The Price of Inequality: How Today's Divided Society Endangers Our Future (15 page)

As the wealthy get wealthier, they have more to lose from attempts to restrict rent seeking and redistribute income in order to create a fairer economy, and they have more resources with which to resist such attempts. It might seem strange that as inequality has increased we have been doing less to diminish its impact, but it’s what one might have expected. It’s certainly what one sees around the world: the more egalitarian societies work harder to preserve their social cohesion; in the more unequal societies, government policies and other institutions tend to foster the persistence of inequality. This pattern has been well documented.
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Justifying inequality

We began the chapter by explaining how those at the top have often sought to justify their income and wealth, and how “marginal productivity theory,” the notion that those who got more did so because they had made a greater contribution to society, had become the prevailing doctrine, at least in economics. But we noted, too, that the crisis had cast doubt on this theory.
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Those who perfected the new skills of predatory lending, who helped create derivatives, described by the billionaire Warren Buffett as “financial weapons of mass destruction,”
or who devised the reckless new mortgages that brought about the subprime mortgage crisis walked away with millions, sometimes hundreds of millions, of dollars.
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But even before that, it was clear that the link between pay and societal contribution was, at best, weak. As we noted earlier, the great scientists who have made discoveries that provided the basis of our modern society have typically reaped for themselves no more than a small fraction of what they have contributed, and received a mere pittance compared with the rewards reaped by the financial wizards who brought the world to the brink of ruin.

But there is a deeper philosophical point: one can’t really separate out any individual’s contributions from those of others. Even in the context of technological change, most inventions entail the synthesis of preexisting elements rather than invention de novo. Today, at least in many critical sectors, a large fraction of all advances depend on basic research funded by the government.

Gar Alperovitz and Lew Daly concluded in 2009 that “if much of what we have comes to us as the free gift of many generations of historical contribution, there is a profound question as to how much can reasonably be said to be ‘earned’ by any one person, now or in the future.”
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So too, the success of any businessperson depends not just on this “inherited” technology but on the institutional setting (the rule of law), the existence of a well-educated workforce, and the availability of good infrastructure (transportation and communications).

Is inequality necessary to give people incentives?

Another argument is often proffered by those who defend the status quo: that we need the current high level of inequality to give people incentives to work, save, and invest. This confuses two positions. One is that we should have no inequality. The other is that we would be better-off if we had less inequality than we have today. I and, as far as I know, most progressives—do not argue for full equality. We realize that that would weaken incentives. The question is, How seriously would incentives be weakened if we had a little bit less inequality? In the next chapter, I will explain why, to the contrary, less inequality would actually enhance productivity.

Of course, much of what is called incentive pay isn’t really that. It’s just a name given it to justify the huge inequality, and to delude the innocent to think that without such inequality our economic system wouldn’t work. That was made evident when, in the aftermath of the financial debacle of 2008, the banks were so embarrassed about calling what they paid their executives “performance bonuses” that they felt compelled to change the name to “retention bonus” (even if the only thing being retained was bad performance).

Under incentive compensation schemes, pay is supposed to increase with performance. What the bankers did was common practice: when there was a decline in
measured
performance according to the yardsticks that were supposed to be used to determine compensation, the compensation system changed. The effect was that, in practice, pay was high when performance was good, and pay was high when performance was bad.
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Parsing out the sources of inequality

Economists are prone to quibble about the relative importance of various factors leading to America’s growing inequality. Increasing inequality in wages and capital income and an increasing share of income going to those forms of income that are more unequally distributed contributed to greater inequality in market income, and, as we saw earlier in the chapter, less progressive tax and expenditure policies contributed to an even larger increase in after-tax and transfer income.

The explanation for the increase in dispersion of wages and salaries has been particularly contentious. Some focus on changes in technology—skill-biased technological change. Others on social factors—the weakening of unions, the breakdown of social norms restraining executive pay. Still others focus on globalization. Some focus on the increasing role of finance. Strong vested interests inform each of these explanations: those fighting to open up markets see globalization as playing a minor role; those arguing for stronger unions see the weakening of unions as central. Some of the debates have to do with the different aspects of inequality that are being focused upon: the increasing role of finance may have little to do with the polarization of wages in the middle, but a great deal to do with the increases of income and wealth at the top. At different times, different forces have played different roles: globalization has probably played a more important role since, say, 2000 than it did in the preceding decade. Still, there is a growing consensus among economists that it is hard to parse out cleanly and precisely the roles of different forces. We can’t conduct controlled experiments, to see what inequality would have been if, keeping everything else the same, we had had stronger unions. Moreover, the forces interact: the competitive forces of globalization—the threat of jobs moving elsewhere—has been important in weakening unions.
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To me, much of this debate is beside the point. The point is that inequality in America (and some other countries around the world) has grown to where it can no longer be ignored. Technology (skill-biased technological change) may be central to certain aspects of our current inequality problem, especially to the polarization of the labor market. But even if that is the case, we don’t have to sit idly by and accept the consequences. Greed may be an inherent part of human nature, but that doesn’t mean there is nothing we can do to temper the consequences of unscrupulous bankers who would exploit the poor and engage in anticompetitive practices. We can and should regulate banks, forbid predatory lending, make them accountable for their fraudulent practices, and punish them for abuses of monopoly power. So too, stronger unions and better education might mitigate the consequences of skill-biased technological change. And it’s not even inevitable that technological change continues in this direction: making firms pay for the environmental consequences of their production might encourage firms to shift away from skill-biased technological change to resource-saving technological change. Low interest rates may encourage firms to robotize, replacing unskilled jobs that can easily be routinized; so alternative macroeconomic and investment policies could slow the pace of the deskilling of our economy. So too, while economists may disagree about the precise role that globalization has played in the increase in inequality, the
asymmetries
in globalization to which we call attention put workers at a particular disadvantage; and we can manage globalization better, in ways that might lead to less inequality.

We have also noted how the growth in the financial sector as a share of total U.S. income (sometimes referred to as the increased financialization of the economy) has contributed to increased inequality—to both the wealth created at the top and the poverty at the bottom. Jamie Galbraith has shown that countries with larger financial sectors have more inequality, and the link is not an accident.
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We have seen how deregulation and hidden and open government subsidies distorted the economy, not only leading to a larger financial sector but also enhancing its ability to move money from the bottom to the top. We don’t have to know precisely the fraction of inequality that should be attributed to the increased financialization of the economy to understand that a change in policies is needed.

Each of the factors that have contributed to inequality has to be addressed, with especial emphasis on those that simultaneously contribute
directly
to the weakening of our economy, such as the persistence of monopoly power and of distortionary economic policies. Inequality has become ingrained in our economic system, and it will take a comprehensive agenda—described more fully in chapter 10—to uproot it.

Alternative models of inequality

In this chapter, we have explained that there are alternative theories of inequality, in some of which inequality seems more ”justified,” the income of those at the top more deserved, and the costs of checking the inequality and redistribution greater than others. The “achievement” model of income determination focuses on the efforts of each individual; and if inequality were largely the result of differences in effort, it would be hard to fault it, and it would seem unjust, and inefficient, not to reward it. The Horatio Alger stories that we described in chapter 1 belong to this tradition: in the more than a hundred tales of rags to riches, it was by dint of the individual’s own efforts that the hero of each tale pulled himself out of poverty. They may contain a grain of truth, but it is only a grain. We saw in chapter 1 that the major determinant of an individual’s success was his initial conditions—the income and education of his parents. Luck also plays an important role.

The central thesis of this chapter and the preceding one is also that inequality is not just the result of the forces of nature, of abstract market forces. We might like the speed of light to be faster, but there is nothing we can do about it. But inequality is, to a very large extent, the result of government policies that shape and direct the forces of technology and markets and broader societal forces. There is in this a note of both hope and despair: hope because it means that this inequality is not inevitable, and that by changing policies we can achieve a more efficient and a more egalitarian society; despair because the political processes that shape these policies are so hard to change.

There is one source of inequality, especially at the bottom, about which this chapter has had little to say: as this book goes to press, we are still in the worst economic downturn since the Great Depression. Macro-mismanagement, in all of its guises, is a major source of inequality. The unemployed are more likely to join those in poverty, the more so, the longer the economic downturn. The bubble gave a few of the poor an illusion of wealth, but only for a moment; as we have seen, when the bubble burst, it wiped out the wealth of those at the bottom, creating new levels of wealth inequality and heightening the fragility of those at the bottom. Chapter 9 will lay out how the macroeconomic (and especially monetary) policies that the United States and many other countries pursued reflected the interests and ideologies of the top.

Another theme of this book is that of “adverse dynamics,” “vicious circles.” We saw in the last chapter how greater inequality led to less equality of opportunity, leading in turn to more inequality. In the next chapter, we’ll see some further examples of downward spirals—how more inequality undermines support for collective action, the kinds of actions that ensure that everyone lives up to his or her potential, as a result, for instance, of good public schools. We’ll explain how inequality fosters instability, which itself gives rise to more inequality.

C
HAPTER
F
OUR

WHY IT MATTERS

W
E SAW IN CHAPTER
1
THAT THE AMERICAN ECONOMY
has not been delivering for most citizens for years, even though, with the exception of 2009, GDP per capita has been increasing. The reason is simple: growing inequality, an increasing gap between the top and the rest. We saw in chapter 2 that one of the reasons that the top has done so well is
rent seeking
—which entails seizing a larger share of the pie and, in doing so, making the size of the pie smaller than it otherwise would be.

We are paying a high price for our large and growing inequality, and because our inequality is likely to continue to grow—unless we do something—the price we pay is likely to grow too. Those in the middle, and especially those at the bottom, will pay the highest price, but our country as a whole—our society, our democracy—also will pay a very high price.

Widely unequal societies do not function efficiently, and their economies are neither stable nor sustainable in the long term. When one interest group holds too much power, it succeeds in getting policies that benefit itself, rather than policies that would benefit society as a whole. When the wealthiest use their political power to benefit excessively the corporations they control, much-needed revenues are diverted into the pockets of a few instead of benefiting society at large.

But the rich do not exist in a vacuum. They need a functioning society around them to sustain their position and to produce income from their assets. The rich resist taxes, but taxes allow society to make investments that sustain the country’s growth. When little money is invested in education, for lack of tax revenues, schools do not produce the bright graduates that companies need to prosper. Taken to its extreme—and this is where we are now—this trend distorts a country and its economy as much as the quick and easy revenues of the extractive industry distort oil- or mineral-rich countries.

We know how these extremes of inequality play out because too many countries have gone down this path before. The experience of Latin America, the region of the world with the highest level of inequality,
1
foreshadows what lies ahead. Many of the countries were mired in civil conflict for decades, suffered high levels of criminality and social instability. Social cohesion simply did not exist.

This chapter explains the reasons why an economy like America’s, in which most citizens’ wealth has fallen, median incomes have stagnated, and many of the poorest citizens have been doing worse year after year, is not likely to do well over the long haul. We will look first at the effects of inequality on national output and economic stability, then at its impact on economic efficiency and on growth. The effects are multiple and occur through a number of channels. Some are caused by the increase in poverty; others can be attributed to the evisceration of the middle class, still more to the growing disparity between the 1 percent and the rest of us. Some of these effects arise through traditional economic mechanisms, while others are the consequence of inequality’s broader impact on our political system and society.

We’ll also examine the fallacious ideas that inequality is good for growth, or that doing anything about inequality—like raising taxes on the rich—would harm the economy.

I
NSTABILITY AND
O
UTPUT

It is perhaps no accident that this crisis, like the Great Depression, was preceded by large increases in inequality:
2
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. The housing bubble created a consumption boom that gave the appearance that everything was fine. But as we soon learned, it was only a temporary palliative.

Moving money from the bottom to the top lowers consumption because higher-income individuals consume a smaller proportion of their income than do lower-income individuals (those at the top save 15 to 25 percent of their income, those at the bottom spend all of their income).
3
The result: until and unless something else happens, such as an increase in investment or exports, total demand in the economy will be less than what the economy is capable of supplying—and that means that there will be unemployment. In the 1990s that “something else” was the tech bubble; in the first decade of the twentieth-first century, it was the housing bubble. Now the only recourse is government spending.

Unemployment can be blamed on a deficiency in aggregate demand (the total demand for goods and services in the economy, from consumers, from firms, by government, and by exporters); in some sense, the entire shortfall in aggregate demand—and hence in the U.S. economy—today can be blamed on the extremes of inequality. As we’ve seen, the top 1 percent of the population earns some 20 percent of U.S. national income. If that top 1 percent saves some 20 percent of its income, a shift of just 5 percentage points to the poor or middle who do not save—so the top 1 percent would still get 15 percent of the nation’s income—would increase aggregate demand
directly
by 1 percentage point. But as that money recirculates, output would actually increase by some 1½ to 2 percentage points.
4
In an economic downturn such as the current one, that would imply a decrease in the unemployment rate of a comparable amount. With unemployment in early 2012 standing at 8.3 percent, this kind of a shift in income could have brought the unemployment rate down close to 6.3 percent. A broader redistribution, say, from the top 20 percent to the rest, would have brought down the unemployment further, to a more normal 5 to 6 percent.

There’s another way of seeing the role of growing inequality in weakening macroeconomic performance. In the last chapter, we observed the enormous decline in the wage share in this recession; the decline amounted to more than a half trillion dollars a year.
5
That’s an amount much greater than the value of the stimulus package passed by Congress. That stimulus package was estimated to reduce unemployment by 2 to 2½ percentage points. Taking money away from workers has, of course, just the opposite effect.

Since the time of the great British economist John Maynard Keynes, governments have understood that when there is a shortfall of demand—when unemployment is high—they need to take action to increase either public or private spending. The 1 percent has worked hard to restrain government spending. Private consumption is encouraged through tax cuts, and that was the strategy undertaken by President Bush, with three large tax cuts in eight years. It didn’t work. The burden of countering weak demand has thus been placed on the U.S. Federal Reserve, whose mandate is to maintain low inflation, high growth, and full employment. The Fed does this by lowering interest rates and providing money to banks, which, in normal times, lend it to households and firms. The greater availability of credit at lower interest rates often spurs investment. But things can go wrong. Rather than spurring
real
investments that lead to higher long-term growth, the greater availability of credit can lead to bubbles. A bubble can lead households to consume in an unsustainable way, on the basis of debt. And when a bubble breaks, it can bring on a recession. While it is not inevitable that policy makers will respond to the deficiency in demand brought about by the growth in inequality in ways that lead to instability and a waste of resources, it happens often.

How the government’s response to weak demand from inequality led to a bubble and even more inequality

For instance, the Federal Reserve responded to the 1991 recession with low interest rates and the ready availability of credit, helping to create the tech bubble, a phenomenal increase in the price of technology stocks accompanied by heavy investment in the sector. There was, of course, something
real
underlying that bubble—technological change, brought about by the communications and computer revolution. The Internet was rightly judged to be a transformative innovation. But the irrational exuberance on the part of investors went well beyond anything that could be justified.

Inadequate regulation, bad accounting, and dishonest and incompetent banking also contributed to the tech bubble. Banks famously had touted stocks that they knew were “dogs.” “Incentive” pay provided CEOs with incentives to distort their accounting, to show profits that were far larger than they actually were. The government could have reined this in by regulating the banks, by restricting incentive pay, by enforcing better accounting standards, and by requiring higher margins (the amount of cash that investors have to put down when they buy stock). But the beneficiaries of the tech bubble—and especially the corporate CEOs and the banks—didn’t want the government to intervene: there was a party going on, and it was a party that lasted for several years. They also believed (correctly, as it turned out) that somebody else would clean up the mess.

But the politicians of the era were also beneficiaries of the bubble. This irrational investment demand during the tech boom helped to offset the otherwise weak demand created by the high inequality, making the Bill Clinton era one of
seeming
prosperity. Tax revenues from capital gains and other income generated by the bubble even gave the appearance of fiscal soundness. And, to some extent, the administration could claim “credit” for what was going on: Clinton’s policies of financial market deregulation and cuts to capital gains tax rates (increasing the returns to speculating on the tech stocks) added fuel to the fire.
6

When the tech bubble finally burst, the demand by firms (especially technology firms) for more capital diminished markedly. The economy went into recession. Something else would have to rekindle the economy. George W. Bush succeeded in getting a tax cut targeted at the rich through Congress. Much of the tax cut benefited the very rich: a cut in the rate on dividends, which was reduced from 35 percent to 15 percent, a further cut in capital gains tax rates, from 20 percent to 15 percent, and a gradual elimination of the estate tax.
7
But because, as we have noted, the rich save so much of their income, such a tax cut provided only a limited stimulus to the economy. Indeed, as we discuss next, the tax cuts had even some perverse effects.

Corporations, realizing that the dividend tax rate was unlikely to remain so low, had every incentive to pay out as much as they felt that they could do safely—without jeopardizing too much the future viability of the firm. But that meant smaller cash reserves left on hand for any investment opportunities that came along. Investment, outside of real estate, actually fell,
8
contrary to what some on the right had predicted.
9
(Part of the reason for the weak investment, of course, was that during the tech bubble many firms had
overinvested.
) By the same token, the cut in the estate tax may have discouraged spending; the rich could now safely stow away more money for their children and grandchildren, and they had less incentive to give away money to charities that would have spent the money on good causes.
10

Strikingly, the Fed and its chairman at the time, Alan Green-span, didn’t learn the lessons of the tech bubble. But this was in part because of the politics of “inequality,” which didn’t allow alternative strategies that could have resuscitated the economy without creating another bubble, such as a tax cut to the poor or increased spending on badly needed infrastructure. This alternative to the reckless path the country took was anathema to those who wanted to see a smaller government—one too weak to engage in progressive taxation or redistributive policies. Franklin Delano Roosevelt had tried these policies in his New Deal, and the establishment pilloried him for it. Instead, low interest rates, lax regulations, and a distorted and dysfunctional financial sector came to the rescue of the economy—for a moment.

The Fed engineered, unintentionally, another bubble, this one temporarily more effective than the last but in the long run more destructive. The Fed’s leaders didn’t see it as a bubble, because their ideology, their belief that markets were always efficient, meant that there
couldn’t
be a bubble. The housing bubble was more effective because it induced spending not just by a few technology companies but by tens of millions of households that thought that they were richer than they were. In one year alone, close to a trillion dollars were taken out in home equity loans and mortgages, much of it spent on consumption.
11
But the bubble was more destructive partly for the same reasons: it left in its wake tens of millions of families on the brink of financial ruin. Before the debacle is over, millions of Americans will lose their homes, and millions more will face a lifetime of financial struggle.