Economics and Cosmology

On Monday of this week, Paul Krugman wrote in the New York Times that the income disparity we currently see is not due to the increasing leverage of education as had been suggested by new Fed chair Ben Bernanke but rather a result of the recent rise of a narrow oligarchy. He points to data showing that only those with incomes in the 99th percentile were really reaping the benefits of increased productivity. College educated people in fact had lost real income in recent years. In an earlier post, I pointed out that the top 400 richest Americans make up of 1% of the entire U.S. GDP.

The prevailing supply side mantra is that "a rising tide floats all boats. " The theory is that increasing wealth at the top will lead to greater investment and higher productivity to which the entire nation will benefit. Unfortunately, this is thinking linearly and not exponentially. When I briefly flirted with Wall Street a decade ago, I was amused to learn that finance was similar to cosmology in that both fields involve stochastic fluctuations on an exponentially expanding manifold. The implication is that small differences will eventually lead to huge differences and this could be an explanation of both galaxy clustering and the growing income disparity.

Only small inhomogeneities in the initial conditions and growth rate can lead to wide disparities in wealth. This is especially true because we must compare all rates against the inflation rate. If you're growth rate is below inflation then you're wealth is essentially heading towards zero. Taxes can serve as a means to slow down the growth rate and nonlinearly saturate the growth for those with great wealth. Cutting taxes on income from capital gains and dividends, which mostly apply to those with disposable income, will only further accelerate the disparity between the rich and poor. The only solution is to try to keep the individual income growth rates as homogeneous as possible and above inflation. Trying to equalize initial conditions (i.e. current wealth) may be harder to achieve politically.

The Greenspan strategy was simply to try to keep inflation in check. However, I think we need to manipulate our current tax system to alleviate the problem. Perhaps we could have a floating tax rate that is calculated on the fly to partially homogenize everyone's growth rate. Another option we could explore is to tax wealth directly rather than income. The one thing we cannot do is to stay the current course.