Originally published on February 18, 2019 on The Irrational Observer.
Introduction
For the past decade or so, there has been a significant increase in the number of publications, articles and research papers regarding the crisis that is inequality. This is not a poor-related only issue, inequality is evident even in the most advanced and richest economies. My curiosity led me to see if there was a genuine overall interest with the term that led me to google trends. The graph below clearly shows some upward trend and a weird seasonal-like pattern.
Inequality here concerns income inequality and it refers to the disproportion of income within a population in a country, city, or neighborhood. Inequality has gained a whole lot of momentum among prominent and well-known economists and researchers in recent times. This is because, at high levels of inequality, growth slows, education is undermined, crime rates rise, health deteriorates, and it weakens social mobility. All the bad stuff!
Remember if inequality rises, it means that a small percentage of people receives a larger portion of income, and a large percentage of people now receive less. The concept should always be thought of in this context. The implications of a rise in inequality of any level of granularity are no small talk. The consequences have severe repercussions on society as stated previously, but it also raises serious doubt over the status quo of existing economic systems that helped make it worse.
The past century has been a tug of war of economic thought between the capitalist- and socialist- mindset. The two offer the promise of prosperity, the former argued for the private-led economy and the latter, a public. The emerging victor over the commanding heights of economic systems has been crowned to capitalism, indeed there has been much growth through a system that promotes trade and industry to be controlled and owned by the private sector for profit rather than by the state. This ideology of capitalism stems from Adam Smith’s magnum opus “The Wealth of Nations” from it the invisible hand theory. Which argues that individuals’ efforts to chase their own interest may often benefit society more than if their actions were directly intending to benefit society.
“..he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”
Adam Smith – Wealth of Nations~ Book IV Chapter II
Did capitalism perform well? The system did do what it intended, it boosted output and the pie got bigger. The graph below plots the relationship between average government size and economic growth. Countries with a smaller government (i.e. more capitalist-driven) grew faster than their counterparts.
The argument is compelling, however, Gross Domestic Product (GDP) is an imperfect proxy of well-being. It simply can not consider anything else other than the size of the pie. It is awful in capturing anything else that is equally or more important to societies, such as revealing information of how the pie is distributed.
The metaphorical pie in economics refers to the size of the economy – the total value of goods and services produced. This is generally referred to as the Gross Domestic Product.
To observe the shortcoming of how GDP is inefficient, one would just examine the plot of GDP per capita and median income. The figure below has the GDP per capita and Median household that are standardized at a 100. The two lines would be much closer than what it is if inequality was not so severe in the United States. Thus, this confirms the statement of how GDP is an imperfect measure of prosperity.
The causes of inequality
The causes of inequality are many and which variables has a stronger explanatory power is still up for debate. So far, there has been remarkable efforts in attempting to explain what factors contribute to inequality. For this post, I review two books and a research paper that I recommend readers to pick up if the subject stirs more interest.
1.Capital by Thomas Piketty
In 2014, the French economist took the world by storm with his book “Capital”. His book has him hailed as the “modern Marx” by the Economist. The book assembles substantial research by Piketty and other economists that studied the historical relationship between income and wealth. Piketty was able to draw out the evolution of inequality dating back to the 18th and 19th century. At the time when western Europe societies were very unequal, wealth concentrated in the hands of the few. That system was disrupted by the chaos of the first and second world wars. It piloted in an era in which both income and wealth were distributed in a more equal manner. As the 20th century became relatively stable, it allowed for wealth to reassert itself to its prior place in society, attempting to usher us back to the 18th and 19th century of the social divide.
Piketty’s research motivates him to derive a theory of capital and inequality, a simple expression that revolves two variables. The Rate of Return to Wealth (r) and Economic Growth Rate (g).
He proposes inequality rises as (r) surpasses (g).
r > g
- When g > r : Reduces the appeal of the return to wealth
- When g < r : Increases the appeal of the return to wealth
Piketty stresses that the world is undergoing a major demographic transition, one that is slowing growth aspects, which in turn makes the return to wealth more appealing. Throughout his book, he recommends governments intervene to reduce inequality and adopt measures to tax the wealthy (which would reduce the (r).
Link to buy the book: Here
2.The price of Inequality by Joseph Stiglitz
In 2012, Stiglitz’ book suggests that inequality is not inevitable in society but is a collection of factors raises inequality. These factors are heavily investigated and integrated throughout his book.
- Rent Seeking
The term refers to when individuals seek to increase one’s share of existing wealth without creating wealth. In other words, an attempt to using influence through any means to gain income without making any contribution to productivity. Stiglitz argues that rent-seeking contributes to income inequality through lobbying for government policies that let the wealthy get more income, not as a reward for creating wealth, but by capturing a larger share of the wealth that would have been produced in the absence of rent-seeking activities.
“a feudal lord who installs a chain across a river that flows through his land and then hires a collector to charge passing boats a fee (or rent of the section of the river for a few minutes) to lower the chain. There is nothing productive about the chain or the collector. The lord has made no improvements to the river and is not adding value in any way, directly or indirectly, except for himself. All he is doing is finding a way to make money from something that used to be free.”
- Rober Schiller
Other examples:
- Elderly seek higher social security payments
- Increase income without earning it
- Steel producers seek tariffs on imported steel to gain market share
- using resources to lobby government rather than make the company more productive
- Deregulation
Regulations are set by the government that established the rules to make systems work better. To ensure competition, prevent abusive practices, and protect those who cannot protect themselves. A continuous deregulatory force usually benefits the few in favor of the abundant others.
- Discrimination
A major force affecting inequality. There is economic discrimination against many minority groups. That is evident if one is to examine the differences in income and wealth across different groups.
- Government
The government has a substantial role in its ability to redistribute wealth. Government taxes all members of society and create programs and hand-outs to help the less fortunate. The government, aware or not, has a huge role influencing the degree of inequality. If inequality is high, the government probably helped create it. Governments need to remember that many of the largest companies in the world would not have come to their status without the apparatus of government. May it be in the form of protection of property rights, the rule of law, safety and security, the soft and hard infrastructure they are all necessary to enable all members of society to function, and function well.
- Polarization of Jobs
When the middle-class jobs are replaceable by robots/automation– due to the reduction of the price of machines and the cost of capital. Middle-class jobs shrink and to get to the high-classes in the society requires an even greater skill set. While at the bottom the required skills are low enough that it is not replaceable. This creates a dilemma for the middle class and as a result a polarization of high- and low- skill jobs that exist in an economy.
- Macroeconomics
Central banks have a determined focus on two indicators inflation and unemployment. Throughout history, the two indicators are inversely (negatively) related, and the relationship is characterized by the infamous Philips curve. However, one should note the relationship is now considered broken and no longer holds. The mechanisms work as follows;
As wages rise – central bankers focusing on inflation targets raise interest rates to tighten credit – effectively casting an eclipse on inflation. This cools down wage increases, while at the same time productivity has been growing faster than wages. The economic doctrine stems from the assumption that all workers are paid up to their marginal product – that is they are paid accordingly to what extent they produce in value. The central bank has been overshadowed the fear of high-inflation of the past that continue to justifying their policies for the future.
Link to buy the book: Here
Where is the land of opportunity? Raj Chetty
The seminal work presented by Chetty’s paper is that it investigates the role of intergenerational mobility – which is how income levels persist from parents to children and inequality. For a long time, many economists have theorized about it – whilst it has been hard to test empirically due to the lack of data. Chetty was able to amass 40 million observations across the United States through the IRS income tax data.
His findings entail a community zone analysis and finds that:
- There is substantial variation intergenerational mobility across community zones
- Some lands of opportunity and some lands of persistent inequality
Chetty’s findings shun the proposition that intergenerational mobility is driven purely by genetics, but rather at the community level, neighborhoods effects are as large as the parent-income persistence (correlation). Which raises the proposition that there are influencing factors that can make income mobility better and in turn reduce inequality.
Conclusion
Inequality presents a pressing concern on how economic systems are rewarding a specific class disproportionately. Many factors are at play, I have cited some in this blog post but there might be others hidden at plain sight. As the world economy advances, and at the brink of the fourth industrial revolution. The cost of highly intelligent machines and their ability to be “artificially intelligent” will decrease over time and that will increase the polarization of jobs. As these machines are estimated to becoming more affordable for governments and businesses will begin to adopt, this will eliminate many middle-class jobs and raise other jobs that are highly skilled.
There has been a rise in populism in many countries. I suspect that the culprit behind it could be the rise of inequality. As people tend to feel neglected where inequality is high. That type of reaction coupled with a democratic system is giving democracy a bad reputation. Inequality must be at forefront of every discussion concerning policy formation to seriously consider any factor that might contribute to it.
Appendix: Calculating inequality and The Great Gatsby Curve
The severity of inequality is measured through the Gini-coefficient is computed from the Lorenz Curve.
Here the x-axis refers the cumulative share of people from lowest to highest incomes, and the y-axis is the cumulative share of income earned. Focus your attention on the green line (line of equality), I drew a vertical line at the 60th percent of people and went all the way up to the line of equality. The corresponding x-axis (income share) is also on the line of equality, (60 %of the people own 60 %of income. In reality, this is not the case, each society has a degree of inequality, and this can be visually seen as anything that is indented inwards (away) from the line of equality. Consider a society of the “yellow” line. This society suggests the 60 percent of people have approximately 33% of income. What this is saying is the top 40 percent own 67% of income. The red is the most unequal since 60% of the population hold less than 15% of the wealth.
The Gini coefficient (G) can then be thought of as the ratio of the area that lies between the line of equality and the Lorenz curve (marked A in the diagram) over the total area under the line of equality (marked A and B in the diagram); i.e., G = A/(A + B). It is also equal to 2A and to 1 − 2B due to the fact that A + B = 0.5 (since the axes scale from 0 to 1).
The Great Gatsby
The Great Gatsby curve plots income persistence and Gini-coefficient, a positive relationship between the two has been revealed by scholars.
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