[In]Securities Guest Blog: Everybody Knows by Aegis Frumento Esq

October 31, 2019

Everybody Knows

The S&P 500 is at a record high. Some think that's good news, but I think what goes up must come down, the coming down usually being the more dramatic. The one silver lining in all this is that when the stock market does collapse, most of us won't much be affected. Over 90% of the value of stocks and mutual funds, which is what really counts, is owned by the top 10% of the population, over half by the top 1%. Those at the top bore the brunt of the collapse in 2008, and no doubt they will again this time around. But they recovered in spades after the last crash, and they will again. Everybody knows the dice are loaded, the rich get rich and poor stay poor. But let's unpack this before wallowing in the cynicism.

Income and wealth inequality are measured by the Gini Coefficient. The Gini Coefficient (for those of you lucky not to be economics geeks) is a mathematical measure of how much the actual distribution of income or wealth in a society deviates from a linear relationship. A Gini Coefficient of zero connotes a linear relationship between population and income or wealth, implying that 25% of the population has 25% of the income/wealth, 50% has 50%, and so on. That level of pure equality hasn't been seen in nature since our hunter-gatherer days, and maybe not even then. Conversely, a Gini Coefficient of 1.0 implies a perfect oligopoly, in which one person has all the income and wealth and the rest of us are his or her slaves. Those extremes are the economists' versions of heaven and hell, and all modern societies exist somewhere in between.

The 1980s will be remembered for disco and "trickle-down" economics. George H.W. Bush labeled the latter "voodoo economics," and most of us who studied economics in the 1970s agreed. But Ronald Reagan bought into it, and he won, and so trickle-down economics became mainstream. Give tax breaks to the rich, the argument still goes, because when they spend it, that money will trickle down to the rest of us. 

Well, 40 years later, Bush and I were right, and Reagan was wrong. In his study, Household Wealth Trends in the United States, 1962-2016, NYU Professor Edward N. Wolff found that the Gini Coefficient for income increased from .428 in 1962 to close to .598 in 2015. https://www.nber.org/papers/w24085.pdf. That 40% exacerbation of income inequality occurred at the same time that the top marginal tax rates were slashed from the confiscatory 90% rates of the Eisenhower era to today's much lower rates. Wealth didn't trickle down. The rich just got richer, as everybody knows.

Arguments about economic inequality are inevitably couched in moral terms. The rich are "greedy," but they object to having their "hard-earned" wealth "stolen" from them and given to the "undeserving." Liberals have no monopoly on this. Last week I passed a pro-Trump demonstrator with a placard "Jail the Banksters." Jailing the banksters requires the very same moral judgment you would hear from a Bernie Bro.

But what if this morality play is all wrong? As reported in next month's Scientific American, Prof. Bruce Boghosian and his colleagues, mathematicians and physicists, modeled the behavior of an economic system based on a very large number of trades between random pairs of 1,000 participants. Classical economics argues that if two traders have equal wealth, information and market access, both will equally benefit from the trade. But in the real world there will always be a winner and a loser, because that's what a bid-ask spread implies. After each trade, one participant will have slightly more wealth than the other. In Baghosian's model, which participant wins any given trade is determined by a simple coin flip (or rather its computer-generated equivalent). Each of the thousand participants starts with exactly the same amount of wealth, each has exactly the same probable outcome after each trade, and whether each is a winner or a loser in any trade is determined strictly at random.

Here's the surprise. "[A]fter a large number of transactions, one agent ends up an ‘oligarch' holding practically all the wealth of the economy, and the other 999 and up with virtually nothing. It does not matter how much wealth people started with. It does not matter that all the coin flips are absolutely fair. It does not matter that the poorer agents' expected outcome was positive in each transaction, whereas the richer agent's was negative." This result stems from an imbalance in the system caused when one participant becomes "richer" than another, which of course happens with the very first trade. "[O]nce we have some variance in wealth, however minute, succeeding transactions will systematically move a "trickle" of wealth upward from poorer agents to richer ones, amplifying inequality until the system reaches a state of oligarchy." https://www.scientificamerican.com/article/is-inequality-inevitable/. The only way to win this game, it seems, is not to play at all, and that's the catch; the economy is a casino from which one cannot walk away.

Prof. Boghosian's research suggests that a free economy has no moral component to it at all. He and his colleagues demonstrate that unbridled capitalism tends to oligarchy not because of the intentions of the participants -- they are all equal and have the exact same opportunities -- but simply because that is how the system is. In other words, Adam Smith was right, and wrong at the same time. There is an "invisible hand" guiding the economy, but it is not a function of the self-interest of any of its participants. Rather, it is a function of the mathematics of a game with captive players. Boghosian and his colleagues also found that with just enough income redistribution to offset the "trickle-up" effect, the economy settles into a steady-state and avoids the collapse into oligarchy. Wealth redistribution is just a tweak of the system, and nothing more.

This is a liberating notion. Like the rest of the inequality discussion, income and wealth redistribution as a remedy is too often couched in terms of the rich not "deserving" their surplus and the poor being "entitled" to it, because neither the rich's advantages nor the poor's disadvantages are truly "earned." The moral underpinnings of this argument were laid in the 1970s by John Rawls and are finally being challenged. Prof. Elizabeth Anderson at the University of Michigan has already argued that egalitarianism should not be about "leveling" any theoretical "playing field," but rather about preventing the wealthy from using raw power to hinder the rest from pursuing their natural opportunities. See http://www.brokeandbroker.com/4675/aegis-frumento-america/. In his new book, The Theology of Liberalism, Harvard government Prof. Eric Nelson argues further that redistribution of wealth as a remedy for inequality doesn't have any moral justification that stands up to scrutiny. Redistribution is better founded on pragmatic reasons about the kind of society we want to live in, rather than dubious appeals to unaccountable moral principles.

If laissez faire capitalism naturally leads to oligarchy, and if income and wealth redistribution tweaks the system so that it won't, that's reason enough to take from the rich and give to the poor. We don't need to engage in elusive arguments about what's "fair," and we don't need to dress up as Robin Hood and the Sheriff of Nottingham to act out a morality play over it. I don't want to live in an oligarchy, not even if I'm the oligarch. None of us does. Let's just leave it at that.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog. 

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