Terry Pratchett’s famous Discworld series of books includes a novel called Men at Arms. Sam Vimes, one of the characters in this book, describes his personal theory for how poverty can be self-perpetuating. Here’s the key quote from the book:
The reason that the rich were so rich, Vimes reasoned, was because they managed to spend less money. Take boots, for example. He earned thirty-eight dollars a month plus allowances. A really good pair of leather boots cost fifty dollars. But an affordable pair of boots, which were sort of OK for a season or two and then leaked like hell when the cardboard gave out, cost about ten dollars. Those were the kind of boots Vimes always bought, and wore until the soles were so thin that he could tell where he was in Ankh-Morpork on a foggy night by the feel of the cobbles. But the thing was that good boots lasted for years and years. A man who could afford fifty dollars had a pair of boots that’d still be keeping his feet dry in ten years’ time, while a poor man who could only afford cheap boots would have spent a hundred dollars on boots in the same time and would still have wet feet. This was the Captain Samuel Vimes “Boots” theory of socioeconomic unfairness.
The underlying idea here is probably familiar to many: we buy some cheap product that breaks or wears out after a few uses, and realize that we would have been better off in the long run with a more durable, long-lasting product, even if it cost more initially. However, if someone cannot save up enough resources to afford that more durable product, they are stuck with the lower quality version and thus have to pay more in the long run. Vimes’s theory is that this leads to a self-perpetuating cycle of wealth disparity: not only do the rich get to enjoy a better product, they save money doing so.
Of course, in real life, the connection between durability and price of consumer goods is not quite as strong as the fictional scenario described by Pratchett. For example, luxury cars often have more expensive upkeep and maintenance costs. Furthermore, they can have worse resale values as a percentage of value compared to something like a Civic or Corolla. So, while someone who is wealthy enough to afford a luxury car may derive additional enjoyment over it, the ability to own that car does not further exacerbate the wealth disparity between them and, say, Civic owners.
Economists often have special names for products or goods that have certain properties, such as Veblen Goods or Giffen Goods. Let’s call a good that behaves like the high-quality leather boots in Vimes’s story a Vimes Good. That is, they are goods that a greater level of wealth gives you access to, but have a lower total cost of ownership than alternatives that are accessible with less wealth. The leather boots of Ankh-Morpork are Vimes goods under this definition, because their higher initial up front cost effectively makes them inaccessible to those that do not have a certain level of wealth or savings. Meanwhile, BMWs are not.
As I suggested earlier, it’s not always so easy to identify Vimes goods for certain broad classes of physical products. But there’s one industry and type of product that offers a very large number of clear-cut Vimes goods: financial products. In the rest of this post, I will give some examples and explain why Vimes goods are so common in this area.
Examples of Financial Vimes Goods
When I say financial products here, I am using a rather broad definition, which will include things like insurance, credit cards, investment, etc. Here are some cases of Vimes goods in these categories:
Insurance: It’s well known that insurance products have negative expected value in a mathematical sense, but they can still be worthwhile to purchase if they can help protect the insured against catastrophic risks. The flip side of this is that if one is wealthy enough to weather certain financial storms, you can save money by self-insuring for certain types of risks, i.e. not buying insurance for those things, but instead just having enough liquid reserves to be able to handle the costs that arise.
For example, if you are financially independent and have retired early, you may not need life insurance to protect your dependents. They can continue to live off of the gains from whatever wealth you have saved (assuming that wealth was not tied to a pension or annuity that ends with your death).
Alternately, a wealthier person can still buy insurance, but just less of it. For example, high-deductible health insurance plans function this way: for someone who is wealthy enough, the costs of the deductibles do not seriously put them at risk. Thus, they can save money on premiums, while still having protection against catastrophic healthcare costs. (That’s aside from all of the other tax advantages that high-deductible plans may open up through health savings accounts.)
Credit and Mortgages: Interest rates of loans are a critical part of their cost. Wealthier people can use their wealth to achieve better interest rates through a variety of means. For example, pledged asset loans are a line of credit where you borrow against the value of securities or investments. Typically, the interest rates on these lines of credit are much lower than the rates available to your average consumer that does not have a large store of wealth. Moreover, at some providers the rates decrease in proportion to the size of the collateral.
Additionally, lenders that offer investment options will sometimes offer lower interest rates on mortgage if a client agrees to transfer a considerable portfolio to their firm. For example, at the time of writing, Charles Schwab will give a .25% interest rate discount if you have $250k-$999k invested with them, with increasing discounts for more invested, all the way up to a full 1% discount for assets over $10 million.
At the other end of the spectrum, folks who are unable to accumulate a “standard” down payment of 20% will typically have to pay for private mortgage insurance (PMI) with their mortgage payments, which is often effectively equivalent to an extra .5%-1% of interest.
Expense Ratios: Some mutual fund providers, like Vanguard, offer different “tiers” or “classes” of shares based on how much you invest in the fund. The higher tier classes can have lower overall expense ratios. That is, the percentage of invested money that you pay in expenses each year is less. Vanguard has three tiers: “Investor”, “Admiral” and “Institutional. For a broad based index fund, you need a minimum of $3,000 to qualify for Admiral shares and $5 million for Institutional shares.
For example, VTSAX and VITSX are respectively the Admiral and Investor share classes for Vanguard’s Total Stock Market index fund. VITSX has an expense ratio of 0.03%, while VTSAX is 0.04%. Now, granted, that’s not that much relatively speaking: for $5 million invested, the difference between these two expenses would only be $500 a year. (Also, people of more modest means sometimes have access to VITSX through retirement accounts, and can also get the lower expenses with the ETF equivalent of these funds.)
Rewards or Bonuses: We’ve already touched on the fact that it’s possible to get an interest rate discount on a mortgage by having a large investment at a brokerage. But there are other perks or rewards that are offered on financial products just from having a large brokerage account. For example, Bank of America gives higher interest rates on savings accounts, larger credit card cash bank rewards, and reduced fees on certain types of transactions if you keep a certain amount of money in your Bank of America or Merrill accounts. Other firms will just directly give a cash bonus from opening a new account funded at a certain minimum level.
On the subject of credit card rewards, a slightly more debatable example are the premium credit cards, like Amex Centurion Card. Without descending into all the intricate details of credit card reward points, it’s not uncommon for something like the Centurion Card to offer bigger cash rewards or better point spend than lower scale cards, which for many people more than makes up for the initiation and renewal fees of these cards. Now, some will argue that the huge amounts you have to the charge to qualify for and keep it are actually a very high “cost” that has to be accounted for, but that’s not true if a person would be spending that money anyway: from their perspective the rewards are just an ancillary bonus they get from a wealthy lifestyle.
Why are Vimes Goods Common in Finance?
Those are just a few examples of Vimes goods that show up in the financial world, and many more could be listed. So why are there so many of these goods in finance? First, financial products are often inherently quantitative, which makes it much easier to directly assess all of the cost/benefit trade-offs. In contrast, for physical goods it can be tough to tell whether the extra cost of a product really buys you greater durability.
Second, consumers often have much less brand loyalty in this space. No doubt there’s some loyalty: people may choose Vanguard over Fidelity out of some preference for the years of good will and branding generated by John Bogle, the founder of Vanguard. But overall, because the properties of a financial product can be quantified so accurately, people will walk away for a better deal. This leads to competition over quality.
Finally, I think it’s often just easier to generate or come up with these deals that lead to benefits for wealthier clients. Producing a higher quality “buy it for life” physical product requires a degree of ingenuity or innovation that is difficult: can you really design a boot that will last longer at only a smaller initial higher cost? In contrast, financial businesses can easily offer the deals mentioned above and still come out ahead. For example, credit cards with high rewards that require bigger spends can generate profits from merchant fees. Loans that have equities as collateral are less risky for a bank because the collateral is liquid and can be priced accurately, meaning they are much less likely to lose money in a default.
So, what’s the take-away? Well, lessons about the power of early savings and compounding interest are some of the most oft-repeated advice in the world of investing and personal finance. The existence of Vimes goods in this space points out yet another way in which early accumulation of wealth can lead to a snowball effect through decreased costs or bonuses.