The L-curve: distribution of income

Great Debates
41

Sam, that short post of yours does not even begin to address the differences between meritocracy and winner-take-all, nor the problems associated with the latter.

It doesn’t even make sense. Firstly, the richest one percent hold most of the wealth, not the richest 20%. Secondly: the richest 20% drive most of the production? In what way? The labour force and the capital markets drive production. Each are useless without the other. The richest 1% pay provide the capital, but they’d be broke without the drones to do the work. And the richest 20% are the hardest working? Do me a favour.

Can we have more than a few soundbites please? Personally, I went to some effort to describe the differences between meritocracy and WTA, the problems associated with the latter, the way the latter perpetuates itself and spirals and how we might address this. Merely restating the simplistic adage that the richest people are the ones who are the hardest working/cleverest/most deserving doesn’t develop the discussion in any way.

pan

42

But Sam, surely there is a point in a redistributive scheme where we don’t fall prey to the law of diminishing returns and yet we still provide better for the bottom 20%.

43

The wealthiest person I know never made more than $18,000 a year through his entire life.

Contrary to popular belief, the most important factor to accumulating significant wealth is not how much you earn.

The key factor is how you percieve quality of life.

People tend to live paycheck to paycheck no matter their income level. As they earn more, they spend more.

Even people with very low income levels have become accustomed to a lot of items which are really luxuries.

Most people, when making the choice between immediate luxuries, and long term wealth for the future tend to decide in favor of the luxuries.

I work in the field of wealth management, and that’s basically the difference between wealthy people and people who are not. You’d be surprised how quickly a significant inheritance can be spent away by one who chooses the luxuries.

I think confiscating wealth at death is an exceedingly bad idea proposed by people with an abundance of ignorance for the way the world really works.

The government is not an efficient redistributor of wealth. A spendthrift heir is. On the other hand, a good custodian of wealth is a positive societal influence as well.

The problem isn’t with the wealthy, nor with the very poor. The problem lies with those who are constantly overextended to the degree where a simple layoff, or a bad quarter can push them into ruinous poverty.

The solution is the way people spend, and how they prioritize the luxuries of life.

44

Probably someone has mentioned in this thread but I will re-iterate here a couple of points:

  1. What is so special about income equality? If you have 100 people and one makes a 99.1 billion dollars and the other nine make 10 million each, you still have the top 1 % controlling over 99 percent of the wealth yet I would hardly think the others are considered “poor”. I am not saying there aren’t pooor, obviously, I am just saying that the notion that a more equal income distribution is in some sense better is simply unsupported.

  2. What may be more important is income mobility. Income inequaltiy stats simeply are a snapshot of a moment in time, they have no dynamism to them. Sure you can compare income inequality over time, but that tells you very little. More important is: How effectively can someone move from say the bottom quintile to say the third quintile? Or vice versa? This seems to me to be much more important issue, because the promise of succeess if you work hard, get an education etc is a extremely important driving factor for growth and well-being. When I was in grad school I had read some articles about income mobility, but alas I cannot recall the results, so I make no claims.

I have just alwasy thought that income inequality stats, which are a snapshot of a moment in time,

45

What I find interesting is that very little has been said about the role of corporations in this. With the recent scandels the topic of executive pay has come up again.

Heck, I don’t care what they make. What I do care about is the tax evading, shareholder raping, and Illegal practices that we keep on seeing. These executives that engage in this type of activity need to be sent to prison (without tennis courts type of prison).

Ideally, the laws will me made stronger, include prison time, and a stripping of all bonuses and wages for those found to be engaged in illegal practices. As it stands, these scofflaws have to sweat out a years worth of congressional hearings before they are able to walk away with basketfulls of money.

With a nice threat of real jail time and financial pain, I think we would see a concerted effort by corporations to pay their actual taxes, and avoid questionable activities. Executive pay would drop only slightly, and in return we could count on good corporate citizenship.

Would this chase some corporations out of the US? Possibly, but governments around the globe would be quickly following suit (corporate greed and corruption isn’t just a US problem)

Kenneth Lay should be explaining to Dirk in San Quentin why he shouldn’t answer to “Peaches”, not explaining to Congress why he won’t answer to them.

46

Let’s look at a married couple at age 18. They are uneducated, and untalented. In fact, let’s only give them one advantage: Frugality.

They both work menial, part time jobs without insurance or benefits, and each make $10,000 a year after taxes.

Their biggest expense is housing. They spend $6,000 a year on it. For the first two years they rent for $200-300 a month, while they accumulate cash for a down payment. Afterwards they buy a house, pay a mortgage and make improvements. Let’s say it’s a $60,000 house when they buy it.

Their next biggest expense is food. They clip coupons, buy in bulk and on sale and eat very well for $5,200 a year. They spend $500 in clothing. They each have $100 a month in sundries. They spend $1,200 a year on insurance.

Do they need a car? If they buy an economy car, run it for 10 years and put 100,000 miles on it before they get a new one, that’s gonna cost them $2,000 a year. If they buy a 5 year old economy car and run it for 10 years at 10k miles per year, they can cut that in half with luck. Let’s assume they need a car and split the difference. $1,500.

We’ll also assume that all these figures increase proportionally with inflation.

They have $3,900 a year left over.

What do they do with it? Do they buy bigger furniture? Vacations? Stereos? Cell Phones? Computers? Do they eat out?

Let’s say they save it in an S&P 500 fund

Where do they stand when they’re 50 years old?

They have two major assets:

  1. Investment savings of 1,032,000.

  2. Real estate of $789,000.

(that’s their wealth in today’s dollars.)

According to Ibbotson, the S&P 500 or the analoguous broad market has returned on average 11% over the last 150 years in total return.

Real estate does much better than 8% with a little intelligent management, but remember, these people are stupid so they just get the 8. In the course of the 30 years, the couple has probably upgraded their house two or three times if they are stupid (which I assumed,) or bought another new house and rented the old one. Had they done the latter, and simply lived bought another cheap house when cash flow gave them a 15% profit margin on rent (about 5-10 years) they’d have between 5,000,000 to 7,000,000 in real estate, but we just assumed they bought a nicer house and lived in it.

So, our 50 year old couple has a net worth of 1.8 million.

We can reduce this number by about $250,000 for each child they had (the kids had to pay their own way through college if they went.)

So, that’s how well a terribly unsuccesful couple can do if they’re frugal.

On the other side of the coin even Bill Gates lived frugally in his early years, opting away from immediate wealth to more completely own his growing business.

Nothing matters so much as how frugal you are when you’re starting off.

47

Tretiak - You Rule! Most people (and isn’t that who we should be primarily concerned with) start out broke, work for 30 or 40 years - usually making a little more every year and saving some along the way, retire and live on less and watch their income slip until they die. So, unless you compare all the 32 year olds, and the 18 year olds, and all the 68 year olds, you don’t get an accurate portrait of what is really going on.

48

The problem is, wealth = power. Wealthy people don’t just spend their money on luxuries. They lobby congress. They contribute to campaigns. They run for office. They become governors, congressmen, senators, and presidents. The rest of us don’t have the time or the money to muck around in politics.

And when you consider that a tiny percentage of the population controls most of the wealth – much of which is inherited – you start seeing something that looks suspiciously like a ruling class.

49

scylla
You make a number of simplifications which don’t seem realistic[ul]
[li]$1500 for a car? I could look a long time without finding a car which would be reliable for 100,000 miles and could be purchased without a down payment for $125/month. [/li][li]I notice you make no allowances for medical expenses, home repairs, etc. which cannot be absorbed in the $200/month combined “sundries” bucket.[/li][li]Inurance (medical, death , disability) for my family, backed by corporate sponsorship, costs considerably more than $1200/yr. This also needs to be augmented by auto insurance, since our couple has a car. They need homeowners insurance, too.[/li][li]The “value” of their S&P account depends entirely upon when they need to sell. If they had been forced to liquidate assets last October, they might have seen a good portion of their gains vanish . Of course, that is why nearly every financial analysts ould recommend that they shift assets into safer investments as they neared an age when they might need the money. Of course, that means expecting 11% annual return is unrealistic.[/li][li]The days of 8% guaranteed return on real estate investments are over. So ar ethe days when one could be guaranteed the ability to rent a property at a profit after a few years. My folks are about to sell a home that they hav owned for 22 years. They are not going to receive 5 times what they paid for it, much less 5 times their adjusted cost of ownership. Saying that they would have $5-7 million in real estate if they were not “stupid” is absurd.[/li][/ul]

50

**

If you think that’s true, you’ll need to back it up. Political history would suggest otherwise. It’s corporations that do the majority of the lobbying/political contributions.

Wealth often becomes a consequence of higher political office, but I challenge you show evidence that the wealthy are more likely to run for office than the nonwealthy. Bill Clinton was by no means wealthy when he became active politically, but acquired wealth along the way. IIRC Clinton started working in Government right out of College.

Just because you didn’t do it, doesn’t mean it can’t be done, but there is by no means a wealth barrier to political office. In fact the opposite is as often true. Political office often serves as an avenue to wealth.

You’re throwing generalities around like popcorn.

What is “much?” 10%? 50%? 90%?

What does “looks suspiciously like a ruling class” supposed to mean?

My daughter’s stuffed animal looks suspiciously like an alligator, but I doubt you’d have to worry about it biting your leg off.

What negative qualities that you associate with a ruling class are you saying that wealthy people emulate? Please be specific and prepared to back up your statements.

51

Spiritus:

I was working on a detailed post to your objections but lost it here.

So here’s the short response:

  1. The numbers are spartan but realistic.

  2. The cost of the car is amortized over a ten year period (it’s uselful life.) That’s $15,000 to spend on a car and maintain it.

  3. A fixed rate major medical policy for two eighteen year olds is budgeted as the only essential insurance. $1,200 a year is realistic. No disability or life insurance was budgeted.

  4. Car insurance comes out of the 15k (about $3,750 worth of it (minimum liability coverage assuming an excellent driving record and a state without an assigned risk pool.)

  5. Homeowners insurance comes out of the $500/mos. as well as taxes (figure a 5k down payment, $300-400/ mos mortgage $1-200/mos insurance/property taxes/repairs over thirty years. In the early years they are more likely to be overbudget than at the end of the analysis, but it’s an average.

  6. The Ibbotson data is raw data. over an extended period of time like 30 years they are likely to recieve very close to the mean return having gone through several major corrections. The only danger is if they decided to sell after a major downturn, like the crash of '87 or no, but seeing as we don’t credit them with selling at the peak, we can’t punish them by assuming they sell at the trough. That’s why i used the mean S&P return figure. We have not assumed intelligence (arguable) where they diversify as they get older, and besides 50 isn’t that old.

  7. 8% is a pretty conservative return figure for residential real estate over the last 150 years. The selling renting scenario was more of an illustration to show the best case scenario but because of the amount of skill and luck needed to pull it off, I didn’t build it in. And, we’re looking at mean returns. If my hypothetical couple bough a house in Love Canal, they would not have recieved the 8%. If they’d done it in Key West 30 years ago, they would likely have done much better. That’s why a choose a historical and conservative mean.

Their budget is stretched tighter than a drum in this illustration, but that’s all it is, an illustration. It is also unlikely that you’d have a working couple bringing down minimum wage without benefits after 30 years of continuous employment, so I feel justified in what liberties I may have taken in the other direction.
Of course, past performance is no guarranty of future returns. Your performance or mileage may vary, professional driver on a closed course, do not attempt this at home, extinguish all smoking materials, put your seat back forward and stept up.

52

You know, this may be true, but there is also nothing preventing one or both members of this hypothetical couple from working more than 40 hours per week. That would easily close any gap Spiritus might be concerned about.

53

**1. The numbers are spartan but realistic. ** I disagree, as noted.

**2. The cost of the car is amortized over a ten year period (it’s uselful life.) That’s $15,000 to spend on a car and maintain it. ** This is not a realistic manner in which to discuss car ownership in a scenario where regular early investment in savings is kay (don’t you love compound interest). Cars cost more in teh early years when you are paying off the loan. Maintenance costs increase with age, but insurance costs decrease. Still, the early years must budget for car payments and comprehensive collision & theft insurance–else no loan.

3. A fixed rate major medical policy for two eighteen year olds is budgeted as the only essential insurance. $1,200 a year is realistic. No disability or life insurance was budgeted. Yes, your young couple exists a single accident away from ruin. Arguing that wealth disparity is unimportant because if they continue to live on the edge of disaster for thirty years (and are lucky enough to not have a disaster) then they will have plenty of accumulated wealth is, IMO, rather badly missing the point.

**4. Car insurance comes out of the 15k (about $3,750 worth of it (minimum liability coverage assuming an excellent driving record and a state without an assigned risk pool.) ** As noted above, this is an unjustified estimate. Cars bought with loans require full coverage for the life of the loan.

**5. Homeowners insurance comes out of the $500/mos. as well as taxes (figure a 5k down payment, $300-400/ mos mortgage $1-200/mos insurance/property taxes/repairs over thirty years. In the early years they are more likely to be overbudget than at the end of the analysis, but it’s an average. ** Okay, $500/month with $5K down @ 8.5% with property taxes of 1.25% and $600/yr in homeowners insurance will put you in a house about $54,000. This still budgets exactly $0 for upkeep of property, home repairs, etc.

**6. The Ibbotson data is raw data. over an extended period of time like 30 years they are likely to recieve very close to the mean return having gone through several major corrections. The only danger is if they decided to sell after a major downturn, like the crash of '87 or no, but seeing as we don’t credit them with selling at the peak, we can’t punish them by assuming they sell at the trough. That’s why i used the mean S&P return figure. We have not assumed intelligence (arguable) where they diversify as they get older, and besides 50 isn’t that old. ** Arguable? Are you suggesting that diversity in an investment portfolio is not a smart thing? Well, I suppose it isn’t if you just find an investment which has historically provided a high rate of return and assume that you will achieve the same results over whatever period you invest.

**7. 8% is a pretty conservative return figure for residential real estate over the last 150 years. The selling renting scenario was more of an illustration to show the best case scenario but because of the amount of skill and luck needed to pull it off, I didn’t build it in. And, we’re looking at mean returns. If my hypothetical couple bough a house in Love Canal, they would not have recieved the 8%. If they’d done it in Key West 30 years ago, they would likely have done much better. That’s why a choose a historical and conservative mean. ** I would be very interested in seeing the numbers behind this historically conservative estimate. I think anybody relying upon seeing an 8% return from their residential property today is quite likely to be sorely disappointed. There are several factors which I suspect might be distorting your “conservative” number, but I’ll withhold judgment until I see the data.

54

**1. I disagree, as noted. ** And you’re in error to do so, as I’ve noted.

**2. This is not a realistic manner in which to discuss car ownership in a scenario where regular early investment in savings is kay (don’t you love compound interest). Cars cost more in teh early years when you are paying off the loan. Maintenance costs increase with age, but insurance costs decrease. Still, the early years must budget for car payments and comprehensive collision & theft insurance–else no loan. ** Yes, it is realistic, because my hypothetical couple is a model or an average, not actual people. There’s a number of very different ways in which a car can be owned or purchased. I did it this way for simplicity. The other way is that we can assume that their first car is a '76 Grenada that they pay $600 cash for, and that they take the bus until they have enough to buy it. They drive the car for a few years and their second car is a better one that they buy for a bigger down payment. Or, if you wish, you can happily adjust the cost of car ownership upwards in your model, and reflect the difference throughout the analysis.

3. Yes, your young couple exists a single accident away from ruin. Arguing that wealth disparity is unimportant because if they continue to live on the edge of disaster for thirty years (and are lucky enough to not have a disaster) then they will have plenty of accumulated wealth is, IMO, rather badly missing the point. Yes. To one degree or another we all spend our lives one single accident away from disaster. How much life insurance should my `18 year old couple buy? Term or universal or whole life? How much do you want to charge them?

**4. As noted above, this is an unjustified estimate. Cars bought with loans require full coverage for the life of the loan. ** So, the first one’s a '76 Ford Grenada. Happy?

**5. Okay, $500/month with $5K down @ 8.5% with property taxes of 1.25% and $600/yr in homeowners insurance will put you in a house about $54,000. This still budgets exactly $0 for upkeep of property, home repairs, etc. ** Jeus Christ! How badly do you want to screw these kids? 8.5% mortgage, WTF? I believe my estimate was a 60k house, and rather than have you pick nits, I’d expect a man of your intellectual honesty to say that I made an excellent rough approximation useful for my model.

6. Arguable? Are you suggesting that diversity in an investment portfolio is not a smart thing? It depends on your risk tolerance and the time horizon of your goals. Contrary to popular belief there’s nothing wrong with an all-equity approach for investors with a time horizon of ten years or more, but we’re really not talking about the advisability of a given investment strategy. It’s my model. I say for the purposes of simplicity that they put it into the S&P 500. The thing about rates of return for various asset classes is that the longer the time horizon of your investment tho more likely you have been to approach mean rates of return. At thirty years I feel entirely justified in assigning the mean, as their standard deviation is gonna fall within half a percent based on rolling 30 year rates of return at monthly intervals. Historically you’ve been able to find an essentially flat rate of return extending for 18 years, but even that reverted to the mean in the following 10. If you doubt me go to some mutual funds website and run a hypothetical based on the S&P for rolling thirty year rates of return and see what your mean is. In the last 100 years there’s been 1,200 possibilities at monthly intervals. If you’re curious go find out how many deviated by more than 10% from the historical mean. Frankly, I don’t give a shit. 11% is the Ibbotson number and that’s what I use.

7. I would be very interested in seeing the numbers behind this historically conservative estimate. I think anybody relying upon seeing an 8% return from their residential property today is quite likely to be sorely disappointed. There are several factors which I suspect might be distorting your “conservative” number, but I’ll withhold judgment until I see the data. You have to use a lot of different sources to assign a rate of return to real estate, and my model is flawed in that there is no generic family home which gets the historical average. On the other hand, I didn’t pull the number out of my ass either, It’s not overweighted to the 70s real estate boom, or ignoring the effects of inflation, or only looking at Reits or commerial urban properties. In trying to get a broad average rate of return sort of useful number for real estate one can do one of two things:

  1. You can extrapolate from historical trends as shown in the FDIC quarterly reports on real estate trends, look at the Berkshire Barnes Mortgeage Index, The Russell NCREIF (Which is the national council of Real Estate Investment Fiduciaries index best used for timberland LP appraisals,) the MAMW (which I have no idea what it stands for,) Wilshire, Callan, and IPC also have indices. These all measure various different aspects of the real estate market and you can try to put them together and come up with a number that you can justify

  2. You can use somebody who’s done such a study and put it together with historical data on home sale records adjusted for inflation and use their #.

I’ve done the latter, and I use TIAA-CREF’s number which is actually 8.25% since I don’t have the time or the millions of bucks to commision a study. If you think the number is bad, please feel free to contact TIAA-Cref, examine their data (make sure you get the right one, one is the historical return, the other is the recquired return of Real estate to maintain a portfolio on the efficient frontier. Since real estate is noncorrelated asset with respect to other asset classes it really can’t be extrapolated from the latter, though they attempt it.)
Hopefully that puts that to rest.

55

Scylla, a sufficiently frugal couple could live in their car, and thus save on rent. They could shower in restrooms and truckstops after eating out of dumpsters.

This, too, is frugal. Just a few years like this and then they can move on up to the east side.

Owning a car in America should be the norm, period. Not everyone has public transportation available, and even when they do they miss out on other methods of frugality like shopping in bulk, which is a practical impossibility on a bus or subway. Apart from that most cities with good public transportation have high rent which totally overthrows any benefit gained from not owning a car.

I don’t think people living from paycheck to paycheck are being stupid (as a rule), I think that the very essence of already living frugally drives them to seek whatever luxury they can to stave off depression.

But hey, maybe you’re right. I guess I should be working three jobs so I can get my 8% return on the house I can’t afford to buy otherwise.

56

erl:

How’s that for inherent contradictions?

“Ahh yes, it was the very essence of living frugally that drove me to spend all my money on luxury items.”

But, I guess if your level of happiness or depression is driven by the amount of money you have to spend on Sharper Image electric tie racks, you’re pretty much screwed from the get-go.

57

Jeez guys, why are you picking nits? Let’s just boil this down to Scylla’s main point: Even a relatively modest income can be parlayed into a significant amount of wealth if you are willing to be frugal. This isn’t rocket science, it’s economics 101.

You are picking at the margins of Scylla’s example, when it doesn’t change the basic point one bit. Okay, increase all the ‘cost’ figures upwards by 20% if you want - but give each of them an average annual income of $20,000 instead of $10,000. That still puts them in the lower middle class, and they’ll still have over a million bucks when they retire if they manage to save even a bit of it.

My own mother is a good example. She never made much more than minimum wage her entire life, she was a single parent, and she raised two children. What she DID do was live at home with her parents for a couple of years after her husband left, then took the money she saved and bought a down payment on a modest duplex. She lived in it for 20 years, saving almost no money, but then when the kids left home she sold her house and took the money and put a large down payment on a little grocery store/home combination. That’s where she lives today. She has re-invested all of her profit either in paying down the mortgage or improving the property. Along the way she fixed up three little house trailers and rented them out on the back lot of her property. They now generate an income of over $1,000/mo, and all three are paid off. She has maybe $150,000 equity in her store. She’s 64 years old now, and is about to put her store up for sale. She’s evaluating whether or not to keep the trailers, but either way she’s set up pretty well for her retirement.

To repeat: That’s what she accomplished as a single mother with a high school education and two children, with no family support and no inheritance. It can be done. But she never owned a car, never flew anywhere on a vacation, her TV was 15 years old, and our furniture was cheap.

58

Three words: Earned Income Tax Credit. (Or a negative income tax, to use Milton Friedman’s terminology). More generally, there are many policy levers that are more effective than minimum wage laws. And much of the increase in inequality has coincided with declines in unionization.

Erislover Indeed, many believe that Europe’s generous welfare state and restrictive labor laws enhance its unemployment rate. Greatly. And that the converse of that is the high child poverty but relatively low unemployment experienced in the US.

However. Some (not all) of those who have examined the details of this theory (eg Katherine Abraham) find it wanting. The issue is a difficult and contentious one. And Europe is not monolithic. For example, Sweden has managed to secure low poverty rates and a current unemployment rate of 2.6% for its citizens. They do so with a combination of high taxes, high social spending but strict rules for the unemployed. If you lose your job, you are given extensive and expensive subsidies for education and retraining. But if you don’t play ball, as it were, they will cut those subsidies off. (Response to this policy in the Netherlands: “That’s not the Dutch way”.)

kabbes No, the old convention is that fiscal and monetary policy can deliver lower inflation or lower unemployment, but not both at the same time. Roughly. It has always been known that different microeconomic policies can change the basis of the tradeoff.

59

Ack! I mean four words! :o

60

Hm. Like popcorn.

Seriously though, here are the wealth distribution figures from 1989. I’m pretty sure they have gotten worse since then, given various developments during the 1990s.

In 1989, the richest 1% had 37% of all net worth (31% in 1983).

The richest 10% had 68% of all net worth (66% in 1983).

And the other 90% has less than a third of all wealth. And dropping.

Source: The New Field Guide to the US Economy (1995) channeling the Survey of Consumer Finances.