The Great Inequality Debate - II: What's Wrong With Inequality?

This is the second part of a rather long blog post on economic inequality that I set out to write a couple of weeks ago. The first part dealt with definitions, scope and taxonomy and established key facts and figures pertaining to income inequality. The main take-aways from the first part were: (a) there's a lot of economic inequality all over the world, with some really large gaps in several countries (b) in most of those countries income disparities have been consistently increasing over the last two or three decades, and (c) in the view of many economists, appropriate policy prioritization, imaginative democratic practices and investments in infrastructure and human capital would go a long way to reinvigorate democracies and economies.

In this second part, I get into the "so what" of the first two points above and explore the "how and why" of the third point. These are good questions to ask, because the search for answers to those questions would reveal whether or not inequality has any bearing on the well-being of society as a whole and therefore on sustainability (which, as you may recall from my earlier post, is the focus of my concern). And if indeed it does, then it is useful to know what its impact is and what kind of difference it would make (if any) to humanity as a whole, if we were to try and fix it. So let's start with the "so what" questions and take it from there. There's a lot of inequality? OK, so what? It has been increasing over the last few decades? OK, so what? Short answer: severe (and growing) inequality brings along many risks, and if we can avoid it we should.

Inequality – a global risk

In January this year, the World Economic Forum (WEF) released their "Global Risks 2011" report, which highlights two very basic risks that are broad in scope and deeply interconnected to each other – economic disparity and global governance failures – both of which "influence the evolution of many other global risks and inhibit our capacity to respond effectively to them". Reproduced here below is an excerpt from the Executive Summary (which, incidentally, makes an interesting note of what it calls a 21st century paradox: "as the world grows together, it is also growing apart"):

Globalization has generated sustained economic growth for a generation. It has shrunk and reshaped the world, making it far more interconnected and interdependent. But the benefits of globalization seem unevenly spread – a minority is seen to have harvested a disproportionate amount of the fruits. Although growth of the new champions is rebalancing economic power between countries, there is evidence that economic disparity within countries is growing.  

Issues of economic disparity and equity at both the national and the international levels are becoming increasingly important. Politically, there are signs of resurgent nationalism and populism as well as social fragmentation. There is also a growing divergence of opinion between countries on how to promote sustainable, inclusive growth. 

Appendix 1 of the report lays out the methodology underlying the WEF study. Here's the introductory portion of the opening paragraph:

The Global Risks Survey seeks the opinion of experts, business leaders and policy-makers on a selection of global risks tracked by the World Economic Forum. This is a perception survey which received approximately 580 valid responses across the 37 global risks in five risk categories. Respondents were asked to assess risk likelihood and impact over a ten year time horizon (2010-2020) and also provided their level of confidence in their answers. Respondents also assessed risk interconnections by choosing up to six other risks they judged were related in some way to the risk being assessed. Respondents also had the option to add data on the dominant type of interconnection between risks. Data were analysed using a range of statistical techniques, both descriptive and analytical.

Clearly, economic inequality has been perceived by many business leaders, policy makers and experts, to be one of the two major global risks. The report lists 3 other risks as "risks in focus", of which the first two are what it calls "the macroeconomic imbalances nexus" and "the illegal economy nexus" (both of these are have strong causal linkages with economic disparity and global governance failures). The report analyzes these in detail and tabulates the direct as well as indirect impact of each, on governments, on businesses and on society at large. But the following paragraph gives us a pretty good flavor of what other kinds of risks the respondents to the WEF survey associated with economic inequality:

Economic disparity is tightly interconnected with corruption, demographic challenges, fragile states, global imbalances and asset-price collapse. Respondents perceived economic disparity as influencing chronic diseases, infectious diseases, illicit trade, migration, food (in)security, terrorism and weapons of mass destruction.

As the Wikipedia page on economic inequality informs us, various studies have been carried out on whether inequality can harm societies and if so, how. One study particularly, conducted by Richard Wilkinson (Professor Emeritus of Social Epidemiology at the University of Nottingham and co-founder of The Equality Trust) and Kate Pickett (Professor of Epidemiology at the University of York, a National Institute for Health Research Career Scientist, and co-founder of The Equality Trust), examines in detail the relationship between inequality and the overall levels of happiness, health and well-being within a society.

Equality and happiness: coincidence? correlation? causation?

Here's a video clip from TED Talks, in which Prof. Wilkinson tells us how, among the more developed countries, economic inequality harms societies, and how societies that are less unequal tend to be healthier and happier on the whole. This conclusion is based on research that has been documented in the book "The Spirit Level: Why Equality is Better for Everyone" by Profs. Wilkinson and Pickett. (Prof. Pickett has also presented these findings at the Green Party conference, where she discussed equality and sustainability).

According to the authors, their research found hard evidence to support their conclusions. (More details and access to source data and other resources are available at The Equality Trust website.) However, some critics claimed that Wilkinson and Pickett had got it all wrong. Peter Saunders and Christopher Snowden, in their respective publications – a report by Peter Saunders and a blog by Christopher Snowden (who has also written a book on the subject) – said that the evidence presented by Wilkinson and Pickett was weak, their analysis superficial and most of the correlations in their book did not stand up. Following such sharp criticism that challenged the very basis of their findings, key contentious issues with regard to the data and the methodology were heatedly debated, and responses to the criticisms were promptly issued by Wilkinson and Pickett. The video clip embedded below captures the RSA debate and is worth watching if you have an additional 40 mins. to spare.

Going by the chronology of events (given that the TED Talks video is more recent than the RSA debate), I would imagine that the Wilkinson-Pickett thesis in its present form has resolved critical objections and now provides a higher degree of confidence in the validity of its claims. Prof. Wilkinson's concluding comments in the TED Talks video, suggesting causation rather than correlation, sound like they arise from a stronger conviction, having overcome at least the big "gotchas". Notwithstanding this, different people may react differently to these exposés by critics like Saunders and Snowden, depending on their own unique outlook and disposition. Conservative skeptics may summarily reject the Wilkinson-Pickett thesis in its entirety, in favor of the Saunders-Snowden antithesis, while others may be more selective. Liberal rationalists may accept those parts that stand up to scrutiny (i.e., where the correlations are indisputably strong or where the critics' arguments are weak). Those who favor an intuitive approach may accept correlations of inequality with factors that they feel have a direct linkage, but not others.

Be that as it may, there's the old saying that is better to be safe than sorry. (And this wisdom holds for climate change debates as well.) If one is so inclined, one may take the view that even if income inequality does not impact the well-being of a society as adversely as Wilkinson-Pickett would have us believe, and even if economic disparities don't pose such serious risks as the WEF report points out, it may still be worthwhile to explore avenues to reduce it. But should it be brought down to zero (a Gini coefficient of 0 means everyone has an equal share of income) in order to have a healthy, happy and risk-free world? Probably not, even if that is physically possible to achieve (which I don't think it is). Many hold the view that a certain quantum of inequality is a good thing in a competitive capitalistic economy.

"Good" inequality and "Bad" inequality

In the book "The Haves and the Have-Nots" author Branko Milanović (lead economist in the World Bank's research department) writes: "There is 'good' and 'bad' inequality, just as there is good and bad cholesterol."  (In an interview with CNN Money he discusses this point in more detail, and also touches on other aspects of inequality covered in his book.) The author argues that "the possibility of unequal economic outcomes motivates people to work harder, although at some point it can lead to the preservation of acquired positions, which causes economies to stagnate" (quoted from the New York Times review of his book). His view is echoed by another article at the New York Times, of which relevant excerpts are presented below:

Some inequality may be necessary to encourage investment for growth. But as recent research shows, intense inequality actually stunts growth, making it more difficult for countries to sustain the sort of long economic expansions that have characterized the more prosperous nations of the world.

[...] 

The economists[1] found that income distribution contributes more to the sustainability of economic growth than does the quality of a country’s political institutions, its foreign debt and openness to trade, the level of foreign investment in the economy and whether its exchange rate is competitive. 

It’s not too hard to see why. Extreme inequality blocks opportunity for the poor. It can breed resentment and political instability – discouraging investment – and lead to political polarization and gridlock, splitting the political system into haves and have-nots. And it can make it harder for governments to address economic imbalances and brewing crises. 

So if a little bit of inequality is a good thing, but too much of it is a bad thing, then exactly how much inequality should we have? I haven't (yet) come across a heuristic or a model that could help answer that question (though earlier studies[2] have tried to calibrate that scale and actually put numbers around how much is too much and how little is too little). What I did come across was some interesting research that contrasts Americans' perceptions (of wealth distribution in the U.S.) with the reality, and then also with their projection of the "right" distribution based on their personal judgment. The chart below plots all three – the perceived (estimated), the real (actual) and the projected (ideal) levels of inequality in the U.S. – based on the report published by Dan Ariely and Michael Norton. (Their research also finds mention in a debate on rising inequality in the New York Times, which may provide additional insights.)

Percent wealth owned | Source: "Building a Better America--One Wealth Quintile at a Time" by Ariely & Norton

The abstract of their research paper may help decode this infographic:

Disagreements about the optimal level of wealth inequality underlie policy debates ranging from taxation to welfare. We attempt to insert the desires of "regular" Americans into these debates, by asking a nationally representative online panel to estimate the current distribution of wealth in the United States and to "build a better America" by constructing distributions with their ideal level of inequality. First, respondents dramatically underestimated the current level of wealth inequality. Second, respondents constructed ideal wealth distributions that were far more equitable than even their erroneously low estimates of the actual distribution. Most important from a policy perspective, we observed a surprising level of consensus: All demographic groups – even those not usually associated with wealth redistribution such as Republicans and the wealthy – desired a more equal distribution of wealth than the status quo.

And speaking of how even the wealthy indicated a preference for a more equitable distribution, I am reminded of how, last month, some millionaires demanded their taxes be raised, in support of the Buffett rule. However, these are exceptional individuals. Most wealthy people would rather not pay tax, and instead choose to rely on the "trickle-down" effect to spread the benefits of prosperity. But does it really work that way?

More on perceptions and realities

The trickle-down effect may be more myth than reality, going by what OECD Secretary-General Angel Gurría pointed out while launching the OECD report:

The social contract is starting to unravel in many countries. This study dispels the assumptions that the benefits of economic growth will automatically trickle down to the disadvantaged and that greater inequality fosters greater social mobility. Without a comprehensive strategy for inclusive growth, inequality will continue to rise. 

Then there's the view that inequality spurs competition, which in turn unleashes creativity and innovation. But as Richard Florida (Director of the Martin Prosperity Institute at the University of Toronto's Rotman School of Management, and Senior Editor at The Atlantic) points out in an article, "It is possible to design an economic system that is innovative and competitive, but that causes far less severe socioeconomic divides than we are experiencing today." In the concluding paragraphs he says:

Our analysis has identified the key factors that shape the competitiveness, happiness, well-being and broad prosperity of nations. Countries with greater levels of creativity (measured on the GCI) have higher levels of economic output, entrepreneurship, and overall economic competitiveness. More creative nations also have higher levels of human development, life satisfaction, and happiness. And perhaps most importantly, highly creative nations are less likely on balance to suffer from the deep class divides that beset the U.S. and U.K. The Scandinavian and Northern European countries as well as Japan combine high levels of innovation and creativity with much lower levels of inequality.

[...] 

A high-road path to prosperity is not only possible, it's already working in some of the world's most advanced, competitive and prosperous nations. Economic growth increasingly turns on the full development of each and every single human being. Real sustainable economic prosperity can and must benefit the many, not just the few.

Let's look at another popular belief – that there are trade-offs between equality and efficiency; that efforts in improving equality result in lowering economic growth. Research by economists Andre Berg and Jonathan Ostry of the International Monetary Fund (referred to earlier; see footnote [1] below) re-examines the relationship that was thought to exist between equality and efficiency. Their report opens by asking: "Do societies inevitably face an invidious choice between efficient production and equitable wealth and income distribution? Are social justice and social product at war with one another?" which it answers with a categorical: "In a word, no", and then goes on to explain:

In recent work (Berg, Ostry, and Zettelmeyer, 2011; and Berg and Ostry, 2011), we discovered that when growth is looked at over the long term, the trade-off between efficiency and equality may not exist. In fact equality appears to be an important ingredient in promoting and sustaining growth. The difference between countries that can sustain rapid growth for many years or even decades and the many others that see growth spurts fade quickly may be the level of inequality. Countries may find that improving equality may also improve efficiency, understood as more sustainable long-run growth.

According to the United Nations Research Institute for Social Development (UNRISD) 2010 report, "growth and equity can be mutually reinforcing, but only when supported by well-thought-out economic and social policies." It notes that "while greater equality is often considered to come at the expense of growth, there is also evidence that under some circumstances, and with appropriate institutional arrangements, lower inequality can contribute to greater economic efficiency." The report then goes on to outline the development experience of Scandinavian countries as an illustrative example.

Arguing as to "Why America Should Spread the Wealth", Mark Thoma (a macroeconomist and time-series econometrician at the University of Oregon) examines the effect of the Bush tax cuts on equality and efficiency, and concludes that: 

The claim that there is a tradeoff between equity and efficiency was a key part of the argument for tax cuts for the wealthy, but the tradeoff didn’t materialize. We sacrificed equity for the false promise of efficiency and growth, and society is now more unequal than at any time since the early part of the last century. It’s time to reverse that mistake.

What exactly were those mistakes? How do we reverse them? These are important questions though they end up stirring the pot of political controversy. As Andrés Velasco (former finance minister of Chile and a visiting professor at Columbia University) notes in an article, the "debate about inequality's causes is complex and often messy; the debate about how to address it is messier still."

Probable causes and possible remedies

If we are looking for an analysis of the causes of inequality that is comprehensive while remaining generic and global, the Wikipedia page on inequality that I keep referring to has a section on causes of inequality. Then there's a paper published by the New Economics Foundation (NEF) titled "Why the Rich Are Getting Richer" (which in my opinion is a rather churlish choice of words for a title, though the NEF's credentials are impeccable and their analysis is excellent). While it addresses economic inequality in the U.K., the NEF paper's main findings appear quite generic and applicable to other countries as well.

But, as Andrés Velasco points out, each expert is likely to have their own theories and their own list of causes and remedies. His own proposed solution for example, applicable to Chile and most of South America, focuses on employment opportunities. He explains:

In the rich countries of the global north, the widening gap between rich and poor results from technological change, globalization, and the misdeeds of investment bankers. In the not-so-rich countries of the south, much inequality is the consequence of a more old-fashioned problem: lack of employment opportunities for the poor.

In a forthcoming book, University of Chile economist Cristóbal Huneeus and I examine the roots of inequality in Chile and elsewhere in Latin America and come away with three policy prescriptions: jobs, jobs, jobs.

In a 3 part series of articles for Slate magazine, Robert H. Frank (Professor of Management and Professor of Economics at Cornell University and author of "The Darwin Economy") starts by asking "Does inequality matter?" in Part 1, in which he describes how "expenditure cascades" are squeezing the American middle class, followed by "Why has inequality been growing?" in Part 2, in which he suggests that technology and winner-take-all markets have made the rich much richer, after which he presents in Part 3 "The Progressive Consumption Tax" as a win-win solution for reducing American income inequality.

The WEF report I quoted at the beginning of this post says the following, by way of causes of economic disparities within countries:

Many factors may have contributed to this trend within countries, including the erosion of employment culture, the decline of organized labour, and failures of education systems to keep pace with the increasing demands of the workplace.

Echoing similar thoughts, Angel Gurría's comments while releasing the OECD report clearly call for investment in human capital as the key to unlock the secret to reduction in inequality:

There is nothing inevitable about high and growing inequalities. Our report clearly indicates that upskilling of the workforce is by far the most powerful instrument to counter rising income inequality. The investment in people must begin in early childhood and be followed through into formal education and work.

To quote again from the UNRISD flagship report for 2010, "Income inequality is on the rise, partly as a result of neoliberal economic policies adopted in the 1980s and 1990s." Even a decade ago, when inequality levels were much less (and, of course, the crisis of 2007-8 was still a long way off), a study by the World Institute for Development Economics Research (referred to earlier; see footnote [2] below) notes:

It is clear that there are some common factors causing the widespread surges in inequality around the world. With the exception of worsening educational inequality in Latin America and Sub Saharan Africa, worsening situations in the 'traditional causes' of inequality, such as land concentration, urban bias, abundance of natural resources and inequality in education, are NOT generally responsible. Rather it is 'new causes' that are crucial. These 'new causes' are linked to the excessively liberal economic policy regimes and the rushed manner in which economic reform policies have been carried out.

Speaking about his book "The Price of Civilization" at the University of Oxford, Professor Jeffrey Sachs (Director, The Earth Institute, Columbia University) lists three fundamental shifts in policy initiated by former U.S. President Ronald Reagan that, according to Prof. Sachs, are the main causes of the growth in inequality: (i) tax cuts that mostly favored the wealthy (ii) reduction of government spending on public goods and services that resulted in significant reductions of investment in infrastructure and human capital, and (iii) deregulation of key sectors of the economy, especially of the financial sector.

Nouriel Roubini (Professor of Economics at the Stern School of Business, New York University and co-author of the book "Crisis Economics") writes in "Instability of Inequality"

But the laissez-faire Anglo-Saxon model has also now failed miserably. To stabilize market-oriented economies requires a return to the right balance between markets and provision of public goods. That means moving away from both the Anglo-Saxon model of unregulated markets and the continental European model of deficit-driven welfare states. Even an alternative "Asian" growth model – if there really is one – has not prevented a rise in inequality in China, India, and elsewhere. 

Any economic model that does not properly address inequality will eventually face a crisis of legitimacy. Unless the relative economic roles of the market and the state are rebalanced, the protests of 2011 will become more severe, with social and political instability eventually harming long-term economic growth and welfare.

These are but a few examples of the many criticisms of the Reagan (U.S.) and Thatcher (U.K.) administrations (and other countries that followed suit), that hold their laissez-faire neo-liberal policies responsible for the sharp increase in inequality over the last 3 decades, and argue for more effective government intervention through suitable changes in policy and regulatory reforms that promote equitable and inclusive growth. These, however, are the voices of intellectuals who tend to take a top-down, systemic view in a calm and rational manner. There have been more visceral reactions against these gross disparities in the recent past – other voices that have been vociferously denouncing businesses and governments and their unholy nexus of collusion (I am channeling those voices here) that has left the 99% in the economic doldrums.

Inequality and the Occupy protests

According to many observers, one of the Occupy movement's main accomplishments is to have legitimized discussion of rising income inequality in the United States. Indeed, the very purpose of the "Occupation" was to bring a sense of urgency to issues surrounding gross inequality – framing it as a protest against the top 1% income earners by the bottom 99% drove that point home very clearly.

I am not going to spend too much time and effort in writing about the Occupy protests, since a lot has already been written and said about this by people far more intelligent and better informed than I. Instead, I will quote from what others have said. Let me start by quoting U.S. President Barack Obama, the leader of the free world.

By coincidence, a day after the OECD report (another thing I've been referring to extensively) was released, President Obama, delivered a speech about the U.S. economy in Osawatomie, Kansas. The speech unequivocally asserts that growing inequality is the result of systemic failures that arose from weaknesses in both – the design of our economic models and also their implementation. Reproduced here below is an excerpt:

Today, we are still home to the world’s most productive workers and innovative companies. But for most Americans, the basic bargain that made this country great has eroded. Long before the recession hit, hard work stopped paying off for too many people. Fewer and fewer of the folks who contributed to the success of our economy actually benefitted from that success. Those at the very top grew wealthier from their incomes and investments than ever before. But everyone else struggled with costs that were growing and paychecks that weren't – and too many families found themselves racking up more and more debt just to keep up.  

For many years, credit cards and home equity loans papered over the harsh realities of this new economy. But in 2008, the house of cards collapsed. We all know the story by now: Mortgages sold to people who couldn't afford them, or sometimes even understand them. Banks and investors allowed to keep packaging the risk and selling it off. Huge bets – and huge bonuses – made with other people’s money on the line. Regulators who were supposed to warn us about the dangers of all this, but looked the other way or didn’t have the authority to look at all.  

It was wrong. It combined the breathtaking greed of a few with irresponsibility across the system. And it plunged our economy and the world into a crisis from which we are still fighting to recover. It claimed the jobs, homes, and the basic security of millions – innocent, hard-working Americans who had met their responsibilities, but were still left holding the bag.

Note the categorical "It was wrong". This was the same speech in which he referred to economic inequality as "the defining issue of our times", as I'd mentioned in my earlier post.

Quotes:

Matt Taibbi (author and journalist) in a blog post in Rolling Stone magazine:

The amazing thing about the wave of corruption that has overtaken the financial services industry is that most of it couldn’t happen without virtually every player at every level signing off on these deals. From the ratings agencies to the law firms to the accounting firms to the regulators to the bank executives themselves, everybody had to be on board in order for a lot of these fraud schemes to work.

Paul Krugman (Nobel Laureate, Professor of Economics and International Affairs at Princeton University, Centenary Professor at the London School of Economics) in "Confronting the Malefactors" in the New York Times:

In the first act, bankers took advantage of deregulation to run wild (and pay themselves princely sums), inflating huge bubbles through reckless lending. In the second act, the bubbles burst — but bankers were bailed out by taxpayers, with remarkably few strings attached, even as ordinary workers continued to suffer the consequences of the bankers’ sins. And, in the third act, bankers showed their gratitude by turning on the people who had saved them, throwing their support — and the wealth they still possessed thanks to the bailouts — behind politicians who promised to keep their taxes low and dismantle the mild regulations erected in the aftermath of the crisis. 

and in "Oligarchy, American Style" (concluding paragraphs):

But why does this growing concentration of income and wealth in a few hands matter? Part of the answer is that rising inequality has meant a nation in which most families don’t share fully in economic growth. Another part of the answer is that once you realize just how much richer the rich have become, the argument that higher taxes on high incomes should be part of any long-run budget deal becomes a lot more compelling. 

The larger answer, however, is that extreme concentration of income is incompatible with real democracy. Can anyone seriously deny that our political system is being warped by the influence of big money, and that the warping is getting worse as the wealth of a few grows ever larger? 

Some pundits are still trying to dismiss concerns about rising inequality as somehow foolish. But the truth is that the whole nature of our society is at stake.

Supplementary reading:

"Bankers' Salaries vs. Everyone Else's" in which Catherine Rampell (an economics reporter with the New York Times) tries to find out why the Occupy Wall Streeters are so angry at bankers.

"How to stop the bogus bonus" by soi-disant "undercover economist" Tim Harford (author, columnist, blogger, economist, presenter on BBC), writing for the Financial Times, comments on how fund managers game the system to claim their bonuses and creating bigger risks in the process.

"What caused the Financial Crisis? The Big Lie goes viral" in which Barry Ritholtz (author, columnist, blogger, equity analyst, guest commentator on Bloomberg TV) tries to separate fact from fiction in the analysis of the causes of the financial crisis, and concludes "The previous Big Lie — the discredited belief that free markets require no adult supervision — is the reason people have created a new false narrative. Now it’s time for the Big Truth."

"A Theoretical Look At Why Societies Become Extremely Unequal" by Rick Bookstaber (senior policy adviser at the SEC; views expressed are his own), which I found interesting because he discusses John Rawls' Theory of Justice at some length, in the context of the Occupy protests, and concludes with the following paragraph:

This discussion was not one of capitalism versus socialism. We can take unfettered, eat-what-you-kill capitalism as a starting point. The knob that is being turned is the level of social stability. From their perch in my version of the veil of ignorance those who are wealthy in the initial state will choose to construct a society that induces less inequality with the knob turned to the "do not disturb" setting.

"The Moral Foundations of Occupy Wall Street" in which Jonathan Haidt (Professor in the Social Psychology area of the Department of Psychology at the University of Virginia) whose research currently focuses on the moral foundations of politics, visits Zuccotti Park and finds that the moral foundations of the Occupy protests are primarily centered around fairness, followed by care and liberty.


This is an excellent segue into my third and final part of this long post, which will deal with ethics and sustainability issues relating to inequality. More about that next week. Actually, make that next year.

Oh, and while we're at it, have a great new year ... and dare I add? ... hopefully a more equal one!

[Continued in Part III: Ethics, Morality and Sustainability]

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Footnotes:

1. This is a reference to research by Andrew Berg and Jonathan Ostry, economists at the International Monetary Fund
   .
2. The Wikipedia page on economic inequality has a section on "Inequality and economic growth" that contains an interesting paragraph about a 2001 study which concluded that inequality below a Gini coefficient of .25 or above a Gini coefficient of .40 negatively impacts growth. 

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