A recent phenomenon: Talk about inequality

I couldn’t but notice that recent articles and publications have commented about increasing inequality in society. It’s interesting to look at the arguments in this debate, at the facts brought to the table and ponder about potential consequences.

First, let’s consider examples of where inequality has been noticeable.

One area relates to a well-trodden subject, the comparison of executive pay to wages of workers and salaries of employees. Executive pay is indeed a multiple of what workers and employees take home these days. A glance in companies’ annual reports provides real figures. Moreover, the growth rate of executive pay has increased versus the growth rate of average wages and salaries not only during boom times but more drastically also during bad economic times as e.g. in the period from 2007 to 2011. This of course gives divergence a further boost.

Although company executives find themselves often at the receiving end of the criticism, inequality in pay is by far not only a corporate theme. Amongst the very rich people we easily find remarkable entrepreneurs, though their take-home pay may sometimes not be as big as the one of other industry captains if measured purely in salary terms (was it $1 for Steve Jobs?). Beyond the world of corporate leaders and entrepreneurs major income accrues to the stars and celebrities of our societies whom the less well-off masses adore so much: in sports, entertainment, TV and film to mention a few.

The phenomenon of growing inequality doesn’t seem to be tightly linked to capitalist countries. Let’s look at the US and China.

Joseph Stiglitz has elaborated on his observations of growing inequality in the US in [3]. He notices that today massive wealth is concentrated in the hands of an elite few. As he states: “The upper 1 percent of Americans are now taking in nearly a quarter of the nation’s income every year. In terms of wealth rather than income, the top 1 percent control 40 percent.” “While the top 1 percent have seen their incomes rise 18 percent over the past decade, those in the middle have actually seen their incomes fall.” This begs the question: What will the figures be in twenty years’ time?

Philip Ryland recently had a closer look at China in [4]. There, the statistics tell us that city dwellers have become rich over the last years, whereas peasants have stayed poor or become poorer. He quotes that average annual income for city dwellers has reached three times that of peasants. Further he notes that rural Chinese authorities are too poor to provide their residents with decent education. That turns into a problem as in a period of growing wealth, the best educated tend to get the best jobs. No wonder salaries diverge.

Though the issue as observable in the US and China has reached the public debate, such differences are not limited to the US or China only. They can be observed in different shades around the globe, including also in South America, Europe, Russia and India.

Before we consider potential consequences of this trend, what might cause it?

A multitude of factors can be considered as the culprits. A few people more recently came up with a series of possible root causes. Here the list goes:

Lack of education and skills.”Close examination suggests that the single biggest difference between those at or above the top tenth percentile of the income distribution and those below the 50th percentile is that the former have a degree or two while the latter, typically, do not. [1]” Gerald Hoerhan, a well-published investment banker strikes a finer note: He detects a lack of economic education. As he mentioned in Chapter 2 of [6], it wasn’t the investment bankers who triggered the financial (and economic) crisis, but it was the middle class, who don’t recognise nonsense for what it is when all collectively engage in the same nonsense (like property speculation, loading up with debt etc.).

Political influences and anti-competitive practices, and that the top 1 percent want it that way [3]. As Stiglitz summarises poetically: “Virtually all U.S. senators, and most of the representatives in the House, are members of the top 1 percent when they arrive, are kept in office by money from the top 1 percent, and know that if they serve the top 1 percent well they will be rewarded by the top 1 percent when they leave office” [3]. He adds his suspicion: “The rich using their wealth to shape legislation in order to protect and increase their wealth” [2].

Unfair tax systems. One may quote the historical moves to lowering tax rates on capital gains [3].

Technological progress saves labour, and thus reduces demand for the so-called middle-class blue-collar workers.

Globalization has created a global and thus much bigger competition for cheap labour. On top of that it has turned some markets into global ones with benefits for consumers but also lots of price takers. When cheap labour is forced to become price taker, it can end in very bad statistics (like the high suicide rates of cotton farmers in rural India in 2011 due to depressed global cotton prices).

Manipulation of the financial system, or say misuse. The financial practices as uncovered during the subprime mortgage crisis benefited some selected but hurt the masses (speak the tax payers). The system where one party engages in a high risk/high reward transaction, harvests the reward but actually doesn’t bear the risk is still firmly in place. The system includes organisations constructed to be too big to fail. A few parties and organisations speculate and finally fail, but in the end get bailed out by the state (exception: Lehman). A few light up the town with their matches, the masses are then called upon the next day to clean up the town the others just burnt down. The regulators are made to oversee it all. As Stiglitz says: “Regulators turned a blind eye to a lack of transparency and to conflicts of interest” [3].

Naiveté and moral hazard on the side of consumers. The consumers who applied for subprime mortgages in the US by providing incorrect details to mortgage brokers, the people who fell victim to mass psychology and embarked on a frenzied property boom as e.g. in Spain or Ireland, the people who simply lived beyond their means, or those who ran after easy credit in an attempt to keep up with the Joneses (though not realising that the Joneses built their seeming wealth on easy credit too or were members of the establishment who managed to engineer a risk-free ride) [1]: Shouldn’t those be subject to criticism in equal measures as those who manipulated the financial system?

Democratisation of consumer credit paired with a long-term consumer binge – with blame apportioned to consumers. As Steve Waldman pointed out [7]: The marginal dollar of consumer expenditure switched from wages to borrowed money in the last decades. Now, unless the consumer invests borrowed money to generate profit, borrowed money will make him poorer. In the short-run this consumer achieves consumption equality (the same BMW on the driveway), not realising that he is well on the road to income inequality.

An economic policy that first enables above consumer binge and a second policy that cures the malaise when a credit-financed consumption as in the last decades reaches its limits and the trend simply stops – with blame apportioned to policy makers. The consumer is the patient who had good times during the period of Great Moderation made possible via certain economic policy. When that comes to an end with consumers defaulting, policy makers apply a second policy, the cure, described by Waldman as “let the debtors default, but make creditors whole with new money” [7]. New money has indeed been printed since then, more in the US and the UK than in the Eurozone, under the name of quantitative easing. More recently the European central bank’s financial support for broken or endangered sovereigns like Greece and Italy may in the end also translate into creation of new money. Waldman apportions criticism to central banks about their first policy: “Maintaining the dynamic (added: of the good times) requires active use of policy instruments to sustain an inequitable distribution of wealth and income”. Waldman then continues his analysis about the second policy, how to clean up the mess: “The balance sheets of debtors can be cured via some combination of bankruptcy, loan modifications, austerity, and youth.” Yes, that may well be what’s going to happen. In the process, inequality is likely to – further increase. Waldman suggests a system “where the playing field isn’t tilted against the poor and disorganized in the name of promoting price stability”. The Economist then posed the question whether limiting the return to asset-bubble-creating financial activities would make investments flow more to productive ends, thereby reducing income inequality [8]. In 2009, ‘limiting the return’ didn’t seem to come along in the short-term. In 2011, ‘limiting the return’ may more realistically happen, when e.g. banks are forced to recapitalise and take a more prudent approach. Still, all else equal, higher equity capital leads to lower return on equity, which in turn one would assume is an incentive to take greater risk through financial activities. But that sounds familiar: Low ROE driven by bank capital requirements (see Basel I), then reduction of required capital through offloading dodgy (mortgage) assets via securitisation… and finally creation of more dodgy instruments like CDO or CDO squared. Once again, we arrive at a 2007/8 style financial crisis.

Reward and performance getting out of step: Raghuram Rajan suggests that companies (specifically very large ones) reward too many of their executives too richly despite lack of outstanding performance. He points out that this holds true especially in the financial sector, where payments have been enormous even despite mediocre performance [1].

What then are the effects?

A growing sense that “that capitalism in the West has become unfair” [5]. As El-Erian says: “Calls for a fairer system will not go away. If anything, they will spread and grow louder.” Hmm, hopefully not too loud.

Underutilised resources, people in idle state. “Around the world, we have underutilized resources – people who want to work, machines that lie idle, buildings that are empty – and huge unmet needs” says Stiglitz [2]. He also contends that this leads to shrinking opportunities. “Whenever we diminish equality of opportunity, it means that we are not using some of our most valuable assets—our people—in the most productive way possible” [3].

Protests, slightly vague in what they primarily want to express, as multiple reasons for anger and resentment are aggregated into single initiatives, like the Occupy Wallstreet movement or the campainers who put up their tents at the steps to St Pauls in London.

The efficiency of the economy declines. Monopoly power of organisations [3] or groups of people, shifting of risk-bearing from influential groups to less influential groups in society, preferential tax treatment for those at the levers of control – all that has the power to reduce the efficiency of the economy and undermine the motivation of those at the receiving end of the stick.

A growing sense of fear. The less well-off worry about being able to hang on to the lower layers of Maslow’s hierarchy of needs, whereas the better well-off may seriously worry about a stronger less capitalism-friendly government to emerge, one that could “adjust the balance, take some of their wealth, and invest it for the common good”, as Stiglitz formulates in [3]. Well, let’s hope the governments of technocrats recently introduced in European countries (Greece, Italy) get it right. They may go for ‘austerity for all’, given that their short-term focus is on the management of the sovereign debt crisis and less on wealth redistribution.

An erosion of people’s sense of identity, a growing disbelief in fair play and equality of opportunity, and a resulting alienation between groups [3]. Maybe that is a driving factor for national reforms and calls like the one for the ‘big society’ as in the UK in 2011.

Youth unemployment appears staggeringly high, not only in the US, but equally in European countries (e.g. Spain or UK). It makes headlines and gets TV prime time.

A reduction of economic growth rate. For example in China the growing inequality can well have detrimental effects on the country’s GDP growth rate. As part of the population cannot keep up with an urban elite education-wise, that young part falls behind. However the problem is exacerbated as the population ages fast in China (median age of 30 today versus 45 by 2050, [4]). Speak, there will be more old people than young people, and inequality among those ‘few’ young people will have further grown by then.

Conclusions

Either some observers just got it wrong, or change is in the making and the impact on the economy won’t be good. How this all pans out has to be seen. I’m not daring to present any final recipes. So much can I say: A degree of rethinking seems appropriate. There is also choice of being pessimistic versus being optimistic. The status quo can be attributed to different players, including consumers, shareholders, policy makers and governments. Two opinions stand out: As Rajan says: “It has the inconvenient implication that the poor have a role in pulling themselves out of the morass.” That’s nearly in unison with Hoerhan’s message to the middle class, which is something like: Guys, wake up and start to sort out the problem yourselves; stop going with the crowd. Similar advice though the sources couldn’t be more different: The former is a professor of Finance in Chicago, the latter a self-made investment banker in Europe. What ties them together, more a coincidence than anything else, is… finance. Whether the (similar) advice from both is good or bad news depends on the reader at the receiving end. El-Erian is clearer in his interpretation of the change in the making: “A global paradigm shift implies a significant change in opportunities, and not just risks.” Opportunities is what people need. That’s a welcomed positive note.

References
[1] Raghuram Rajan, The Undeserving One Percent? 2011-11-10, Project Syndicate, http://www.project-syndicate.org/commentary/rajan23/English
[2] Joseph E. Stiglitz, The Globalization of Protest, 2011-11-04, Project Syndicate, http://www.project-syndicate.org/commentary/stiglitz144/English
[3] Joseph E. Stiglitz, Of the 1%, by the 1%, for the 1%, May 2011, http://www.vanityfair.com/ This URL may not render properly in some browsers.
[4] Philip Ryland, Beware China, Investors Chronicle, 4 Nov 2011.
[5] Mohamed A. El-Erian, The Anatomy of Global Economic Uncertainty, 2011-11-18, Project Syndicate, http://www.project-syndicate.org/commentary/elerian11/English
[6] Gerald Hoerhan, Investment Punk, Ullstein, 2011. (in German)
[7] Steve Randy Waldman, Asset inflation, price inflation, and the great moderation. http://www.interfluidity.com/posts/1256656346.shtml. 27 Oct 2009.
[8] Economist, Rethinking the Great Moderation.
http://www.economist.com/blogs/freeexchange/2009/10/rethinking_the_great_moderatio, 28 Oct 2009.

2011-11-21 Addendum 1:
Worthwhile to also point out a comment by Lawrence Summers from Harvard (“Inequality can no longer be held at bay by the usual ideas”, Financial Times p15, Mo 21 Nov 2011). He rightly observes that the topic is much debated in two ways. Some people polarise and blame income inequality on the wealthy; others brush the debate off as simply misplaced or exaggerated. Both approaches don’t help. As shown above, it’s more complicated. Summers suggests three remedies: i) Governments not to nurture inequality through providing special concessions to the wealthy, ii) pro-fairness, pro-growth tax reforms (considering e.g. estate tax), iii) the public sector to ensure greater future equality. As example he mentions ensuring opportunities for children of middle-class families to get a decent education (in face of increased tuition fees and budget cutbacks at public universities and colleges). He concludes that ways need to be found to protect the interests of the middle class in the post-industrial economy. Two points relate directly to above article: 1) Education is crucial though the point above was to stress “don’t rely on the state but be proactive yourself”. 2) The future of the middle class is considered to be lacking a degree of brightness. G Hoerhan actually argues the middle class was a historical aberration. Where Summers detects the m-class’s interests at stake, Hoerhan boldly forecasts its evaporation in the decades to come (unless things change and he encourages a rethinking). Both points of view can be reconciled if one considers ‘ordinary’ synonymous with ‘less well off, locked into rat race or just poor’. In the words of Summers what then remains are “the affluent and the ordinary” and Hoerhan would add: with empty space in the middle. Bottom-line unchanged: Time for innovative thinking.

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A recent phenomenon: Talk about inequality — 21 Comments

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