File Under Fascinating

By James Kwak

A reader pointed me to “Instability and Concentration in the Distribution of Wealth,” a paper by Ricardo and Robert Fernholz (Vox summary here). It’s a pretty mathematical paper (and I’m not just talking about the usual multivariate regression here), and I didn’t make it through all the equations. But the basic idea is to come up with a model that might explain the high degree of income and wealth inequality we see in advanced economies and particularly in the United States, where 1 percent of the population holds 33 percent of all wealth.

What’s fascinating is that the model assumes that all households are identical with respect to patience (consumption decisions) and skill (earnings ability). Household outcomes differ solely because they have idiosyncratic investment opportunities—that is, they can’t invest in the market, only in things like privately-held businesses or unique pieces of real estate. Yet when you simulate the model, you see an increasing share of wealth finding its way into fewer and fewer hands:

As the authors emphasize, “it is luck alone – in the form of high realised random investment returns – that generates this extreme divergence.”  In the absence of redistribution, either explicit or implicit, this is the kind of society you end up with.

Obviously this isn’t a complete explanation of the high and increasing degree of inequality in American society today. People are not equal in their earning ability, for one. But you could view the variance in career outcomes—that is, from equivalent starting points, some people will just be luckier and earn more than others—as a type of the idiosyncratic risk that Fernholz and Fernholz focus on.

I think this is a useful antidote to the widespread belief that outcomes are solely due to skill, hard work, or some other “virtuous” attribute. Even if everyone starts off equal, you’re going to have a few big, big winners and a lot of losers. Because we want to find order and meaning in the universe, we like to think that success is deserved, but it almost always comes with a healthy serving of luck. Bear that in mind the next time you hear some gazillionaire hedge fund manager or corporate CEO insisting that he knows how the country ought to be run.

22 responses to “File Under Fascinating

  1. I think the question that needs to be asked is just at what point of wealth disparity do you cause anarchy? A second reason for Lincoln to free the slaves was the known fact that if treated to badly for an extended period of time, the slaves could revolt and over take the masters for whom they had toiled so hardly for, and for so many generations, just by physical force alone. I believe the # was something like 5% of the population owned 95% of the wealth, mostly land at that time. But it was leaning towards the 1% owning 99% of the wealth, and that was certainly an equation for revolt among the future educated blacks like Booker T Washington. It all turned around with the proclamation, but we don’t a civil war situation, but we do have a lot of slaves to money, and a further concentration of money in the hands of the few. Expiration of the Bush tax cuts will go a long way to reduce that scene, change some laws, balance the budget, and we could reverse that trend.

  2. “Obviously this isn’t a complete explanation of the high and increasing degree of inequality in American society today. People are not equal in their earning ability, for one.” Nor are they equal in their spending patterns. Some people seem to need to spend every nickel that is in their pockets.

    I also believe that the welfare state keeps people poor. Many people rely on this welfare, generation after generation. If they don’t get out of this state, they will never achieve anything. Giving out money so freely encourages laziness and other bad behaviors. Put people to work in order to collect benefits and the welfare/poor state will decrease. I can think of many jobs that they could do to make this country a better place.

  3. Cost of buying a uterus for making a baby = $20,000 (more or less)

    Throwing a baseball 90+ MPH = millions of $$$$

    I don’t think “welfare” and “charity” are the problem with unequal earning ability.

    And as for spending every penny they get – how to make NECESSITIES cost the exact amount as everything you got in a minimum wage job – well, that’s what all you “e-CONS” do – predators set the price on producers.

    We certainly have the same “feeling” for you, bhans, as you have for We The People.

  4. Could we turn this into a computer game? It might change some minds. But you might have to make it assigned classwork–games where skill doesn’t count are no fun.

  5. Still reading Polyani’s ” The Great Transformation” ….
    Monopoly is a great board game… Very instructive. The game always ends with one person holding all the money.. Then the money is re-distributed and the game begins anew.
    “It takes money to make money” Money concentrates….
    Money is a commodity. People and labor cannot be commoditized because they cannot be destroyed by the market……
    Technology puts labor at a continued disadvantage…(“Lights in the Tunnel”)


  6. Easily refuted with just a cursory read of “Why Nations Fail” or by observing reality. Not sure why anyone would require some intensely overblown mathematical formula to comprehend that wealth is power and those with power are almost always intent on getting more – if not all – of it.

  7. @ghickey – “….Technology puts labor at a continued disadvantage…(“Lights in the Tunnel”)….”

    Best piece of “technology”, ever, is a seed. And you did not build that. Next “idea”…

    Global billionaires club is just trying to figure out how many *slaves* they need – everyone else will continue to be herded into factories to make the bullets that they then can use to kill each other and themselves in order to get to that majik number.

  8. @timmO – sort of agree with you: why would you trot out sophisticated math to proove that something can happen in some theoretical universe, while ignoring much much more important things:
    The law, in it’s majestic equality, forbids equally the rich man and the poor man from stealing a loaf of bread or sleeping under a bridge…”
    wealth, in the real world, comes from power, and use of power: M Romney and his class buy a congress, which in turn writes a tax code that makes Mitt and his class wealthier…

    I also wonder if you really *need* the math they use; isn’t the first rule of math to use no more complexity then you need ?
    Its hard to believe you need such complexity – maybe someone who knows something can correct my ignorance

  9. “I’m Lucky” so easy to overlook

  10. Models are like toddlers in both their logic and insistence that one pay full attention to them. Inputs and outputs.

  11. “I also believe that the welfare state keeps people poor.”

    I have to disagree. If it was such a great deal, how come more people don’t do it? I think people have an inherent level of drive and they live in a certain society/economy/environment that can help or hurt how they are able to execute that drive.

    Across this vast country there are very different environments (which include how safe one feels, what kind of jobs are available within the area you are able to move, what the culture of work is around you, etc), and think these environmental factors do much to mitigate an inherent level of drive.

    Looked at from the other direction, anyone who makes over $100,000/year has all most of their basic human needs met (except perhaps the need to make as much or more than everyone around you). But some people make $1,000,000/year and they are still working? Why is that? It’s not an economic incentive, it’s because they are driven to work and compete and succeed. I guarantee, if the government dole were of the type that paid everyone a check for the poverty level as a basic social security, these successful people wouldn’t quit their jobs and sit on the couch all day.

  12. Despite of the mathematical nature of this paper, the reason for this phenomenon, given the assumptions is actually very simiple.
    The authors assume that house holds invests according to their wealth — the more money you have, the higher the risk tolerance, the more you invest in a risky asset. As a result, on average, rich households have a higher expected return on their investment (risk premium). Then law of large number then demands that the rich will eventually have more and more. This is the same as throwing an uneven coin many many times, the person who bets on the more probable face will eventually win.
    While this is clearly one of the mechanisms that lead to wealth inequality, the assumptions of this paper is still too simplistic. We need more understanding. And writing a overly mathematical paper is not helping with this :)

  13. Calvin – I agree with almost all of what you say wholeheartedly. People do want to succeed and most do have an inherent level of drive. There are those, of course, who would rather just sit back and do nothing but “enjoy” life and have others support them. Think of some young adults, and older adults, who are always dependent on mom and dad, and the parents don’t put a stop to it. If they keep supporting their adult child, this situation will never change. Why should it. If they can’t get mom and dad to continue to support them, they move on to someone else to support them. There always seems to be that someone else. I believe that any time you pay people to do nothing, you are walking down a slippery slope. These people are not getting the education or job skills they need to be self-sufficient.

    Then we have the young women who keep having more and more babies in order to collect more and more welfare. They don’t marry the working daddy who is giving them money, because then they wouldn’t be able to collect welfare too. They may be motivated to raise their babies in a nice manner. They also may be motivated to have more babies than they otherwise would have in order to get more welfare. Eventually, with no education or job skills, they truly will be dependent on the government for their support.

    But then there are families that are married but the husband works under the table. These people are numerous. I’m always seeing my neighbors hiring workers who are working under the table so they can claim they are poor, not pay taxes and, if fact, get money back from the government that they never put in, and maybe collect welfare for the kids, I even run into licensed people who want to be paid under the table. I believe that this is the biggest problem. Yes, these people are motivated to make as much money as they can and be able to spend it all. Many don’t save any of this money, or else how could they prove that they were poor. Because they have no savings for retirement, these people also will eventually be truly dependent on the government. They will have nothing to pass on to their children. Yes, many of these families will end up poor and truly end up on the dole when they can’t work any more.

    I don’t believe that it takes $100,000 in income per year to live comfortably and have all of your needs met. I believe that most individuals who make much less than that live comfortable lives. The majority of American’s have what they need to be comfortable. I believe that it mainly comes down to lifestyle that determines how much help you are eventually going to need. Some people truly need help from the get-go, but these are not the people that I am referring to. Let’s not make people welfare families when they don’t have to become welfare families. You give something for free, and they will have their hands out.

    True fact – when I was young and living on a houseboat on a river for the summer and could have very well worked, I went in to collect food stamps for 2 months. The food stamp employee asked me about getting a job. I told her/him that I was not going to look for work nor do any work. They gave me the food stamps and I was absolutely amazed that they did that. That was the extent of my asking for handouts, but there was no requirement that I do anything to collect them. I could have lived fine without them, but they were free. Welfare benefits are even more free today when all you have to do is show that you have no visible money or low to no earnings. Why not make more requirements to get the handouts. Our welfare numbers would go down.

  14. “Behind every great fortune is a great crime.”. This old Sicilian addage cuts to the heart of the income distribution reality. The extreme divergence of thehaves and thehavenots has nothing to do with luck and everything to do with crime. History proves that whenever the basic math of income distribution reaches extremes (ie 1% owning and controlling 33% of the wealth and resources for example) – the end is always bloody revolt. Let the games begin. Burn it all down. Reset! It couldn’t be worse for the 99%!

  15. Reblogged this on Brucetheeconomist's Blog and commented:
    Luck matters.

  16. Two words.
    “survivorship bias”

  17. bhans, thanks for responding, you provoked much thought. You sounded very respectful and honest, I hope I can do the same in sharing my views.

    I agree that there are these “takers” in all societies, but I think that there are people who try to extract from society selfishly in lots of areas, not just those on welfare. Why focus on the ones who are getting a relatively small benefit from the government and who have basically nothing else (whatever their reason for having nothing else)? There are many ways the government gives hand outs. Anyway, my point is, are we ever going to get rid of these people? Or change them? What percentage are they? How much would it cost to just give everyone a basic social security (food, shelter, etc)? I argue that it would cost much less than all the tax rebates and deductions given to those who are taking but also have other incomes. And my main point is should it be the government’s job to make that decision as to who is cheating or not? I like to practice unconditional love and I like to do it through the machinery of democracy — although, whether we have much of one is debatable. But I think social and family pressures go a lot farther than government rules and regs. Which leads me to your food stamps comment. I don’t think they should hector you or make you prove how poor you are. That’s a form of making someone grovel before you will help them. I consider that very bad behavior whether done by family, friends, church or gov’t. *You* obviously have the moral and social fortitude to not abuse such a thing. So, the assumption was that you were in need and you were helped. Is that so bad? Let’s say we got rid of the mortgage interest deduction and just gave food stamps to anyone who asked for it. There might be a rich miser who went down there and got them. So what? Most people wouldn’t, they’d be embarrassed. There might also be a poor person who is able to work who is abusing the system, but again, so what? It’s not that expensive to provide such a thing. Not compared to bank bailouts and hundreds of military bases around the world that have little to do with any war that was declared by congress.

    I definitely agree with you about the perverse incentives of paying a citizen more for having a baby. Similarly, I happen to think there should not be an “married” category for citizens coming from the government. Every citizen should have the same rights and responsibilities. We should all file our own tax returns, individually, and pay the same rates, it should not matter what legal associations we have with others (marriage, corporations…and yes, I would like to abolish all corporate taxes so that we know exactly how much our government costs and none of it is hidden in the cost of labor, goods, etc.)

    And the black market, totally agree with you on that, but I have about zero ideas how to make that problem go away. However, why the focus on the worker who is making even the large figure of $100k on the black market? Sure, they are doing everything in their power to “game” the system. Perhaps a system they see as corrupt and they need to get what they can out of it. But why are you more concerned with a poor or middle class person doing that than with people who do the same thing (everything in their power to get more for themselves, legal or illegal) who have millions in income every year?

    ps. I picked $100k because I figured that is a good number to insure I wasn’t talking about someone struggling or poor. I wanted to make the point that even that comfortable value is 1,000 times less than someone making $1M/yr, clearly showing that human needs, as accessed by money are clearly not the incentive to keep working. Money as a fetish, as dominance, as political power all may factor in, though.

  18. I agree that there are many takers in society and I am totally in agreement with Simon and James when they talk about the big banks and what needs to be done with them. When the 1% do something, it is often not so in-your-face as when the 99% do something. The bankers have gotten in-our-faces though. And bravo to Simon for attempting to take them on. Same goes for other wealthy people and large corporations. I don’t believe that there should be special governmental handouts to them either.
    Unconditional love is one thing, but unconditional support is entirely different. Unconditional support makes the one who is giving it feel good, but I believe that it is harmful to the person on the receiving end. My position is that I will give you what you need, but you are going to have to work for it or get an education. I am not referring to those who are unable to work because of disability, but free, unconditional giving does not help the person on the receiving end, it hinders them.
    “Which leads me to your food stamps comment. I don’t think they should hector you or make you prove how poor you are”. No, not hector you, but I totally expected them to say I needed to be willing to look for work in order to collect.
    “That’s a form of making someone grovel before you will help them. I consider that very bad behavior whether done by family, friends, church or gov’t.” I guess this is our main difference in opinion. I don’t consider trying to get someone motivated to do something with their lives grovelling. I consider it trying to help the individual help themselves.
    “There might also be a poor person who is able to work who is abusing the system, but again, so what? It’s not that expensive to provide such a thing. Not compared to bank bailouts and hundreds of military bases around the world that have little to do with any war that was declared by congress.” Totally agree on the bank bailouts, military bases, etc. The expense to the system of people abusing the system is unknown by me, but why not allow the people who want to contribute to what I consider to be the “deliquency of whoever” to do the contributions. You have a free will to give if you want. Why force people who don’t share your opinions or want to contribute to this “deliquency” to contribute to it? If it isn’t that expensive, not every honest citizen needs to provide for those people who cheat or are lazy, only the ones that want to provide for them need do so.
    And the black market – seems like that is the same problem that Greece is having. Not a good situation.
    No, I am not more concerned with the poor and middle class people taking advantage of the system than the wealthy, banks, corporations, etc. I see this all in the same light.
    I’m a fan of Thomas Jefferson. Some quotes from him are as follows:
    I believe that banking institutions are more dangerous to our liberties than standing armies.

    Our greatest happiness does not depend on the condition of life in which chance has placed us, but is always the result of a good conscience, good health, occupation, and freedom in all just pursuits.

    A wise and frugal Government, which shall restrain men from injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government, and this is necessary to close the circlue of our felicities.

    I hope we shall crush in its birth the aristocracy of our monied corporations which dare already to challenge our government to a trial by strength, and bid defiance to the laws of our country.

    The democracy will cease to exist when you take away from those who are willing to work and give to those who would not.

    “To compel a man to subsidize with his taxes the propagation of ideas which he disbelieves and abhors is sinful and tyrannical.”

    A government big enough to give you everything you want, is big enough to take away everything you have.

    I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretense of taking care of them.

    My reading of history convinces me that most bad government results from too much government.

    Experience hath shewn, that even under the best forms of government those entrusted with power have, in time, and by slow operations, perverted it into tyranny.

    Experience demands that man is the only animal which devours his own kind, for I can apply no milder term to the general prey of the rich on the poor.

    Rightful liberty is unobstructed action according to our will within limits drawn around us by the equal rights of others. I do not add ‘within the limits of the law’ because law is often but the tyrant’s will, and always so when it violates the rights of the individual.

  19. I find these blame the poor and downtrodden arguments and supremist assertions repugnant. Have no shame sirs? Have you no shame.

    Granted there may be a few individuals who cheat the welfare medicare and foodstamp systems and could work, but don’t. When caught they should be denied aid. But two simple math realities cut the heart of these issues. First and foremost – the finance oligarch alone received $17trillion in government largess and every new round of QE adds to this gargantuan number. This is taxpayer money printed out of the myst, funneled into the offshore accounts of the den of vipers and thieves in the finance sector and the predatorclass. I will remind you supremists that these are the same sociopaths and criminals that are singularly responsible for the most severe and longest lasting economic crisis since the great depression. If you were to add up every single penny of abuse gleaned by no-gooders in the wellfare, Medicare, and food stamp systems – the total would amount to less then the total wealth of any three predatorclass CEO’s of the finance oligarchs. Your math is more wildly awry and disturbed than your lack of compassion and supremist pathos. Wealthy should willingly provide for those less fortunate. Its as much a security issue as a moral prerogative.

    Lastly – the predatorclass brutes this absurd insanity and naked lie that there is fairness in the system, free markets, equal justice under the law, and that the people have any voice in the conduct of the government. I personally don’t and never had any government aid, but I know realities you imperious supremist can’t imagine. There are no good jobs. Working at McDonalds or Wall Mart for $8:50 an hour is indentured servitude and even working two or three of these jobs can barely provide enough income to raise a family. My circles can forget about sending their children to college. Fiendish employers have the unholy gall to dismiss employment for candidates with bad or poor credit. This is one of the most despicable, insidious and immoral practices in the history of American business. Forget about securing loans, investing for the future, buying a new car, or taking a vacation. Many of your fellow Americans are one health issue or other crisis away form homelessness. And these are not freeloaders or people who would ever think or robbing any one, or ripping off any government aid program. They are hard working diligent law abiding citizens who have literally been screwed by the criminal den of vipers and thieves in the predatorclass.

    Know this – there is a fast approaching limit to how much abuse and hopelessness the people will endure. Once that critical threshold is breached – there will be a reckoning and a balancing and there will be blood!!!

    In a world where there are no laws – there are no laws for anyone predatorclass biiiiaaatches!!! Sent from my iPhone

  20. bhans sez, “…I don’t consider trying to get someone motivated to do something with their lives grovelling. I consider it trying to help the individual help themselves….”

    That’s the PRIMARY PURPOSE of education, Sir. Motivating people to create interesting and fruitful lives for themselves – standing on the shoulders of those who came before instead of stepping on their toes. Right now all you have is people helping themselves to what other people EARNED THROUGH HONEST WORK. Via f’n algorithms, no less. Like that’s “genius” math!

    Because of insane circumstances beyond any indivudual’s ability to be “responsible” for the actions of others – like having your teeth knocked out when insisting on a discussion about whether launching a pre-emptive war is a good idea – you have a situation in the USA where NO ONE can rise above this new global institutionalized poverty by “helping themselves” through education and honest work.

    Turning people into prey and then telling them that they’re not “motivated” enough to do what, exactly? Fight or flight? What other choices do prey have when being stalked THROUGH TAXES AND *law* that isn’t even jungle law?

    Quote, “Our greatest happiness does not depend on the condition of life in which chance has placed us, but is always the result of a good conscience, good health, occupation, and freedom in all just pursuits.”

    The Middle Calss of USA was SLAMMED down financially below the GLOBAL War/Drug/Slave Lords. Like Tony F. observes and I put it this way – you’ve got to be kiddin’ me that they’re on a higher MORAL ground and can BUY the resources to psychobabbalize everyone 24/7 over PUBLIC air waves. They’re even too stupid to STFU (for 4 YEARS!) and go slither away to roll around in their billions – which proves to a complete lack of common sense on top of extreme character deficiencies.

    Vote the pols in who won’t be “Deliverance Boyz” *motivated*. Putting in public snarky and sadistic mouthpieces for the 480 worth 2.08 TRILLION will start blood shed…your choice.