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.

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.

As I mentioned, income redistribution helps these things a bit, but it doesn't account for the whole difference. The rich probably save more than the poor for many more reasons besides the simple fact that they're rich. In fact, being willing to save more is probably a big part of how the rich got rich in the first place. "Cheap" is an insult, but being cheap is how you get rich. If you consume everything you earn, your consumption will be higher today, but lower twenty years down the road; in our consumption-focused society, a lot of people are caught in this trap. And government can and should help them get out.

SAVING THE POOR THROUGH SAVINGS

What can government do to get middle-class and poor people to save more? Higher interest rates don't do the trick -- people didn't save more in the early 80s when interest rates were stratospheric. High stock returns don't do the trick either -- in the booming 1990s, people actually saved less, seeming to prefer to "let the market do their saving for them."

Instead, the answer is to change America's culture of (not) saving. This sounds hard, but actually it is probably very doable. For years, behavioral economists such as Richard Thaler have been studying ways to "nudge" people to save more. The most famous "nudge," which has been endorsed by President Obama, is to make employee pension plans "opt-out" instead of "opt-in". But there are plenty of others. In lab experiments, just giving people information on how to save money makes them save a lot more.

This means that more financial education in public schools is a must. I'm not talking about teaching kids the Capital Asset Pricing Model. I mean what Bob Shiller calls "basic Suze Orman stuff." How to make a monthly budget. What "saving" and "borrowing" mean. How wealth builds over time. How to avoid borrowing lots of money at high interest rates (e.g. credit cards and payday loans). Etc. The new Consumer Financial Protection Bureau can help a lot with this too, by preventing companies from tricking poor people into taking out high-interest debt.

RETURN TO EQUALITY

In addition to "nudging" middle-class and poor Americans to save more, we can help them get a better return on their assets -- the second thing that has a huge effect on wealth in the long run. This means helping middle-class people invest in stocks without paying high fees. The first part of this is teaching middle-class people to avoid making frequent changes in their stock portfolios. Studies show that individual investors consistently lose money when they try to buy and sell and buy and sell, mostly because they tend to ignore trading costs. So financial education should teach people to let their stock portfolios just sit there for decades, and ignore the ups and downs.

The second way to get better returns is to avoid actively managed funds. Actively managed mutual funds charge high fees to purchase portfolios of stocks that, statistically, are no better than simply buying a low-cost "index" fund that tracks the overall level of the market. Pension plans like TIAA-CREF tend to charge even higher fees, meaning even worse returns. Financial education can teach middle-class people what a low-cost index fund is, and how to invest in one.

This is not to say that middle-class people should put all their money in stocks. And many poor people can't afford to take the risk of investing in stocks. But in the long run, "asset allocation" -- i.e., how much of your savings you put in stocks and other high-return assets like corporate bonds -- is a major determinant of whose wealth grows and whose stays the same. The government, through financial education and "nudge" programs, can help people take advantage of high-return investment opportunities without paying high fees and trading costs.

In the short run, wealth equality is closely tied to income equality. But in the long run, it's all about thrift, frugality, and saving -- in other words, cheapness. If America's middle-class and poor people learn to be more cheap, then in 30 years, we will see a very different distribution of wealth.

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