Friday, February 14, 2014

Is inequality approaching a tipping point?

As with my last post, I'm trying to catch up here in linking to my recent Bloomberg pieces. This is my last one from two weeks ago. Given all the recent discussion of rising inequality, I wanted to point to a really fascinating paper from about 15 years ago that almost no one (in economics, at least) seems to know about. The paper looks at a very general model of how wealth flows around in an economy, and points to the existence of a surprising phase transition or tipping point in how wealth ends up being distributed. It shows that, beyond a certain threshold (see text below), the usual effect of wealth concentration (a small fraction of people owning a significant fraction of all wealth) becomes much worse: wealth "condenses" into the hands of just a few individuals (or, in the model, they might also be firms), not merely into the hands of a small fraction of the population.

Are we approaching such a point? I've mentioned some evidence in the article that we might be. But the important thing, I believe, is that we have good reason to expect that such a threshold really does exist. We are likely getting closer to it, although we may still have a ways to go. 


We know that inequality is on the rise around the world: The richest 1 percent command almost half the planet’s household wealth, while the poorest half have less than 1 percent. We know a lot less about why this is happening, and where it might lead.

Some argue that technological advancement drives income disproportionately to those with the right knowledge and skills. Others point to the explosive growth in the financial sector. Liberals worry that extreme inequality will tear society apart. Conservatives argue that the wealth of the rich inspires others to succeed.

What if we could shed all our political prejudices and take a more scientific approach, setting up an experimental world where we could test our thinking about what drives inequality? Crazy as the idea might sound, it has actually been done. The results are worth pondering.
Imagine a world like our own, only greatly simplified. Everyone has equal talent and starts out with the same wealth. Each person can gain or lose wealth by interacting and exchanging goods and services with others, or by making investments that earn uncertain returns over time.

More than a decade ago some scientists set up such a world, in a computer, and used it to run simulations examining fundamental aspects of wealth dynamics. They found several surprising things.

First, inequality was unavoidable: A small fraction of individuals (say 20 percent) always came to possess a large fraction (say 80 percent) of the total wealth. This happened because some individuals were luckier than others. By chance alone, some peoples’ investments paid off many times in a row. The more wealth they had, the more they could invest, making bigger future gains even more likely.

For those who worry about the corrosive effects of wealth inequality on social cohesion and democracy, the idea that it follows almost inexorably from the most basic features of modern economies might be unnerving. But there it is. A small fraction owning most of everything is just as natural as having mountains on a planet with plate tectonics.

Suppose we reach into this experimental world and, by adjusting tax incentives or other means, boost the role of financial investment relative to simple economic exchange. What happens then? The distribution of wealth becomes more unequal: The wealth share of the top 20 percent goes from, say, 80 percent to 90 percent.

If you keep boosting the role of finance and investment, something surprising happens. Inequality doesn’t just keep growing in a gradual and continuous way. Rather, the economy crosses an abrupt tipping point. Suddenly, a few individuals end up owning everything.

This would be a profoundly different world. It’s one thing to have much of the wealth belonging to a small fraction of the population -- 1 percent is still about 70 million people. It’s entirely another if a small number of people -- say, five or eight -- hold most of the wealth. With such a chasm between the poor and rich, the idea that a person could go from one group to the other in a lifetime, or even in a number of generations, becomes absurd. The sheer numbers make the probability vanishingly small.

Are we headed toward such a world? Well, data from Bloomberg and the bank Credit Suisse suggest that the planet’s 138 richest people currently command more wealth than the roughly 3.5 billion who make up the poorest half of the population. Of course, nobody can say whether that means we’ve reached a tipping point or are nearing one.

Experimental worlds are useful in that they exploit the power of computation to examine the likely consequences of complex interactions that would otherwise overwhelm our analytical skills. We can get at least a little insight into what might happen, what we ought to expect.

Our experimental world suggests that today’s vast wealth inequality probably isn’t the result of any economic conspiracy, or of vast differences in human skills. It’s more likely the banal outcome of a fairly mechanical process -- one that, unless we find some way to alter its course, could easily carry us into a place where most of us would rather not be.

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