Photo by Nick Benjaminsz
Introduction: The Economic Game
Imagine watching a chess game without knowing any of the rules of chess.
Complicated moves are being made; players are being captured; games are
being won. Without being able to ask questions, how long would it take
you to deduce the complete rules of chess from simply watching chess games?
How many times would you make mistakes and postulate rules that later observations
would disprove?
Now imagine a more complicated game in which some
of the moves are random events not determined by the explicit rules of
the game. Accidents occur. The game is also being played by players who
do not always act in accordance with the rules. They make mistakes. In
such a game, constructing the rule book would be a monumental task. Yet
it is just such game that economists are trying to dissect. What are the
rules of the economic game? How are economic prizes distributed? What determines
the actions of individual players?
Ultimately, the purpose of knowing the rules of
any game is to be able to explain how the game works, to predict the outcome
of the game, to play the game better, or, perhaps, to design a better game.
The starting point however, is our knowledge of the outcome of the current
economic game—a game played for life-and-death stakes. We can observe
this game directly by looking at the distributions of earnings and wealth.
These are the prizes that the economy has distributed. Once we know the
distribution of economic prizes, we can begin the task of working backward
to understand the process whereby prizes are generated and distributed.
(pp. vi-vii).
The random-walk model shows that most large fortunes are not created via
a patient process of earnings, savings, investments, reinvestment, and
accumulation at market rates of interest. Instead, large fortunes are created
in a matter of a few years, although they may be passed on from generation
to generation. Compared to the conventional model of wealth accumulation,
they are instantaneous fortunes. To understand instantaneous fortunes it
is necessary to understand the distributional implications of the random-walk
hypothesis, which argues that there are persistent disequilibriums in the
real capital markets (the market for real plant and equipment) that are
capitalized into equilibrium in the financial markets. This process of
capitalizing disequilibrium into equilibrium leads to a lottery like process
with equal ex ante expected returns but an unequal ex post array
of returns. Different individuals making the same type of investments with
the same expected rates of return will actually earn enormously different
returns. This unequal ex post array of returns leads to the random-walk
process of distributing wealth.
In both the job-competition and random-walk models,
the world in not as deterministic as simple marginal-productivity models
would imply. As far as the individual is concerned, he or she is subject
to large stochastic shocks in his or her earnings and wealth. Although
these shocks are random as far as the individual is concerned, they are
in integral systematic part of achieving an efficient economy.
… the policy implications of the job-competition and random walk models are examined. It these theories are correct what economic policies should be altered or put in place?…
… it is important to know which distributional mechanisms are at work in the economy. Depending upon the answer, very different policies will be adopted to accomplish exactly the same objectives. In the end it is not possible to be an agnostic about the distributional mechanisms if you wish to design effective economic policies for accomplishing your objectives. To be an agnostic is to support current economic policies and the distributional mechanisms upon which they are implicitly based. (pp. xii-xiv)
Imagine that you were to be asked to establish rules for distributing economic prizes. The easiest way to envision yourself in the position of everyone else in society is to imagine a giant lottery. You can set any distribution of prizes, but you do not know what prizes you yourself will receive. You might get the largest prize or you might get the smallest prize. As far as each person knows, he has an equal chance of landing at the top or middle or bottom of the social order. Perform the mental experiment. What distribution of prizes would establish if a giant lottery were going to be used to determine your position in life? (p. 29)
Although the random walk has been extensively tested and is widely accepted
among professors of finance in business schools, it has not percolated
into either the public arena or into basic courses in economics.
The random-walk literature attempts to prove several
hypotheses. First, the expected rate of return on any financial investment
is equal to the expected rate of return on any other financial investment
in the same risk class. Financial markets are like the economist’s
vision of perfect capital markets in that they equalize rates of return
but only expected ex ante rates of return are equalized. Actual
ex post returns will differ since returns are generated in a probabilistic
process.
Second, once the appropriate adjustment is made
for the risk class of an investment, the expected rate of return on any
investment will be equal to the average rate of return on all investments
(the market average). Once again, the financial market is like a perfect
market in that every investment earns the same rate of return but only
on an expectational basis. (149-150)
Throwing darts at the financial pages of the New York Times is just as good an investment strategy as trying to accumulate all of the relevant information about a stock. Dart throwing is in fact a better investment strategy since it costs nothing whereas attempts to collect information are expensive. (150)
The random walk is a process that will generate a highly skewed distribution
of wealth regardless of the normal distribution of personal abilities and
regardless of whether the economy does or does not start from an initial
state of equality. … It should be emphasized that there is no equalizing
principle in the random walk. Those that have good luck are not more apt
to be subject to bad luck than the random individual. There is no tail
of large negative losses to balance the tail of large positive gains. You
cannot lose more than you have, but you can make many times what you have.
What is the evidence for the random-walk hypothesis?
First an examination of large financial firms (such as mutual funds) indicates
that none of them is able to outperform the market averages. Professional
financial managers able to make large investments in obtaining market information
are not able to outperform the market average or a random drawing of stocks.
Second, no one has been able to design rules (when to buy and sell) that
yields a greater than average rate of return. Third, tests indicate that
stock prices quickly adjust to changes in information (announcements of
stock splits, dividend increases, etc.). Fourth, there is no serial correlation
among stock prices over time. The price at any moment in time or its history
cannot be used to predict future prices. When put together, all of these
findings form an impressive body of evidence of the random walk.
The net result is a process that generates a highly
skewed distribution of wealth from a normal distribution of abilities.
Fortunes are created instantaneously or in very short periods of time.
Personal savings behavior had little or nothing to do with the process.
Once created large fortunes maintain themselves through being able to diversify
and through inheritance. …
If you the Fortune biographies that accompany its lists of the most wealthy,
the winners will be described as brighter than bright, smarter than smart,
quicker than quick. But look beyond the description to see if they were
simply lucky or possess some unique abilities. Remember the unsuccessful
entrepeneur of equal ability will not be featured in Fortune. To what extent
were they like many other people but in the right place at the right time? … (151-153)… Under
the random-walk model, however, the wealthy are not wealthy because of
their productive contribution is higher than others, but because they are
luckier than others. For most people luck does not command the same respect
as productive merit when it comes to determining whether or not individuals
should be allowed to retain control over large aggregations of wealth.
(197)… The economic system is deterministic in the sense that it
will generate some known and predictable distribution of outcomes, but
the position of any one individual is not deterministic. In this sense,
job-competition and the random walk are similar to quantum mechanics. The
overall distribution of atoms is known, but the place of any one individual
atom is stochastic. Ex post individuals who make identical contributions
are going to be rewarded very differently. (208)Conclusions
In the end the reader must decide whether the do-it-yourself distributional
mechanisms that he or she has constructed are better or worse that the
job-competition model for distribution earnings and the random-walk model
for distributing physical wealth. Hopefully, there is a net gain from this
book even if you decide that your own models of distribution are superior.
You will at least have been forced to outline your own theory of distribution
more completely and perhaps to have refined them. The ultimate aim of this
book is not to create a new orthodoxy that will completely supplant the
existing amorphous marginal-productivity theories, but to reopen the process
of investigating the actual mechanisms by which earnings and wealth are
distributed. (209)
Thurow, Lester C. Generating Inequality: Mechanisms of Distribution in the U.S. Economy, Basic Books Inc. 1975.
