Friday, April 27, 2007

In Praise of Kenneth Griffin

Earlier this week, we read that the three top hedge fund managers--James Simons, Kenneth Griffin, and Edward Lampert--each earned more than a billion dollars in compensation last year. In his column today, Paul Krugman has this to say:


Consider a head-to-head comparison. We know what John D. Rockefeller, the richest man in Gilded Age America, made in 1894, because in 1895 he had to pay income taxes. (The next year, the Supreme Court declared the income tax unconstitutional.) His return declared an income of $1.25 million, almost 7,000 times the average per capita income in the United States at the time.

But that makes him a mere piker by modern standards. Last year, according to Institutional Investor’s Alpha magazine, James Simons, a hedge fund manager, took home $1.7 billion, more than 38,000 times the average income. Two other hedge fund managers also made more than $1 billion, and the top 25 combined made $14 billion.

How much is $14 billion? It’s more than it would cost to provide health care for a year to eight million children — the number of children in America who, unlike children in any other advanced country, don’t have health insurance.

The hedge fund billionaires are simply extreme examples of a much bigger phenomenon: every available measure of income concentration shows that we’ve gone back to levels of inequality not seen since the 1920s.
For reasons that will be clear below, I'll focus on the case of Ken Griffin, who earned $1.4 billion. This makes him (1.4/1.7)*(38000/7000) = 4.5 times as high-income relative to the typical person as J.D. Rockefeller according to Krugman's metric. Krugman's use of the term "mere piker" suggests that he thinks these hedge fund managers are even worse in some way than Rockefeller.

Let's continue the comparison. Consider that Rockefeller's Standard Oil had the advantage of being a near-monopoly. Griffin has no such luxury--he's in one of the most fiercely competitive industries you will ever find. He makes his money not by shrinking from competition but by surpassing it. According to some estimates, his firm, Citadel Investments, is responsible for over 3 percent of the average daily trading volume in New York, London, and Tokyo. It takes a very unusual person to build a business that can do that.

I know whereof I speak. I was an acquaintance of Ken's both in high school and in college. He attended a rival high school in the same county, and we competed in math tournaments. He and I entered Harvard the same year, both majored in Economics, and both graduated in three years. But let me not suggest to you that we were similar in too many ways. Most significantly, while I was busy with my studies and my interest in economics inside the classroom, Ken was pursuing his interests in economics outside the classroom. I didn't see him on campus more than a handful of times. This profile gives a good description of his background, how he got his start in finance, and his business strategy.

What emerges is someone who is intensely intelligent--in the sense of being able to integrate knowledge from disparate sources to solve a specific problem--and extremely independent-minded--it's his way or the highway, at least at Citadel. He builds the financial capacity to pick up the pieces where others fail--whether Amaranth or Enron--at a bargain price. He doesn't pull his punches--I don't think anyone who offers the "toxic convert" is shy about being a financial intermediary. He's also not trying to win the "Boss of the Year" award. But these are details. To sum him up in three words, he is successful because he is confident, contrarian, and accurate.

I spend a lot of time around college students. I spend a lot of my energy trying to get them to display those three characteristics. Krugman seems to think that one "Kenneth Griffin" is overvalued at 4.5 "John D. Rockefellers." On the contrary, I think it's a buy.

11 comments:

Anonymous said...

I don't think Krugman is saying that
Griffin is overvalued compared to
Rockafeller. He is simply claiming
that income inequality has increased.

Anonymous said...

You state: "To sum him up in three words, he is successful because he is confident, contrarian, and accurate." I think it important to add "lucky" to these three main characteristics. Of course, without the former three one could not take advantage of such good fortune.

Lord said...

More so than Rockefeller though? After all, Rockefeller created his monopoly, an even greater achievement some would say.

Anonymous said...

Krugman is playing to people's mistaken belief that Griffin has taken $14 billion dollars from someone else (hence the analogy to children's health insurance), rather than creating it. If Griffith had never started his firm, the economy would be $14 billion less. There would not be $14 billion more for kids.

I have a hard time believing that Krugman fails to recognize this. However, I have a easier time believing that Krugman is being purposefully disingenuous and playing to people's class envy in order to score political points against the current regime.

Anonymous said...

I have a question for Andrew, and for the 2:49 commenter. I don't mean to be flip on this point -- I really don't know the answer. What social value does a hedge fund trader create? If I earn $1.4 billion this year by trading stocks, is total economy $1.4 billion larger, more than this, or less than this?

If I'm John Rockefeller, it's easy to see what I create. I sell oil to people who want oil, I make a profit. The marginal value that SO adds is the difference in total surplus created in my transactions minus that surplus that would be created were SO to disappear and the next firm to take over. (Arguably negative in a case of a noncompetitive market with some element of increasing returns to scale, certainly positive in a "normal" market, but this is neither here nor there.)

What about trading stocks, though? My impression is that, if I invest in a firm which otherwise would not have been able to attract capital, and the firm ends up being successful, then I am truly adding value to the rest of the economy. But if I'm just finding price discrepancies, buying low and selling high, every penny I earn is someone else's loss. Where do hedge fund traders stand?

I don't doubt that Kenneth Griffin is a brilliant and talented man who is earning his money by outcompeting his rivals. But if hedge fund trading is essentially rent seeking, then on the level of society as a whole his brilliance is not only wasted but is harmful to the rest of us who no longer get those rents. Indeed, if that were the case then we would want to disincentive hedge fund trading through taxes or regulations so that these brilliant people might rather choose to work in a more socially productive industry.

Andrew Samwick said...

It's possible to overthink this one. Up to a statistical discrepancy, Gross Domestic Product and Gross Domestic Income are the same number. Every dollar of Griffin's $1.4 billion contributes to Gross Domestic Income, assuming it is paid out to him as compensation (rather than as unrealized capital gains). It doesn't have to be more complicated than that.

It's not Griffin who should be in some other line of work--it's the guy who took the opposite side of the trades, no?

Anonymous said...

(same anonymous as 9:02)

I think you're missing my point. My concern was that his impressive skills are being used for rent-seeking rather than for socially productive purposes. This matters to us as a society when we think about inequality.

If Hedge Fund trading is socially productive, then the inequality it creates has benign roots -- by improving the efficiency of capital markets (or whatever), he's better off and so are we. He is to be applauded. More generally, if inequality comes about because new technology allows the skilled to produce more, we shouldn't be too worried about it. Attacking inequality would be attacking growth.

If Hedge Fund trading is pure rent-seeking, then there's no problem with regulating the industry, taxing away his wealth and redistributing it to yours truly. The increase in inequality is a pure and simple "bad": changes in the economy have just allowed one group to better fleece the rest of us.

One other question -- I invest in mutual funds and an S&P index fund. Am I on the opposite side of some of those trades?

Andrew Samwick said...

I did not mean to be flip in my answer. I do recognize the larger point, but I don't agree with your terminology, in two places.

First, I don't think his behavior is appropriately characterized as rent seeking. From what I can tell, he is not enjoying the fruits of a monopoly conferred upon him by the government, which is thought to be the root of most rent seeking behavior. He may enjoy some economies of scale, but that's a different matter.

A standard definition of rent seeking would not include the behavior of hedge funds operating legally (and there is nothing here to suggest that Citadel is not operating legally). Take a look at the Wikipedia page:

Rent-seeking behavior is distinguished in theory from profit-seeking behavior, in which entities seek to extract value by engaging in mutually beneficial transactions.

Griffin is a profit seeker, not a rent seeker. Everyone with whom he trades expects to benefit by the trade; otherwise, given the absence of coercion, how could the trade happen? So how do you claim this is rent seeking, as opposed to him just being very good at what he does? (I can appreciate that, ex post, some people would probably prefer that they had not traded with him. I need to think more about the implications of that.)

Second, you assert that there is a difference between the social and private value of his actions. Why would you say this? In my comment above, I noted that I could get to the sum total of GDI by adding up everyone's sources of income. It is true that, because Griffin is much better at trading than others, he has a high income, and some of the people he trades with have a lower income. So his private value comes at the expense of someone else's private value. Neither one of them has a social value of their activities beyond that. It's true that if Griffin didn't exist, some people who are less good at trading would now receive more income. That's true in any competitive market, but I think it makes more sense to think of that as a pecuniary externality.

As an S&P 500 index holder, I don't think you are on the other of too many of his trades, since index funds aren't active traders. The value of your portfolio is affected by Citadel's trades, but that is no different from anyone else's trades, except in the size of the effect.

I have the same sinking feeling that you do--such a bright person, isn't there something he should be doing that "benefits more people in a tangible way?" It's a loaded question, but I'll answer that in a similar way to my last comment.

If you want more people to be pediatricians and fewer to manage hedge funds, then you've got to be willing to pay pediatricians more. And you could pay them a lot more, and Griffin would still manage his hedge fund instead. But others--those people who aren't as good at trading as Griffin is--might become pediatricians.

I enjoy the exchange--please feel free to write more if you like and we can see where we agree or disagree.

Anonymous said...

The next sentence on the Wikipedia page: Critics of the concept point out that in practice, there may be difficulties distinguishing between beneficial profit seeking and detrimental rent seeking. Count me among the confused. :)

I meant the term "rent-seeking" in an informal sense of behavior which helps oneself but in the process decreases the aggregate welfare of others rather than increasing it. In a classic market environment, trades are positive-sum: I have a valuation above the price, you have a cost below the price, and when you sell a widget to me we are both better off. But it seems to me that, to the first order at least, speculative stock trades are essentially zero-sum transactions. People don't actually have different valuations of the stocks so much as different beliefs on a common valuation. I don't know how much of what Citadel does is this sort of zero sum transaction, but I think it's reasonable to distinguish this type of transaction from more classical economic ones.

If I make a dollar by being a very good player in a zero-sum game, there is no net increase in GDI.

Moving back to the broader point, in an economy with a few very large winners, understanding the roles of the winners is crucial in understanding the proper response to inequality. Do their winnings come from being great at creating value for the rest of us, or from being great at winning?

Anonymous said...

I thought you would use the "market efficiency" argument. He is helping make the market more efficient. Not that I know a smiggin of economics theory or practice.

Anonymous said...

You're wrong about the monopoly part -- Citadel is a major market maker in options (in which it has a near monopoly), and pursues similar strategies in other markets. So the comparison with Rockefeller is quite apt. (Do you know what market makers do to retain monopoly power?)

I find the following statement interesting:
"Griffin is a profit seeker, not a rent seeker. Everyone with whom he trades expects to benefit by the trade; otherwise, given the absence of coercion, how could the trade happen? So how do you claim this is rent seeking, as opposed to him just being very good at what he does?"

Conditional on buying an option using a market order, you have virtually no choice but to trade with Griffin. Conditional on shorting a stock, you have no choice but to borrow it from Griffin or a small group of highly colluding lenders. Conditional on buying oil in the Standard era, you had no choice but to buy it from Rockefeller. You may benefit (ex ante) by doing these trades -- the question is how much the counterparty eats into your profit.