The Price of Inequality

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Joseph E. Stiglitz. The Price of Inequality: How Today’s Divided Society Endangers Our Future (Norton, 2012)

As the economic fortunes of the rich and the not-so-rich have diverged in the last quarter century, opinions about wealth and inequality have also become sharply divided. The disagreement is partly over matters of fact, such as how many Americans are truly poor. But it is also a moral disagreement, an argument over who is deserving and who is not, a dispute over the moral frame in which the facts about inequality are interpreted and understood. The traditional conservative view associating economic success with moral worth is very much alive. Mitt Romney and Paul Ryan presented their own versions of it during the presidential campaign, Romney with his “47%” comments and Ryan with his “makers and takers” argument based on the philosophy of Ayn Rand. The more successful are the enterprising Americans who make things and create jobs, and surely deserve the economic rewards they receive, no matter how large. Taxing those rewards to support the less successful punishes success and rewards failure. The less successful are the freeloaders or takers who pay no income taxes but expect gifts from the government, gifts that the Democratic Party is happy to provide in return for votes. Progressives have their own moral narrative, in which the heroes and villains are reversed. The rich and powerful can reap large rewards even when they do irresponsible things, like market toxic securities or damage the environment, while working families who “play by the rules” can’t get ahead because the game is rigged against them. In this narrative the greedy rich are the real takers, and the Republican Party is the enabler that gives out gifts of subsidies, tax breaks and lax regulation in return for large campaign contributions.

Any discussion of inequality is likely to include arguments between its conservative defenders and its more liberal critics, and economists often fall into one camp or the other. If that’s all the discussion includes, it can easily degenerate into an exercise in moral vilification. Economists and other social scientists must try to go beyond the moral outrage to address researchable questions. They can ask what actual relationship exists between economic inequality and other economic variables, such as the productivity, efficiency and growth of an economy. Those who study such matters may be more receptive to one answer or another because of their moral commitments, but at least they have to put their evidence out there for others to examine and contest, so the discussion remains somewhat connected to reality.

In this book, Joseph Stiglitz makes his case that the growing economic inequality has weakened the US economy. I don’t doubt that his personal values have helped lead him to this conclusion, but he does have some strong arguments and evidence to back it up. In recent US history, the economy has grown more in periods of relative equality than in periods of relative inequality. Recent studies by the International Monetary Fund have also found a positive association between greater equality and sustained economic growth.

The first chapter describes the extent of the inequality in income and wealth. For example, the richest fifth earn more after-tax income than the other 80% of the population. Even before the financial crisis, 65% of the increase in national income was going to the richest 1%, and in the recovery year of 2010, 93% of it did. “The simple story of America is this: the rich are getting richer, the richest of the rich are getting still richer, the poor are becoming poorer and more numerous, and the middle class is being hollowed out. The incomes of the middle class are stagnating or falling, and the difference between them and the truly rich is increasing.”

Stiglitz emphasizes that this can’t be a result of global economic forces alone, since many other countries are more egalitarian: “Even before the burst in inequality that marked the first decade of this century, the United States already had more inequality and less income mobility than practically every country in Europe, as well as Australia and Canada.” Although many argue that inequality of outcomes is not a problem as long as a country has equality of opportunity, the evidence suggests that extreme inequality reduces opportunity as well. Stiglitz fears that the US will become like Latin America, the region with the greatest economic disparities, often accompanied by high levels of civil conflict, crime, and economic instability.

Throughout the book, Stiglitz contrasts the actual functioning of the economy with an idealized model based on neoclassical economics. Markets are supposed to be efficient mechanisms for aligning supply and demand. They should insure that economic activity channels available resources into the production of valued goods and services. Marginal productivity theory has said that “those with higher productivities earned higher incomes that reflected their greater contribution to society. Competitive markets, working through the laws of supply and demand, determine the value of each individual’s contributions. If someone has a scarce and valuable skill, the market will reward him amply, because of his greater contribution to output.” Stiglitz accepts the implication that some inequalities of reward are normal and inevitable. However, also implicit in the theory is the idea that markets can also mitigate inequality. Skills or products that are in high demand but short supply should command a higher price, but that price should come down as more economic actors acquire those skills or produce those products. The flow of labor toward productive activity in a freely competitive market should generate economic gains for all. Rather than being a sign of an efficient economy, extreme and persistent inequality may be a sign of rigidities and inefficiencies.

Stiglitz gives several reasons why real markets are less efficient–and less egalitarian–than the idealized model suggests. Markets aren’t fully competitive, since successful actors can use their power to erect barriers to competition. Prices may not reflect the true social value of a product, since they don’t factor in “externalities” (social costs and benefits affecting others, such as the cost of cleaning up the pollution caused by the production process). The information needed to evaluate the worth of a product or a worker may be unavailable or unevenly distributed. Such inefficiencies create many opportunities for economic actors to engage in “rent-seeking” behavior. In this economic context, the term “rent” refers to an unearned benefit one obtains without actually adding anything of real economic value. A company that holds a monopoly can raise prices without adding anything of value to the product. Multinational corporations operating in poor countries try to gain access to natural resources at bargain prices and avoid paying the environmental cost of extracting them. Corporate executives use their position to influence–and inflate–their own compensation. Marketers take advantage of a consumer’s lack of information by exaggerating the benefits of a product or concealing its defects. The trouble with idealizing the verdicts of “the market,” as if the invisible hand of the market were the hand of God, is that markets are subject to so many human limitations and deliberate manipulations. The fact that the rich can do so well, even when the economy is contracting or barely growing, leads Stiglitz to conclude that many of their fortunes are obtained by rent-seeking, not just by creating value for society as a whole.

At the lower end of the economic scale, Stiglitz acknowledges that structural economic changes have hurt many workers. The decline of manufacturing and the increased skill requirements of many jobs have decreased demand for unskilled workers, while globalization has increased the supply of such workers available to capital. In theory, displaced or low-wage labor should flow toward more productive uses, so that income or job losses are temporary. But the private market hasn’t done very well creating such new opportunities. The business leaders who are supposed to be the “job creators” seem more eager to downsize, cut wages and destroy unions than to invest in activities that would employ more workers. Part of the problem is that so many of the things America needs to do involve the creation of “public goods,” which private companies don’t find it profitable to produce. Some public goods aren’t marketable commodities at all, such as clean air (since you can’t charge people for breathing), while others can be commodified only when sold to those who can afford them, such as private education or private health insurance. But many things are good for society whether individuals can afford them or not, such as public education, public health insurance, law enforcement, infrastructure, and basic research. The private market tends to underinvest in such things, and the rich may resist public investments because that often means taxing the rich to benefit the needy. The poor are hurt both by inadequate job creation and by difficulties improving their human capital due to inadequate education and health care. Their struggles to make ends meet, including sending both fathers and mothers into the labor force to compensate for low wages, also interfere with providing stable homes and preparing their children for success. Extreme income inequality thus undermines economic opportunity and social mobility.

Economic inequality also impedes economic growth by limiting the aggregate demand for goods and services. Some of society’s wealth needs to be controlled by people who can afford to save and invest it, to provide capital for economic expansion. But in recent years, the economy has suffered from underutilized capital because of insufficient product demand. The economy would be in better balance if the rich had less to save, and the rest of society had more to spend. “It is perhaps no accident that this crisis, like the Great Depression, was preceded by large increases in inequality: when money is concentrated at the top of society, the average American’s spending is limited, or at least that would be the case in the absence of some artificial prop, which, in the years before the crisis, came in the form of a housing bubble fueled by Fed policies.” Families compensated for low wages by going heavily into debt, especially to acquire housing and educations. Predatory lenders made excessive profits by “taking advantage of the least educated and financially unsophisticated in our society by selling them costly mortgages and hiding details of the fees in fine print incomprehensible to most people.” They quickly sold the shaky loans to others so they wouldn’t be hurt by any defaults, and investment banks bundled them into overrated securities to be sold to unsuspecting investors. The bursting of the housing bubble almost brought down the entire financial system. Another form of predation was by for-profit schools that collected student loan money and provided little real education in return. The banks could charge interest in excess of the actual risks they took (since the government backed many of the loans and federal law made students liable for them even if they went bankrupt). The extraordinary growth of the financial sector was due partly to rent-seeking, an unearned transfer of wealth from the bottom to the top, rather than to fairly rewarded service to customers. [For other examples, see John Bogle’s critique of the mutual fund industry in The Battle for the Soul of Capitalism and William Black’s account of the savings & loan scandal in The Best Way to Rob a Bank Is to Own One.]

This side of Stiglitz’s analysis concerns the market inefficiencies that allow more inequality than is necessary to reward productive activity. The excessive inequality then undermines social mobility, aggregate demand, investment in public goods, and economic growth in general. One very interesting research finding is that low wages at the bottom hurt productivity more than exorbitant wages at the top help it. Low-level workers can be demoralized and alienated by their wages and working conditions, while higher-level workers may receive intrinsic benefits that make additional financial incentives like bonuses or merit pay unnecessary. Traditional economic theory assumes that each worker is a calculating individual motivated only by extrinsic rewards, and that inequalities of reward serve to optimize productivity, but more recent research and theory challenges those assumptions. Similarly, economists have argued that the market should work against discrimination, since it is in the employer’s interest to employ and promote the most talented workers, especially those whose wage expectations are depressed by discrimination by other employers. That may make sense if discrimination is merely an individual failure of rationality, but not if it’s an institutionalized tradition that is enforced by an entire dominant group and that actually damages the human capital development of the subordinate group. In the United States, entrenched inequalities have an ugly racial and gender aspect to them that makes them especially hard to rationalize.

The other side of Stiglitz’s analysis concerns the role of the government in either alleviating or aggravating the inefficiencies and inequalities of economic markets. He believes that recent government failures in this respect are another big reason for the country’s problems. “What is striking about the United States is that while the level of inequality generated by the market–a market shaped and distorted by politics and rent seeking–is higher than in other advanced industrial countries, it does less to temper this inequality through tax and expenditure programs.” That’s the topic for the next post.


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