Tuesday, December 3, 2013

“Pay no attention to the man behind the curtain!”
― L. Frank Baum, The Wonderful Wizard of Oz

Charles Hugh Smith made an interesting observation based on the famous 80/20 Pareto Principle. For those of you new to this blog, The Pareto Principle states that in business roughly 80% of results come from 20% of the causes. The principle is named after an Italian economist, Vilfredo Pareto. In 1906 he observed that 80% of the land in Italy was owned by 20% of the population. Pareto also observed that 20% of the pea pods in his garden contained 80% of his harvest.

The more things change the more they remain the same. Smith determined that there is a key difference between the top quintile measured by net worth and the bottom 80%. The bottom 80% pay interest on debt. The top 20% receive interest payments from corporations and individuals.

It would seem the magic key to accumulating wealth is avoiding debt.

What does it mean to be in the top 20%? There are basically two ways to measure wealth, income and net worth. According to the famous Wall Street Journal Rich-O-Meter 3.0, \$100,000 a year will put you in the eighty first percentile. Given the number of two income households in this country, I wish they measured household income rather than individual income. For comparison, the current median household income in the United States is \$51,000.

A net worth of \$500,000 will land you in exactly the eightieth percentile. Interestingly, using the formula proposed by Stanley and Danko, this would be exactly what one would expect for a single income family earning \$100,000 a year, assuming a 50 year old breadwinner.

500,000 = (100,000 X 50) / 10

Now let me pull back the curtain and reveal the magic. Money is a shared illusion. It is created by Governments with printing presses or by Banks through fractional reserve lending. Fiat currencies are only more real than Bitcoins because more people believe in Dollars or Euros than currently believe in Bitcoins. Who knows? That may change.

Wealth is created by ingenuity and hard work, your ingenuity and hard work. Wealth is real. Think about it. The Government or the Federal Reserve has created a castle of debt built on a foundation of thin air. It is your ingenuity and hard work that keeps it afloat. When the interest on a debt comes due, (whether it is your personal debt or our public debt) it is your time and your effort that is actually putting your wealth into the hands of the top 20%.