Inequality and Skin in the Game

Inequality and Skin in the Game

The static and the dynamic—How to go bankrupt and be loved by the many—Piketty’s equals

INEQUALITY VS. INEQUALITY

Nassim Nicholas Taleb distinguishes inequality backed by personal risk from inequality protected against loss.

The first is the inequality people tolerate, such as one’s understanding compared to that of people deemed heroes, say, Einstein, Michelangelo, or the recluse mathematician Grisha Perelman, in comparison to whom one has no difficulty acknowledging a large surplus. This applies to entrepreneurs, artists, soldiers, heroes, the singer Bob Dylan, Socrates, the current local celebrity chef, some Roman Emperor of good repute, say, Marcus Aurelius; in short, those for whom one can naturally be a “fan.” You may like to imitate them, you may aspire to be like them, but you don’t resent them.

The second is the inequality people find intolerable because the subject appears to be just a person like you, except that he has been playing the system, and getting himself into rent-seeking, acquiring privileges that are not warranted—and although he has something you would not mind having (which may include his Russian girlfriend), you cannot possibly become a fan. The latter category includes bankers, bureaucrats who get rich, former senators shilling for the evil firm Monsanto, clean-shaven chief executives who wear ties, and talking heads on television making outsized bonuses. You don’t just envy them; you take umbrage at their fame, and the sight of their expensive or even semi-expensive car triggers some feeling of bitterness. They make you feel smaller.fn1

There may be something dissonant in the spectacle of a rich slave.

The author Joan C. Williams, in an insightful article, explains that the American working class is impressed by the rich, as role models—something people in the media, who communicate with one another but rarely with subjects in the real world, don’t realize, as they impart normative ideas to people (“this is how they should think”). Michèle Lamont, the author of The Dignity of Working Men, cited by Williams, did a systematic interview of blue-collar Americans and found a resentment of high-paid professionals but, unexpectedly, not of the rich.

I see this resentment directed especially at highly paid salarymen whose income is insulated from the risks they impose on others. This is indeed generalized to other countries: a few years ago the Swiss, of all people, ran a referendum for a law capping salaries of managers to a set multiple of the lowest wage. The law didn’t pass, but the fact that they thought in these terms is rather significant. For the same Swiss hold rich entrepreneurs, and people who have derived their celebrity by other means, in some respect.

Further, in countries where wealth comes from rent-seeking, political patronage, or regulatory capture (which, I remind the reader, is how the powerful and the insiders use regulation to scam the public, or red tape to slow down competition), wealth is seen as zero-sum.fn2 What Peter gets is extracted from Paul. Someone getting rich is doing so at other people’s expense. In countries such as the U.S., where wealth can come from creative destruction, people can easily see that someone getting rich is not taking dollars from your pocket; odds are he is even putting some in yours. On the other hand, inequality, by definition, is zero sum.

What people resent—or should resent—is the person at the top who has no skin in the game. Because he doesn’t bear his allotted risk, he is immune to the possibility of falling from his pedestal, exiting his income or wealth bracket, and waiting in line outside the soup kitchen. Again, on that account, the detractors of Donald Trump, when he was still a candidate, not only misunderstood the value of scars as risk signaling, but they also failed to realize that, by advertising his episode of bankruptcy and his personal losses of close to a billion dollars, he removed the resentment (the second type of inequality) people may have had toward him. There is something respectable in losing a billion dollars, provided it is your own money.

In addition, someone without skin in the game—say, a corporate executive with upside and no financial downside (the type to speak clearly in meetings)—is paid according to some metrics that do not necessarily reflect the health of his company; he can manipulate these metrics, hide risks, get the bonus, then retire (or go do the same thing at another company) and blame his successor for subsequent results.

The distinction depends on whether we take a static view of inequality or examine how people’s fortunes change over time.

Two principles guide the argument:

True equality is equality in probability.

and

Skin in the game prevents systems from rotting.

THE STATIC AND THE DYNAMIC

Visibly, a problem with economists (particularly those who never took risk) is that they have mental difficulties with things that move and are unable to consider that things that move have different attributes from things that don’t. That’s the reason complexity theory and fat tails are foreign to most of them; they also have (severe) difficulties with the mathematical and conceptual intuitions required for deeper probability theory. Blindness to ergodicity is indeed in my opinion the best marker separating a genuine scholar who understands something about the world from an academic hack who partakes of ritualistic paper writing.

A few definitions:

Static inequality is a snapshot view of inequality; it does not reflect what will happen to you in the course of your life.

Consider that about 10 percent of Americans will spend at least a year in the top 1 percent, and more than half of all Americans will spend a year in the top 10 percent.fn3 This is visibly not the same for the more static—but nominally more equal—Europe. For instance, only 10 percent of the wealthiest five hundred American people or dynasties were so thirty years ago; more than 60 percent on the French list are heirs and a third of the richest Europeans were the richest centuries ago. In Florence, it was just revealed that things are even worse: the same handful of families have kept the wealth for five centuries.

Dynamic (ergodic) inequality takes into account the entire future and past life.

You do not create dynamic equality just by raising the level of those at the bottom, but rather by making the rich rotate—or by forcing people to incur the possibility of creating an opening.

The way to make society more equal is by forcing (through skin in the game) the rich to be subjected to the risk of exiting from the 1 percent.fn4

Our condition here is stronger than mere income mobility. Mobility means that someone can become rich. The no-absorbing-barrier condition means that someone who is rich should never be certain to stay rich.

Now, even more mathematically,

Dynamic equality is what restores ergodicity, making time and ensemble probabilities substitutable.

Let me explain ergodicity—something that we said is foreign to the intelligentsia. Chapter 19 at the back of the book goes into the details; it cancels most crucial psychological experiments related to probability and rationality. The intuition for now is as follows. Take a cross-sectional picture of the U.S. population. You have, say, a minority of millionaires in the one percent, some overweight, some tall, some humorous. You also have a high majority of people in the lower middle class, yoga instructors, baking experts, gardening consultants, spreadsheet theoreticians, dancing advisors, and piano repairpersons—plus of course the Spanish grammar specialist. Take the percentages of each income or wealth bracket (note that the inequality of income is typically flatter than that of wealth). Perfect ergodicity means that each one of us, should he live forever, would spend a proportion of time in the economic conditions of the entire cross-section: out of, say, a century, an average of sixty years in the lower middle class, ten years in the upper middle class, twenty years in the blue-collar class, and perhaps one single year in the one percent.fn5fn6

The exact opposite of perfect ergodicity is an absorbing state. The term absorption is derived from particles that, when they hit an obstacle, get absorbed or stick to it. An absorbing barrier is like a trap: once in, you can’t get out, good or bad. A person gets rich by some process, then, having arrived, he stays rich. And if someone enters the lower middle class (from above), he will never have the chance to exit from it and become rich should he want to, of course—hence will be justified to resent the rich. You will notice that where the state is large, people at the top tend to have little downward mobility—in such places as France, the state is chummy with large corporations and protects their executives and shareholders from experiencing such descent; it even encourages their ascent.

And no downside for some means no upside for the rest.

PIKETTISM AND THE REVOLT OF THE MANDARIN CLASS fn7

There is a class often called the Mandarins, after the fictionalized memoirs of the French author Simone de Beauvoir, named after the scholars of the Ming dynasty (the high Chinese language is also called Mandarin). I have always been aware of their existence, but a salient—and pernicious—attribute came to me while observing the reactions of its members to the works of the French economist Thomas Piketty.

Piketty followed Karl Marx by writing an ambitious book on capital. A friend gave me the book as a gift when it was still in French (and unknown outside France) because I find it commendable that people publish their original, nonmathematical work in social science in book format. The book, Capital in the Twenty-first Century, makes aggressive claims about the alarming rise of inequality, adding to it a theory of why capital tends to command too much return in relation to labor and how the absence of redistribution and dispossession might make the world collapse. Piketty’s theory about the increase in the return of capital in relation to labor is patently wrong, as anyone who has witnessed the rise of what is called the “knowledge economy” (or anyone who has had investments in general) knows.

A change in inequality from year one to year two does not tell you whether those at the top are the same people. Measuring the distribution and measuring mobility answer different questions; my objection is that Piketty’s account neglects the latter. But the problem doesn’t stop there. Soon, I discovered that—aside from deriving conclusions from static measures of inequality—the methods he used were flawed: Piketty’s tools did not match what he purported to show about the rise in inequality. There was no mathematical rigor. I soon wrote two articles (one in collaboration with Raphael Douady, another with Andrea Fontanari and Pasquale Cirillo, published in Physica A: Statistical Mechanics and Applications), about the measure of inequality that consists in taking the ownership of, say, the top 1 percent and monitoring its variations. The flaw is that if you take the inequality thus measured in Europe as a whole, you will find it is higher than the average inequality across component countries; the bias increases in severity with processes that deliver a high degree of inequality. All in all, the papers had enough theorems and proofs to make them about as ironclad a piece of work as one can have in science; although it was not necessary, I insisted on putting the results in theorem form because someone cannot contest a formally proved theorem without putting in question his own understanding of mathematics.

These errors went unnoticed, I argue, because economists who work with inequality were not familiar with … inequality. Inequality is the disproportion of the role of the tail—rich people were in the tails of the distribution.fn8 The more inequality in the system, the more the winner-take-all effect, the more we depart from the methods of thin-tailed Mediocristan in which economists were trained. The wealth process is dominated by winner-take-all effects. Any form of control of the wealth process—typically instigated by bureaucrats—tends to lock people with privileges in their state of entitlement. So the solution is to allow the system to destroy the strong, something that works best in the United States.

But there was something far, far more severe than a scholar being wrong.

The problem is never the problem; it is how people handle it. What was worse than Piketty’s flaws was the discovery of how that Mandarin class operates. They got so prematurely excited by the “evidence” of the rise in inequality that their reactions were like fake news. Actually, they were fake news. Economists got so carried away; they praised Piketty for his “erudition” because he discussed Balzac and Jane Austen, the equivalent to hailing as a weight lifter someone spotted carrying a briefcase across Terminal B. And they completely ignored my results—and when they didn’t, it was to declare that I was “arrogant” (recall the strategy of using formal mathematics as a way to make it impossible to say you are wrong)—which is a form of scientific compliment. Even Paul Krugman (a prominent economist and public intellectual) wrote, “If you think you’ve found an obvious hole, empirical or logical, in Piketty, you’re very probably wrong. He’s done his homework!” When I met him in person and pointed out the flaw to him, he evaded it—not necessarily out of malice, but most likely because probability and combinatorics eluded him, by his own admission.

Now consider that the likes of Krugman and Piketty have no downside in their existence—lowering inequality brings them up in the ladder of life. Unless the university system or the French state goes bust, they will continue receiving their paychecks. The fellow you just saw in the steak restaurant dripping with gold chains is exposed to the risk of the soup kitchen, not them. Just as those who live by the sword die by the sword, those who earn their living taking risks will lose their livelihood taking risks.fn9

We’ve made a big deal out of Piketty here because the widespread enthusiasm for his book was representative of the behavior of that class of people who love to theorize and engage in false solidarity with the oppressed, while consolidating their privileges.

COBBLER ENVIES COBBLER

Regular people, in my view, are less acrimonious than the “intellectuals” and bureaucrats because envy does not travel long distances or easily cross social classes. Envy does not originate with the impoverished, concerned with the betterment of their condition, but with the clerical class. Simply, it looks like it was the university professors (who have “arrived”) and people who have permanent stability of income, in the form of tenure, governmental or academic, who bought heavily into Piketty’s argument. From conversations, I became convinced that people who counterfactual upwards (i.e., compare themselves to those richer) want to actively dispossess the rich. As with all communist movements, it is often the bourgeois or clerical classes who are the early adopters of revolutionary theories. So class envy doesn’t originate from a truck driver in South Alabama, but from a New York or Washington, D.C., Ivy League–educated IYI (say Paul Krugman or Joseph Stiglitz) with a sense of entitlement, upset some “less smart” persons are much richer.

Aristotle, in his Rhetoric, postulated that envy is something you are more likely to encounter in your own kin: lower classes are more likely to experience envy toward their cousins or the middle class than toward the very rich. And the expression Nobody is a prophet in his own land, making envy a geographical thing (mistakenly thought to originate with Jesus), originates from that passage in the Rhetoric. Aristotle himself was building on Hesiod: cobbler envies cobbler, carpenter envies carpenter. Later, Jean de La Bruyère wrote that jealousy is to be found within the same art, talent, and condition.fn10

So I doubt Piketty bothered to ask blue-collar Frenchmen what they want, as Michèle Lamont did. I am certain that they would ask for better beer, a new dishwasher, or faster trains for their commute, not to bring down some rich businessman invisible to them. But, again, people can frame questions and portray enrichment as theft, as was done before the French Revolution, in which case the blue-collar class would ask, once again, for heads to roll.fn11

INEQUALITY, WEALTH, AND VERTICAL SOCIALIZATION

If intellectuals are overly worried about inequality, it is because they tend to view themselves in hierarchical terms, and thus think that others do too. Furthermore, as if by pathology, discussions in “competitive” universities are all about hierarchy. Most people in the real world don’t obsess over it.fn12

In the more rural past, envy was rather controlled; wealthy people were not as exposed to other persons of their class. They didn’t have the pressure to keep up with other wealthy persons and compete with them. The wealthy stayed within their region, surrounded by people who depended on them, say a lord on his property. Except for the occasional season in the cities, their social life was quite vertical. Their children played with the children of the servants.

It was in mercantile urban environments that socializing within social classes took place. And, over time, with industrialization, the rich started moving to cities or suburbs surrounded by other people of similar—but not completely similar—condition. Hence they needed to keep up with each other, racing on a treadmill.

For a rich person isolated from vertical socializing with the poor, the poor become something entirely theoretical, a textbook reference. I have yet to see a bien pensant Cambridge don hanging out with Pakistani cab drivers or lifting weights with cockney speakers. The intelligentsia therefore feels entitled to deal with the poor as a construct; one they created. Thus they become convinced that they know what is best for them.

EMPATHY AND HOMOPHILY

Recall the scaling problem, the idea that people’s ethical rules are not universal; they vary according to whether someone is “Swiss,” that is, an outsider or not.

The same applies to empathy (the reverse of envy). You can see that people feel more for those of their class. Traditionally, the upper class engaged in rescuing those from ruined families by making them “stewards” or dames de compagnie. Such in-group protection has a self-insurance attribute—something that can only work for a limited number of people and can’t be universalized: you take care of my progeny if they are ruined; I will take care of yours.

DATA, SHMATA

Piketty’s ambitious volume was loaded with charts and tables. But data is not necessarily rigor. One reason I—as a probability professional—left data out of The Black Swan (except for illustrative purposes) is that it seems to me that people flood their stories with numbers and graphs in the absence of solid or logical arguments. Further, people mistake empiricism for a flood of data. Just a little bit of significant data is needed when one is right, particularly when it is disconfirmatory empiricism, or counterexamples: only one data point (a single extreme deviation) is sufficient to show that Black Swans exist.

Traders, when they make profits, have short communications; when they lose they drown you in details, theories, and charts.

Probability, statistics, and data science are principally logic fed by observations—and absence of observations. For many environments, the relevant data points are those in the extremes; these are rare by definition, and it suffices to focus on those few but big to get an idea of the story. If you want to show that a person has more than, say $10 million, all you need is to show the $50 million in his brokerage account, not, in addition, list every piece of furniture in his house, including the $500 painting in his study and the silver spoons in the pantry. So I’ve discovered, with experience, that when you buy a thick book with tons of graphs and tables used to prove a point, you should be suspicious. It means something didn’t distill right! But for the general public and those untrained in statistics, such tables appear convincing—another way to substitute the true with the complicated.

For instance, the science journalist Steven Pinker played that trick with his book The Better Angels of Our Nature, which claims a decline of violence in modern human history, and attributes this to modern institutions. My collaborator Pasquale Cirillo and I, when we put his “data” under scrutiny, found out that either he didn’t understand his own numbers (actually, he didn’t), or he had a story in mind and kept adding charts, not realizing that statistics isn’t about data but distillation, rigor, and avoiding being fooled by randomness—but no matter, the general public and his state-worshipping IYI colleagues found it impressive (for a while).fn13

ETHICS OF CIVIL SERVICE

An unfairness worse than inequality is the sore sight of back-office non-risk-takers getting rich from public service.

When, on leaving office, Barack Obama accepted a sum of more than $40 million to write his memoirs, many people were outraged. His supporters, statists who were defending him, on the other hand, were critical of the rich entrepreneurs hired by the subsequent administration. Money is greed, for them—but those who did not earn the money via commerce were illogically exempt. I had a rough time explaining that having rich people in a public office is very different from having public people become rich—again, it is the dynamics, the sequence, that matters.

Rich people in public office have shown some evidence of lack of total incompetence—success may come from randomness, of course, but we at least have a hint of some skill in the real world, some evidence that the person has dealt with reality. This is of course conditional on the person having had skin in the game—and it is better if the person felt a blowup, has experienced at least once the loss of part of his or her fortune and the angst associated with it.

As usual, there is a mix of the ethical and the effective here.

It is downright unethical to use public office for enrichment.

A good rule for society is to oblige those who start in public office to pledge never subsequently to earn from the private sector more than a set amount; the rest should go to the taxpayer. This will ensure sincerity in, literally, “service”—where employees are supposedly underpaid because of their emotional reward from serving society. It would prove that they are not in the public sector as an investment strategy: you do not become a Jesuit priest because it may help you get hired by Goldman Sachs later, after your eventual defrocking—given the erudition and the masterly control of casuistry generally associated with the Society of Jesus.

Currently, most civil servants tend to stay in civil service—except for those in delicate areas that industry controls: the agro-alimentary segment, finance, aerospace, anything related to Saudi Arabia …

A civil servant can make rules that are friendly to an industry such as banking—and then go off to J.P. Morgan and recoup a multiple of the difference between his or her current salary and the market rate. (Regulators, you may recall, have an incentive to make rules as complex as possible so their expertise can later be hired at a higher price.)

So there is an implicit bribe in civil service: you act as a servant to an industry, say, Monsanto, and they take care of you later on. They do not do it out of a sense of honor: simply, it is necessary to keep the system going and encourage the next guy to play by these rules. The IYI-cum-cronyist former Treasury Secretary Tim Geithner—with whom I share the Calabrese barber of the Prologue—was overtly rewarded by the industry he helped bail out. He helped bankers get bailouts, let them pay themselves from the largest bonus pool in history after the crisis, in 2010 (that is, using taxpayer money), and then got a multimillion-dollar job at a financial institution as his reward for good behavior.