Whose risk is it anyway (part 2)?

Who takes on more risk: capital or labor?

This post continues my reflections on the capital return: If we compensate people for taking risk, what do we mean by risk?

Alice – a capitalist – provides a tool to Brian in exchange for a portion of what Brian produces with that tool. Suppose the tool is an axe and the produce is firewood. Brian would take the axe, chop enough wood for himself and his household. In the contract we call debt he would agree to return the axe (or an equivalently good one) at a specific point in time and hand over a fixed amount of firewood, what we call interest. In the contract we call equity he could keep the axe indefinitely but he would have to give Alice all the wood he managed to produce over and above an agreed amount, but at least enough to cover Brian’s firewood needs. That’s what we call profit. And Alice would be able to demand the axe back at any time and give it to someone else.

In both arrangements, some risks are faced by both Alice and Brian, e.g., Brian fails to find suitable trees. But Alice additionally faces the risk that Brian will misrepresent how much wood he needs, or conceal some of his produce, or take off to distant shores along with the axe and the firewood. Initially it looks like Alice bears a layer of risk over and above what Brian bears.

This is the justification of the capital return: The provider of capital must be compensated for the incremental risk she takes by forgoing the use of her capital. And the incremental risk that her counter-party, labor, does not bear is the risk that labor welshes on the deal. There may be other risks, but they would have been borne by the capitalist if she had used the capital herself.

In the previous installment I pointed out that this is not the full story. The user of a tool takes on many risks that the capitalist owner of the tool does not. Hence the axe as a telling example: Felling trees is a dangerous activity. If you owned an axe but could get someone else to produce firewood for you, that person would be supplying a risk-mitigation service in addition to the provisioning service. If risk is something that ought to be rewarded, something that generates a legitimate claim, then using a dangerous tool on someone’s behalf ought also to be rewarded. Hence my previous argument that, if the capitalist has a moral claim on a capital return based on risk she uniquely bears, then labor has a claim on something like health and disability insurance; a claim whose legitimacy is rooted in the same foundation as the capitalist’s claim to her return.

Are there other risks that are unevenly distributed between capital and labor?

If there’s one thing the world of investment teaches us it’s the value of diversification. Every investor knows that she can mitigate risk by spreading her capital across asset classes, currencies, sectors, issuers, etc. By doing so, she likely gives up some potential reward. But in return, she almost certainly preserves her capital. With highly developed capital markets, a capitalist can generate a stream of income – her capital return – from a nearly infinite array of sources.

Can a laborer do the same?

Clearly not, at least not as a laborer. For one thing, there are practical upper limits on the number of employers from whom an employee can generate an income. Never mind the restrictions an employee would have on working for competing companies, a restriction no investor faces: Nowadays, via index funds, it’s likely the average investor owns shares and debt of competing companies. In other words, while an investor can choose to take on concentration risk and potentially earn a higher reward, an employee is forced to concentrate.

Especially in the context of accelerating innovation, employees face an additional risk out which they – unlike investors – cannot diversify: obsolescence risk. Innovation goes hand in hand with increased innovation-oriented specialization, which in turn goes hand in hand with education and training. But a new technological development can make your specialization and education obsolete overnight.

Meanwhile, acquiring new specializations requires an ever-increasing investment in new skills. How many career leaps can you really make? Chances are, you will be forced to step down to a lower-skill, less remunerative job when your coal-mining skills become obsolete, rather than being able to re-skill to coding, wind turbine installation, or brain surgery. Meanwhile, an investor can place simultaneous bets on coal, natural gas, solar power, and cold fusion with just a few keystrokes.

So: Who is the bigger risk-taker – capital or labor?

I do not think the answer to this is simple. Which is why I believe we have to, as a society, come to grips with what we mean by risk, and place it front and center in political economy.