Essays

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Inequality and Risk

(This essay is derived from a talk at Defcon 2005.)

Suppose you wanted to get rid of economic inequality. There are two ways to do it: give money to the poor, or take it away from the rich. But they amount to the same thing, because if you want to give money to the poor, you have to get it from somewhere. You can't get it from the poor, or they just end up where they started. You have to get it from the rich.

There is of course a way to make the poor richer without simply shifting money from the rich. You could help the poor become more productive-- for example, by improving access to education. Instead of taking money from engineers and giving it to checkout clerks, you could enable people who would have become checkout clerks to become engineers.

This is an excellent strategy for making the poor richer. But the evidence of the last 200 years shows that it doesn't reduce economic inequality, because it makes the rich richer too. If there are more engineers, then there are more opportunities to hire them and to sell them things. Henry Ford couldn't have made a fortune building cars in a society in which most people were still subsistence farmers; he would have had neither workers nor customers.

If you want to reduce economic inequality instead of just improving the overall standard of living, it's not enough just to raise up the poor. What if one of your newly minted engineers gets ambitious and goes on to become another Bill Gates? Economic inequality will be as bad as ever. If you actually want to compress the gap between rich and poor, you have to push down on the top as well as pushing up on the bottom.

How do you push down on the top? You could try to decrease the productivity of the people who make the most money: make the best surgeons operate with their left hands, force popular actors to overeat, and so on. But this approach is hard to implement. The only practical solution is to let people do the best work they can, and then (either by taxation or by limiting what they can charge) to confiscate whatever you deem to be surplus.

So let's be clear what reducing economic inequality means. It is identical with taking money from the rich.

When you transform a mathematical expression into another form, you often notice new things. So it is in this case. Taking money from the rich turns out to have consequences one might not foresee when one phrases the same idea in terms of "reducing inequality."

The problem is, risk and reward have to be proportionate. A bet with only a 10% chance of winning has to pay more than one with a 50% chance of winning, or no one will take it. So if you lop off the top of the possible rewards, you thereby decrease people's willingness to take risks.

Transposing into our original expression, we get: decreasing economic inequality means decreasing the risk people are willing to take.

There are whole classes of risks that are no longer worth taking if the maximum return is decreased. One reason high tax rates are disastrous is that this class of risks includes starting new companies.

Investors

Startups are intrinsically risky. A startup is like a small boat in the open sea. One big wave and you're sunk. A competing product, a downturn in the economy, a delay in getting funding or regulatory approval, a patent suit, changing technical standards, the departure of a key employee, the loss of a big account---any one of these can destroy you overnight. It seems only about 1 in 10 startups succeeds. [1]

Our startup paid its first round of outside investors 36x. Which meant, with current US tax rates, that it made sense to invest in us if we had better than a 1 in 24 chance of succeeding. That sounds about right. That's probably roughly how we looked when we were a couple of nerds with no business experience operating out of an apartment.

If that kind of risk doesn't pay, venture investing, as we know it, doesn't happen.

That might be ok if there were other sources of capital for new companies. Why not just have the government, or some large almost-government organization like Fannie Mae, do the venture investing instead of private funds?

I'll tell you why that wouldn't work. Because then you're asking government or almost-government employees to do the one thing they are least able to do: take risks.

As anyone who has worked for the government knows, the important thing is not to make the right choices, but to make choices that can be justified later if they fail. If there is a safe option, that's the one a bureaucrat will choose. But that is exactly the wrong way to do venture investing. The nature of the business means that you want to make terribly risky choices, if the upside looks good enough.


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