Economic Inequality

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January 2016

Since the 1970s, economic inequality in the US has increased
dramatically. And in particular, the rich have gotten a lot richer.
Nearly everyone who writes about the topic says that economic inequality
should be decreased.

I'm interested in this question because I was one of the founders of
a company called Y Combinator that helps people start startups.
Almost by definition, if a startup succeeds, its founders become
rich. Which means by helping startup founders I've been helping to
increase economic inequality. If economic inequality should be
decreased, I shouldn't be helping founders. No one should
be.

But that doesn't sound right. What's going on here? What's going
on is that while economic inequality is a single measure (or more
precisely, two: variation in income, and variation in wealth), it
has multiple causes. Many of these causes are bad, like tax loopholes
and drug addiction. But some are good, like Larry Page and
Sergey Brin starting the company you use to find things online.

If you want to understand economic inequality — and more importantly,
if you actually want to fix the bad aspects of it — you have to
tease apart the components. And yet the trend in nearly everything
written about the subject is to do the opposite: to squash together
all the aspects of economic inequality as if it were a single
phenomenon.

Sometimes this is done for ideological reasons. Sometimes it's
because the writer only has very high-level data and so draws
conclusions from that, like the proverbial drunk who looks for his
keys under the lamppost, instead of where he dropped them, because the
light is better there. Sometimes it's because the writer doesn't
understand critical aspects of inequality, like the role of technology
in wealth creation. Much of the time, perhaps most of the time,
writing about economic inequality combines all three.

The most common mistake people make about economic inequality is
to treat it as a single phenomenon. The most naive version of which
is the one based on the pie fallacy: that the rich get rich by
taking money from the poor.

Usually this is an assumption people start from rather than a
conclusion they arrive at by examining the evidence. Sometimes the
pie fallacy is stated explicitly:

...those at the top are grabbing an increasing fraction of the
nation's income — so much of a larger share that what's left over
for the rest is diminished....
[1]

Other times it's more unconscious. But the unconscious form is very
widespread. I think because we grow up in a world where the pie
fallacy is actually true. To kids, wealth is a fixed pie
that's shared out, and if one person gets more, it's at the expense
of another. It takes a conscious effort to remind oneself that the
real world doesn't work that way.

In the real world you can create wealth as well as taking it from
others. A woodworker creates wealth. He makes a chair, and you
willingly give him money in return for it. A high-frequency trader
does not. He makes a dollar only when someone on the other end of
a trade loses a dollar.

If the rich people in a society got that way by taking wealth from
the poor, then you have the degenerate case of economic inequality,
where the cause of poverty is the same as the cause of wealth. But
instances of inequality don't have to be instances of the degenerate
case. If one woodworker makes 5 chairs and another makes none, the
second woodworker will have less money, but not because anyone took
anything from him.

Even people sophisticated enough to know about the pie fallacy are
led toward it by the custom of describing economic inequality as a
ratio of one quantile's income or wealth to another's. It's so
easy to slip from talking about income shifting from one quantile
to another, as a figure of speech, into believing that is literally
what's happening.

Except in the degenerate case, economic inequality can't be described
by a ratio or even a curve. In the general case it consists of
multiple ways people become poor, and multiple ways people become
rich. Which means to understand economic inequality in a country,
you have to go find individual people who are poor or rich and
figure out why.
[2]

If you want to understand change in economic inequality, you
should ask what those people would have done when it was different.
This is one way I know the rich aren't all getting richer simply
from some new system for transferring wealth to them from
everyone else. When you use the would-have method with startup
founders, you find what most would have done
back in 1960, when
economic inequality was lower, was to join big companies or become
professors. Before Mark Zuckerberg started Facebook, his default
expectation was that he'd end up working at Microsoft. The reason
he and most other startup founders are richer than they would have
been in the mid 20th century is not because of some right turn the
country took during the Reagan administration, but because progress
in technology has made it much easier to start a new company that
grows fast.

Traditional economists seem strangely averse to studying individual
humans. It seems to be a rule with them that everything has to start
with statistics. So they give you very precise numbers about
variation in wealth and income, then follow it with the most naive
speculation about the underlying causes.

But while there are a lot of people who get rich through rent-seeking
of various forms, and a lot who get rich by playing zero-sum games,
there are also a significant number
who get rich by creating wealth. And creating wealth, as a source
of economic inequality, is different from taking it — not just
morally, but also practically, in the sense that it is harder to
eradicate. One reason is that variation in productivity is
accelerating. The rate at which individuals can create wealth
depends on the technology available to them, and that grows
exponentially. The other reason creating wealth is such a tenacious
source of inequality is that it can expand to accommodate a lot of
people.

I'm all for shutting down the crooked ways to get rich. But that
won't eliminate great variations in wealth, because as long as you leave
open the option of getting rich by creating wealth, people who want
to get rich will do that instead.

Most people who get rich tend to be fairly driven. Whatever their
other flaws, laziness is usually not one of them. Suppose new
policies make it hard to make a fortune in finance. Does it seem
plausible that the people who currently go into finance to make
their fortunes will continue to do so, but be content to work for
ordinary salaries? The reason they go into finance is not because
they love finance but because they want to get rich. If the only
way left to get rich is to start startups, they'll start startups.
They'll do well at it too, because determination is the main factor
in the success of a startup.
[3]
And while it would probably be
a good thing for the world if people who wanted to get rich switched
from playing zero-sum games to creating wealth, that would not only
not eliminate great variations in wealth, but might even
exacerbate them.
In a zero-sum game there is at least a limit to the upside. Plus
a lot of the new startups would create new technology that further
accelerated variation in productivity.

Variation in productivity is far from the only source of economic
inequality, but it is the irreducible core of it, in the sense that
you'll have that left when you eliminate all other sources. And if
you do, that core will be big, because it will have expanded to
include the efforts of all the refugees. Plus it will have a large
Baumol penumbra around it: anyone who could get rich by creating
wealth on their own account will have to be paid enough to prevent
them from doing it.

[...]

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