Saturday, January 20, 2007

Why Income Inequality Matters

The holiday season was very joyous on Wall Street. CEOs and lots of others took home some of the biggest checks ever.

I like a $50 million bonus as much as the next guy (although the most I can recall getting was $1,000), but those huge paydays beg a larger social and economic question: Does income inequality matter?

Mind the Gap

I'm not asking if we should care about the well-being of our poorest citizens. We should. This is a more subtle question: Should we care about the size of the gap between the rich and poor?

If we succeed in raising the incomes of the poor, does it matter if incomes at the top are rising even faster, making us a more unequal society overall?

By coincidence, I was in Brazil in December while those giant Wall Street bonuses were being handed out. Brazil has one of the largest gaps between rich and poor on the planet. Having experienced that gap firsthand -- from the slums run by drug traffickers at one end to the lovely apartments with bulletproof doors at the other -- I'm convinced that income inequality does matter.

If the gap between rich and poor gets too large, and if those at the bottom feel they have no meaningful route to the riches at the top, then the fabric of society will fray, or even come unraveled entirely.

Violence Literally Doesn't Pay

Life gets pretty scary -- no matter how much money you've got -- when a segment of society decides that they're no longer going to play by the rules.

Shortly before I arrived in Brazil, a British tour bus was hijacked and robbed in broad daylight on the way from Rio's international airport to a ritzy beach area. While I was there, two Supreme Court justices were carjacked on the same road.

Overall, the murder rate in Brazil is five times that of New York City. As in the United States, much of that violence is poor-on-poor, although the toll redounds everywhere. The New York Times reported recently on a World Bank study concluding that if Brazil had the much lower homicide rate of Costa Rica, Brazil's GDP would have been three to eight percent higher in the 1990s.

As one economist explained in the article, "You have money spent on guarding stuff rather than making stuff." And when international investors look around the globe, they choose safer places.

The Gini Out of the Bottle

Is this violence a direct result of income inequality? Almost certainly not. Brazil has a history of slavery and colonization that was far more brutal than the U.S. It would require a team of sociologists, historians, economists, and criminologists to explain the roots of violence in Brazil. Based on my knowledge of academics, I don't think they would come to a conclusion anyway.

Still, one can't spend time in Brazil without wondering about income inequality at home. Let's take a look at some numbers.

The most convenient statistic for measuring income inequality is called a Gini coefficient, which measures a country's distribution of income from 0 (absolute equality, with each person sharing the same amount of wealth) to 1 (absolute inequality, with one person controlling all of the nation's wealth).

Here's what that statistic looks like for a handful of countries, including contemporary and historic figures for the U.S.:

  • Japan: .25
  • Sweden: .25
  • India: .33
  • The United States 1970: .39
  • The United States 2005: .47 (Note that a small fraction of the increase over time is due to a change in the methodology for calculating the Gini coefficient; still, income inequality has climbed steadily by this measure over the past four decades.)
  • Brazil: .58

A Reason to Get Up in the Morning

So what? Obviously income inequality is just one statistic; it doesn't reflect the size of the pie, only how it's divided. The Soviet Union was a very equal place -- equally poor.

In fact, there are some really good things about income inequality, namely that it motivates risk, hard work, and innovation. I'm sure Wall Street bankers are motivated by a love of their work -- but a $50 million bonus can also help you get out of bed in the morning.

As a matter of fact, high salaries motivate not only the people who get them, but also the people who would like to get them in the future -- a phenomenon that economists refer to as a "tournament effect."

Thus, a $50 million bonus for a Wall Street CEO also inspires that ambitious guy in the mailroom to get out of bed if he thinks he's got a shot at being CEO someday. Even my undergraduate economics students work harder because they need good grades in order to get coveted investment banking jobs.

A Bigger Pie, or a Bigger Slice?

What's the problem, then? I think there are at least two reasons to be cognizant of income inequality in the U.S.:

  1. Is there still really a path from rags to riches?

    I've spent enough time in inner-city schools to wonder if we're really providing an opportunity for the motivated and gifted to make their way from the projects to Wall Street.

    Yes, it happens -- you can watch Will Smith do it at your local multiplex in The Pursuit of Happyness, which is inspired by a true story. But how often does it not happen?

    I'm convinced that part of what's going on in Brazil is that the socioeconomic ladder is broken. There's no real path from favela to bulletproof apartment, and some people with guns have decided that they don't want to play by the rules made by the people in those apartments.

    Income inequality doesn't motivate anything good when there's no hope of sharing in the pot of gold.

  2. There's a very interesting strain of economic research showing that our sense of well-being is determined more by our relative wealth than by our absolute wealth.

    In other words, we care less about how much money we have than we do about how much money we have relative to everyone else. In a fascinating survey, Cornell economist Robert Frank found that a majority of Americans would prefer to earn $100,000 while everyone else earns $85,000, rather than earning $110,000 while everyone else earns $200,000.

    Think about it: People would prefer to have less stuff, as long as they have more stuff than the neighbors.

    The point -- and this is still a nascent field -- is that a nation may be collectively better off (using some abstract measure of well-being) with a smaller, more evenly divided pie than with a larger pie that's sliced less equitably. Reasonable people can and should argue about that.

    What's clear, however, is that one key difference between poverty in 1900 and poverty in 2007 is that even the poorest households -- in Brazil or the U.S. or anywhere else -- can turn on the television and see how the other half lives. It's one thing to be poor; it's another to be continually reminded exactly how poor you are.

    At a minimum, we should question whether a bigger pie is always better.

Name Your Poison

There's no right answer as to how society ought to look. That's a matter of personal philosophy. Indeed, I still find a thought experiment proposed by philosopher John Rawls as relevant as anything that economics can offer.

Rawls argued that decisions about economic justice should be made behind a "veil of ignorance." How would you want the world to look if you were going to be born tomorrow but didn't know the economic station into which you would be born?

If you were going to be born somewhere in America tomorrow -- in the projects of Chicago or perhaps into one of those families that brought home $50 million this bonus season -- what would you want the economic landscape to look like today?

Would you want a distribution of income that looked more like Sweden's, or Brazil's? It's worth thinking about.

Charles Wheelan, Ph.D.

Naked Economics: Undressing the Dismal Science


Post a Comment

<< Home