Unit 9 Lenders and borrowers and differences in wealth

9.12 A poverty trap for those with limited wealth

Remember risk in economics means not knowing whether a good or bad outcome will occur. This is unlike the ordinary use of the term in which a risk means the possibility that something bad will occur.

People with limited or no wealth are limited by their access to credit in their ability to engage in investment projects. In addition, their higher levels of risk aversion lead them to avoid taking risks, even if on average (for example, over a lifetime) they would very likely be better off had they taken more risks rather than choosing the certain outcome.

People with less wealth take fewer risks and as a result remain less wealthy

We considered the decisions about investing and lending that Marco and Julia could make. In that model, they faced no risks—they knew the rate of return on the investment and the loan would be repaid with certainty. But in real economies, there is uncertainty about each. And many other decisions that we make are also risky. We already mentioned buying a house and choosing a subject to study at university. Others include training in a new skill or moving to a different part of the country, or even a different country, in search of a better job. In all of these cases, having limited wealth is likely to lead to risk-averse choices that in the long run result in less income on average than would have been possible if the person had been wealthier, and hence, less risk-averse.

Figure 9.20 also shows that countries differ in how much risk people of similar wealth levels take. People of every level of relative wealth level in the US and the UK hold more risky assets than the corresponding segments in the wealth distribution in other countries. People in Spain appear to hold much less risky assets than in other countries.

This fact is evident in what kind of assets people choose to purchase and hold. You already know that people can choose between low-risk assets that have low yields, such as deposit accounts or higher-risk assets such as stocks, that on average have higher yields. Figure 9.20 shows that across many countries, those with less wealth tend to invest in safer but lower-yielding assets than those with greater wealth.

In this scatterplot, the horizontal axis shows the quintile of gross assets, and the vertical axis shows the risky asset share. Data for six countries is provided. In the 1st (poorest) quintile, the risky asset share is: Germany 13%, UK 12%, USA 11%, France 8%, Spain 7%, Italy 6%. In the 2nd quintile, the risky asset share is: UK 36%, USA 30%, Germany 22%, France 19%, Italy 17%, Spain 10%. In the 3rd quintile, the risky asset share is: UK 42%, USA 40%, Germany 35%, France 20%, Italy 18%, Spain 17%. In the 4th quintile the risky asset share is: UK 55%, USA 50%, Germany 31%, France 28%, Italy 25%, Spain 20%. In the 5th (richest) quintile the risky asset share: UK 66%, USA 62%, Germany 41%, France 40%, Italy 32%, Spain 30%.

Figure 9.20 Share of risky assets in total assets held: evidence from six countries. The holding of risky assets is concentrated among wealthier people.

J. Y. Campbell. 2016. ‘Restoring rational choice: The challenge of consumer financial regulation’. American Economic Review 106 (5): pp. 1–30.

A poverty trap: A vicious circle of limited wealth perpetuating limited wealth

To understand how risk aversion of those without wealth can perpetuate wealth inequalities, think about two people who are identical, except that one of them has substantial wealth and the other does not. We might as well call them Marco (the wealthy) and Julia (without wealth), but now they are making choices about assets subject to risk.

What this means is that over many investment decisions made by the two, or for a population made up of many Marcos and many Julias, the average rate of profit on the investments made by Julia (or the class of Julias) will fall short of the average return to Marco (or his class of wealthy Marcos).

Consider Figure 9.21. Julia faces the vicious circle on the left, in which having limited wealth, she holds low yielding assets (her car, a savings account, or pension). The value of these assets do not increase much over time, so she remains not very wealthy.

Marco, on the other hand, enjoys the virtuous (good for him, at least) circle in which substantial wealth allows him to be not so risk-averse or maybe even risk-neutral. So he holds high-yielding assets and his wealth grows or at least is sustained.

This is one of the ways that wealth differences and the social inequalities associated with them are self-perpetuating.

The different tales of these two circles need not have anything to do with Julia’s or Marco’s basic psychology, that is, their intrinsic risk aversion.

The two might be both equally risk-averse if they held the same amount of wealth. If their intrinsic risk aversion was no different then if Julia had been as rich as Marco, she would have made the same risky choices that he made, and sustained her wealth in the long run, even if some of her risky bets did not pay off.

Or if Marco had been as poor as Julia, like Julia he would have been risk-averse. How they differed could have been only their initial wealth. Had Julia instead of Marco started off wealthy, her circle would have been virtuous (and she would have remained wealthy). And it would have been Marco whose circle was vicious, perpetuating his lack of wealth.

One diagram shows that limited wealth leads to heightened risk aversion, which leads to low yielding assets, which leads to lower returns on assets chosen, which leads again to limited wealth. The other diagram shows that substantial wealth leads to less risk aversion or risk neutrality, which leads to high yielding assets, which leads to higher returns on the assets chosen, which leads again to substantial wealth.

Figure 9.21 A vicious circle perpetuating poverty (a poverty trap) and a virtuous circle perpetuating wealth. Together they show that risk aversion is one (of many) reasons why wealth inequalities persist.

Question 9.17 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

  • Based on Figure 9.20, the 4th quintile in Germany holds a smaller percentage of risky assets than the 3rd quintile.
  • Based on Figure 9.20, the gap in the share of risky assets held by the poorest quintile and the richest quintile is smaller in the UK than it is in France.
  • Based on Figure 9.21, Julia experiences the vicious cycle because she is inherently more risk-averse than Marco.
  • Based on Figure 9.21, there is a causal relationship between wealth and risk aversion, between risk aversion and type of investments chosen, between investment and the return on investments, and between the return on investments and a person’s wealth.
  • In Germany, the 3rd quintile holds a slightly higher percentage of risky assets than the 4th quintile. This is an exception, for every other group in the countries shown, the share of risky assets rises with wealth.
  • In the UK, the poorest quintile holds just over 10% of their assets as risky assets, while the richest quintile hold over 60% of their assets as risky assets, so the difference is more than 50%. In France, it is less than 40%.
  • As discussed in the text, the different experiences of Marco and Julia in regard to these cycles are due to their initial level of wealth. This situation would apply even if both had identical attitudes toward risk, given an equivalent level of wealth.
  • All of these causal relationships are demonstrated in the figure and explain how someone’s initial condition can be perpetuated through these mechanisms.