Why Automated Funds Pose a Threat to the Justification for Capitalism

Much has been written about how automation of labour poses a threat to the political support for capitalism.  But the issue has a flipside.  In the UK the best performing investment fund last year was a fully automated one.

For the sake of argument we don’t have to agree with the efficient markets hypothesis.  We are simply exploring its implication that alpha is zero and so human action cannot add to it.  Its assumption is that all information is reflected in the market price.  This implies that any alpha exits at all this is due to lack of information.  So if you throw enough computing power at the problem you will eliminate all such arbitrage opportunities as they chase down ever smaller pools of alpha.  This conclusion even survives a radically uncertain and unknowable future, for if this is so you have only beta and cannot by definition do better in the long run that an automated tracking fund.

Consider a hypothetical case of close to perfect competition where there are no resources charging economic rent.  I make one relaxation in this model, labour time, as time will always be scarce.  Assume then a random schedule of existing wealth endowments and these agents making portfolio decisions where they are less risk adverse the larger their wealth, and a similar random schedule of potential investments of varying returns and risks.  We assume an uncertain future but perfect information so each agent can accurately calculate risk rated returns.

In this scenario those agents with largest endowments will snap up the investments with the largest risk rated returns first.  So even if the economic outcome is random the law of large numbers indicates that over a sufficient large number of runs (if one adopts the ergodic fallacy) for over a sufficiently long length of time the rich will automatically get richer.  Those with less wealth will be forced to invest in alternatives with lower risk rated returns and earning a lower rate of profit.  There relative wealth will be less.

This only consider factor returns on capital invested, not returns to labour.  Anticipating a criticism that this model does not consider the gains from higher wages in the higher risk rated return investments lets consider this.

As the only scarce factor in this model is labour profits are equivalent to ‘longfield wages’ (after the economist who first made this point).  They are the interest costs on the labour payments made before the final consumer goods are delivered.  If the proportion on these profits are high then the residual proportion of wages must by definition fall so wages and profits equal unity.

This I think completely undermines Edwin Conards argument for the efficiency of extreme income inequality in his book ‘Unintended Consequences’.  The argument put simply is the rich do us a favour because big investments at big risks yield high returns.  Granted but if all shares in  investment funds were held equally but these funds were of different sizes and took a random series of positions on risk adversity the economic benefits (in this model) would be the same, except that all would benefit from them equally.

You could argue that the models assumptions are too strict and you should assume scaricty in one or more resources.  Doing so however allows for economic rent, returns to those who own land and the resources that come with them due to accidents of birth and for those people to take wealth from those that produced it rather than generating it.

Similarly it could be argued that wealth ought to accrue to those that study hard and gain skills.  Those that do so however need time and if they have limited endowments they will need to borrow.  So proportionately again the more the poor study the richer the rich will get.

The only argument remaining is that innovation improves wealth for all and therefore there should be incentives for innovation.  But firstly there is no empirical evidence that huge inequalities are necessary to generate innovation and wealth.  Counting patents is not a good measure of innovation.  Secondly a more equal society gives more opportunities for people to become better eductated hence raising innovation.

So the if justification of the 1% is that they are good at investment it is no justification at all.

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