The poor can save too: Here’s how we can help

Noah Smith has an article in The Atlantic about wealth inequality in the United States. A viral video caught the attention of the economics-blogosphere, and Noah is the latest to comment.  The import of Noah’s argument is the importance of thrift:

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.

Progressives have a hard time ascribing wealth inequality to savings rate and (predictably, though not incorrectly) blame structural issues like falling wage share of income. As one very popular commentator notes:

This is absurd. The real wealth gap is based in capital gains, not direct income. Teaching Americans to be frugal is not going to address any of the systemic differences that make it easier by orders of magnitude for the already rich to keep making money.

The fact is, poor American’s can save, they just have really bad habits. For example, as Derek Thompson notes, the poor spend a whopping 9% of their income on lottery tickets. So let’s be honest here, the whole diatribe against Noah that the poor can’t save is crap.

If we’re going to talk about wealth inequality, it’s pretty informative to understand its emergence, why it’s fundamentally different from income inequality, and why an “equal” society won’t help. Consider, an island which is functionally equal – you might say socialist. I’m not suggesting this is a plausibly sustainable situation, but it’s an interesting starting point. Let’s also assume that somehow socialism hasn’t eroded work ethic and desire to innovate. In reality, this isn’t a reasonable assumption, but I’m not making an argument about economic ideology.

So, on day one, the Keynesian economist, farmer, laborer, and lawyer each earn $100 a year. The economist is a spendthrift, with a good taste for Portuguese wine and Victorian clothes, and has only $10 left each year. The laborer, saves diligently, and has $50 leftover. Very soon, an island that once had income equality becomes very unequal, both in income and wealth. The wealth inequality comes first, but soon the laborer has more money to invest in his daughter’s education, and to loan to the moderately-thrifty lawyer and farmer to earn a good return.

So wealth inequality comes first. This is especially true if you consider, in our society, income derived from education to be a capital gain (though, legally, it is treated as labor). In the island, wealth and income inequality were both functions of preference.

However, in our society, as wealth inequality isn’t just a function of preferences, but income itself (in the island this isn’t the case because future income inequality is derived from wealth inequality which itself is derived from preferences). But, in a given snapshot, wealth inequality grows as, in some ways, the integral, roughly speaking, of income inequality.

This is because, if preferences are randomly distributed, the savings become a function of income. As income inequality rises (as it has in the past 40 years), the ability to save gets rather more concentrated amongst the rich. This, and not preferences, becomes the key force of wealth inequality. This is further compounded by the fact that, in a very literal sense, wealth begets wealth through capital income.

So my point of all this is I think Noah’s wrong that somehow altering preferences will fix the situation. Noah argues that, for a “return to equality”, the poor need to be nudged and educated:

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.

The first point is rather interesting, and Richard Thaler has the best evidence that it might work (Save More Tomorrow – fantastic study, I think everyone should read it). I don’t have much to say about personal finance education, I think it’s important, but I just don’t think it will have a lasting effect on habits in a consumer culture. Education will be artificial and instituted in the context of grades, which will be the only reason people pursue the subject.

But, as I argued, changing preferences will have only an ephemeral effect. What we need are:

• Robust risk sharing programs (particularly universal healthcare, strong social insurance, and unemployment insurance). This will a) decrease the need for wealth, mitigating the effect of wealth inequality and b) allow the poor to invest most of their income in stocks, so that they can take part in America’s wonderful capital market. Noah mentions China a country that’s poor but manages to save a lot. One of the many reasons for this, I believe, is an underdeveloped insurance market, creating a greater need for wealth.
• Ban lotteries. This is simple. Sure, states make a lot of money from them, but this is absolutely the most regressive tax in the country. Not only are educated people informed enough to know that the state has an edge, but it’s a very small part of their income.
• “Nudge” Americans to save through opt-out programs sponsored by an employer.
• Institute a progressive consumption tax with negative income
• Fix income inequality.

The integral-relation with income inequality explains why it will always grow as income inequality is constant, but wealth distribution doesn’t need to be as skewed as it is. Preferences will go some way, but the real change needs to come from income distribution (by investing in human capital) and access to capital markets (by pooling risk).

The falling role of labor in our economy will make wealth very important. Acting now is a pretty good idea. But, moving on, let’s remember a few things: demand creates supply, and wealth inequality creates income inequality. Let’s not mistake cause and symptom.