The Price of Inequality: How Today's Divided Society Endangers Our Future (8 page)

The third response is to quibble about the statistics. Some might claim that inflation may be overestimated, so growth in incomes may be underestimated. But, if anything, I suspect that the numbers under-estimate the travails facing the typical American family. As family members work longer hours to maintain their standard of living—“for the family”—family life often suffers. Earlier in this chapter, we described the increasing level of insecurity that the poor and the middle class in America face—and this, too, is not reflected in the income statistics. Plausibly, true inequality may be far larger than the measures of inequality of income would suggest. Indeed, as we noted earlier, when the Census Bureau recently took a more careful look at the poverty statistics, it found that the poverty rate for 2010 went up from 15.2 percent to 16 percent.
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The final retort by the Right makes reference to an economic and moral justification of inequality, accompanied by a claim that attempting to do anything about it will simply “kill the golden goose,” and so weaken America’s economy that even the poor will suffer.
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As Mitt Romney put it, inequality is the kind of thing that should be discussed quietly and privately.
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The poor, in this land of opportunity, have only themselves to blame. In later chapters we’ll address these arguments. We’ll show that, for the most part, not only should we not blame the poor for their plight but also that the claim of those at the top, that they earned their money “on their own,” doesn’t have much merit. We’ll see that the 1 percent are by and large not those who earned their incomes by great social contributions—the great thinkers who have transformed our understanding of the world or the great innovators who have transformed our economy. We’ll also explain why creating a more equal society can create a more dynamic economy.

The trauma of the Great Recession—with large numbers of people losing their jobs and homes—has triggered a chain reaction, affecting not just the lives of the individuals concerned but also society as a whole. We now see that, for most Americans, the economy wasn’t really performing as it should even before the recession. We can no longer ignore America’s growing inequality and its grave economic, political, and social consequences. But if we are to understand what to do about it, we have to understand the economic, political, and social forces that give rise to it.

C
HAPTER
T
WO

RENT SEEKING AND THE MAKING OF AN UNEQUAL SOCIETY

A
MERICAN INEQUALITY DIDN’T JUST HAPPEN.
I
T WAS
created. Market forces played a role, but it was not market forces alone. In a sense, that should be obvious: economic laws are universal, but our growing inequality—especially the amounts seized by the upper 1 percent—is a distinctly American “achievement.” That outsize inequality is not predestined offers reason for hope, but in reality it is likely to get worse. The forces that have been at play in creating these outcomes are self-reinforcing.

By understanding the origins of inequality, we can better grasp the costs and benefits of reducing it. The simple thesis of this chapter is that even though market forces help shape the degree of inequality, government policies shape those market forces. Much of the inequality that exists today is a result of government policy, both what the government does and what it does not do. Government has the power to move money from the top to the bottom and the middle, or vice versa.

We noted in the last chapter that America’s current level of inequality is unusual. Compared with other countries and compared with what it was in the past even in the United States, it’s unusually large, and it has been increasing unusually fast. It used to be said that watching for changes in inequality was like watching grass grow: it’s hard to see the changes in any short span of time. But that’s not true now.

Even what’s been happening in this recession is unusual. Typically, when the economy weakens, wages and employment adjust slowly, so as sales fall, profits fall more than proportionately. But in this recession the share of wages has actually fallen, and many firms are making good profits.
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Addressing inequality is of necessity multifaceted—we have to rein in the excesses at the top, strengthen the middle, and help those at the bottom. Each goal requires a program of its own. But to construct such programs, we have to have a better understanding of what has given rise to each facet of this unusual inequality.

Distinct as the inequality we face today is, inequality itself is not something new. The concentration of economic and political power was in many ways more extreme in the precapitalist societies of the West. At that time, religion both explained and justified the inequality: those at the top of society were there because of divine right. To question that was to question the social order, or even to question God’s will.

However, for modern economists and political scientists, as also for the ancient Greeks, this inequality was not a matter of a preordained social order. Power—often military power—was at the origin of these inequities. Militarism was about economics: the conquerors had the right to extract as much as they could from the conquered. In antiquity, natural philosophy in general saw no wrong in treating other humans as means for the ends of others. As the ancient Greek historian Thucydides famously said, “right, as the world goes, is only in question between equals in power, while the strong do what they can and the weak suffer what they must.”
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Those with power used that power to strengthen their economic and political positions, or at the very least to maintain them.
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They also attempted to shape thinking, to make acceptable differences in income that would otherwise be odious.

As the notion of divine right became rejected in the early nation-states, those with power sought other bases for defending their positions. With the Renaissance and the Enlightenment, which emphasized the dignity of the individual, and with the Industrial Revolution, which led to the emergence of a vast urban underclass, it became imperative to find new justifications for inequality, especially as critics of the system, like Marx, talked about exploitation.
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The theory that came to dominate, beginning in the second half of the nineteenth century—and still does—was called “marginal productivity theory”; those with higher productivities earned higher incomes that reflected their greater contribution to society. Competitive markets, working through the laws of supply and demand, determine the value of each individual’s contributions. If someone has a scarce and valuable skill, the market will reward him amply, because of his greater contribution to output. If he has no skills, his income will be low. Technology, of course, determines the productivity of different skills: in a primitive agriculture economy, physical strength and endurance is what mattered; in a modern hi-tech economy, brainpower is of more relevance.

Technology and scarcity, working through the ordinary laws of supply and demand, play a role in shaping today’s inequality, but something else is at work, and that something else is government. A major theme of this book is that inequality is the result of political forces as much as of economic ones. In a modern economy government sets and enforces the rules of the game—what is fair competition, and what actions are deemed anticompetitive and illegal, who gets what in the event of bankruptcy, when a debtor can’t pay all that he owes, what are fraudulent practices and forbidden. Government also gives away resources (both openly and less transparently) and, through taxes and social expenditures, modifies the distribution of income that emerges from the market, shaped as it is by technology and politics.

Finally, government alters the dynamics of wealth by, for instance, taxing inheritances and providing free public education. Inequality is determined not just by how much the market pays a skilled worker relative to an unskilled worker, but also by the level of skills that an individual has acquired. In the absence of government support, many children of the poor would not be able to afford basic health care and nutrition, let alone the education required to acquire the skills necessary for enhanced productivity and high wages. Government can affect the extent to which an individual’s education and inherited wealth depends on that of his parents. More formally, economists say that inequality depends on the distribution of “endowments,” of financial and human capital.

The way the American government performs these functions determines the extent of inequality in our society. In each of these arenas there are subtle decisions that benefit some group at the expense of others. The effect of each decision may be small, but the cumulative effect of large numbers of decisions, made to benefit those at the top, can be very significanat.

Competitive forces should limit outsize profits, but if governments do not ensure that markets are competitive, there can be large monopoly profits. Competitive forces should also limit disproportionate executive compensation, but in modern corporations, the CEO has enormous power—including the power to set his own compensation, subject, of course, to his board—but in many corporations, he even has considerable power to appoint the board, and with a stacked board, there is little check. Shareholders have minimal say. Some countries have better “corporate governance laws,” the laws that circumscribe the power of the CEO, for instance, by insisting that there be independent members in the board or that shareholders have a say in pay. If the country does not have good corporate governance laws that are effectively enforced, CEOs can pay themselves outsize bonuses.

Progressive tax and expenditure policies (which tax the rich more than the poor and provide systems of good social protection) can limit the extent of inequality. By contrast, programs that give away a country’s resources to the rich and well connected can increase inequality.

Our political system has increasingly been working in ways that increase the inequality of outcomes and reduce equality of opportunity. This should not come as a surprise: we have a political system that gives inordinate power to those at the top, and they have used that power not only to limit the extent of redistribution but also to shape the rules of the game in their favor, and to extract from the public what can only be called large “gifts.” Economists have a name for these activities: they call them rent seeking, getting income not as a reward to creating wealth but by grabbing a larger share of the wealth that would otherwise have been produced without their effort. (We’ll give a fuller definition of the concept of rent seeking later in the chapter.) Those at the top have learned how to suck out money from the rest in ways that the rest are hardly aware of—that is their true innovation.

Jean-Baptiste Colbert, the adviser to King Louis XIV of France, reportedly said, “The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing.” So, too, for the art of rent seeking.

To put it baldly, there are two ways to become wealthy: to create wealth or to take wealth away from others. The former adds to society. The latter typically subtracts from it, for in the process of taking it away, wealth gets destroyed. A monopolist who overcharges for his product takes money from those whom he is overcharging and at the same time destroys value. To get his monopoly price, he has to restrict production.

Unfortunately, even genuine wealth creators often are not satisfied with the wealth that their innovation or entrepreneurship has reaped. Some eventually turn to abusive practices like monopoly pricing or other forms of rent extraction to garner even more riches. To take just one example, the railroad barons of the nineteenth century provided an important service in constructing the railroads, but much of their wealth was the result of their political influence—getting large government land grants on either side of the railway. Today, over a century after the railroad barons dominated the economy, much of the wealth at the top in the United States—and some of the suffering at the bottom—stems from wealth transfers instead of wealth creation.

Of course, not all the inequality in our society is a result of rent seeking, or of government’s tilting the rules of the game in favor of those at the top. Markets matter, as do social forces (like discrimination). This chapter focuses on the myriad forms that rent seeking takes in our society, and the next turns to the other determinants of inequality.

G
ENERAL
P
RINCIPLES

Adam Smith’s invisible hand and inequality

Adam Smith, the father of modern economics, argued that the private pursuit of self-interest would lead, as if by an invisible hand, to the well-being of all.
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In the aftermath of the financial crisis, no one today would argue that the bankers’ pursuit of their self-interest has led to the well-being of all. At most, it led to
the bankers’
well-being, with the rest of society bearing the cost. It wasn’t even what economists call a zero-sum game, where what one person gains exactly equals what the others lose. It was a negative-sum game, where the gains to winners are less than the losses to the losers. What the rest of society lost was far, far greater than what the bankers gained.

There is a simple reason for why financiers’ pursuit of
their
interests turned out to be disastrous for the rest of society: the bankers’ incentives were not well aligned with social returns. When markets work well—in the way that Adam Smith hypothesized—it is because private returns and social benefits are well aligned, that is, because private rewards and social contributions are equal, as had been assumed by marginal productivity theory. In that theory, the social contribution of each worker is exactly equal to the private compensation. People with higher productivity—a larger social contribution—get higher pay.

Adam Smith himself was aware of one of the circumstances in which private and social returns differ. As he explained, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
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Markets by themselves often fail to produce efficient and desirable outcomes, and there is a role for government in correcting these market failures, that is, designing policies (taxes and regulations) that bring private incentives and social returns into alignment. (Of course, there are often disagreements about the best way of doing it. But few today believe in unfettered financial markets—their failures impose too great a cost on the rest of society—or that firms should be allowed to despoil the environment without restriction.) When government does its job well, the returns received by, say, a worker or an investor are in fact equal to the benefits to society that his actions contribute. When these are not aligned, we say there is a market failure, that is, markets fail to produce efficient outcomes. Private rewards and social returns are not well aligned when competition is imperfect; when there are “externalities” (where one party’s actions can have large negative or positive effects on others for which he does not pay or reap the benefit); when there exist imperfections or asymmetries of information (where someone knows something relevant to a market trade that someone else doesn’t know); or where risk markets or other markets are absent (one can’t, for instance, buy insurance against many of the most important risks that one faces). Since one or more of these conditions exist in virtually every market, there is in fact little presumption that markets are in general efficient. This means that there is an enormous potential role for government to correct these market failures.