The Price of Inequality: How Today's Divided Society Endangers Our Future (18 page)

We now consider an altogether different reason why the high inequality makes for a less efficient and productive economy than we could otherwise achieve. People are not like machines. They have to be motivated to work hard. If they feel that they are being treated unfairly, it can be hard to motivate them. This is one of the central tenets of modern labor economics, encapsulated in the efficiency wage theory, which argues that how firms treat their workers—including how much they pay them—affects productivity. It was, in fact, a theory elaborated nearly a century ago by Alfred Marshall, the great economist who wrote in 1895 that “highly paid labour is generally efficient and therefore not dear labour,” though he admitted that “a fact which, though it is more full of hope for the future of the human race than any other that is known to us, will be found to exercise a very complicating influence on the theory of distribution.”
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The revival of this theory began in development economics, where theorists recognized that malnourished workers are less productive.
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But the insight applies as well to more advanced industrial countries, as America discovered in World War II when it found that many recruits were sufficiently malnourished that it might impair their effectiveness in the military. Education scholars have shown that hunger and inadequate nutrition impede learning.
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That’s why school lunch programs are so important. With one of seven Americans facing food insecurity, many poor American children also face impaired learning.

In a modern economy, efficiency is affected not so much by malnutrition as by a host of other factors. The immiseration of the bottom and the middle of the population has forced upon them a host of anxieties: Will they lose their home? Will they be able to give their children an education that will allow them to succeed in life? How will the parents survive in retirement? The more energy that is focused on these anxieties, the less energy there is for productivity at the workplace.

The economist Sendhil Mullainathan and psychologist Eldar Shafir have found evidence from experiments that living under scarcity often leads to choices that exacerbate the conditions of scarcity: “The poor borrow at great cost and stay poor. The busy [the time-poor] postpone when they have little time only to become busier.”
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Results of a very simple survey illustrate the cognitive resources that the poor expend for day-to-day survival and that the better-off do not. In the survey, individuals who have just exited a grocery store are asked what they had spent in total at the store and what the price of a few of the items in their shopping bags were. The poor typically could answer these questions precisely, whereas the nonpoor often did not know. An individual’s cognitive resources are limited. The stress of not having enough money to meet urgent needs may actually impair the ability to take decisions that would help alleviate the situation. The limited stock of cognitive resources is depleted and this can lead people to make irrational decisions.

Stress and anxiety can also impair the acquisition of new skills and knowledge. If that learning is impaired, productivity increases will be slower, and this bodes ill for the long-run performance of the economy.

Equally important in motivating workers is their sense that they are being fairly treated. While it is not always clear what is fair, and people’s judgments of fairness can be biased by their self-interest, there is a growing sense that the present disparity in wages is unfair. When executives argue that wages have to be reduced or that there have to be layoffs in order for corporations to compete, but simultaneously increase their own pay, workers rightly consider that what is going on is unfair. That will affect both their effort today, their loyalty to the firm, their willingness to cooperate with others, and their willingness to invest in its future. As any firm knows, a happier worker is a more productive worker; and a worker who believes that a firm is paying senior employees too much relative to what everyone else receives is not likely to be a happy worker.
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A detailed case study by Krueger and Mas of the plants that manufactured Bridgestone/Firestone tires provides a particularly chilling illustration. After a profitable year management demanded moving from an eight-hour to a twelve-hour shift, which would rotate between days and nights, and cutting pay for new hires by 30 percent. The demand created the conditions that led to the production of many defective tires. Defective tires were related to over one thousand fatalities and injuries until the recall of Firestone tires in 2000.
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In Russia under communism, the widespread sense by workers that they were not being adequately paid played a major role in the collapse of their economy. As the old Russian adage had it, “They pretended to pay us, and we pretended to work.”

Recent experiments in economics have confirmed the importance of fairness. One experiment showed that raising wages of workers who felt that they were being treated unfairly had a substantial effect on productivity—and no effect on those who felt they were being treated fairly. Or take another situation, involving a group of workers performing a similar job. One might have expected that increasing the wages of some and lowering that of others would increase productivity of the higher-wage worker, and lower that of the lower-wage workers in offsetting ways. But economic theory—confirmed by the experiments—holds that the decrease in productivity of the low-wage worker is greater than the increase in productivity of the high-wage worker, so total productivity diminishes.
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Consumerism

We have described how inequality adversely affects the economy’s growth and efficiency—and societal well-being, in both the short and the long run—through a variety of what might be viewed as
economic
mechanisms, reinforced and shaped by politics and public policy. But there are deeper, distorting effects of inequality on our society. Trickle-down economics may be a chimera, but trickle-down behaviorism is very real. People below the top 1 percent increasingly aspire to imitate those above them. Of course, for those at the very bottom, living like the wealthiest 1 percent is unimaginable. But for those in the second percentile, the 1 percent provides an aspiration, for those in the third percentile, the second percentile provides an aspiration, and so on down the line.

Economists talk about the importance of “relative income” and relative deprivation. What matters (for an individual’s sense of well-being, for instance) is not just an individual’s absolute income, but his income relative to that of others.
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The importance of relative income in developed countries is so great that it is a completely unsettled question among economists whether there is
any
long-run relationship between GDP growth and subjective well-being in those countries.
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Individuals’ concerns with their consumption relative to that of others—the problem of “keeping up with the Joneses”—helps explain why so many Americans live beyond their means—and why so many work so hard and so long.

Many years ago Keynes posed a question. For thousands of years, most people had to spend most of their time working just to survive—for food, clothing, and shelter. Then, beginning with the Industrial Revolution, unprecedented increases in productivity meant that more and more individuals could be freed from the chains of subsistence living. For increasingly large portions of the population, only a small fraction of their time was required to provide for the necessities of life. The question was, How would people spend the productivity dividend?
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The answer was not obvious. They could decide to enjoy more and more leisure, or they could decide to enjoy more and more goods. Economic theory provides no clear prediction, though one might have assumed that reasonable people would have decided to enjoy both more goods and more leisure. That is what happened in Europe. But America took a different turn—less leisure (per household, as women joined the labor force) and more and more goods.

America’s high inequality—and individuals’ sensitivity to others’ consumption—may provide an explanation. It may be that we are working more to maintain our consumption relative to others, and that this is a rat race, which is individually rational but futile in terms of the goal that it sets for itself. Adam Smith pointed out that possibility 250 years ago: in “this general scramble for preeminence, when some get up, others must necessarily fall undermost.”
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While there is no “right” answer to Keynes’s question according to standard economic theory, there is something disturbing about America’s answer.
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Individuals say they are working so hard
for the family,
but as they work so hard there is less and less time for the family, and family life deteriorates. Somehow, the means prove inconsistent with the stated end.

T
HE
A
LLEGED
I
NEQUALITY
E
FFICIENCY
T
RADE-
O
FF

In the previous pages, I explained how inequality—in all of its dimensions—has been bad for our economy. As we saw in earlier chapters, there is also a counternarrative, advanced primarily by those on the political right, which focuses on incentives. In this view incentives are essential for making an economy work, and inequality is the inevitable consequence of any incentive system, since some will produce more than others. Any program of redistribution will accordingly necessarily attenuate incentives. Proponents of this view argue, too, that it is wrong to fixate on the inequality of outcomes, particularly in any single year. What matters is lifetime inequality, and what matters even more is opportunity. They then maintain that there is a trade-off between efficiency and equality. While different people may differ in how much efficiency one would be willing to give up to get more equality, in the view of the Right the price we have to pay for any more equality in America is just too great. Indeed, it’s so high that even the middle and the bottom, especially those who depend on government programs, would likely suffer; with a weaker economy, incomes for all would be down, tax revenues would be lower, and government programs would have to be cut.

We have argued in this chapter, to the contrary, that we could have a more efficient and productive economy with more equality. In this section, I recap the essential points of divergence: The Right has in mind a perfectly competitive economy with private rewards equal to social returns; we see an economy marked by rent seeking and other distortions. The Right underestimates the need for public (collective) action, to correct pervasive market failures. It overestimates the importance of financial incentives. And, as a result of all of these mistakes, the Right overestimates the costs and underestimates the benefits of progressive taxation.

Rent seeking and the
inequality/efficiency trade-off

A central thesis of this book is that rent seeking is pervasive in the American economy, and that it actually impairs overall economic efficiency. The large gaps between private rewards and social returns that characterize a rent-seeking economy mean that incentives that individuals face often misdirect their actions, and that those who receive high rewards are not necessarily those who have made the largest contributions. In those instances where private rewards of those at the top exceed by a considerable amount their marginal social contribution, redistribution could both reduce inequality and increase efficiency.
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Making markets work better, by aligning the two and reducing the scope for rent seeking, and by correcting other market failures, whose effects are especially hard felt at the bottom and in the middle, would also simultaneously reduce inequality and increase efficiency—just the opposite of what the Right contends.

Market failures and the
inequality/efficiency trade-off

The Right has underestimated the importance of other imperfections in our economy: if capital markets were perfect, then each individual would be able to invest in himself up to the point where additional returns equal the cost of capital. But capital markets are far from perfect. Individuals do not have easy access to capital and cannot divest themselves of risk.

A lack of wealth restricts families’ opportunities to be productive in a variety of ways. It reduces their ability to invest in their children, to become homeowners and thereby participate in the financial rewards of improving their neighborhoods, and to offer collateral that can credibly show lenders that the uses to which they will put borrowed funds are sound—which is useful for obtaining bank credit on affordable terms.

Wealth in the form of collateral plays a kind of catalytic role rather than a role of input that gets used up in the process of producing output.
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The most important consequence of these imperfections is that in a world in which many families have little or no wealth, and in which only limited educational opportunity is provided by the government, there is underinvestment in human capital.

The result is that, especially without a good public education system, parental wealth (education, income) will be a primary determinant of that of their children. It is not a surprise, then, that America, with its high level of wealth and income inequality, is also a society with a lack of equality of opportunity, as we saw in chapter 1. Increasing equality and equality of opportunity, by the same token, would enhance the nation’s productivity.

There is still another reason why the alleged inequality/inefficiency trade-off may not exist. Risk markets—giving individuals the ability to buy insurance in the private market against the important risks that individuals face, like unemployment—are imperfect and absent; that imposes a huge burden on those with limited resources. Because risk markets are imperfect, in the absence of social protection, individual welfare is lower—and the willingness to undertake high-return and high-risk ventures is lower. Providing better social protection can help create a more dynamic economy.