How to Fix America's Wealth Inequality: Teach Americans to Be Cheap

Today, wealth equality is closely tied to income equality. But in the long run, it's all about thrift, frugality, and saving -- in other words, teaching a consumer nation a lesson in cheapness.

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There's a video making the rounds, showing America's staggering wealth inequality. As the sheer magnitude of the disparity unfolds behind the narrator's calm, steady voice, one struggles not to feel a sense of creeping horror. Did you know that the richest 1% of Americans owned 40% of the country's total wealth? I actually didn't!

Now, a word of caution: A lot of that wealth inequality is actually age, not class. Young people tend to have a lot of debt and not much savings, meaning they have negative wealth (a prime example being yours truly). Also, these statistics don't include things like entitlements, or human capital (the value of your skills and education). So Americans aren't quite as unequal as the video makes out. But they are still very, very unequal.

So what should we do about this? First, we need to ask ourselves if we should do anything about wealth inequality. At first it seems obvious, but consider this: Usually, what we care about is not the wealth of the poor and the middle class, but how much they get to consume. Those aren't the same thing. In the short run, in fact, they're the opposite - every dollar you save (which goes straight to your "wealth") is a dollar you don't spend on food, or clothes, or gas, or housing, or something else you can actually use. So maybe we should just worry about consumption equality, and let the rich sit on their useless stock portfolios like Smaug the dragon sitting on his giant pile of gold.

Or maybe not. First of all, living hand-to-mouth is no way to live. Wealth gives people a security cushion, meaning they don't have to borrow money if they get sick or lose their job. Security translates to peace of mind. Also, wealth affects political power; a more unequal wealth distribution means that government will be captured by a narrower range of interests. But most importantly, though there is a wealth/consumption trade-off in the short run, in the long run there is quite the opposite; the rich, it turns out, make a hefty chunk of their income from the returns that accrue to their wealth.

THE ORIGIN OF WEALTH INEQUALITY

The math of wealth is actually pretty simple: It all boils down to four things: 1. How much you start with, 2. How much income you make, 3. How much of your income you save, and 4. How good of a rate of return you get on your savings.

So one obvious thing we could do to make wealth more equal is - surprise! - redistribution. It turns out that income redistribution and wealth redistribution have much the same effect on the wealth of the poor and middle-class. Income redistribution is probably a bit better, for two reasons. First, people with higher incomes tend to save more, meaning they build wealth more rapidly. Second, people with higher incomes tend to have less risk aversion, meaning they are more willing to invest in assets like stocks (which get high average rates of return, although they are risky) rather than safe assets like savings accounts and CDs that get low rates of return.

In other words, giving the poor and middle-class more income will boost the amount they are able to save, the percentage they are willing to save, and the return they get on those savings. Part of the reason America's wealth distribution is so unequal in the first place is that our income distribution is very unequal.

But there are reasons to believe that redistribution can't fix all of the problem, or even most of it. If you do the math, you discover that in the long run, income levels and initial wealth (factors 1 and 2 from above) are not the main determinants of wealth. They are dwarfed by factors 3 and 4 -- savings rates and rates of return. The most potent way to get more wealth to the poor and middle-class is to get these people to save more of their income, and to invest in assets with higher average rates of return.

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Noah Smith is an assistant professor of finance at Stony Brook University. He writes regularly at Noahpinion.

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