Friday, October 26, 2012

Economic inequality

I have long thought about the causes, nature and effects of economic inequality amongst people. It includes inequality of income, wealth and opportunity. My first essay on this matter was written in September 2005 (available here). It attempted to forecast two long term paths of evolution possible as regards inequality. One was the utopian path where inequality dwindles with increasing average level of prosperity – due to reducing population, increasing stock of capital and increasing productivity. The other was dystopian path where inequality is forced down by uprising amongst the have-nots, but the overall prosperity on the decline. I had then taken no stand regarding which one was more likely.

The topic was brought forward in my thinking by what was probably an interesting set of co-incidences. Firstly, I recently came across and bought two books on inequality namely "Price of Inequality" by Joseph Stiglitz and "The Winner Take All Society" by Robert H. Frank, Philip J. Cook. One talks of the general increase in inequality in US in particular and its likely ill-effects on the American society. The second talks of the institutions which have evolved in the modern society – mostly informal, some formal – that make for a winner-take-all situation across most major walks of economic life.

Secondly, I happened to start reading "The General Theory of Employment, Interest and Money" by John Maynard Keynes, around the same time. I am still on the first few chapters. It is clear from this part already that Keynes was fairly unorthodox in his approach and wrote the book primarily to question the classical economic theory assumptions, and proposing an alternative. Part of the theory relates to the full employment ideology of classical economics and its theoretical limitations which make it so unlikely to observe in real life anywhere.

Thirdly, the latest issue of The Economist (link here and here), speaks of a progressive politico-economic system that attempts to reduce inequality without hurting economic growth. It echoes part of Stiglitz’s ideas including the claim that inequality now has reached a level that threatens prosperity of many (if not all, eventually) and is clearly sub-optimal. This is different from the typical neo-classical position that some amount of inequality is inevitable and probably even desirable to allow for genuine difference amongst individuals as regard their endowments, skills, risk appetite and some would say even luck. The desirability of inequality comes from its effect on entrepreneurial individuals who in the pursuit of individual riches end up enriching the society as well – through inventions, better run organizations, innovations, new products and so on. Some have now started wondering if the current level of inequality is well past the basic minimum required to get all these benefits.

My thoughts in this matter are driven by two independent starting points/positions. For one, I believe that the extent of opportunity, behavior of entrepreneurs, nature of institutions and intervention from government are not uniform across time and space to make any material statement about inequality which is general and universally applicable in nature. Coming to the specific question of current times, in advanced economies and in emerging economies, and especially in India, can we say that inequality is too high and is likely to start affecting collective well-being?

The west has it worse. The opportunities have gone down, corporations have started to become predatory, profit pursuit has pushed low end jobs out of the economies and service sector is reeling under real estate bubble burst and financial services crash. In the interim the capitalist institutions have made it difficult for all but the most innovative and lucky entrant to make it big (a Google here, a Facebook there but nothing else). The shortage of opportunities means that everyone is now looking to grab share from others rather than try to create new “pies”. The governments across the rich world are divided over their response. The left leaning ones (current US, France, Scandinavia) are using Keynesian fiscal intervention to boost falling incomes thus hoping inequality does not become worse. The right leaning ones (Romney’s US) are likely to go for lower fiscal spend and smaller government intervention. Beyond that though, as Stiglitz painstakingly details, rent-seeking on part of the established corporations is not always necessarily through explicit government largesse. A variety of other mechanisms persist. Depending on the relative strengths of the transparency-seekers (mostly NGOs and some individuals and rare politicians) on one hand and the rent-seekers (mostly large corporations in some industries) on the other this may play out to favor few or the many.

The emerging markets are not that badly placed. Growth has slowed down but not enough to warrant a grabbing of each other’s pie yet. There is a different problem that is starting to plague emerging markets though. The emergence of rentiers – connected with and benefitting from the government policies – is causing at worst loss of welfare and at best serious distraction from pursuit of prosperity by the general public and the well meaning companies.

The economic future of the emerging markets hence is likely to be strongly influenced by how the rentiers are handled. If they were to have a free reign, inequality will increase and to make matters far worse, people’s prosperity will not! The political and economic institutions in the emerging world hence have the nuanced task ahead of them – to leave the economic participants alone to pursue growth and prosperity while guarding against the most unscrupulous of the lot that is trying to grab economic rents (wealth without adding value).

The second starting point of my position is the relevance of wealth for individual well-being. Our global social evolution in last few years is towards the milieu of supremacy of money and wealth as the ultimate and overarching drivers of well being. This trend has been more pronounced in Anglo-Saxon world (US, UK), BRICs and Middle East while considerably attenuated in Western Europe and probably Japan. In general though, we have started implicitly or explicitly agreeing with the money income and consumption being the most important drivers of individual well-being.

This trend has meant a vigorous pursuit of higher incomes and consumption at the cost of much else. While the liberal position on this matter is to leave people alone to decide their preferences, the real life society knows that it influences the thinking and value system of its constituent individuals. Hence while everyone is free to believe what she thinks is right, she has to start some place in deciding this – and that’s where the social set up she finds herself in exerts the most powerful and yet most subtle effect. In the context of individual pursuits hence most individuals in the modern world are under a fair bit of pressure to earn more and spend more. There are more opportunities to earn and there are more avenues to spend.

The less heeded part of the equation though is that the link between consumption and well being is not linear. At low levels of consumption, more is definitely better. At higher levels, more is neither necessarily better nor worse. The rich are not miserable at all, but they are not happier as a rule. An empirical graph I came across in this connection showed a very low variation amongst individuals at the lower end of this consumption-wellbeing curve. This means at low levels of consumption, as income and consumption grows, most people become better off. Hence one can be confident of a trend. At high level of income and consumption the variation balloons. Now there is no trend. Some individuals get much better off with more income while others are unaffected and many become worse off.

If we took away the emotionally charged titles of the x and y axis and showed the scatterplot to any student of statistics or econometrics, she would tell us that these variables are not correlated – there is no statistically significant relationship between them. Hence it is most likely that at these levels of income people are better off or worse off because of entirely other factors – health, fame, meaning etc.

What does that have to do with inequality? Well, the optimizing optimist in me thinks that the informal institution of unlimited wealth pursuit that we as a society have established is in complete contrast to what our nature allows us and offers us in terms of well-being. Inequality, from the standpoint of a grand population level optimization, is irrelevant when it is relatively small but is terribly sub-optimal when it is large. It gets worse because of the constant reinforcing feedback it provides to the sub-optimal institution of unlimited wealth. Solutions? That is a long path! (The Economist’s special report on true progressivism might be good starting point, though)