Why Big Wealth Flows Straight to the Top

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I love when a chart tells a story, and I can't stop thinking about this one from the president's recent report on the economy:

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Source: Piketty and Saez, via President's Report of the Economy.


The most common response to this chart is some form of outrage. By and large, it's viewed as either a symbol of destructive wealth inequality or the propaganda of those looking to instigate class warfare.

Both may be true, but forget about that. What I want to know is, what's caused the big shift in the first place?

That's nearly impossible to answer -- it's too complicated a subject to reduce to simple explanations. You can write entire books on the subject. And many have.

But however incomplete, some thoughts and analyses from various commentators make enough sense to merit paying attention to. Let's talk about a few of them.  

Diane Swonk, chief economist of Mesirow Financial, had this to say when I asked her about wealth inequality last year:

We peaked in educational attainment in this country in the 1970s, just at the very moment that we were yielding the industrial age to the information age, and paying a premium for ideas and education and higher levels of education rather than manual labor. As a result, the bottom 50% of wage earners started to stagnate while the top 10%, those with graduate degrees, started to see their wages absolutely skyrocket.

This stretches beyond graduate degrees, actually. Thirty years ago, those with a bachelor's degree earned an average of 40% more than those with only a high school diploma. Today, the difference is more than 80%, according to economist Tyler Cowen. According to James Heckman and Paul LaFontaine of the Bureau of Economic Research, high school graduation rates peaked almost 40 years ago and have since declined by 4% to 5%. Furthermore, "the real wages of high school dropouts have declined since the early 1970s while those of more skilled workers have risen sharply," they write. So there's one reason for growing inequality.

Next comes from an interview I did last year with Reuters editor Chrystia Freeland, who has written extensively on wealth inequality in recent years. When asked about the rise in inequality, she noted:

My personal view is I don't think there is a single cause. I think it's a number of things going on. One is definitely globalization. Another probably more important is the technology revolution. A third, I do think that there are some political and cultural factors going on.

About those cultural factors (emphasis mine):

I think where it has become a kind of cultural factor is when it comes to the compensation of CEOs. Some of that is being driven by companies being bigger, absolutely, with globalization and technology coming into play. But part of it is that it's more socially acceptable to pay CEOs a great deal of money. And in historical periods or in cultures where it wasn't, you didn't see these huge salaries.

That's a big one. Of those classified as the 1% of wage earners, a third are non-entrepreneur business executives, according to data from Williams College, the U.S. Treasury, and Indiana University. And while all business executives aren't CEOs, the trend in CEO pay is clear and staggering: In 1994, the average CEO earned 90 times more than an average worker, and in 2007, 180 times more, according to the Congressional Research Service. Other analysis shows that the trend in exploding CEO pay has been ongoing for decades.

Warren Buffett commented on this in his 2005 letter to shareholders:

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won't change, moreover, because the deck is stacked against investors when it comes to the CEO's pay. The upshot is that a mediocre-or-worse CEO -- aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo -- all too often receives gobs of money from an ill-designed compensation arrangement.

Now back to Freeland, who made this observation about inequality in general:

What's really striking to me is the extent to which this is really a global story. It's happening in the United States, it's happening in Britain. It's also happening in the emerging markets. This is a huge issue in India, in Russia. It's the thing that the communist leaders of China are most concerned about.

That, I think, suggests that growing inequality is more about technology, globalization, and cultural shifts than political policy (though the latter is where most of the blame is targeted).

Finally, we know that the biggest shift in the composition of the 1% over the last 30 years has been a jump in those working in the financial sector. Financial workers made up less than one-tenth of the 1% in 1979, but 14% by 2005. And not only did their ranks grow, but the share of income they took home utterly exploded. Financial workers in the 1% captured 0.8% of national income in 1979, but 2.8% by 2005. That's also consistent with the rise in finance as a share of the economy. Finance made up 8.5% of GDP in 2010, up from 3.5% in the 1960s.

Here's what Berkshire Hathaway (NYS: BRK.B) Vice Chairman Charlie Munger has to say about the incredible rise of finance:

We would be better off if we downsized the whole financial sector by about 80%. I don't think the rest of us have anything to gain having massive trading between computers which try to outwit one another with their algorithms to the extent that when one succeeds, the rest of us are all paying for it. And why should we want to encourage our brightest minds to do what amounts to code-breaking and electronic trading? I think the whole system is stark-raving mad. Why should we want 25% of our graduating engineers going into finance? ... I don't see any social contribution.

Berkshire has investments in Goldman Sachs (NYS: GS) , Bank of America (NYS: BAC) , and Wells Fargo (NYS: WFC) , so this is mildly hypocritical. But Munger's broader point is no doubt true. As long as finance pays like it does, the best and brightest will flock to it. And as long as the best and brightest flock to it, it will find ways to grow -- whether at someone else's expense or not.

What do you think about income inequality? Sound off in the comments section below.

At the time this article was published Fool contributorMorgan Houselowns shares of Berkshire and B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Berkshire Hathaway and Wells Fargo. The Fool owns shares of and has created a covered strangle position in Wells Fargo. Motley Fool newsletter serviceshave recommended buying shares of Wells Fargo, The Goldman Sachs Group, and Berkshire Hathaway. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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