What’s driving our inequality?

 

good economics actual economics

good economics : actual economics

If there was a one line answer for why inequality is growing, someone would have said it elegantly a long time ago. It seems the answer is a mix of systemic, economic and political factors, which I will wade through somewhat inelegantly below.

Trends – Global and Local

The Economist ran a feature late last year looking at the dynamics of income distribution. They point out that up until the 1970s, inequality within countries was largely falling, while inequality between countries grew. Globalisation and technological advancement since then have served to enrich the rich in developed countries (as their companies become global in scale), and the rich and middle class in developing countries (as markets open and jobs are outsourced); while hurting the poor and middle class in developed countries (whose jobs disappear overseas) and leaving the poor in the developing world largely unaffected. The result is a decrease in inequality between countries, and an increase in inequality within countries.

One of the key dynamics that comes into effect as we globalise is that of “superstar economics”: The argument that the best in any given field will earn disproportionately more than the second best in a globalised, technologically enabled set up. Nassim Nicholas Taleb describes this effect in his hugely insightful book “The Black Swan.” The argument goes that a hundred years ago, a modestly talented footballer could earn a good living as local people would be willing to pay to see them play. Nowadays, everyone can tune in to Barcelona v Real Madrid to watch the best in the world. This crowds the averagely talented player out of the market, while grossly inflating Christiano Ronaldo’s pay, as his audience grows exponentially.

The sectors that have become less equal are the same ones that are growing the quickest. Urbanisation and industrialisation (particularly in the developing world) mean that more and more people are working in a winner-takes-most “extremistan” environment. In an argument first put forward by Simon Kuznets in 1955, this sectoral change in itself has become a driver for increased inequality.

One of the most headline-friendly modes of discussion of inequality is around CEO compensation. There is ample evidence of CEO pay mushrooming in the last thirty years, with a growth rate 127 times greater than the US industrial average since 1978. This idea of superstar economics goes a good way to explaining why: Intuitively, CEOs run much larger organisations. Interestingly, looking at their pay compared to their next two most senior lieutenants, they have risen from 40% higher in the 1980s to 150% higher by 2000. This suggests the same dynamic dictates the relationship between the 99% and the 1% as the relationship between the top 1% and the top .1%.

And the politics

In 1955, Simon Kuznets was confused as to why inequality was falling. The industrialisation of society mentioned above, combined with disproportionately large returns on capital (held by a small proportion of society) should have seen inequality growing. One of the key mechanisms for inequality falling that he proposed was the flow of political power from the super-rich to the urban poor.

To quote fully:

“In democratic societies the growing political power of the urban lower income groups led to a variety of protective and supporting legislation, much of it aimed to counteract the worst effects of rapid industrialisation and urbanisatuion and to support the claims of the broad masses for more adequate shares of the growing income of the country” (Kuznets 1955: p17)

Can anyone seriously say today that political power has continued to flow from the wealthy to the urban lower income groups? At a time when Barack Obama, campaigning for the Presidency in 2012, can overtly state that “We can be outspent and still win — but we can’t be outspent 10 to 1 and still win”?

At a time when Saez and Pickety have demonstrated that 93% of the money from the economic recovery in the US between 2008-2011 went to the top 1%; with 33% going to the top 0.01%?

Whether pursued consciously or not, it is impossible to avoid the conclusion that inequality within countries is growing today; and the forces pushing it – be they globalisation, urbanisation, market-based compensation or a shift in political power toward the super-wealthy, are not dissipating any time soon.

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Inequality, Happiness and how Economics got us lost

lost

It’s increasingly obvious that one of the issues that emerges from our current social set up is growing inequality. No longer the domain of marginal voices on the far left, talk of a crisis in capitalism and inequality that is economically inefficient is now firmly mainstream. This post will look at why equality is a worthy goal to pursue in its own right.

Economics’ focus

Orthodox economics tends to focus on growth (and to a lesser extent, employment) as the primary goals of economic policy. This wasn’t always the way however.

Jeremey Bentham, a pioneer of the discipline in the Eighteenth century argued the goal of economic policy should be to bring about the greatest happiness of the greatest number of people. What happened next is crucial. Typifying the best and the worst of economic thinking, there was a move to produce a simpler, intellectually more elegant model. Rather than attempting to measure all the intangible inputs to societal happiness, it was assumed that people would spend their money in a way that maximised their personal happiness. Following this logic, giving people more money to spend increases the amount of happiness each individual can buy, and thus the most efficient way in increase total societal happiness is to increase total societal income.

As with any classical reductionist model, it is contingent on a number of assumptions. The passage of time has made these assumptions less and less tenable.

1. Increasing income will increase happiness

This was difficult to measure initially, but advances in neuroscience and survey methods have given us reliable measures of happiness. While increasing income leads to increasing happiness initially, beyond a certain point the relationship breaks down – as argued by Richard Layard – and demonstrated in the graph from the World Values Survey below.

Graph of income against happiness from the World Values Survey

The upshot of this is that increasing the wealth of the wealthiest has minimal impact on their own happiness.

2. If a country maximises income, wealth will trickle down and questions of distribution will take care of themselves

This assumption has its basis in the work of Simon Kuzntes. Kuznets completed a study showing an inverted u-shaped relationship between GDP and equality. As countries grow, they become less equal initially. Kuznets suggested that a tipping point is reached however, and wealth is redistributed. Kuznets completed his study at a time when data was not available for any country over time. Instead, Kuznets used a cross-section of countries at one point. Despite being well received, the theory has failed to predict what would actually happen.

More importantly as time series data has become available,for individual countries the “Kuznets curve” has failed to manifest itself.

While Kuznets’ hypothesis is now widely discredited, the orthodoxy of focusing on growth and ignoring equality remains.

3. Happiness comes from growth in absolute income – not growth in our own income relative to peers

While this initially seems logical, there is a range of research showing the rivalrous nature of income – again excellently outlined in Richard Layard’s book, “Happiness“. Habituation and social comparison mean that beyond a basic level, absolute income is less important than income relative to peers.

4. The market will lead to a fair distribution of resources

Fairness matters to people’s happiness; and acting in a fair and cooperative way has been shown to activate neurotransmitters in the brain associated with happiness. For reasons discussed in the next post, inequality is growing, and increasingly there is a sense that the way the market distributes income is not fair. The last two points taken together mean that current policies that increase the wealth of the wealthiest can actually have a detrimental effect on societal happiness.

Taken together, we are pursuing happiness by maximising GDP, allowing the market to determine a relatively fair initial outcome and trusting the Kuznets curve to correct this initial distribution as necessary.

But maximising GDP is increasing the wealth of the wealthiest – whose happiness is largely unaffected by this increase; the initial market outcome is no longer perceived to be fair, decreasing everyone else’s sense of happiness; and the mechanism by which we thought society would correct this distribution turns out not to exist. These are clear signs of a failing and a need to intervene to ensure a more equitable outcome.

While classic economic theory might have produced seemingly fair outcomes up until now, that is less and less the case. The reality is the middle is being squeezed, the rich are becoming ostentatiously wealthy and the poor are being left behind and isolated as never before. Whether that is down to social dynamics, crony politics or something entirely random, its not good for us as a society. We have to recognise that a laissez-faire approach is no longer producing a fair, equitable or happy result.