Hedge funds and Adam Smith

From Julian Robertson’s obituary:

In later years, Robertson said if he were beginning afresh he would probably avoid hedge funds. “People wonder why they aren’t doing better,” he said. “I think it is from increasing competition from other hedge funds.”

There is a time and a tide etc.

Or, as we can construct from Adam Smith, although in most un-Smithian language. Capitalists are both greedy and also lazy. Finding the Big New Thing is difficult.

Well, OK, there’s a parade of Big New Things past the door every morning. Finding the one that works is difficult. The one that works is the one that produces economic profit - a return over and above the normal and standard return to capital within that current economy.

Some capitalists, through work or sheer good luck, do find these new things. They then gain economic profit. The other capitalists, being both lazy and greedy, note then copy. Invest into that same sector, along very much the same lines. The competition is what drives the economic profit down - and sometimes below - that normal return in that economy at that time.

Economic profit is also known as “adding value”. The output is worth more than the costs of the inputs. Those inputs being valued at the prices of their alternative uses. This is exactly what we desire to be happening in the economy of course. We might not be so happy at the capitalists harvesting all of that economic profit but we’re still delighted that it is being created. For that’s what we all eat, drink and play with - value added.

The competition being the very thing which switches that economic profit rom the capitalists’ pocketbooks - in time - into the consumer surplus, the value add that we enjoy out here.

The maths of all this is in the Nordhaus paper, Schumpeterian Profits. But the simple truth of it is in that Robertson point. Hedge funds were wildly profitable in the 1980s and 90s. Now they’re not. The reason being that the capitalists saw those economic profits, saw that they were good, then competed them away.

All of which gives an insight into the value of this free market capitalism thing. We harness the greed and laziness of the capitalists to transform economic profit into consumer surplus. There’s a transition period, oh yes indeed there is, one where hedgies vomit money around London’s flashier quarters. But the end result is the same as with all other technological advances - we out here get richer.

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