Sunday, April 20th, 2014 - 5:06 PM

The distribution of wealth affects risk taken

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Distribution of wealth in the world society always remained a point of discussion and there are views which are either pro-rich or pro-poor. But as a whole, the world society is still deliberating the distribution of wealth vis-a-vis the risk taking capacity across the globe. In this context, some of the important aspects which are equally important but among them the most crucial one is the proven fact that the economic activity is always proportional to risk taking capacity of nation/individual(s).  Thus the willingness to take a risk drives both investment and consumption in the society.

Consumers may take more risk by consuming rather than hoarding their incomes (which is happening in US and also in Europe). Parallely, they can take even more risk by investing rather than consuming (as one of the option). Therefore, there is a significant possibility in the society that investment, unlike consumption, will produce value, coupled with the spectrum of risks and may be adding inventory in response to growing demand is less risky sometime than building additional capacity. This is what is happening in the growing economies across the globe.

For example, a company that adds inventory can subsequently sell it off if demand contracts, whereas capacity additions are fixed in the long run regardless of the ebbs and flows of demand. Sometimes the investments to produce innovations are riskier and often produce no value at all to the society. But, if they work, innovations often create enormous value and subsequently add to economic activities of the country. Capacity additions, on the other hand, are often duplicative and transfer value from one investor to another rather than increasing value overall. For example, adding a restaurant’s seat, may do little more than customers from the restaurant down the street. One investor’s gain is another’s loss.

The willingness to take risk is largely a function of wealth. Wealth and equity are the same thing. A consumer who believes he has equity embedded in his home, for example, might be willing to spend rather than hoard a greater share of his income. In this regard, Economist Robert Shiller, coined a phrase “wealth effect” also named later on as equity effect.

The risk taking is a function of the amount of  wealth, namely equity, available to underwrite risk and the willingness to take risk say per dollar/rupee/ngultrum of equity. Equity investors have the right to save the profit which is left over in a business after everyone else has been paid. Unlike equity investors, short-term debt holders demand capital preservation and the right to withdraw and consume their savings at any time. Because of these demands, short-term debt may fund investment but only if equity holders underwrite investment risk.

Short-term debt bears too little risk to grow the economy. The amount of equity, and its tolerance for risk, grows the economy and that is the truth of the day.

In the long run the amount of equity accumulates slowly over a time and its tolerance for risk remains relatively fixed. In the short run, however, perceptions of the value of the equity can change rapidly, sometimes the same is proven by the fluctuations in the market value of the assets. The willingness to put equity at risk ebbs and flows in parallel with the change in beliefs. The economy contracts and fall into recession when the willingness to take risk recedes which has already been seen by us in the European economy.

Keynes the famous economist recognized that the rich, and not the poor could save the financial crisis if triggered across the globe. His argument is that the inequality of the distribution of wealth could make it possible to vast accumulations of the fixed wealth in the few hands which at the crucial times acts as a catalyst in turnaround the situation to the great benefit of mankind.

Wealthier the economy, the more risk it should logically bear, for example, if you look at the US stock market related to its GDP, the economy is still willing to take risk almost twice as large as Europe’s and Japan’s.

Proponents of income redistribution argue that it does little good to encourage savings (in context of US) due to cross border flows of capital. These flows will bring capital to the country if investment opportunities are attractive regardless the savings and tolerance for risk. And capital will easily flow out of the country to underwrite risk elsewhere if we encourage the savings.

In this context, it is not out of place to mention here that US has used the opportunity to take advantage of the rest of the world’s savings without the need to increase their own. Infact, the equity could be created through the innovations and the same shall be existing as the market value of future cash flows. But it is true that the future cash flows can’t fund investments required today (take the case of the Indian investments).


Contributed by  A.K. Mishra

Managing Director

Mangdechhu HE Project Authority

Thimphu, Bhutan

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