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August 2005  
  
 _(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.   
  
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.  
  
VCs are currently paid in a way that makes them focus on the upside: they get
a percentage of the fund's gains. And that helps overcome their understandable
fear of investing in a company run by nerds who look like (and perhaps are)
college students.  
  
If VCs weren't allowed to get rich, they'd behave like bureaucrats. Without
hope of gain, they'd have only fear of loss. And so they'd make the wrong
choices. They'd turn down the nerds in favor of the smooth-talking MBA in a
suit, because that investment would be easier to justify later if it failed.  
  
**Founders**  
  
But even if you could somehow redesign venture funding to work without
allowing VCs to become rich, there's another kind of investor you simply
cannot replace: the startups' founders and early employees.  
  
What they invest is their time and ideas. But these are equivalent to money;
the proof is that investors are willing (if forced) to treat them as
interchangeable, granting the same status to "sweat equity" and the equity
they've purchased with cash.  
  
The fact that you're investing time doesn't change the relationship between
risk and reward. If you're going to invest your time in something with a small
chance of succeeding, you'll only do it if there is a proportionately large
payoff.  If large payoffs aren't allowed, you may as well play it safe.  
  
Like many startup founders, I did it to get rich. But not because I wanted to
buy expensive things. What I wanted was security. I wanted to make enough
money that I didn't have to worry about money. If I'd been forbidden to make
enough from a startup to do this, I would have sought security by some other
means: for example, by going to work for a big, stable organization from which
it would be hard to get fired. Instead of busting my ass in a startup, I would
have tried to get a nice, low-stress job at a big research lab, or tenure at a
university.  
  
That's what everyone does in societies where risk isn't rewarded. If you can't
ensure your own security, the next best thing is to make a nest for yourself
in some large organization where your status depends mostly on seniority.   
  
Even if we could somehow replace investors, I don't see how we could replace
founders. Investors mainly contribute money, which in principle is the same no
matter what the source. But the founders contribute ideas. You can't replace
those.  
  
Let's rehearse the chain of argument so far. I'm heading for a conclusion to
which many readers will have to be dragged kicking and screaming, so I've
tried to make each link unbreakable. Decreasing economic inequality means
taking money from the rich. Since risk and reward are equivalent, decreasing
potential rewards automatically decreases people's appetite for risk. Startups
are intrinsically risky. Without the prospect of rewards proportionate to the
risk, founders will not invest their time in a startup. Founders are
irreplaceable. So eliminating economic inequality means eliminating startups.  
  
Economic inequality is not just a consequence of startups. It's the engine
that drives them, in the same way a fall of water drives a water mill. People
start startups in the hope of becoming much richer than they were before. And
if your society tries to prevent anyone from being much richer than anyone
else, it will also prevent one person from being much richer at t2 than t1.  
  
**Growth**  
  
This argument applies proportionately. It's not just that if you eliminate
economic inequality, you get no startups. To the extent you reduce economic
inequality, you decrease the number of startups.  Increase taxes, and
willingness to take risks decreases in proportion.  
  
And that seems bad for everyone. New technology and new jobs both come
disproportionately from new companies. Indeed, if you don't have startups,
pretty soon you won't have established companies either, just as, if you stop
having kids, pretty soon you won't have any adults.  
  
It sounds benevolent to say we ought to reduce economic inequality. When you
phrase it that way, who can argue with you? _Inequality_ has to be bad, right?
It sounds a good deal less benevolent to say we ought to reduce the rate at
which new companies are founded. And yet the one implies the other.  
  
Indeed, it may be that reducing investors' appetite for risk doesn't merely
kill off larval startups, but kills off the most promising ones especially.
Startups yield faster growth at greater risk than established companies. Does
this trend also hold among startups? That is, are the riskiest startups the
ones that generate most growth if they succeed? I suspect the answer is yes.
And that's a chilling thought, because it means that if you cut investors'
appetite for risk, the most beneficial startups are the first to go.  
  
Not all rich people got that way from startups, of course. What if we let
people get rich by starting startups, but taxed away all other surplus wealth?
Wouldn't that at least decrease inequality?  
  
Less than you might think. If you made it so that people could only get rich
by starting startups, people who wanted to get rich would all start startups.
And that might be a great thing. But I don't think it would have much effect
on the distribution of wealth. People who want to get rich will do whatever
they have to. If startups are the only way to do it, you'll just get far more
people starting startups. (If you write the laws very carefully, that is. More
likely, you'll just get a lot of people doing things that can be made to look
on paper like startups.)  
  
If we're determined to eliminate economic inequality, there is still one way
out: we could say that we're willing to go ahead and do without startups. What
would happen if we did?  
  
At a minimum, we'd have to accept lower rates of technological growth. If you
believe that large, established companies could somehow be made to develop new
technology as fast as startups, the ball is in your court to explain how. (If
you can come up with a remotely plausible story, you can make a fortune
writing business books and consulting for large companies.)   
  
Ok, so we get slower growth. Is that so bad? Well, one reason it's bad in
practice is that other countries might not agree to slow down with us. If
you're content to develop new technologies at a slower rate than the rest of
the world, what happens is that you don't invent anything at all. Anything you
might discover has already been invented elsewhere. And the only thing you can
offer in return is raw materials and cheap labor. Once you sink that low,
other countries can do whatever they like with you: install puppet
governments, siphon off your best workers, use your women as prostitutes, dump
their toxic waste on your territory — all the things we do to poor countries
now. The only defense is to isolate yourself, as communist countries did in
the twentieth century. But the problem then is, you have to become a police
state to enforce it.  
  
**Wealth and Power**  
  
I realize startups are not the main target of those who want to eliminate
economic inequality. What they really dislike is the sort of wealth that
becomes self-perpetuating through an alliance with power. For example,
construction firms that fund politicians' campaigns in return for government
contracts, or rich parents who get their children into good colleges by
sending them to expensive schools designed for that purpose. But if you try to
attack this type of wealth through _economic_ policy, it's hard to hit without
destroying startups as collateral damage.  
  
The problem here is not wealth, but corruption. So why not go after
corruption?  
  
We don't need to prevent people from being rich if we can prevent wealth from
translating into power. And there has been progress on that front. Before he
died of drink in 1925, Commodore Vanderbilt's wastrel grandson Reggie ran down
pedestrians on five separate occasions, killing two of them. By 1969, when Ted
Kennedy drove off the bridge at Chappaquiddick, the limit seemed to be down to
one. Today it may well be zero. But what's changed is not variation in wealth.
What's changed is the ability to translate wealth into power.  
  
How do you break the connection between wealth and power? Demand transparency.
Watch closely how power is exercised, and demand an account of how decisions
are made. Why aren't all police interrogations videotaped? Why did 36% of
Princeton's class of 2007 come from prep schools, when only 1.7% of American
kids attend them? Why did the US really invade Iraq? Why don't government
officials disclose more about their finances, and why only during their term
of office?  
  
A friend of mine who knows a lot about computer security says the single most
important step is to log everything. Back when he was a kid trying to break
into computers, what worried him most was the idea of leaving a trail. He was
more inconvenienced by the need to avoid that than by any obstacle
deliberately put in his path.  
  
Like all illicit connections, the connection between wealth and power
flourishes in secret. Expose all transactions, and you will greatly reduce it.
Log everything. That's a strategy that already seems to be working, and it
doesn't have the side effect of making your whole country poor.  
  
I don't think many people realize there is a connection between economic
inequality and risk. I didn't fully grasp it till recently. I'd known for
years of course that if one didn't score in a startup, the other alternative
was to get a cozy, tenured research job. But I didn't understand the equation
governing my behavior. Likewise, it's obvious empirically that a country that
doesn't let people get rich is headed for disaster, whether it's Diocletian's
Rome or Harold Wilson's Britain. But I did not till recently understand the
role risk played.  
  
If you try to attack wealth, you end up nailing risk as well, and with it
growth. If we want a fairer world, I think we're better off attacking one step
downstream, where wealth turns into power.  
  
  
  
**