Friday, March 23, 2012

Social And Economic Equality: It’s Not Enough To Be Equal, You Have To Work At It

In the US, it’s always been the practice to measure the “equality” of society more along the lines of economic and social mobility rather than purely through income or wealth measures.

The idea is to have people begin at more or less the same starting point, then proceed in accordance to their own ability and willingness to work – pure meritocracy. Economic mobility means in this sense that whatever your personal circumstances, you can reach the top of the social and economic ladder.

It’s the American Dream, where anyone can make it big. And we’ve the inspirational stories to back up those dreams, like Steve Jobs and Mark Zuckerberg.  The rewards, at the end of the day, are what you rightly deserve. This kind of viewpoint tolerates high income and wealth inequality as the product of a system where everyone has a fair chance.

The problem is of course in reality, if you start off disadvantaged, the odds are stacked against you. For the vast majority of the population, educational attainment and lifetime earnings are as much a product of your background as they are your innate abilities. In other words, where you start from actually matters and intergenerational transfer of wealth skews things considerably.

Worse, as this paper makes clear, even a completely equal and meritocratic society will degenerate into a fully unequal society unless there is social or public intervention (excerpt; emphasis added):

Wealth distribution without redistribution

What does the distribution of wealth look like in an economy in which all households have identical skills and patience, but there is no redistribution? This column argues that without some redistributive mechanism – either explicit in the form of government tax or fiscal policies, or implicit in the form of limited intergenerational transfers – the wealth in the economy tends to concentrate at the top.

A notable collection of recent research has described the significant concentration of income and wealth that exists in many countries of the world…

…The protests in Western countries suggest that it is not just academic economists who get this point.

Macroeconomists have adopted a number of different approaches to account for the high degree of inequality (see Cagetti and DeNardi 2008 for a recent survey). One of the most recent focuses on the role of uninsurable investment risk and the multiplicative process of wealth accumulation (Benhabib et al 2011)…These authors show that households hold significant fractions of their total wealth in the form of principal residence ownership and private business equity, both of which are volatile sources of idiosyncratic investment risk that are not easily diversified away.

In new research (Fernholz and Fernholz 2012), we embrace the insights from this empirical literature and analyse an economy in which households that are identical with regard to patience and skill face uninsurable investment risk, and there is neither explicit redistribution in the form of government tax or fiscal policies nor implicit redistribution in the form of limited intergenerational transfers of wealth.

In this setting, we show that in the absence of redistributive mechanisms, the distribution of wealth is unstable and becomes increasingly concentrated over time until virtually all wealth is held by a single household…

Extremely strong stuff, and to be fair, you’re looking at a multigenerational process – starting from complete equality, it will take 300 years to generate an income distribution similar to the US today, and 1000 years before you get an 80% concentration of wealth in the top 1%.

But the point of the exercise is less about the generated results than it is about the principle it demonstrates – striving for equality alone is not enough. For example, ensuring that kids from all backgrounds receive the same quality of education and educational facilities, and the same economic opportunities, won’t be a sufficient condition to maintain the stability of the distribution of income.

In other words, meritocracy alone won’t be enough to maintain a fair society, as income generation processes and intergenerational transfer of assets work to concentrate the distribution of wealth. You still have to have some redistributive mechanism, even if its just a progressive tax regime. Even better if you can address the sources of instability, which are capital income and inheritances.

Technical Notes:

Fernholz, Ricardo & Robert Fernholz, "Wealth distribution without redistribution", VoxEU, February 2012, (accessed March 23, 2012)

Fernholz, Ricardo & Robert Fernholz, "Wealth distribution without redistribution", Claremont McKenna College working paper, January 2012, (accessed March 23, 2012) (warning: pdf link)


  1. hey, it's me again.

    Just a note here. While this paper shows a very counter intuitive benchmark result on wealth redistribution in the economy, one ought to pause and ponder. Do we want to redistribute wealth or do we want to redistribute income?

    They sounds remarkably similar but they're quite different in their own way.

    While one can argue that if I own more wealth, I stand to make more income; it is vital to notice that simultaneously, by me owning more wealth, you stand to earn more income as well.

    For instance, you're a factory owner. You own all of the equipments and machineries. Those are your wealth. You stand to earn income from it. But, employees, at the same time, are more capable of producing goods and this allow firms to pay them more.

    Also, do remember that the underlying assumption is a perfectly competitive market. But, it is also the same assumption made in this paper. I'm merely extrapolating from their work.

    So, what one really want to redistribute is income. Not wealth. And, one redistribute income not because it's wrong to make more if you work harder. It's just that we can't accurately gauge people's innate talent. The best proxy we have so far, is income.

  2. I'd actually prefer to tax wealth than income - from the point of view of redistribution, it's fairer. Much of the build up in inequality (as in the paper above) comes from wealth being passed down through generations.

    In any case, it's a moot point. Income is taxed for the simple reason that its largely measurable, while wealth has all sorts of valuation and computation problems.

  3. Read a research paper..wealth GINI in 2007 was 0.56.Guess with escalation of financial assets n property over last 5 years..wldn't be surprised if its gone above 0.65 today.However, whats striking is 15% hv zero wealth.And most of the wealth of the lower 80% is in property(house they r living in most probably) n savings (EPF?)i.e non tradeable assets thus no capital gains opprtunities.
    And following the conventional ETP wealth centric policy inequality will continue to widen.Surely govt must appreciate the risk of growing disparities n the frustrations of the lower incomes that makes thevsociety non sustainable..Arab Spring in 2015 right here at our doorstep?

  4. I'm familiar with that paper. Yes, when we're talking about low to middle income groups in Malaysia, they have almost no exposure to financial assets (and as such, suffer generally lower returns on their savings and investments).

  5. That's weird. Even if they have large exposure to fixed savings only, it doesn't necessarily guarantee them a lower returns after risk.
    Unless risk is systemically underpriced, those holding more risky assets should not out-perform those holding less risky assets. It's the risk adjusted returns that matter. and, on wealth redistribution, how is it fairer?

    I'll let friedman do the talking here