By Mark Buchanan
reprinted from The
Australian Financial Review
(originally in New Statesman)
Why is wealth so unevenly distributed
among individuals? This is perhaps the most controversial and inflammatory
of all topics in economics. As JK Galbraith noted, the attempt to explain
and rationalize inequality "has commanded some of the greatest, or
in any case some of the most ingenious, talent in the economics profession".
We all know that a few people are very
rich and that most of us have far less. But inequality in the distribution
of wealth has a surprisingly universal character. You might expect the distribution
to vary widely from country to country, depending not only on politics and
culture but also, for example, on whether a nation relies on agriculture
or heavy industry. Towards the end of the 19th century, however, an Italian
engineer-turned-economist named Vilfredo Pareto discovered a pattern in
the distribution of wealth that appears to be every bit as universal as
the laws of thermodynamics or chemistry.
Suppose that, in Britain, China, the
US or any other country, you count the number of people worth, say, $10,000.
Suppose you then count the number worth $20,000, $30,000 and so on, and
finally plot the results on a graph. You would find, as Pareto did, many
individuals at the poorer end of the scale and progressively fewer at the
wealthy end. This is hardly surprising. But Pareto discovered that the numbers
dwindle in a very special way: towards the wealthy end, each time you double
the amount of wealth, the number of people falls by a constant factor.
Big deal? It is. Mathematically, a
"Pareto distribution" implies that a small fraction of the wealthiest
people always possess a lion's share of a country's riches. It is quite
easy to imagine a country where the bulk of people in the middle of the
distribution would own most of the wealth. But that is never so. In the
US, something approaching 80 per cent of the wealth is held by 20 per cent
of the people, and the numbers are similar in Chile, Bolivia, Japan, South
Africa and the nations of western Europe. It may be 10 per cent owning 90
per cent, 5 per cent owning 85 per cent, or 3 per cent owning 96 per cent,
but in all cases, wealth seems to migrate naturally into the hands of the
few. Indeed, although good data are sadly lacking, studies in the mid-1970s,
based on interviews with Soviet emigrants, suggested that wealth inequality
in the Soviet Union was then comparable to that in Britain.
What causes this striking regularity
across nations? The question is all the more urgent now that inequality
seems to be growing. In the US, according to the economist Paul Krugman:
"The standard of living of the poorest 10 per cent of American families
is significantly lower today than it was a generation ago. Families in the
middle are, at best, slightly better off. Only the wealthiest 20 per cent
of Americans have achieved income growth anything like the rates nearly
everyone experienced between the 1940s and early 1970s. Meanwhile the income
of families high in the distribution has risen dramatically, with something
like a doubling of real incomes of the top 1 per cent."
Something similar is taking place on
the global stage. Globalisation is frequently touted - especially by those
with vested economic interests, such as multinational corporations and investment
banks - as a process that will inevitably help the poor of the world. To
be sure, greater technological and economic global integration ought to
have the potential to do so. Yet as Joseph Stiglitz, the former chief economist
of the World Bank, notes in his recent book Globalisation and Its Discontents:
"Despite repeated promises of poverty reduction made over the last
decade of the 20th century, the actual number of people living in poverty
has actually increased by almost 100 million. This occurred at the same
time that total world income actually increased by an average of 2.5 per
What is the origin of these distinct but seemingly related trends: the greater
inequality within nations (which applies to Britain, and many other countries,
especially in eastern Europe, as well as to the US) and the greater inequality
between them? We can blame tax cuts, liberalization of capital markets,
new communication technologies, the policies of the International Monetary
Fund and so on. But might there be a general science that could illuminate
the basic forces that lead to wealth inequity?
Conventional economic theory has never
before managed to explain the origin of Pareto's universal pattern. But
two physicists, Jean-Philippe Bouchaud and Marc Mezard of the University
of Paris, venturing across the lines between academic disciplines, have
recently done so.
Forget for the moment about ingenuity,
intelligence, entrepreneurial skills and other factors that might influence
an individual's economic destiny. Instead, take a step into the abstract,
think of an economy as a network of interacting people, and focus on how
wealth flows about in this network.
It will flow - causing individuals' wealth to go up or down - in one of
two fundamental ways. The first is through the bread-and-butter transactions
of our daily economic lives: your employer pays you for your work; you buy
groceries; you build a fence to keep in the dog; you take a holiday. The
second is though rises and falls in asset values: houses and shares, for
example. The physicists have shown how the interplay of these two basic
forces largely determines how wealth is distributed.
Bouchaud and Mezard formulated a set of equations that could follow wealth
as it shifts from person to person, and as each person makes random gains
or losses from his or her investments. They also included one further feature
to reflect how the value of wealth is relative. A poor single parent might
face near-ruin over the loss of a $50 note; in contrast, a very rich person
wouldn't flinch after losing a few thousand. In other words, the value of
a little more or less wealth depends on how much one already has. This implies
that when it comes to investing, wealthy people will tend to invest proportionally
more than the less wealthy.
The equations that capture these basic
economic processes are quite simple. However, there is a catch.
For a network of many people - say,
a thousand or more - the number of equations is similarly large. A model
of this sort, therefore, lies well beyond anyone's mathematical abilities
to construct (and this explains why it has not appeared in conventional
economics). But the philosopher Daniel Dennett has for good reason called
the digital computer "the most important epistemological advance in
scientific method since the invention of accurate timekeeping devices".
The work of Bouchaud and Mezard falls into a rapidly growing area known
as "computational economics", which uses the computer to discover
principles of economics that one might otherwise never identify.
Bouchard and Mezard explored their model in an exhaustive series of simulations.
And in every run, they found the same result - after wealth flows around
the network for some time, it falls into a steady pattern in which the basic
shape of wealth distribution follows the form discovered by Pareto. Indeed,
this happens even when every person starts with exactly the same amount
of money and exactly the same money-making skills.
Why? Transactions between people should
spread wealth around. If one person becomes terrifically wealthy, he or
she may start businesses, build houses and consume more products; in each
case, wealth will tend to flow out to others in the network. Likewise, if
one person becomes terrifically poor, less wealth will flow through links
going away from him, as he will tend to purchase fewer products. Overall,
the flow of funds along links in the network should wash away wealth disparities.
But it seems that this washing-out effect never manages to gain hold, because
the random returns on investment drive a counterbalancing "rich-get-richer"
phenomenon. Even if everyone starts out equally, and they remain equally
adept at choosing investments, differences in investment luck will cause
some people to accumulate more wealth than others. Those who are lucky will
tend to invest more, and so have a chance to make greater gains still. Hence,
a string of positive returns builds a person's wealth not merely by addition
but by multiplication, as each subsequent gain grows ever bigger. This is
enough, even in a world of equals where returns on investment are entirely
random, to stir up huge disparities of wealth in the population.
This finding suggests that the basic
inequality in wealth distribution seen in most societies - and globally
as well, among nations - may have little to do with differences in the backgrounds
and talents of individuals or countries. Rather, the disparity appears as
a law of economic life that emerges naturally as an organizational feature
of a network.
Does this mean that it is impossible
to mitigate inequities in wealth? Pareto found (as many other researchers
found later) that the basic mathematical form of wealth distribution is
always the same. You find that, each time you double the amount of wealth,
the number of people having that much falls by a constant factor. This is
the pattern that always leads to a small fraction of the wealth possessing
a large fraction of everything.
Nevertheless, the "constant factor"
can vary: there is a huge difference between the richest 5 per cent owning
40 per cent of the wealth, and their owning 95 per cent. An additional strength
of the Bouchaud-Mezard network model is that it shows how this degree of
inequity can be altered.
The physicists found two general rules. First, the greater the volume of
wealth flowing through the economy - the greater the "vigour"
of trading, if you will - then the greater the equality. Conversely, the
more volatile the investment returns, the greater the inequity. This has
some curious practical implications, some obvious and some not so obvious.
Take taxes, for instance. The model
confirms the assumption that income taxes will tend to erode differences
in wealth, as long as those taxes are redistributed across the society in
a more or less equal way. After all, taxation represents the artifical addition
of extra transactional links into the network, along which wealth can flow
from the rich towards the poor. Similarly, a rise in capital gains taxes
will tend to ameliorate disparities in wealth, both by discouraging speculation
and by decreasing the returns from it. On the other hand, the model suggests
that sales taxes, even those targeted at luxury goods, might well exaggerate
differences in wealth by leading to fewer sales (thus reducing the number
of transactional links) and through encouraging people to invest more of
The model also offers an excellent
test of some arguments that politicians commonly use. For example, the pro-free
market policies of Britain and the US in the 1980s and 1990s were defended
on the grounds that wealth would "trickle down" to the poor. Everything
was done to encourage investment activity, regardless of the risks involved.
As we know, the wealth did not trickle down and wealth in both countries
is now significantly less equally distributed than it was three decades
ago. Under the network model, this is just what one would expect - a dramatic
increase in investment activity, unmatched by measures to boost the flow
of funds between people (such as higher taxes), ought to kick up an increase
in wealth inequality.
What about globalisation? Our model
suggests that, as international trade grows, it should create a better balance
between richer and poorer nations: Western corporations setting up manufacturing
plants in developing nations and exporting their computing and accounting
to places such as India and the Philippines should help wealth flow in to
these countries. But, as Stiglitz notes, Western countries have pushed poor
nations to eliminate trade barriers, while keeping up their own barriers,
thus ensuring that they garner a disproportionate share of the benefits.
As the Bouchaud-Mezard model illustrates, free trade could be a good thing
for everyone, but only if it enables wealth to flow in both directions without
If we go back to the model, it reveals
another, rather alarming prospect. Bouchaud and Mezard found that if the
volatility of investment returns becomes sufficiently great, the differences
in wealth it churns up can completely overwhelm the natural diffusion of
wealth generated by transactions. In such a case, an economy - whether within
one nation, or across the globe - can undergo a transition wherein its wealth,
instead of being held by a small minority, condenses into the pockets of
a mere handful of super-rich "robber barons". Some countries,
particularly developing nations, may already by in this state. It has been
estimated, for example, that the richest 40 people in Mexico own nearly
30 per cent of the wealth. It could also be that many societies went through
this phase in the past.
In Russia, following the collapse of
the USSR, wealth has become spectacularly concentrated; inequality there
is dramatically higher than in any country in the West. The model would
suggest that both the increased volatility of investment and lack of opportunities
for wealth redistribution might be at work. In the social vacuum created
by the end of the Soviet era, economic activity is less restricted than
in the West, as there are few regulations to protect the environment or
to provide safety for workers. This not only leads to pollution and human
exploitation, but also generates extraordinary profits for a few companies
(the politically well-connected, especially; a popular pun in Russia equates
privatization with the "grabbing of state assets"). Economists
have also pointed out that Russia has been slow to implement income taxes
that would help to redistribute wealth.
The Bouchaud-Mezard model is not the
last word in explaining the distribution of wealth, or how best to manage
it. But it offers basic lessons. Though wealth inequity may indeed be inevitable,
its degree can be adjusted. With laws to protect the environment and workers'
rights, free trade and globisation should be forces for good, offering better
economic opportunity for all. But we will do this only if global integration
is carried out sensibly, carefully and, most important of all, honestly.
Mark Buchanan is the
author, most recently, of Small World: Uncovering Nature's Hidden Networks
(Weidenfeld & Nicolson, $55)
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