Economic Theory

Chicken and egg inequality

The FT’s Martin Wolf weighs in on ‘Why inequality is such a drag on economies’. This is the question that was bugging me last week. Why is inequality a problem in and of itself, rather than representing a symptom of problems that should be fixed for their own sake?

Since last week’s review of these ideas was rather scathing, I hoped Wolf would offer some new, and better tested ideas. Alas, and interestingly, no.

Just why is inequality ‘a drag?’ Why is it that ‘big divides in wealth and power have hollowed out republics before and could do so again?’ Notice the clear cause and effect here.

Most of the column summarises facts on inequality, which are not important to the title and the thesis. Here is the ‘why’ part:

‘A report written by the chief US economist of Standard & Poor’s, and another from Morgan Stanley, agree that inequality is not only rising but having damaging effects on the US economy.

…These reports bring out two economic consequences of rising inequality: weak demand and lagging progress in raising educational levels.

…The economy will not become buoyant again without a redistribution of income towards spenders or the emergence of another source of demand. 

…The “secular stagnation” in demand, to which Lawrence Summers, the former US Treasury secretary, has referred, is related to shifts in the distribution of income.’ 

Aha, inequality is a drag because a ‘report’ says so. And the ‘report’ says we have to confiscate the wealth of the rich and give it to the government because the rich, and our economies overall, don’t spend enough. (Except, as reviewed last week, when the rich are spending too much.)

I reviewed the S&P report before. The grand total sum of documentation it offered for this proposition was a quote from Robert Reich, opining that the marginal propensity to consume of the poor was greater than that of the rich.  Wolf cites Larry Summers, but if you actually read him, Larry is admirably clear that he has neither model, measurement (of strongly negative ‘natural rate’ of interest), or test; it’s an idea resurrected from a 75 year old speech that he thinks might be worth investigation.

The interesting point here is how by issuing a ‘report’, the S&P can turn pure speculation into theory that is apparently completely worked out, empirically tested, and ready for implementation in one of the greatest wealth transfers of all time. And similarly just by quoting Larry’s speculations. In other contexts there is a lot of debate about one side or the other ‘ignoring science’. This is not science.

The education angle is new, and I’m looking for new mechanisms. Let’s read and see if we find something there:

‘American education has also deteriorated. It is the only high-income country whose 25-34 year olds are no better educated than its 55-64 year olds. … It is also because children from poor backgrounds are handicapped in completing college. 

[statistics on poor not going to college] … Yet, without a college degree, the chances of upward mobility are now quite limited. As a result, children of prosperous families are likely to stay well-off and children of poor families likely to remain poor. 

This is not just a problem for those whose talents are not fulfilled. The failure to raise educational standards is also likely to impair the economy’s longer-term success. …Yet a better educated population would also raise everybody to a higher level of prosperity.’

The facts are fine, and just what I was writing about last week. You bet ‘children from poor backgrounds are handicapped in completing college’. They go to terrible schools, hijacked by inner city teachers’ unions. They come from broken homes, where nobody reads to them at night. They don’t see anyone around them who is working at legal jobs. And so on. This is just the case that Kevin Murphy and others have made about the increasing skill premium.

But that’s all inequality as a symptom of other things gone wrong, and those things desperately needing fixing no matter how much the top 1 per cent earn. This article is supposed to be about how inequality is the cause of bad education. That ‘fixing inequality’ will by itself improve ‘lagging progress in raising educational levels’. Leave the schools, the jails, all the social ills in place…if we just tax away the wealth of the rich, and reduce ‘inequality’, the poor will suddenly go to Harvard? I expected a lot more clarity on cause and effect.

Now, of course, Wolf’s column will be re-cited and re-tweeted, that ‘Wolf Shows Inequality is a Drag on The Economy’. I regretted a bit last week saying that inequality theories were being made up and passed around like internet cat videos. I think now I was being unfair to internet cat videos.

This article was originally published on The Grumpy Economist blog.

2 thoughts on “Chicken and egg inequality”

  1. Posted 14/10/2014 at 07:02 | Permalink
  2. Posted 14/10/2014 at 11:14 | Permalink

    Does high levels of inequality reduce productivity? That all depends what it is the wealthiest spend their money on.

    Gains in productivity comes from economies of scale and innovation. For this, you need as wide and diverse a market as possible. Think of all the consumer goods we enjoy.

    If wealth is concentrated into the hands of a tiny elite who spend most of it on property/luxury goods/holidays etc that would seem to me to be bad for the overall health of the economy.

    Of course, taxing labour and capital reduces everyone’s wealth.

    However, this is a choice we make, not a necessity. We could and should only pay for the services we share from the value we create together i.e land rent.

    Anyone whose rental value of land they enjoy exceeds the amount they pay in tax is a net burden on the rest of society.

    The top 1% of households own about 50% of land by value, yet only contribute <18% of all domestic tax revenues. This is the mechanism by which wealth trickles up from the poorest to the richest.

    While this may or may not harm GDP, it is no doubt terrible for inequality and totally unmeritocratic.

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