Jon Lukomnik, an experienced institutional investor and former deputy comptroller of New York City, shared insights on how inequality poses risks to people, companies, and the broader economy during a workshop organized by Shift and Harvard Business School’s Institute for Business in Global Society. The discussion focused on the systemic nature of inequality and its far-reaching economic consequences.
Inequality affects the economy in three significant ways. First, higher levels of inequality tend to slow economic growth. According to the World Bank, for the average country, a 1% annual increase in inequality can reduce GDP by about 1% over five years. Second, inequality leads to more frequent and deeper recessions, as lower-income individuals often rely on borrowing and struggle to recover financially. Third, inequality erodes trust and increases risks related to governance, including autocracy.
The systemic nature of inequality stems from how it impacts the entire economy rather than isolated sectors. In the short term, increased inequality means more of the economy’s productive capacity goes to the wealthy, who tend to consume less. Since consumption drives most economic activity, this imbalance reduces overall demand. In the long term, inequality harms social structures, particularly at the lower end of the income spectrum. Low-income workers may face barriers such as childcare responsibilities, transportation costs, or lack of healthcare, which prevent them from fully participating in the workforce. Additionally, limited access to education reduces productivity in a knowledge-based economy. These effects compound over time, affecting both consumption and human capital investment across the entire economy.
Lukomnik also discussed how portfolio returns are largely influenced by the overall health of the market. Studies suggest that between 6% and 25% of returns come from security selection and portfolio construction, while the remaining 75% to 94% depend on the general market condition. This highlights the importance of focusing on systemic risks rather than just relative performance benchmarks.
Institutional investors play a crucial role in addressing these systemic risks. Through system-level investing, they can identify and mitigate risks that affect diversified portfolios. This approach involves evaluating consensus, relevance, effectiveness, and magnitude of potential risks. Investors must determine whether there is broad agreement on a risk, whether it affects their portfolio, whether they can take meaningful action, and whether the risk is significant enough to warrant attention.
Some investors are already taking steps to address inequality. In private equity and infrastructure, certain investors require fair labor practices and address executive compensation issues. In the UK, initiatives like the fair living wage campaign have gained traction. Others focus on fair taxation policies or invest in solutions like affordable housing to alleviate symptoms of inequality.
Lukomnik emphasized the need for changes in investment education. Modern portfolio theory assumes that markets influence portfolios without acknowledging that portfolios can also influence markets. However, real-world actions—such as engaging with companies through governance—can impact risk and value creation. As investors increasingly recognize this, they are shifting their focus from theoretical models to practical, on-the-ground strategies to manage systemic risks.
— news from (Harvard Business School)
— News Original —
The broad economic impact of inequality
Editor’s Note: Jon Lukomnik is a longtime institutional investor, former deputy comptroller of New York City and an adjunct professor at Columbia University. He has authored several books, including “Moving Beyond Modern Portfolio Theory: Investing That Matters.” We caught up with him at a workshop in June organized by Shift and the Harvard Business School’s Institute for Business in Global Society to explore how businesses can address the risks that inequality creates for people, companies and the broader economy. The interview has been edited for length, clarity and style.
How is inequality a systemic risk?
There are three major impacts of inequality on the economy. First, high levels of inequality slow economic growth. The World Bank says for the average country in the world, an increase of 1% a year in inequality will slow GDP by about 1% over five years. Second, you have more frequent recessions and deeper recessions and less resiliency with inequality, because the bottom of the economic pyramid winds up borrowing and being in debt, and you can’t get out of it that quickly. The third thing is that inequality actually decreases trust and increases country risk, autocracy risk, and a bunch of other things.
Why is this a systemic risk, though? And why is it not just isolated to certain industries that might be overexposed to the people that are most impacted by inequality?
Well, let’s talk about how this works. On an immediate basis, increased inequality means more of the productive capacity of the economy is going to the wealthy. The wealthy consume less. The vast bulk of the economy is based on consumption, not on investment. Secondly, longer term increased inequality results in some social damage to the bottom of the economy. So more low-income workers can’t go to work because they have to take care of children, or they can’t afford to get to work, or they don’t have healthcare. You’re also not educating them. So in a knowledge-based economy, they are less productive. You have both short-term, decreased consumption, and long-term, decreased human capital investment that work across the entire economy, that doesn’t just affect one company or another.
You’ve talked about how a large portion of the returns of a portfolio are driven by just the health of the market writ large. Can you unpack that a little bit more?
Depending on which academic study you look at, between 6% and 25% of your total return is driven by your security selection and your portfolio construction. That means that 75% to 94% of your return is driven by the overall health of the market.
Part of the issue is that we are dominated by the asset management industry, and the asset management industry’s job is to beat a relative return index, right? Here’s the issue: if you’re a pension fund and the market’s down 10%, and you’re only down 8%, your managers did a really good job. The problem is you still only have 92 cents on the dollar to pay your pensions. If the market’s up 10 and you underperform by two basis points, your managers did a rotten job, but you have a [positive return]. So which one do you want? Do want your managers to do a good job or do you want to have the money to offset your liabilities?
What people in the real world actually invest for — saving for retirement, paying for college, a mortgage, even just saving for a vacation or the necessities of life — those are real-world, liability-driven investments. You’re not trying to beat a benchmark. But for years the conversation was dominated by sort of relative return language, instead of, are we making enough money to do what we have to do?
So given that, what does it suggest for the role of these institutional investors? I teach something called system-level investing, and what that says is, let’s figure out what the systemic risks to a diversified portfolio are. What are the things that contribute to the health of the environmental, social, and financial system? We look at consensus, relevance, effectiveness, and magnitude.
Investors can’t do everything. But they can pick and choose a few systemic risks that are relevant to them particularly. So, for instance, if you’re in the Middle East, you might be concerned about water, and you start looking at, what are things I can do around water? Are there technological investments I can make? Are there ways to make the companies in which I invest more water efficient? Are there ways to decrease pollution?
Can you go back to the four criteria that you use to think through a systemic issue?
The first is consensus. For something to be a systemic risk, there’s generally a broad base of knowledge about it. The impact of climate change has been studied pretty severely. Relevance. Is it a systemic risk that’s going to affect my portfolio? To do that, you have to be able to trace the transmission mechanisms for the systemic risk to the impact on the system to the economy. Effectiveness. Is there anything I can do about it? There’s a possibility of an asteroid hitting the earth. Institutional investors can’t do very much about it. And magnitude. Is it big enough for me to care?
What are some of the strategies investors are taking to address inequality?
In private equity and in infrastructure, a number of investors are requiring fair labor practices. Many obviously have programs that deal with executive compensation issues. In the UK, there’s a whole fair living wage campaign. There are some investors who are starting to look at fair taxation issues, more European than American, but some. Many investors invest deliberately in things that alleviate some of the symptoms of inequality, like affordable housing. When I ran the city of New York’s pension fund investments, we built thousands of units and financed tens of thousands more, because New York City has an affordable housing problem, and had it in the 1990s as well. We haven’t solved it, but it would be worse if we hadn’t done anything.
What is missing in curricula that doesn’t account for the rise of the system-level risk that you’re talking about?
Modern portfolio theory, which is why you diversify, assumes that the market affects your portfolio, but you don’t affect the market. The reality is you do. The question is, can you intentionally impact the market? And what’s missing is this idea that you can, but you have to go into the real world to do it. The courses assume that investing takes place on a Bloomberg terminal, that it doesn’t happen in the real world, that someone exercising their governance rights with a company is less important than a trader. I’m not sure that’s true, because risk and value are created in the real world; they’re priced to the capital markets. And if you want to decrease risk and increase value, you have to go into the real world to do it. And increasingly, investors are doing just that.