Income and Wealth. Investment, success, and inequality.
- W. Brian Arthur. 1990. “Positive Feedbacks in the Economy.” Scientific American (February): 92-99.
- Andrei Shleifer amd Lawrence H. Summers. 1990. “The Noise Trader Approach to Finance.” The Journal of Economic Perspectives 4(Spring): 19-33.
- W. Brian Arthur. 1996. “Increasing Returns and the New World of Business.” Harvard Business Review (July-August)
- Thomas Piketty and Emmanuel Saez. 2006. “The Evolution of Top Incomes: A Historical and International Perspective.” American Economic Review 96(2): 200-205.
- Paul Krugman. 2006. “The Great Wealth Transfer.” Rolling Stone (December 22).
- Louis Uchitelle. 2006. “Lure of Great Wealth Affects Career Choices.” New York Times (November 26).
- Film: Enron: The Smartest Guys in the Room (screened April 25, in Green: ZDVD 11317)
Entries (RSS)
April 30th, 2007 at 1:37 pm
The role of positive feedback loops in creating economic inequality serves, much like the role of the nobel prize in aiding research ventures, to create continuous, on-going inequality which appears hopeless to resolve. As the Arthur, Krugman, and Uchitelle readings make apparent, those who start off wealthy have a greater likelihood of remaining wealthy than on has of climbing the increasingly-steeper economic ladder. Likewise, those who end up successful are those who have the good fortune of beginning well-off, just as tech ventures end up being successful by launching their products at the right place and the right time, rather than by being the best and the brightest. Arthur suggests this in his discussion of VHS and Beta tapes for the VCR, as the better-linked VHS outperformed the more-advanced Beta. Krugman’s article echoes the chance involved for the millions of workers who had the misfortune of being born into the working class, as compares the wages of working Walmart employees making $18,000 per year, working under slave conditions with little hope for advancement, in relation to its CEOs making $23 million per year, who can only look forward to even greater sums of money as the general pay rate for CEOs increases.
This discussion brings me to my biggest problem with this week’s readings: Krugman’s discussion of “Myth 2: Inequality is mainly a problem of education.” In a society which has not only not achieved the stipulations guaranteed by Brown v. Board, but has not yet achieved the preceding stipulations guaranteed by Plessy v. Ferguson, the argument that education is not a source of inequality is difficult to believe. The institutions students attend depend on property taxes for funding, which guarantee that children of wealthy parents will be provided with greater access to educational resources in their school than those of lower socioeconomic status. In a society which relies on increasingly higher levels of education to attain high-paying jobs, those who are not given proficient enough education to even be qualified to apply to college are essentially sentenced to slave-wage conditions for the duration of their lives (while there surely some anomalies, generally this is the case). While Krugman suggests that being well-educated won’t bring society’s members millions of dollars, it does serve to open doors to opportunities to attain affluence. The fact that thousands of people compete to acquire a space in our nation’s top schools, knowing the likely positive financial consequences of graduating from one of these institutions, speaks to the economic value placed on higher education in this country. Additionally, medical research has found that not only is a person’s health related quality of life better as one’s education increases, but the better educated a person is, the longer he/she is predicted to live. Without an education, people cannot land jobs on Wall Street, in the tech industry, or in prestigious law offices. To undercut the value of an education is nonsensical. Though these positive feedback loops in attain ridiculous wealth exist, one cannot expect to advance lest one start from a point where one’s wealth will take off. Much like the research funding in academia, if one does not start off well, one should not expect any success at all.
April 30th, 2007 at 2:27 pm
I don’t think “Myth 2″ was intended to completely undercut the value of education. He was merely trying to explain that fixing the education system will not alleviate the rich-poor gap, because other more powerful feedback mechanisms are also in play. This is not, however, to say that the education problems in America aren’t exacerbating the problem. I would agree with you, and I think Krugman would as well, that the sad state of our education is a strong conspirator in the creation of this divide. It’s just that blaming education, so fundamentally, has the effect of distracting people from other, possibly more powerful, influences.
April 30th, 2007 at 10:56 pm
Given the ideology behind the American Dream, I think there’s a belief that somehow those who are poor simply have not worked hard enough to lift themselves out of poverty. I think that understanding that education serves as a barrier to their advancement, given the way our system is run, is an important concept. I do not mean to suggest that the positive feedback mechanisms in place do not exist, but instead that there might be a second loop keeping the most poor, poor, just as another loop serves to accelerate the advancement of the most well-off.
May 2nd, 2007 at 2:19 pm
I found it fascinating that these ideas are, in a sense, so new to economics. In his ‘89 article, Arthur finally acknowledged that Marshall, so commonly associated with evil, rigid, Victorian economics, realized that under the proper conditions such positive feedback patterns could arise; but this idea went largely ignored. The historic background Arthur gives in his later article explains very clearly why, for circumstantial reasons, increasing return economics was less relevant even a century ago. Only recently has it been worth developing these ideas, as our economy evolves away from the production of strict commodities.
These positive feedback loops, as explained in the article, have a very destabilizing affect on the economy, and, perhaps more importantly, on economic theory. Not as dire as Hicks thought, perhaps, but it should be clear that many of the assumptions of legacy economists have been challenged. I think the most important challenge we face is the realization that this new-view economy, which has the ability to act chaotically in regions influenced by positive feedback, is no longer necessarily efficient. As we have seen by example, resources are no longer alloted in the best manner, and if virtuous products actually reign victorious then it may only be due to pure happenstance. This is not, I think, what we want.
Authors like Arthur and Summers do a rough job defending the virtue of increasing return economic systems, explaining that better products (or, say, better scientific researchers) have a greater /chance/ of being selected at the outset, and the good ones have a much better chance of success; meaning that the economy’s choice has a better chance than random of being pretty darn decent. In other words, increasing return economies are not /all/ bad. This was the only answer to the other authors, like Uchitelle and Krugman, who simply lamented the sorry state of increasing return economies: rich poor gaps and the loss of valuable sectors (i.e. cancer research) due to poor overall resource allocation. What we did not see much of in these readings are ideas for how to counter-act the negative effects of the positive feedback loops. That is, what measures could be put in place to make the economy again self-correcting and efficient. Some answers seem obvious: plenty of pundits advocate reactionary tax reform. Others are not so obvious: Arthur suggests the vague policy of “Don’t allow head-starts for the privileged” for preventing undesirable affects; however, realizing the spirit of such a policy in today’s economy seems almost intractable.
I am eager to find modern economists’ responses on this subject: what to do about a positive feedback economy.
May 2nd, 2007 at 5:44 pm
Broadly speaking, the readings in class this week covered two kinds of feedback loops in the economy: one about the wealth of individuals, the other about the expansion of products and companies. In the first story, negative feedback influences that control runaway acquisition of wealth have been eroded in the English-speaking first world countries, with the effect that the disparity between rich and poor has grown much larger. In the second story, the rise of the knowledge-based economy has ushered in a positive-feedback economy because negative influences on the more traditional economy don’t apply as much (e.g. limited land, resources) and the strengthening or introduction of positive influences (up-front costs, network effects, customer “groove-in”).
One interesting thing to consider would be how the two positive feedback cycles have influenced each other. Are they largely independent, or have the increasing disparity in wealth and the rise of the knowledge-based economy fueled each other? I think they probably have significant influence on each other. “Increasing Returns and the New World of Business” points out one obvious way there might be a connection in comparing the technology economy to a casino. In order to play in the casino, you already need to have a significant amount of resources and education. And when you win at the casino, you win big. Another factor is the way in which the service economy is slowly shifting to the increasing returns model. The article points out that franchises operate on the principle of increasing returns — the more McDonald’s or Wal-Marts are out there, the more recognizable they are and the easier it is for these franchises to grow bigger. And not only have large franchises such as Wal-Mart have been some of the worst employers of Americans on the lowest parts of the economic ladder, but they displace mom-and-pop stores run by middle-class families. And as technology progresses, service industries will start replacing jobs with technology more and more. Finally, although increasing-returns economies tend to flatten hierarchies, this does not necessarily reduce income disparity. In fact, by eliminating middle management, it might increase disparity between people at the top and everyone else.
The Pikkity/Saez article shows that, historically, increasing income-disparity has not been associated with economic growth. However, the article also states that in recent decades, English-speaking countries with increasing income-disparity have also had faster economic growth. Could this have to do with the rise of the knowledge-based economy and how it may reinforce and be fueled by income-disparity?
May 2nd, 2007 at 5:54 pm
Going off what Erich said, I’m actually more interested in what governments should be doing given all of this. In a sense, all monetary policy is grounded in the idea that money is a resource that shows diminishing returns. And indeed the Weimar Republic is a pretty good example of what happens when you print too much money. However, take a look at China. Partly through what has been a very generous monetary policy the Chinese government’s economy is expanding rapidly, even exponentially. Now, while they’re still largely an industrial economy that as Arthur explains should experience diminishing returns in most areas, they’ve also very rapidly moved toward an information economy to the point where they’re growing very very rapidly. So, perhaps even monetary policy should be rethought.
Now, another area to consider is what protections the government should provide. Arthur makes a comment about protectionism that in the area of Bioengineering, one might want to be slightly protective to increase mind share and profits to jumpstart the acceleration since otherwise random chance might wreck your area’s chances. Thus, if he’s right, then California with its Stem Cell Research program might have sealed California’s chances at becoming a major player in that field.
But more importantly, what about “Intellectual Property”, the favorite topic of hackers everywhere. “Information wants to be be” goes the current logic. Historically of course, the government wanted to encourage innovation by protecting the fruits of their labor through copyright and patent laws. This was protectionism on behalf of the economy as a whole: you’d get more people innovating over all if you had people innovating. On the other hand, this kind of knowledge protectionism is also a limiting agent, especially when you’d otherwise have exponential growth or a positive feedback cycle of any sort. If only one company can benefit from improving the LZW algorithm, then the chance of no one improving it goes up drastically, which hampers the growth of knowledge.
So it seems to me that you need a new system of encouraging innovation. The profit motive is key, but it needs to not be protectionistic, since that’s a diminishing returns concept. In academia, we have the reputation system and government grants as we saw last time, but there’s no way the government can be as lucrative licensing Amazon’s one-click-to-buy patent or a drug patent or something. One possibility is to set mandatory licensing on all patents at a certain price. That is, somehow for $X and Y% you can demand a license to anyone’s patent, and perhaps that number could be tied to the patent application price: the more you pay in the more you can demand. Then all that other money from the application fees can be used to fund innovation through government grants.
This is just brainstorming… but thoughts on a system to bring the reputation positive feedback system to corporate IP, where we have something could turn negative?
May 2nd, 2007 at 5:58 pm
Like Erich, I am surprised that the idea of positive feedback has not been around for longer in relation to economics. Certainly, endowments take advantage of the feedback phenomenon on a grand scale – the fact that an organization has a lot of money allows it to make money purely on the basis of this original capital. Obviously, systems like this naturally lead to a morphogenetic economy.
“The Smartest Guys in the Room” was an especially shocking example of this phenomenon. Throughout the movie, I found myself wondering how the company could remain financially solvent without providing valued services to the public. After a while, it became clear that the reason Enron was able to persist exclusively because of the money and credibility that it had already accumulated (much like an endowment). This seems like the logical extension of the idea that it’s capital that creates capital and not talent or hard work.
This idea naturally leads into a discussion of the Rolling Stone article. Although the article is fairly polemic in its rhetoric, it does broach some interesting topics. For example, I’m fascinated by the thesis that economic disparity is what caused the retardation of development in Third World Latin American countries (although I don’t think this theory is completely sound. Africa, for example, possessed extremely economically homogenous, tribal cultures before being taken over by European conquerors. The reason they have such corrupt leaders right now and economic disparity between the elite and the working poor is the fact that Europeans tried to establish democratic governments before educational and economic safeguard systems were put in place. It’s not that economic disparity caused lack of development – rather that lack of development led to underdeveloped economic institutions).
At the same time, it is alarming that the United States’ economic disparity is much greater than that of other developed nations. In the end, the worth of a society is measured in how it champions its citizens. Ignoring the positive externalities associated with relatively even distribution of wealth is certainly short-sighted and, as the article hints at, has the potential to be devastating to the society’s overall success. In fact, I believe that many of the positive feedback processes in the economy are caused because of the abundance of positive and negative externalities that cannot be measured. This emphasizes the importance of a proactive government – to ensure that everyone’s interests are taken into account. As such, it makes sense that the Rolling Stone article was so hard on Bush and his tax policies that favor the rich…in the end, it is his duty to levy taxes on the public. The responsibility falls to him to restore some degree of linearity to the economy and restores the idea that people who are the most deserving and hard-working really do generate the most capital. Indeed, it is government that should be the negative feedback to keep a growing economy from spiraling out of balance and out of control.
May 2nd, 2007 at 6:22 pm
The readings this week definitely illustrate the varied presence of positive feedback loops in the economy. However, I don’t think it is useful to uniformly portray positive feedback loops as a “bad thing”. For things like format wars and competing standards (Betamax vs VHS, Blu-Ray vs HD-DVD, USB vs Firewire, CDMA vs GSM, etc), I think there is an argument to be made that it is economically advantageous to settle on a single format. Positive feedback loops help steer the market towards settling onto a single format. While positive feedback loops are very susceptible to initial conditions and perhaps even to seemingly insignificant chance events, perhaps it is more important for the market to settle on a single format quickly than it is more the market to settle on the correct single format. These effects can also be observed in the standardization of English as the “international” language, as well as the adoption of the Metric system of measurements. While there are some holdouts (the French are notably reticent to use English, whereas the Scandinavians are not; likewise the Americans are inexplicably stubborn in burying Imperial units once and for all), in general everyone benefits from such standardization.
This can raise several concerns. Is Metric really better than Imperial? Why is English the world’s language and not Spanish or French or Chinese or Xhosa? Are we losing out by having less diverse landscapes? Wouldn’t it be better if consumers could choose whether to rent VHS or Betamax? They would have more freedom of choice, but then rental stores would have to stock twice as many tapes, increasing costs for consumers. It is true that these systems are extremely sensitive to initial conditions, but it might be the case that -any- equilibrium (even a suboptimal one) is better than no equilibrium. Indeed, finding the “best” equilibrium is a complicated problem of nonconvex optimization. Arthur advocates “steering an economy with positive feedback so that it chooses the best of its many possible equilibrium states”. This is a noble goal, but one that might prove to difficult in practice, as nonconvex optimization problems are notoriously difficult.
While it is not clear to me that all positive feedback loops in the economy are bad, it is clear that some of them are. The readings on income inequality and the Enron movie stressed to me the importance of keeping the correct checks in place to control bad positive feedback loops. In the case of Enron, there was clearly a lack of oversight on the part of the government, on the part of the board, and on the part of investors. The company’s management was running a pyramid scheme, whereby they used the company’s stock to borrow money which was listed as revenue which raised the stock’s value which in turned allowed more money to be borrowed… etc. While this strategy worked to raise the company’s stock price in the short-term, it was not a very good long-term strategy. A minimal amount of oversight on the company’s management would have discovered this and hopefully corrected it.
Likewise, the readings on income inequality show that the positive feedback loop of “the rich get richer” happens because checks that used to be in place are removed (tax cuts for the rich, weakening unions, etc). Reinstating the checks (for example, Ireland introducing progressive taxation, as mentioned in Piketty/Saez) sucessfully curbs the runaway feedback loops.
In conclusion, I got the distinct feeling that the readings considered all positive feedback loops to be “bad”. I don’t believe this to be the case (for example, in the case of VHS vs Betamax; I’m glad we settled on a standard). However, it is clear that if a certain positive feedback loop is bad, it is possible to control it with the appropriate checks.