increase in relative pay of top executives and an increase in executive job-hopping. In the 1970s, 85 percent of CEOs had come up through the ranks in the companies they headed. By the 1990s, when CEO pay was rising at 10 percent per year, the share of outside executives had risen to 25 percent, and those outside hires were earning a premium of more than 20 percent over inside hires.

Freeland leaves these intriguing facts hanging, but I have a guess about where the relationship between job-hopping and increased pay comes from. The mechanism that explains it is the “winner’s curse.”

The winner’s curse is a term from the theory of auctions. Suppose you are auctioning off something that has the same intrinsic value to all bidders. A common classroom example is a jar full of pennies; a real-world example is a lease to drill for oil on a certain sector of seabed. The number of pennies in the jar or the quantity of oil in the ground is the same for all bidders, but none of them knows just how much the prize is worth. They have to base their bids on estimates that have a risk of being too optimistic or too pessimistic. The highest bidders in such auctions will typically be the ones who most egregiously overestimate the true value of the prize. Only when they open the jar and count their pennies, or drill their exploratory wells, do they find themselves cursed by their own over-optimism.

The market for job-hopping CEOs is not formally an auction, but it is enough like one to apply the same principle: The winning bidders for the services of on-the-market CEOs are likely to be the corporate boards that most overestimate the contribution they will make to their shareholders’ profits. And if, as Kahneman thinks, the skill they are bidding for is largely illusory, then their overestimates are likely to be egregious indeed.

The Bottom Line

The bottom line: There are many reasons for the rise of today’s plutocracy. Some of them seem benign. For example, it is presumably all to the good that an increasingly globalized economy allows more people to use the best software, enriching its writers in the process. Other sources of wealth, especially those that arise from political corruption and influence peddling, are clearly undesirable. Also problematic is personal wealth that stems from peoples’ foolishness in too highly estimating and too generously rewarding their own talents and those of others, often at the expense of the institutions they work for.

We need to keep all three of these reasons in mind when invited, as we so often are, to view the super-rich as god-like “job creators” who deserve our deference and protection.

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