One of the most important social questions of the next few decades is clearly going to be how we respond as a society to the overt growing inequality in the United States.
As this discussion becomes more mainstream, the narrative that gets shared blames some combination of technology (which gives more leverage to individuals than ever before) and unequal access to “opportunity” (in the form of education, access, etc.).
While I am sure these two factors play a role, I am convinced that they are not the major source of growing inequality in the U.S. The real cause is the compounding advantage that some people have in their ability to take certain types of financial risk in a world where access to capital is commoditized. Real returns come from high-variance, low-probability outcomes.
If we want to have an honest conversation about how to address inequality in our society, we need to have an honest conversation about how risk capacity and returns increasingly work against the backdrop of increasingly efficient capital markets.
Why Risk Capacity Is the Real Source of Inequality
Imagine a group of people thrust into a fresh world with no history. What would lead to inequality over time? Broadly speaking, there are four things which, starting from zero, can lead to one person to do better or worse than their neighbor: differences in ability, differences in work habits, differences in knowledge and difference in risk taking.
Differences in ability and work habits can lead to differences in outcome, but only linearly. Someone might work twice as hard as someone else, or be twice as talented at a given task—but you can only be so smart or work so hard. A smarter, stronger and harder-working person might do better than their neighbor, but at most by a few multiples, not orders of magnitude.
Differences in knowledge might at first blush seem like they can provide compounding advantage of one person over another in this over-simplified world, and explain what we see today. But the reality is that knowledge tends to diffuse quite rapidly. It is hard to keep an idea or invention private forever to your own advantage—though throughout history many individuals and organizations have certainly tried.* So, a great idea or a unique piece of information you figure out might provide some advantage for a while, but it is generally not sustainable or compounding.
That leaves risk taking as the final input to differences in outcome in our oversimplified world. The interesting thing about risk taking is that its impact on outcomes can be almost unbounded on the upside, and unlike other forms of advantage, its advantages very clearly compound.
Let’s explore why this is...
Imagine at the start of our oversimplified new world, some people have a proclivity to take more risk than others. They could naturally be willing to take on more risk because they are inherently more ambitious, because they were less satisfied with the life their peers enjoyed, or they were just unrealistically optimistic.
Let’s assume that this handful of oddballs takes on unnatural and ill-advised risk—and goes exploring new territories or ideas. For most, the risk-taking doesn’t pay off, and these people end up worse off than their non-risk-taking neighbors. We need not discuss them further.
For a minority, however, imagine that their risk taking pays off, and they get dramatically richer than their neighbors when they find a “gold mine,” invent new technology, conquer the country, whatever the framework might be.
If those “risk-taking winners” simply then consumed their excess wealth and lived better than their neighbors for a generation or two, that might be fine and then the end of momentary inequality. But what really happens for the risk takers is that they now effectively have “free” options on taking more and more risks throughout their lives.
Unlike the first-round risk-taking losers, the winners can now afford to take more and more risks. And it is OK if they lose what would be a fortune to someone else—as that fortune is a rounding error to them—so long as they occasionally win big.
In this way, unlike other drivers of inequality—the ability to take on “risks” compounds, as the relative cost of risks declines the more capital or success you have already had.
In our theoretical discussion, over time, we end up in a society where some people can afford to take rational risks with time and capital, but most cannot. This in my mind describes the core of the inequality problem we face today.
Why Compounding Risk-Capacity Is Leading Our Society Toward Increasing Inequality
One might reasonably ask, if risk taking is the fundamental driver of inequality, what is different about today versus earlier periods that is driving the increasing inequality we see?
I think there are a series of factors at play. Many of these factors can be traced back to technology in one form or another, but not all of them.
1. Big wins have both gotten much bigger and can consume more capital than ever before. This should be fairly obvious looking at the venture capital community and Silicon Valley. Because of technology, when things work they can work faster and at a greater scale than ever before in history. That creates unfathomable upside in a tiny minority of cases.
At the same time, the biggest wins consume more capital on their way up than ever before. A big win is always great, but a big win that requires or can only make use of a small amount of capital is less optimal for investor returns than one that can use a lot of capital (assuming that the investors have infinitely deep pockets). In a world where cash-on-cash returns is king, it is just as important that high-risk investors can now plow billions of dollars into winners as it is that when they win, they win big.
This creates shocking inequality even in the rarified world of high-risk venture capital investments. Seed investors who take the first “risk” on companies often don’t make the most money when those companies succeed. Usually, it is the investors who come in slightly later—but put orders of magnitude more dollars at risk—who end up making the most money. This is effectively the simple explanation of the SoftBank Vision Fund—the rich will get richer in a world of nearly limitless capital demand.
2. Capital markets have become much more efficient (which counterintuitively benefits risk takers over everyone else). Gone are the days of individuals in a local market, community or industry being able to get good rates of return based on provincial knowledge and access. When everyone has access to invest in everything, the rate of return on low-risk good investments approaches zero rapidly. Those who want to take risk can always find it across the whole world and not be limited by running out of opportunities in their “local” market.
If you want to see how this has manifested in the last few years in the technology world, look no further than the valuation step-up pattern in the most successful companies. Where once valuations climbed more linearly through successive rounds of financing, now the general pattern is that companies start out pricing equity at very low prices when risk is high—and then the second they “turn the corner” valuations massively step up to public company levels, even before they are public. The smooth growth of gradual de-risking has been replaced by spot jumps.
3. Regulation has locked most people out of high return investment opportunities. Consumer protections have their place. But there is no question that regulations, which disincentivized companies from going public quickly—and bar unaccredited investors from taking financial risks or investing in funds which do—drive inequality. In the name of protecting people we have set up a world where—quite literally—in order to have access to the best performing investments you need to already be rich.
I think that the appeal of Bitcoin to millennials is a good demonstration of the impact of these regulatory blocks in practice. I strongly believe that part of the reason Bitcoin has been such a talked about and exciting opportunity for millennials is that it is perhaps the only asset with the potential to increase in value by orders of magnitude versus the single-digit percentages they have access to.
4. If you are not already very wealthy, taking risks has become increasingly more risky than it was historically for a litany of reasons. Social capital and insurance from families and communities have declined over time, removing a historically important well of safety beyond the capital markets. The broad availability of good jobs that afford good lifestyles has dramatically declined, meaning you can’t always go back if you fail or make a poor investment. The usefulness of having capital to address life situations like illness has increased as new treatments are possible, making relatively safe savings more important. The list of reasons why the middle class is being priced out of taking risk goes on and on.
The longer we can live, the better life can be. The downside of losing the capital necessary to have a good life largely explains why the risk taking that generates returns is becoming less accessible to most people. That also explains a lot of the angst of the upper middle class.
This is obviously just a sampling of the myriad factors that make our time unique in terms of the impact that risk dynamics have on inequality. Hopefully the general point is clear. The factors that are driving inequality in our society come down to risk-capacity coupled with a changing landscape of the types of risk available to people and their capacity and willingness to take risk.
The Path Forward
I don’t know anyone who thinks that a world of spiraling inequality is healthy for our society or sustainable. Even the most unapologetic libertarian Silicon Valley caricatures fear that inequality taken to the extreme leads to revolution.
So, the question is, if you accept that risk-capacity is at the root of inequality, what should we do about it? Here are a few suggestions on how we should reframe certain popular policy debates in a language of opening access to risk to more people:
1. We should help everyone take more risks, and pool risk more efficiently. In my mind, advocates of things like universal healthcare and universal base income would be better served by positioning programs like those as ways to help everyone take more risk with their time and whatever capital they have. If you know that you will always have access to reasonable medical care, shelter, that you won’t starve, etc., then people will have the capacity to take on more risk.
We have had success before with things like this. The abolition of debtors’ prisons and establishment of bankruptcy law was massively effective in driving our economy forward by limiting the risk of starting new businesses. I think there is an argument that forms of social insurance could be as effective in the future.
2. We should look to limit the debt burden of students, so young people can take more risks earlier in their careers. Some politicians are proposing plans for free college (which I do not agree with). Other politicians and organizations are excited about using ISAs to get rid of fixed debt and align school outcomes with students (which I very much believe in).
These ideas are more related than some people might like to admit. The idea is to make sure that young people are not stuck in dead-end jobs and unable to afford risk so that they can service fixed debt.
In terms of more equality-distributing risk-taking capacity, this seems like a critical step. As a society, we shouldn’t accept a world where certain children from certain families have access to take on dramatically more risk in their lives earlier than others when compounding risk plays such an obvious role in financial outcomes.
3. We are probably going to end up with a wealth tax, starting with the hyper-wealthy, in order to more equally distribute risk-taking capacity. In a world where wealth begets wealth so mathematically based on risk, it is hard to see how we avoid this conclusion.
To draw on a somewhat flippant illustration: Imagine a massively multiplayer video game where some people have infinite “free lives.” First, those people will always win, which will just make the game un-fun for everyone else and make them not want to play. That situation is an inefficient allocation of resources versus distributing “extra lives” more broadly.
To be clear, I am the first to point out all the massive practical problems with a wealth tax (you can read my view on the challenges of a wealth tax and how one could possibly be instituted). But I do believe that if you accept the risk-driving-inequality analogy, something like a wealth tax will be needed for our society going forward.
Living in a World of Increasingly Random and Extreme Outcomes
In the United States, the narrative for centuries has centered on a combination of hard work and ingenuity.
We celebrate our inventors—the Franklins, Bells, Fords, Wrights—and basically are all happy to reward them richly for their contributions to moving the world forward.
We have also always celebrated hard work, back to the Puritans and their gospel of wealth.
We have always been more ambivalent toward the risk-takers who happened to win at the roulette table. As a society we have a far more challenging relationship with the pioneer families who made fortunes in the gold rush, and the Wall Street families who mastered markets and risk.
There will still be inventors, and there will still be hard workers in our future. But as we come to grips with the fact that in modern times economic outcome compounds less on innovation and work, and more on risk taking, either our national identity is going to have to dramatically shift, or we are going to have to think about how we evolve our social structures.
I hope we can have a thoughtful conversation about the latter, and how to open more risk-taking to more people.
* Historically, institutions like medieval guilds were designed, at least in part, as knowledge cartels to try to preserve information advantages. There is a risk that, in the future, the increasing specialization of human work and black-box algorithms will make it hard for individual workers to learn a process by simply participating in the work process.