Shortly after I wrote How the Rich Get Richer I started reading Why the Rich Are Getting Richer by Robert Kiyosaki, author of Rich Dad Poor Dad.
The author says the following about both books:
If Rich Dad Poor Dad was elementary school, this book (Why the Rich Are Getting Richer) is graduate school.
That sounded good to me. I’m always up for a higher-level money book.
Plus I was also curious about answering the question — why do the rich get richer? I’ve taken my shot at it in the post above, but I was also interested in Kiyosaki’s take on it.
Besides, I knew he’d have an “interesting” perspective. 🙂
Unfortunately, like his other books, there just wasn’t a logical flow of the “___ Reasons Why the Rich Get Richer.” As usual, he was all over the place with one thought after another. I would have preferred each reason being a chapter, but he mixes everything up, making the answers harder to find.
As he says about himself, he’s a best SELLING author, not a best WRITING author. LOL! I couldn’t agree more.
To make it easier on you, I’m going to dig through the book (I highlighted as I read it) and give you the reasons he thinks the rich get richer.
Here we go, in chronological order they appear in the book…
1. The rich understand how money works.
In the book’s introduction Kiyosaki lists his first reason as follows:
One reason why rich entrepreneurs are getting richer is because they have extremely high financial IQs.
We’ll get into his thoughts on what having an “extremely high financial IQ” means as we get further into the book, but for now, let’s just take the statement at face value.
I think this relates back to education, a topic he’s fairly adamant about (that people in general are not financially educated). If someone is reading about money, talking to others about money, and learning about money in practical ways (as simple as having a budget, starting investing in a 401k at work, etc.), and so forth, then he’s going to have a higher financial IQ.
And as a result of being smarter about money, it’s more likely that he’ll become smarter with money. Not always, of course, but much of the time. And certainly more than someone with no financial education.
As a result, he’s going to become wealthy and, over time, even wealthier.
To look at it from the opposite point of view, very rarely do you see someone who is wealthy who knows little about money. One exception would be most lottery winners, and you know what generally happens to their wealth! Ha!
I like this tip as it’s accessible to almost everyone. Even if you can’t afford books, there’s the library and much of the good stuff on the internet is free — like ESI Money. 😉
2. The rich pay less in taxes (as a percentage of income).
Here’s his second point in why the rich become richer:
One of the reasons for wealth and income inequality is tax. Simply stated, the rich know how to make more money and pay less in taxes than the poor and middle class — legally.
Paying less in taxes is one of the big two themes in this book, so we’ll stick with it a bit.
Kiyosaki says that the rich pay less in taxes because most of them are 1) big business owners or 2) professional investors and there are many tax breaks available to these people. This is because they are in partnership with the government to provide jobs, housing, products, etc. (In other words, the government gives them tax breaks for certain behaviors.)
There’s no doubt that taxes are a HUGE expense for most people. They are probably a top-three expense for almost everyone.
If you look at our expenses over 28 years you’ll see that taxes were our #3 expense — if you count “savings” and “giving” as expenses. Most would not count the first two as expenses, and thus taxes would rank #1 for us, eating up 21% of our gross income.
And this doesn’t include all taxes, simply federal and state income taxes. There’s also sales tax (which is scattered among a ton of categories in our budget, lost in the total cost of items), real estate taxes, and a whole host of fees/licenses that could be listed as taxes.
Just think how much your net worth would benefit if your largest expense was cut by 25% or even 50%. It would make a huge difference, right?
Well, that’s Kiyosaki’s point.
Later in the book he digs more into the benefits of cutting taxes starting with his three types of income: ordinary income, portfolio income (capital gains), and passive income.
He says that ordinary (earned) income is the highest taxed of all three incomes. Then he says you can grow richer by earning more money with the last two types of income versus the first.
Here’s an example he uses in the book…
There’s a CEO who receives options to buy his company’s stock at $10 a share. He gets 1 million options. The stock goes to $16 a share, the CEO exercises his options, then sells all shares. He’s made $6 million.
The CEO pays roughly 25% (used in the book, the amount could be different now but the principle is the same) in federal and state taxes which is $1.5 million.
If he had made $6 million in ordinary income, he would be taxed at roughly 45% (Kiyosaki’s number) and owe $2.7 million.
By earning the money in portfolio income versus ordinary income, the CEO nets an extra $1.2 million.
The same is true for the average person, the numbers are just lower.
Oh, and most of us don’t get stock options either, so that’s a bit different. 😉
We’ll come back to taxes again as they play another role in a different way.
[Update: A couple of people have pointed out that stock options are taxed as ordinary income. As I googled around, I found there are actually different kinds of stock options and they are taxed differently. Details can be read here if you’re interested. My guess is that Kiyosaki is assuming the best-case scenario and that the rich would employ CPAs to make sure the options were taxed as little as possible. The point remains valid no matter what: if you can get income taxed at a lower rate, you’ll be better off. 🙂 Oh, and ask your CPA about any specific tax questions you have — don’t just believe a guy in the internet (or in a book).]
3. They make mistakes.
The short version here is that:
- The rich aren’t afraid to make mistakes.
- When they do make mistakes, they learn from them.
- They then apply what they have learned from their mistakes and become richer.
Kiyosaki says the poor and middle class are risk adverse and see making mistakes as “wrong” (he cites the American education system where we equate mistakes with something “bad”.)
I can’t say I disagree with this either…I think it’s correct…with one caveat…the mistakes can’t be catastrophic.
The millionaires I’ve talked to have made plenty of mistakes. So have I. But we haven’t killed our finances in the process. We had missteps, learned from them, got better, and moved on. Much like Kiyosaki says.
The best example I can think of making mistakes and still succeeding is found in the book How to Fail at Almost Everything and Still Win Big: Kind of the Story of My Life. It’s written by Dilbert creator Scott Adams. The book is a great read if you’re looking for a personal finance/business book with lots of tongue-in-cheek comedy. It’s very entertaining and educational.
4. They take advantage of crashes.
Here’s the way Kiyosaki summarizes this point:
If Walmart was having a 50%-off sale, you could not get into the store. If Wall Street has a 50%-off sale, [the poor and middle class] run and hide.
Kiyosaki expands on this point with the following:
Unfortunately most people shop for things that make them poorer, things like new flashy cars, new clothes, and jewelry.
The rich shop for bargains that make them richer. They wait for stock market crashes to buy the best stocks at bargain prices. They’re poised for crashes so they can buy real estate at bargain prices. They buy gold and silver, and businesses, at bargain prices.
This line of thinking is similar to that in this famous Warren Buffett quote:
Be fearful when others are greedy and greedy when others are fearful.
I have a couple thoughts on this point. Generally I agree with it but with some questions.
First of all, I know that lots of money can be made if you go against the flow and buy things at lower prices. I’ve seen this happen several times to me including:
- When the 2007-2008 financial crisis hit, we invested a significant amount of cash in the market. It was gut-wrenching to buy funds and see our money fall big the next day (we did it in waves so it was death by a thousand investments). But eventually the market roared back and we made out well.
- A few years after that, when our cash reserves had built back up, we did the same thing with real estate, buying buildings at a fraction of what they used to sell for (and a fraction of what they are now worth).
- Then into retirement, I bought Rockstar Finance. Many would say I over-paid since I bought it for way more than what traditional metrics would say was its fair value. But to me, I bought it at a discount to what I thought I could turn it into. I did just that, made a good amount, then sold it a bit over a year later for more than twice what I paid.
So I see what he means.
That said, how do the rich pounce on opportunities unless they have a ton of cash on hand — which is something Kiyosaki says is for losers? Maybe they borrow the money? (As we’ll see in a moment, he loves debt in certain cases.)
For us, we had an ever-widening gap between what we made and what we spent, so we were churning off tons of cash (we lived on 17% of our gross income which was helped by the fact that we had no debt — even our mortgage had been paid off years before — so expenses were quite low). We had enough to fully fund our 401ks with plenty left over.
In addition, I always kept a year or more’s worth of emergency fund money. Between the cash we churned off and cutting the emergency fund down to six months, we had enough to buy our apartments for cash.
Is that how the rich do it?
5. They use debt to buy assets.
Kiyosaki is a big fan of using debt to buy assets, which he would define as “something that puts money in your pocket.”
Examples of assets worth buying with debt include businesses, real estate, paper assets (stocks and bonds), and commodities. He favors real estate because it’s easier to get loans (since banks use the property as collateral).
Note that he does NOT list a personal residence as an asset. He claims it’s a liability since it doesn’t put money in your pocket (it does the opposite — it costs you money).
He also notes that “savings are taxed and debt is tax-free money which is another reason for the rich getting richer.”
We’ll see what he means by this in the next point.
He does give this word of warning:
You must be very careful with debt. It takes financial education to learn how to use debt to get rich.
Debt is a double-edged sword. Debt can make you rich and then, suddenly, something changes and that same debt is making you poor, very poor.
It’s been said that those who live by the sword die by the sword and that seems to be the case with debt.
For us debt was something we wanted to avoid. Of course we paid off debt in the days of very high rates, so borrowing didn’t make as much sense as some could argue it does today.
That said, I’m not sure we’d do anything differently if we were starting out today. There’s a sense of comfort in knowing you don’t owe anyone anything.
6. They create phantom income.
This uses a couple of the points above (namely debt and taxes) to “create income”, which he calls “phantom income.”
IMO, phantom income is best described by using an example. This is from the book — cobbled together and paraphrased in parts to make it shorter and clearer:
Let’s say a $100,000 property requires a 20% down payment.
If an investor is in the 40% tax bracket, the $20k down payment really cost him $35k in ordinary income since roughly $15k went to taxes.
If the investor borrows the $20k instead, he “saves” $15k or generates $15k in phantom income.
Kiyosaki says that “the phantom income from debt is the time and money you save renting money rather than working to earn it, paying taxes on it, and saving it.”
Then the property goes up in value to $150k. The $50k is phantom income known as appreciation.
Then tenants pay off your mortgage and your debt is reduced. This amortization of your debt is also phantom income — as it reduces debt/grows the value of your asset.
In addition, you can take depreciation off your income. Depreciation costs you nothing and hence it’s another form of phantom income, saving you even more in taxes.
The professional investor can keep things rolling by either 1) borrowing on the appreciated property to buy more properties or 2) sell the property, roll it into a 1031 exchange to buy a bigger place (using debt too), and owing no taxes on it.
Here’s another example from the book:
Suppose your one rental property cost $100,000. You have no debt and you have $100,000 of property, all of which came from after-tax income.
Instead, you borrow $200,000 and buy three properties. Now you have real estate worth $300,000.
Let’s say your appreciation is 10% on your properties. If you have one property, your appreciation, or phantom income is $10,000 ($100,000 * 10%).
However, if you have three properties worth $300,000, your appreciation or phantom income is $30,000 ($300,000 * 10%). In this case your debt tripled your phantom income.
A few thoughts on this subject:
- I see what he means. If you work the system, you can certainly play it to your advantage. That said…
- His examples assume there’s always appreciation. I think we all know that’s not the case. In fact, if the value of the rentals goes down, owning more of them loses you more than you would have lost if you’d bought with cash.
- Try buying food with phantom income.
Anyway, those are the six reasons Kiyosaki gives for the rich getting richer.
As in his other books, he has a ton of additional thoughts and opinions that don’t fit neatly under any of these topics (and don’t really relate to the rich getting richer). I’ll share those separately in another post.
For now, what do you think of his list? I’m particularly interested in your thoughts on phantom income…
Barry says
The idea of phantom income could also be considered as leverage -as you say, great when things are going up, not so great when they go the other way especially if there are real costs – mortgage, repairs, etc in the case of property, or margin calls in the case of Forex – and you can very quickly find yourself in a situation where your main income has to be used to cover these real costs.
The other point I would make about this is that the landscape has changed, certainly in the UK, wrt property investment in the last few years; there has been a strong, cross party drive to reduce the impact of buy to let on the general housing market via taxation in particular. This has cut off a key mechanism for tax management from the middle classes here, leaving fewer options that don’t impact on the day job. There are still strong advantages to owning your own business and the income available via use of dividends etc vs paying PAYE or payroll tax is dramatic. Over a three year period as a contractor to a US company my marginal tax was around 23% vs 40/45% I would have paid as an employee. However, it is very difficult to set that up below a certain level. For example, I work ASAP an enterprise sales rep, so my HR team dictate my terms of employment for the most part; if I was a CEO or VP Sales in a global company there is much more ability to discuss the structure of your contract.
The real reason the rich get richer is in your summary of the points in the book; across the western world, we tax income far more highly than assets, primarily because the people who own assets also have access to the people who decide the rules I taxation.
Xrayvsn says
Great review. I agree that leverage can magnify gains (but can also do the same with losses as you pointed out.)
The one thing that makes the rich get Richer is that there is more working capital in play. It is hard for someone not making a lot of money to have a lot left over to invest it the majority of it goes to taxes and living expenses.
There is a tipping point when your invested capital starts pulling its fair share or more. That’s why they say the first million is the hardest to make. After that the money typically grows at a much faster rate as more of it is working for you
Maca says
Spot on. Mr. Market has helped increase our net worth significantly this year despite it being a down year in w2 income.
MMiguel says
To your last point, I’m finding that at a certain “tipping point” asset growth starts to significantly exceed what one can save from one’s earned income. In fact, my asset growth (including automatically reinvested dividends) has actually exceeded my gross income the past few years – that’s a weird feeling when you realize that is happening, not that I’m complaining. I guess it illustrates the leverage of compounding asset wealth vs income wealth.
Jerry Schroeder says
My father explained this phantom income concept to me back in the early 80’s. He told me anyone can make a dollar work one way, saving, investing, spending. The trick was to make a dollar work 3 or 4 different ways. Back then in those extreme high interest days you could borrow up to 50% of your pension and profit sharing plans. You could borrow from your plans at an interest rate comparable to current rates say 16%. Use this money to buy rental property and the rents you collect would pay back your retirement plan, while depreciating the property on your taxes while enjoying the appreciation. Your dollars were now working 4 different ways for the bottom line. Unfortunately you can now only borrow a max of $50,000 from your retirement plans unless it’s for a first home I believe.
MMiguel says
Thanks for the review. I’ve certainly utilized all of these concepts at one time or other. I think there is actually a lot of conventional financial wisdom in this post/book, but while Kiyosaki is not necessarily original here, he certainly has a knack for recasting these ideas in very unusual terms.
If I understand “phantom income” its just another way of saying knowledgeably using debt to buy assets creates greater opportunity and juices return on investment. Indeed, I believe that access to capital and access to knowledge are the fundamental reasons “the rich get richer”. If you distill most of the conventional wisdom on the topic of the rich getting richer it comes down to the concept of access. Unfortunately, even with access, for example there is a wealth of info on the web these days, its hard to know what you don’t yet know you need to know. So, the un-woke keep going down blind alleys.
One of the other driving factors of wealth divide is that early mistakes are difficult to make up for. In my case, I made numerous financially destructive mistakes in my early adulthood, both career-wise and money-wise. It wasn’t until I was in my early 30’s that I truly came into my own in terms of more sophisticated personal finance knowledge. I do wonder sometimes what a difference in NW it would have made if I had started out with the kind of knowledge and coaching that makes for outstanding financial success. Notwithstanding the above, my 30’s and 40’s were excellent catchup years, so very fortunate in that respect.
In addition to early mistakes and delays taking a big toll, it is simply very very difficult to start from scratch. Again, knowledge comes into play – even if your parents didn’t have the funds to help you out, if they passed along knowledge, discipline, and confidence, those are assets that can be built upon. My observation is that most people don’t even receive that, hence are doomed to repeat multi-generational mistakes over and over. Certainly, one of the reasons the rich get richer because they are recipients of and pass along both capital and knowledge from which their families can keep building.
MMiguel says
FYI, my references to “knowledge” above, mean “financial IQ” in Kiyosaki terminology.
Matt says
Kiyosaki’s example on stock options in #2 is incorrect though. I understand the point he’s trying to make, but stock option gains upon exercise are taxed as compensation & ordinary income, not favorable capital gains tax rates.
I think a better example to use would be there’s an 83b election that’s common for executives. You can be taxed on restricted stock grants at the grant date rather than the vest date. If you have a high degree of confidence the stock will increase, then ordinary income applies to the lower amount at grant date, and capital gains applies to the increase in value beyond the grant date.
I think it’s accurate to say the rich are more savvy about paying less in taxes as a percentage of income, he just uses a bad example to get the point across.
M-147 says
Phantom Income or appreciation is clearly how the rich get “rich”, how they get “richer” and stay this way is by applying other wealth habits, for example: They don’t spend all or any of the phantom income or appreciation, they let it grow over time, reduce their leverage, when they have this security, then they use this income. This is what creates lasting wealth.
The one thing missing from the list of “how the rich get richer” is HABITS of the richer. Most wealthy people I know would rather use their time making sure they are secure financially. (Studying how, saving, going without, sweat equity) They will also delay gratification, something that non wealthy people have trouble controlling. The wealthy also maintain a high credit rating, which allows them to access the lowest cost debt when they choose to use leverage.
Everyone in the last 25 years has exposure to book stores, libraries or the internet on how to become wealthy, stop blaming your parents! My husband understood at 12 that all he needed to do was the exact opposite of his non wealthy parents.
Chuck says
I enjoyed the analysis. One thing missing about real estate is that the depreciation we “write off” is actually just deferred, because when a property is sold there is a recapture tax on any gain above the newly depreciated value. One way to avoid or put off this tax (as well as the capital gains tax) is to do a 1031 exchange for another property, if that’s an option for you.
Also, I have used leverage to make more money on real estate investments and it works. However, market factors can reverse this and make the debt work against you. I have chosen to avoid debt on investments so I can sleep better.
CMS says
I really love your very last thought about phantom income, I am still smiling.
I am new to real estate investing, for me the biggest advantage to it is the depreciation expense to lower your overall taxes. Unless you really bought the properties with high equities, it is so easy in a year to get your rental income diminished by a bad renter and in the meantime you are paying for the mortgage interest and taxes, not to mention scary cost of repairs and your sweat equity needed when this happens. I evaluate every year (for three years now) if I can use this to fund my semi retirement and wonder if putting it in any other safe instrument would be better.
Thanks for the summary, no wonder I can not finish reading any of his books.
Apex says
Depreciation is a nice advantage, but it is far from the biggest. It is also temporary. You have to pay it all back someday unless you die and your heirs get a stepped up basis. Don’t count on the stepped up basis surviving the tax fights over the next 30 years though. If I had to bet I would bet that stepped up basis is eventually eliminated from the tax code.
The most POWERFUL advantage of real estate is leverage and nothing is a close second. Assume 75% leverage. Then with 100K you can buy 400K of assets vs 100K of assets.
Leverage lets you expand your portfolio 4 times faster than cash. Leverage lets you gain appreciation value 4 times faster than cash. Leverage will grow your real estate net worth 4 times faster than cash.
It is true that leverage increases risk so it must be done wisely. Thus is must be pared with the most IMPORTANT advantage of real estate. Strong cash flow. As long as you have a portfolio of properties that provide strong cash flow then leverage risk is mostly irrelevant. Any decrease in value of the underlying asset does not matter because you have no need to sell the asset as long as the cash flow remains positive. If you had strong cash flow to start with then even a reduction in rents to retain occupancy is of no real concern.
Real estate success has many facets. But these two build the empire.
Cash flow is the back bone.
Leverage is the muscle.
Paul says
Apart from everything you highlighted, a factor that was overlooked is just simple compounding and percentages. For example, my daughter and I both have Roth IRAs. She has a couple of thousand dollars and made around $400 in capital gains last year. I have $800k+ in mine and received ~$75k. A 2% salary increase for someone making $150k is much different from one making $25k.
Maverick says
“…he does NOT list a personal residence as an asset. He claims it’s a liability since it doesn’t put money in your pocket (it does the opposite — it costs you money).”
Yep, and I’m surprised that so many millionaire interviewees claim their primary residence as an asset. Ya gotta live somewhere, and the living expenses including the house are all liabilities.
apex says
It is an asset and most millionaires know what an asset is.
You are right that you gotta live somewhere. That is exactly why what Kiyosaki calls the “liability costs” associated with owning a house are completely irrelevant. Housing is an expense. You have to pay it whether you own or not. It could be paid for through rent or it could be paid for via a mortgage/owning. As long as you don’t buy a house that is significantly more expensive than what it would cost you to rent then it is cheaper in the long term to own than to rent. This would have to be true in the aggregate right? Otherwise who would own real estate for renting it out.
The distinction is it is not an asset that provides you with cash flow (neither does gold), and it has maintenance costs (so does gold if you have a lot of it and want to store/protect it, unless you think its a good idea to keep 400K of gold stored in your closet. It seems gold may be a liability). This is why he calls a house a liability. For some people this “paradigm shift” in thinking may be useful. But of course this is all just semantics that he uses for effect to wrinkle people’s brain. it is absolutely an asset.
Here’s a test case to see if you really think its an asset or a liability.
2 people each with 1 million in stocks.
Perons 1 rents a 2500 square foot house for $2000 per month.
Person 2 owns a 2500 square foot house with a $1200 per month mortgage, another $400 per month in property tax and insurance costs leaving him with $400 per month for maintenance costs. His mortgage is for $200,000 and his house has a market value of $400,000.
20 years from now the house will almost certainly be worth considerably more than $400,000. His mortgage debt will be close to zero if not paid off, reducing his mortgage payment to zero. Person 2’s rent will be considerably higher, probably $3000 or more. He will have gotten no appreciation from the “liability” that he doesn’t own.
Person 1 using Kiyosaki’s terminology is worth 1 million dollars with no liabilities.
Person two is worth 1 million dollars but has a 200,000 mortgage liability plus on going maintenance liabilities. By his formula Person two is worth way less, depending how you account for the 200K mortgage on something that is not an asset and thus has no intrinsic value.
Which person would you sooner be?
Another problem with not counting a house in your net worth is how it can drastically distort your true financial picture. If you have a 400K house with a 200K mortgage do you take a 200K hit to your net worth but not get to offset it with any asset value since a house is not an asset? Say you are a renter and buy a house with a 200K mortgage. Does your net worth drop by 200K on that day? If not how do you account for the fact that you owe 200K but have no asset to offset the liability? Do you just ignore the 200K mortgage as a liability? Because that is a real liability. How about when you retire and decide to travel the world and have a 600K house fully paid for and decide to sell it and and live in short term rentals. Does your net worth jump 600K on that day. This would not provide an accurate picture of your financial health.
It seems fairly clear that a house is an asset. How do I know that? You can sell it. Try selling a liability.
MMiguel says
Maverick,
I have over $2mm equity in my primary residence, and fully leased out it has the potential to generate $150K gross rent (tax-deferred I should add) annually, and I’ve borrowed against it as a piggy bank to make other investments. Are you surprised I’m including that equity in my NW?
Because it has been the gift that just keeps giving. I could sell it and take the windfall (minus the capital gains tax if not carefully transacted) or I could move to a lower cost area and live on all that glorious inflation-friendly rental income. I really don’t think its a liability considering how much its added to my financial picture.
Now granted, this is an unusual situation. Nonetheless, what I’ve observed is that for even middle-class families, home ownership is an important store-house of wealth. Not only does it provide a roof over your head (and oftentimes over the heads of adult children and/or extended family members), but maintained properly and mortgaged responsibly, it is an “asset” that can provide access to an amount of capital that might otherwise by inaccessible. This is of course a double-edged sword – treated irresponsibly you get some nasty effects, but this is true of just about any financial endeavor.
Mr. Hobo Millionaire (MI-149) says
>>If an investor is in the 40% tax bracket, the $20k down payment really cost him $35k in ordinary income since roughly $15k went to taxes.
This concept hit me a few years ago, and it changed the way I look at everything. When you’re at the higher tax brackets, literally everything you spend your money on is really 30%-40% more than what you’re spending. It really makes you consider what you’re putting your money into.
While I’m a bit “gun shy” to use debt for down payments, I get the logic, and I’m still battling the two sides of my brain to find the right balance of using debt to acquire more assets.
Silly Snoopy says
When it comes to leverage, it certainly is a double-edge sword. After a historic run in most asset class in the last decade, thanks to cheap money from all major central banks around the world, it is prudent to watch the leverage level. As long as you are not forced to sell when the market goes down (perhaps due to cash flow related issue), and assuming the underlying asset quality is high (meaning there is no reason why price wouldn’t bounce back over time); then you should be fine. Otherwise, may want to dial back the leverage while the party is still going, and not get caught swimming naked when the tides go out.
PWilliam says
I appreciate these thoughts by the book’s author, and tax and income management and leverage certainly makes a difference. However, I am pretty sure that the driving force is that modern technology has made high-value workers’ salaries much higher, relative to years past. And they tend to marry high earning people too.
OzzieinNJ says
Appreciate the perspective of all, but if you want another interesting read that doesn’t assign anything other than mathematical probabilities to three variables that can explain 99.83% of the wealth distribution in the US, try reading the following:
https://www.scientificamerican.com/article/is-inequality-inevitable/
It is notable that all of the complexity of our economic system can be so simply modeled and can be attributed to three variables: the fraction of your wealth you are prepared to put at risk, wealth redistribution and allowing some people to have negative wealth.
Two of the final conclusions are also sobering:
1) “In fact, these mathematical models demonstrate that far from wealth trickling down to the poor, the natural inclination of wealth is to flow upward” (Not that surprising…)
2) “It is true that an individual’s location on the wealth spectrum correlates to some extent with cleverness and industriousness, but the overall shape of that spectrum can be explained to better than 0.33 percent by a statistical model that completely ignores them…”
Apex says
Did you comprehend the premise of their model?
They reduced the entirety of all free market systems to a casino event where on each flip of the coin you either gain or lose a certain percent of your wealth.
Their reason for doing so was that they argued in a market economy the only way for wealth to change hands was for one of the actors to make a mistake in the economic exchange. For those familiar with economics this is not how free markets work. The market works among millions of actors to set a price based on the collective supply/demand of all the actors in the market. It’s not based on millions of actors making mistakes. Certainly mistakes are made but the idea of the market is that anyone can come in and compete. If seller A is charging way too much money such that the buyers are making mistakes, then seller B will come in and charge less and still make money and so will seller C and D and E until the market clears and supply matches demand setting a price that the buyers are willing to buy all the supply at that price and no seller is willing to provide more supply at that price. This is not a system dictated by constant mistakes as this model depends on, it is a system based on equilibrium between supply and demand which doesn’t happen with constant mistakes.
Every mistake that happens is not an equal dollar amount mistake but an equal percent mistake. For instance. If you had $100 and had a postive 20% mistake you would now have $120 but then if you had a negative mistake (it would also be some fixed number, they used 17% as an example of a mistake hurting you less but 17 was chosen carefully so that when compounded with your 20% positive mistake you have now lost 20.4%). They suggested mistakes could easily be more equally weighted but then it would get to inequality even quicker. However this is a known feature of percentage based systems. We see it in the stock market every day. If you lose 50% in the market you need to gain 100% to get back to even. So over time your gains must be larger than your loses or you will oscillate yourself to zero. That is exactly what their model shows. This is basic math. There is nothing profound here at all and it bears no resemblance to how an economy actually operates. This was the most egregious of their flaws.
Of course these systems all collapse in complete oligarchy very quickly which doesn’t model real economies. It’s contrived and they admit as much. So they added new variables to make it “resemble reality.” Pay attention to those words. Resemble reality. All they did was add 3 different variables, one for a wealth redistribution factor, one for a wealth unfairness factor, and one for a negative wealth factor and then play with those variables until they got the outcome they wanted.
They played with these variables until they could make the system fall into a wealth distribution that roughly mirrored the current US wealth distribution, and presto, they have explained how wealth distribution and inequality actually works in the real world apart from anything real, just made up math factors.
It is note worthy that it was written by physicists and mathematicians not economists.
The paper also seems to have an agenda against free market systems.
If someone hates capitalism they can find what they are looking for from these physicists. I will let my physicists explain the universe to me, not the economy.
What this paper didn’t address which could have been quite useful (although they should still get economists involved), was what happens in markets that have structural barriers that drastically limit the number of competitors need to set a market clearing price. This is what we are facing today because of the internet and giant tech companies. Network effects make it such that you cannot compete with facebook, or amazon, or google. They are winner take all systems. Once a dominate player emerges all others fall to way side offering no real competition. This is an area that has the potential to drastically transfer wealth because the market can’t be relied on to set a clearing price due to a limit on competition. It is the monopoly effect but it is happening naturally and consistently in the internet age.
Unfortunately all we got here was a contrived example of how an economy that operates like a casino is detrimental to wealth equality. I think we all knew this already and thank God our economy is not a casino.