The free-rider problem

Don’t blame populists, lobbyists and index trackers. This time I address the free-rider problem that challenges both democracy and capitalism which results in less innovation and lower economic growth. If are easily depressed, you might need to take an anti-depressant before reading it.

The Yin and Yang of the free world

The government is elected by the people and the main purpose of the government is to serve the people. The role of capitalism is to meet the need of the consumers (the people) and competition drives down the profit margins for products and services. If competition doesn’t work in the market, then it is the role of the government to intervene and levelling the playing field.

Democracy and capitalism are the Yin and Yang of the free world. A successful capitalistic market requires a strong government that implement anti-trust laws, breaking up oligopolistic and monopolistic markets. If that is not the case, there will be less innovation resulting in lower levels of overall economic growth.

The foundation for a functioning capitalism is twofold. First that a significant proportion of the people are politically engaged and participating in forming the political agenda. Second that a shareholders of companies hold management accountable and/or vote with their feet. It seems to be a foolproof system, at least on paper...

Democracy is only as strong as its foundation.

Although most people show up at the election day to vote for candidates appointed by the political parties, very few have been involved in shaping the party program and nominating the party leaders. The election reminds me of the framing trick that toddler parents use when giving the child a choice between porridge and spinach.

I decided to take a closer look at three countries that I know reasonably well: Netherland, Sweden and United Kingdom. Between 60 and 80 percent of the electorate vote, but only 2 to 3 percent of the electorate are members of a political party. This is probably the most worrying statistics that I came across in years, as it is a clear sign that the foundation on which democracy rests is not very strong.

Given the small talent pool and the negative selection bias of those who do join a political party, it does not come as a surprised that most leaders appointed by political parties are, at best, quite mediocre. As a result, the door is wide open for vocal individuals with more populist views to sway the small member base. Around 97 to 98 percent (including myself) of the people are free-riders, assuming that others will take the burden of becoming a member of a political party and actively shape the politics for the future.

Capitalism is only as strong as the shareholders.

The core doctrine in capitalism is that the owners (shareholders) of a company are keeping management under pressure and force them to act in the best interest of the shareholders. A key function of the stock market price is that it acts as a barometer of trust in management as investors can vote with their feet. In theory that means investors are selling the shares in the companies they expect to be losers and buy in the expected future winners.

The stock market is often represented by a capital weighted portfolio covering all stocks in the market (benchmark). The most cost-efficient way to invest (as a free-rider) is to buy the benchmark and automatically benefitting from others investors who we assume are informed shareholders. A large proportion of the capital invested in the stock markets today, are ordinary peoples savings and pensions. This is mostly done via investment managers who are either closely tracking a benchmark (index investing) or make relatively small deviation from a benchmark (active investing).

Fundamental investment strategies focusing on individual companies have lost is popularity as more and more asset managers moves towards low cost index strategies. This means that the shareholders influence over management has weakened significantly and the role of the stock market as the barometer of investors trust in management is not that relevant anymore. In practice, most companies don’t have strong owners that is forcing management to allocate capital efficiently.

The answer is blowin’ in the wind.

The small member base of political parties mean that they are thin on both competence and ideology. As a result, lobbyist organisations have been very effective in influencing politics by pushing their sponsors agenda.

Combine this with index investing which has led to less efficient capital allocation within companies as the power has been shifted to the management of the company. It is no surprise the management often is engaged in share buyback programs as well as merger and acquisition activities with the goal to become one of top 5 in their sector. Building oligopolistic structures and actively lobbying for new regulation to create entry barriers for new competitors is natural when the checks and balances are all but absent.

The result is obvious, as a society, we will face less competition and lower economic growth. It would be too easy to blame the populists, lobbyists, and index trackers for this, but the answer is closer to ourselves than we think. Most of us, me included, expect that someone else should selflessly take care of the problem for us, and that is the free-rider problem.