Getting inequality wrong
by Emmanuel Martin
Thomas Piketty captured something essential in the post-Lehman mood with
his study of income and wealth differentials in the developed world. More’s the
pity that his policy recommendations are misguided, in part because he missed
the worst kind of inequality.
During periods of economic crisis and slow growth, concerns about
inequality loom larger than in times of prosperity. This was true after the
2008 financial collapse, when movements like Occupy Wall Street mobilized to
fight the so-called 1 percent that was supposedly robbing the other 99 percent
of society.
The post-crisis preoccupation with inequality found its most vivid
analytical expression in the work of the French economist Thomas Piketty. When
the English translation of his Capital in the Twenty-First Century was
published in 2014, the weighty academic tome received almost reverential
treatment from many readers (usually on the left), but also very rapidly
stirred up a heated professional debate.
On one level, the work was nearly perfectly in tune with the
sensitivities of the post-crisis era, when Oxfam, the United Kingdom-based
development charity, could shock the public with a world poverty report
claiming that 62 billionaires controlled as much wealth as the poorest 3.6 billion
members of humanity. Mr. Piketty even figured in the United States presidential
race when he endorsed Senator Bernie Sanders, a contender for the Democratic
nomination.
Because Mr. Piketty’s book encapsulates so many of the ideas and
policies behind the “fight against inequality,” the professional critiques of
its arguments repay close analysis. They reveal much that is misleading or
mistaken in current thinking on the subject, along with more dangerous aspects
of inequality that have been neglected.
Grand theory
The central idea of Capital in the Twenty-First Century is that
capitalism naturally generates a vicious circle of inequality. Because capital
incomes grow faster than the economy (and thus wages), the rich can only get
richer.
The author warns that inequality in both incomes and wealth is returning
to levels not seen since the Gilded Age of the late 19th century. The
inequality trend described by Mr. Piketty has a “U shape,” suppressed from the
1930s to the 1970s by the effects of two world wars, the Great Depression and
“progressive” tax policies that equalized incomes and wealth.
Deregulation and the adoption of more free-market policies in the 1980s
then made inequality rise again, according to this argument. Slower economic
growth in the 21st century has brought matters to a head, by increasing the
differential between the growth rate of capital incomes (“r”) and that of the
economy (“g”). As Mr. Piketty’s “fundamental inequality” of r>g diverges
ever more rapidly, his main policy solution is to impose more taxes on the rich
– for example, an 80 percent top marginal rate on income and a global wealth
tax to discourage evasion and “optimization.”
Gloomy vision
The common thread of
Oxfam’s or Mr. Piketty’s analysis is a vision of the economy as a zero-sum game
in which one man’s gain is another’s loss, reminiscent of a Marxist class
struggle. In such a “fixed-pie” economy, social mobility is minimal. The rich
are rentiers who automatically collect capital gains or super-managers
siphoning money from shareholders. The poor cannot accumulate capital and
indeed should not, because in their case investing is too risky a game. In the
real world, things are quite different. The economy is not a fixed pie.
Mobility exists in both directions, meaning that the rich can go broke. Capital
accumulation is far from automatic and usually requires some talent. The rich
are not only heirs to vast fortunes but, more and more often, successful
entrepreneurs and managers who create value for their companies, their customers
and society. Creative destruction means that industry leaders must continually
remake themselves or perish, like Kodak and Borders. New rich people emerge
with the expansion of economic opportunities. In reality, poor people
accumulate capital and exit poverty, as the basic theory of development
economic holds; all successful developing countries follow this path. The lot
of the world’s poor has never been better, as shown by the dramatic convergence
of life expectancy and access to consumer goods, education and healthcare. All
the evidence points to decreasing inequality on the global level, combined with
increasing social mobility and a bigger economic “pie.” The theoretical
assumptions required to make Mr. Piketty’s model of cumulative divergence work
have been severely criticized by such economists as Matthew Rognlie. Other
researchers have shown the absurdity of the cumulative process he describes,
which would logically lead to the 1 percent seizing all available wealth in
less than a generation.
Suspect data
Even as Capital in the Twenty-First Century won praise for its empirical
scope, many researchers took issue with its statistical apparatus. For example,
figures drawn from Internal Revenue Service forms are meaningless unless one
takes into account the evolution of the U.S. tax system.
Changes in tax law during the 1980s had a profound impact on income
declarations. Lower marginal income tax rates meant companies could pay more in
wages and less in other forms of compensation, while affluent taxpayers were
more likely to declare income on their individual IRS forms rather than keep it
in special-purpose companies enjoying lower tax rates.
Similarly, lower taxes on dividend income encouraged investors to invest
in higher-risk, higher-yield assets.
To look at income through tax data is to risk succumbing to an optical
illusion. Mr. Piketty’s other questionable decisions are to include housing
assets in “wealth” (ignoring distortions created by scarcity-generating urban
policies), omit redistributions and other public benefits from poor peoples’
incomes, use an inappropriate deflator to account for the evolution of prices
and real incomes, and ignore changes in household size and structure.
Each of these “selection choices” has been shown to bias the study’s
results. If corrected, the cumulative rise in U.S. median household income
would amount to 36 percent between 1979 and 2007 – not 3 percent, as the French
economist claims. Other economists have criticized the inconsistent methodology
used to help make Mr. Piketty’s inequality curve “stick” to its U-shaped
pattern, along with his inclusion of the communist world in an analysis
supposedly devoted to capitalism.
Most problematic of all may have been the failure to perform any
econometric tests of the r>g theory; other researchers who used various sets
of data have not been able to verify its accuracy.
Procedural inequality
Policies based on such unreliable data should be treated with extreme
caution. Radical tax policies, including a global levy to combat inequality,
would inevitably destroy the incentives to create wealth and thus lead to
increased poverty.
Yet this is not to say that inequality is a matter of indifference for
economic development. In fact, there is a category of inequality that seriously
inhibits wealth creation and the reduction of poverty.
Oddly, it is rarely given much attention by advocates of social justice.
Their nearly exclusive focus on inequality in outcomes (wealth and income)
causes them to overlook the importance of inequality in procedures – the
economic and social rules that favor certain groups or professions over others.
From the standpoint of economic growth and political stability, this
form of inequality is much more pernicious than differences in wealth or
income. Using links to political power for economic gain is the most pervasive
example of such inequality. It can take the form of connections allowing
preferential treatment, shielding a form of “corporatism” from exposure to
market competition.
Recent examples include the violent protests of licensed taxi drivers
against Uber and the privileges enjoyed by public employees versus their
private-sector counterparts in Greece and France. It is all too easy for
politicians to protect the income and status of well-organized groups by
spending taxpayers’ money.
Such collusion undermines the rule of law and institutionalizes
inequality. It distorts incentives for insiders (by fostering rent-seeking) and
for outsiders (by discouraging honest effort). Inequality that derives from
process rather than outcome fundamentally skews the rules of the game. In some
countries, institutional collusion has become so pervasive that the economy’s
main function is to extract wealth for the benefit of a few.
Sometimes these privileges can be much more subtle. In Mr. Piketty’s own
country, giving favors to “national champions” such as Minitel or Bull is
almost part of the DNA. This has seldom worked to the benefit of the French
economy.
Procedural inequality is illustrated by the “social privileges” enjoyed
by a caste of civil servants and employees at state-owned companies, along with
members of “closed professions” such as notaries.
Perhaps the worst offenders are elected public officials, whose avid
collection of perks has fueled a populist backlash against the political
establishment.
The financial crisis and recent developments in the global economy
(especially the rise of a state-subsidized renewable energy industry) have
created new opportunities for cronyism. In the U.S., big food and drug
companies are regularly accused of regulatory capture of the Food and Drug
Administration (FDA).
Such procedural inequality can stifle competition and innovation by
excluding small businesses – all with the government’s stamp of approval.
Blowing bubbles
Such political connections extend to the heart of our financial system.
To a large extent, central banks have used unconventional monetary policies to
abolish the price of time.
The result has been a “great deformation” of capitalism that misdirects
investment into a bubble economy and discourages savings amid a prevalent
attitude of short-termism.
This collusion between central banking authorities, big banks and
politicians is profoundly disturbing. It corrupts the basic allocation of
capital and labor in modern society by making irresponsible banks “too big to
fail” and shielding irresponsible governments from accountability and default.
In this sense, the Occupy Wall Street protesters were right – if only they had
looked beyond greedy “banksters.”
The unmistakable effect of cronyism in the financial/monetary nexus has
been to expand the gap between rich and poor.
Financial markets on monetary steroids allow investors to artificially
multiply their wealth, while the less fortunate must be content with zero
interest on their savings.
Curiously, inequality fighters are prone to applaud such monetary
policies.
Wrong answers
The current policy debate largely ignores the crucial distinction
between outcome- and process-derived inequality. Instead, in countries such as
France, people just want their fair share of privileges.
Economy Minister Emmanuel Macron was one of the rare politicians willing
to tackle the problem of closed professions, but his efforts were hamstrung by
an almost worshipful attitude toward status, which is nothing more than
institutionalized procedural inequality.
People with this mindset tend to blame their problems on “market
capitalism” rather than “crony capitalism.”
Instead of openness and transparency, they want even more protection. This
mentality is making a comeback even in America, as both the Republican and
Democratic presidential primaries demonstrate.
Donald Trump wants to erect a wall to protect white Americans from
“dishonest” Mexican competition. Bernie Sanders wants the top 1 percent to pay
back the struggling middle class. In the end, both want to entrench procedural
inequality.
Since inequality has become a fundamental political issue, its hijacking
by populists does not bode well for the stability of Western democracies.
Building protective walls and chanting “eat the rich” will not do much
to level the playing field. - See more at: http://www.austriancenter.com/2016/04/08/getting-inequality-wrong/#sthash.17iS9YBh.dpuf
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