What explains rising wealth inequality?

At the University of Chicago, where I went to graduate school, they sell a t-shirt that says “that’s all well and good in practice, but how does it work in theory?” That ode to nerdiness in the ivory tower captures the state of knowledge about rising wealth inequality, both its causes and its consequences. Economic models of the distribution of wealth tend to assume that it is “stationary.” In other words, some people become wealthier and others become poorer, but as a whole it stays pretty much the same. Yet both of those ideas are empirically wrong: Individual mobility within the wealth distribution is low, and the distribution has become much more unequal over the past several decades.

Several recent working papers by Mariacristina De Nardi of the Federal Reserve Bank of Chicago attempt to match theory with reality. The problem theorists of wealth inequality face is, essentially, figuring out why people save. In the models of a stationary distribution, the reason that people save is to guard against future misfortune. But misfortune rarely happens to the rich, which is part of why they keep getting richer, and thus why the wealth distribution is getting more skewed. The other reason why is that people who are already wealthy have the highest savings rates, which is a problem for theories that rely on precautionary savings as a motive.

De Nardi offers some more promising candidates. One is that people want to secure their children’s wellbeing through bequests. Another is that entrepreneurs need capital to finance otherwise-constrained new businesses. This entrepreneurial accumulation mechanism is similar to the one theorized by economist Charles Jones of Stanford University, who models how a highly unequal wealth distribution gets more unequal over time thanks to the statistical properties of entrepreneurial wealth growth.

Third, since there’s a high correlation between parental earnings and children’s subsequent earnings, and higher-income people save much more, high-earning family dynasties can accumulate a large stock of wealth.

What do these findings tell us about the consequences of wealth inequality? Economists typically highlight individual or inter-generational mobility within the wealth distribution as both a reason not to care that the distribution itself is unequal and as an argument that having wealthy parents (or not) doesn’t matter that much for children’s outcomes. In fact, an influential model by the late Gary Becker and Nigel Tomes, both of the University of Chicago , predicts that accumulated wealth reduces income inequality because parents who love all their children equally allocate their bequests to compensate for their stupid children’s likely lower earnings potential in the labor market. According to those two authors, families redistribute from the smart to the dumb, and therefore, by implication, governments don’t have to redistribute from the rich to the poor.

But as Thomas Piketty and numerous other scholars point out, those reasons not to care about wealth inequality are not empirically valid. There’s scant evidence that parents leave larger inheritances to stupid children. Nor is there much evidence that native ability is the major determinant of earnings in the labor market or other life outcomes. The weakness of these explanations gets to a much larger question, one of the most important (and unanswered) ones in economics: Why are some people rich while others are poor? What economists are just finding out (while others have known for awhile now) is, essentially, “because their parents were.”



April 22, 2015


Economic Inequality

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