The Price of Inequality: How Today's Divided Society Endangers Our Future (9 page)

Government never corrects market failures perfectly, but it does a better job in some countries than in others. Only if the government does a reasonably good job of correcting the most important market failures will the economy prosper. Good financial regulation helped the United States—and the world—avoid a major crisis for four decades after the Great Depression. Deregulation in the 1980s led to scores of financial crises in the succeeding three decades, of which America’s crisis in 2008–09 was only the worst.
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But those governmental failures were no accident: the financial sector used its political muscle to make sure that the market failures were
not
corrected, and that the sector’s private rewards remained well in excess of their social contributions—one of the factors contributing to the bloated financial sector and to the high levels of inequality at the top.

Shaping markets

We’ll describe below some of the ways that private financial firms act to ensure that markets
don’t work well.
For instance, as Smith noted, there are incentives for firms to work to reduce market competition. Moreover, firms also strive to make sure that there are no strong laws prohibiting them from engaging in anticompetitive behavior or, when there are such laws, that they are not effectively enforced. The focus of businesspeople is, of course, not to enhance societal well-being broadly understood, or even to make markets more competitive: their objective is simply to make markets work
for them
, to make them more profitable. But the consequence is often a less efficient economy marked by greater inequality. For now, one example will suffice. When markets are competitive, profits above the normal return to capital cannot be sustained. That is so because if a firm makes greater profits than that on a sale, rivals will attempt to steal the customer by lowering prices. As firms compete vigorously, prices fall to the point that profits (above the normal return to capital) are driven down to zero, a disaster for those seeking big profits. In business school we teach students how to recognize, and create, barriers to competition—including barriers to entry—that help ensure that profits won’t be eroded. Indeed, as we shall shortly see, some of the most important innovations in business in the last three decades have centered not on making the economy more efficient but on how better to ensure monopoly power or how better to circumvent government regulations intended to align social returns and private rewards.

Making markets less transparent is a favorite tool. The more transparent markets are, the more competitive they are likely to be. Bankers know this. That’s why banks have been fighting to keep their business in writing derivatives, the risky products that were at the center of AIG’s collapse,
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in the shadows of the “over the counter” market. In that market, it’s difficult for customers to know whether they’re getting a good deal. Everything is negotiated, as opposed to how things work in more open and transparent modern markets. And since the sellers are trading constantly, and buyers enter only episodically, sellers have more information than buyers, and they use that information to their advantage. This means that on average, sellers (the writers of the derivatives, the banks) can extract more money out of their customers. Well-designed open auctions, by contrast, ensure that goods go to those who value them the most, a hallmark of efficiency. There are publicly available prices for guiding decisions.

While lack of transparency results in more profits for the bankers, it leads to lower economic performance. Without good information, capital markets can’t exercise any discipline. Money won’t go to where returns are highest, or to the bank that does the best job of managing money. No one can know the true financial position of a bank or other financial institution today—and shadowy derivative transactions are part of the reason. One would have hoped that the recent crisis might have forced change, but the bankers resisted. They resisted demands, for instance, for more transparency in derivatives and for regulations that would restrict anticompetitive practices. These rent-seeking activities were worth tens of billions of dollars in profits. Although they didn’t win every battle, they won often enough that the problems are still with us. In late October 2011, for instance, a major American financial firm
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went bankrupt (the eighth-largest bankruptcy on record), partly because of complex derivatives. Evidently the market hadn’t seen through these transactions, at least not in a timely way.

Moving money from the bottom
of the pyramid to the top

One of the ways that those at the top make money is by taking advantage of their market and political power to favor themselves, to increase their own income, at the expense of the rest.

The financial sector has developed expertise in a wide variety of forms of rent seeking itself. We’ve already mentioned some, but there are many others: taking advantage of asymmetries of information (selling securities that they had designed to fail, but knowing that buyers didn’t know that);
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taking excessive risk—with the government holding a lifeline, bailing them out and assuming the losses, the knowledge of which, incidentally, allows them to borrow at a lower interest rate than they otherwise could; and getting money from the Federal Reserve at low interest rates, now almost zero.

But the form of rent seeking that is most egregious—and that has been most perfected in recent years—has been the ability of those in the financial sector to take advantage of the poor and uninformed, as they made enormous amounts of money by preying upon these groups with predatory lending and abusive credit card practices.
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Each poor person might have only a little, but there are so many poor that a little from each amounts to a great deal. Any sense of social justice—or any concern about overall efficiency—would have led government to prohibit these activities. After all, considerable amounts of resources were used up in the process of moving money from the poor to the rich, which is why it’s a negative-sum game. But government didn’t put an end to these kind of activities, not even when, around 2007, it became increasingly apparent what was going on. The reason was obvious. The financial sector had invested heavily in lobbying and campaign contributions, and the investments had paid off.

I mention the financial sector partly because it has contributed so powerfully to our society’s current level of inequality.
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The financial sector’s role in creating the crisis in 2008–09 is apparent to all. Not even those who work in the sector deny it, though each believes that some other part of the financial sector is really to blame. Much of what I have said about the financial sector, though, could be said about other players in the economy that have had a hand in creating current inequities.

Modern capitalism has become a complex game, and those who win at it have to have more than a little smarts. But those who win at it often possess less admirable characteristics as well: the ability to skirt the law, or to shape the law in their own favor; the willingness to take advantage of others, even the poor; and to play
unfair
when necessary.
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As one of the successful players in this game put it, the old adage “Win or lose, what matters is how you play the game” is rubbish.
All that matters is whether you win or lose.
The market provides a simple way of showing that—the amount of money that you have.

Winning in the game of rent seeking has made fortunes for many of those at the top, but it is not the only means by which they obtain and preserve their wealth. The tax system also plays a key role, as we’ll see later. Those at the top have managed to design a tax system in which they pay less than their fair share—they pay a lower fraction of their income than do those who are much poorer. We call such tax systems regressive.

And while regressive taxes and rent seeking (which takes money from the rest of society and redistributes it to the top) are at the core of growing inequality, especially at the top, broader forces exert particular influence on two other aspects of American inequality—the hollowing out of the middle class and the increase in poverty. Laws governing corporations interact with the norms of behavior that guide the leaders of those corporations and determine how returns are shared among top management and other stakeholders (workers, shareholders, and bondholders). Macroeconomic policies determine the tightness of the labor market—the level of unemployment, and thus how market forces operate to change the share of workers. If monetary authorities act to keep unemployment high (even if because of fear of inflation), then wages will be restrained. Strong unions have helped to reduce inequality, whereas weaker unions have made it easier for CEOs, sometimes working with market forces that they have helped shape, to increase it. In each arena—the strength of unions, the effectiveness of corporate governance, the conduct of monetary policy—politics is central.

Of course, market forces, the balancing of, say, the demand and supply for skilled workers, affected as it is by changes in technology and education, play an important role as well, even if those forces are partially shaped by politics. But instead of these market forces and politics balancing each other out, with the political process dampening the increase in inequality in periods when market forces might have led to growing disparities, instead of government
tempering
the excesses of the market, in America today the two have been working together to increase income and wealth disparities.

R
ENT
S
EEKING

Earlier, we labeled as
rent seeking
many of the ways by which our current political process helps the rich at the expense of the rest of us. Rent seeking takes many forms: hidden and open transfers and subsidies from the government, laws that make the marketplace less competitive, lax enforcement of existing competition laws, and statutes that allow corporations to take advantage of others or to pass costs on to the rest of society. The term “rent” was originally used to describe the returns to land, since the owner of land receives these payments by virtue of his ownership and not because of anything he
does.
This stands in contrast to the situation of workers, for example, whose wages are compensation for the
effort
they provide. The term “rent” then was extended to include monopoly profits, or monopoly rents, the income that one receives simply from the control of a monopoly. Eventually the term was expanded still further to include the returns on similar ownership claims. If the government gave a company the exclusive right to import a limited amount (a quota) of a good, such as sugar, then the extra return generated as a result of the ownership of those rights was called a “quota-rent.”

Countries rich in natural resource are infamous for rent-seeking activities. It’s far easier to get rich in these countries by gaining access to resources at favorable terms than by producing wealth. This is often a negative-sum game, which is one of the reasons why, on average, such countries have grown more slowly than comparable countries without the bounty of such resources.
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Even more disturbing, one might have thought that an abundance of resources could be used to help the poor, to ensure access to education and health care for all. Taxing work and savings can weaken incentives; in contrast, taxing the “rents” on land, oil, or other natural resources won’t make them disappear. The resources will still be there to be taken out, if not today, then tomorrow. There are no adverse incentive effects. That means that, in principle, there should be ample revenues to finance both social expenditures and public investments—in, say, health and education. Yet, among the countries with the greatest inequality are those with the most natural resources. Evidently, a few within these countries are better at rent seeking than others (usually those with political power), and they ensure that the benefits of the resources accrue largely to themselves. In Venezuela, the richest oil producer in Latin America, half of the country lived in poverty prior to the rise of Hugo Chavez—and it is precisely this type of poverty in the midst of riches that gives rise to leaders like him.
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Rent-seeking behavior is not just endemic in the resource-rich countries of the Middle East, Africa, and Latin America. It has also become endemic in modern economies, including our own. In those economies, it takes many forms, some of which are closely akin to those in the oil-rich countries: getting state assets (such as oil or minerals) at below fair-market prices. It’s not hard to become wealthy if the government sells you for $500 million a mine that’s worth $1 billion.

Another form of rent seeking is the flip side: selling to government products at
above
market prices (noncompetitive procurement). The drug companies and military contractors excel in this form of rent seeking. Open government subsidies (as in agriculture) or hidden subsidies (trade restrictions that reduce competition or subsidies hidden in the tax system) are other ways of getting rents from the public.

Not all rent seeking uses government to extract money from ordinary citizens. The private sector can excel on its own, extracting rents from the public, for instance, through monopolistic practices and exploiting those who are less informed and educated, exemplified by the banks’ predatory lending. CEOs can use their control of the corporation to garner for themselves a larger fraction of the firms’ revenues. Here, though, the government too plays a role, by not doing what it should: by not stopping these activities, by not making them illegal, or by not enforcing laws that exist. Effective enforcement of competition laws can circumscribe monopoly profits; effective laws on predatory lending and credit card abuses can limit the extent of bank exploitation; well-designed corporate governance laws can limit the extent to which corporate officials appropriate for themselves firm revenues.