The consequences of widening inequality

Inequality is fast emerging as one of the biggest challenges facing the global economy. Conservatives have long argued that inequality underpins the incentive system that drives economic growth. They claim that it is not inequality but poverty that should agitate policy makers.

The most famous proponent of the "inequality is bad for the economy" hypothesis is Raghuram Rajan. In his book, Fault Lines, he blames the political response induced by growing inequality for the sub-prime mortgage bubble and the Great Recession. He argues that governments, especially in the US, found in credit an easy route to propping up living standards of those at the bottom. The asset bubbles that followed generated an income effect that would paper over the widening real inequality.

The concentration of wealth is stunning. Credit Suisse estimates that there were 24.2 million people in mid-2010 across the world who had assets exceeding $1 million. This 0.5% of the global adult population control $69.2 trillion in assets, more than a third of the global total. The richest 1% of adults control 43% of the world’s assets; the wealthiest 10% have 83%. The bottom 50% have only 2%.

Consider this superb and cognitively striking illustration of inequality in the US by Jean Pen

"Imagine people’s height being proportional to their income, so that someone with an average income is of average height. Now imagine that the entire adult population of America is walking past you in a single hour, in ascending order of income.

The first passers-by, the owners of loss-making businesses, are invisible: their heads are below ground. Then come the jobless and the working poor, who are midgets. After half an hour the strollers are still only waist-high, since America’s median income is only half the mean. It takes nearly 45 minutes before normal-sized people appear. But then, in the final minutes, giants thunder by. With six minutes to go they are 12 feet tall. When the 400 highest earners walk by, right at the end, each is more than two miles tall."

The Economist had a recent survey on inequality that laid down the conservative defence (or atleast rationalization) of inequality. It documented the spectacular rise in income inequality across the world and draws several conclusions. However, the survey is shockingly disingenuous in both what it presents as its conclusions and what it ignores.

The omissions first. I can think of two concerns about rising inequality and resultant concentration of wealth that screams out to any reasonably perceptive observer. The series of articles in The Economist has conveniently overlooked both, without even a passing reference.

1. The first is a political economy issue. The extreme concentration of wealth in the hands of the richest 0.1% has naturally raised questions about its impact on the political balance of power. There is enough meat from sociology and political science that highlight the inevitability of gravitation of power into the hands of those who populate the top of the income and wealth ladder.

In addition, of relevance to our times, there is a growing body of literature that documents how this extremely narrow group of people are fast becoming the new "power-elite". The Economist article itself points to the work of David Rothkopf who shows how the world economy is disproportionately influenced by 6000 politicians, chief executives and other bigwigs (remember Government Sachs!).

However, it ignores the most obvious conclusion and rationalizes by arguing that democratic electoral politics takes care of such concerns. This, as again widely documented, is doubtful, since an electoral change only replaces one group of "power-elite" with another. This is all the more so since political parties across the spectrum owe their existence to moneyed interests.

All this is not to say that the "power-elite" have edged out all other shades of opinion. I would only claim that the extent of their influence on important political decisions (which have deep economic and social implications) grows as inequality widens and concentration of wealth increases. And no right-minded individual would dispute the harmful effects of this trend.

The recent example of the US Government's response to the sub-prime crisis is a case in point. No stone was left unturned to bail out the too-big-to-fail financial institutions and repair corporate balance sheets. However, nothing remotely similar in commitment and urgency was evident when it came to bailing out homeowners stuck with negative equity and repairing household balance sheets.

The era of financial deregulation that preceded the two decades leading to the sub-prime crisis is another example of the power of this new elite. A small clique of Wall Street bankers and lobbyists, supported by politicians and regulators who stood to benefit, led a movement that systematically dismantled all regulatory oversight on dubious ideological grounds.

2. The second issue is socio-economic. The rich beget the rich. The world economy is increasingly one where the superstars, be it any field, rule the roost. By their very nature, superstars have to be a small sliver of the working population. This path to super-stardom is ever so more determined by the capricity of an ovarian lottery.

It is increasingly true that there are considerable entry-barriers to accessing opportunities that enables people gain a seat at the top-most income table. The major share of opportunities in the knowledge-driven economy are linked with either wealth endowments or educational attainments.

The wealthy inherit the business or assets of their parents. Their achievements are built on this formidable foundation. It is almost like running a marathon where a privileged few join the race at the last lap!

Access to the best education, itself confined to a handful of top universities, is increasingly a function of privileged birth than merit. This is especially so since the number of such educational institutions remain the same, while competition increases exponentially. The super-rich with their deep pockets are many times more likely to pass this competition than the poor or even the mere-rich.

In this context, the argument about merit is positively misleading. We all know that getting a seat in the best university is not merely about studying hard and writing an examination. It is about access to a number of smaller opportunities that spans the entire student-life (especially early childhood and family background), all of which present their own particular entry-barriers, which prepares the ground for accessing and competing successfully in the best educational institutions.

Even accepting the odd brilliant individuals who get past the formidable array of entry-barriers and access such education, it cannot be denied that the probability of such people are small and fast declining. This is in stark comparison to the near certainty of those at the top of the income ladder accessing such education. The competition to even access the opportunities that determine future life outcomes could not have been more unfair.

For every visible example of a person with uncommon intelligence rising from the bottom of the income pile and succeeding, there are numerous untold stories of disappointments suffered by such people. Further, while there cannot be any example of people from the bottom pile with commonplace intelligence striking rich, there is more than an even chance that people with similar biological endowments will find a place at the top of the income table.

The best example of this trend is the growing evidence of the alarming decline in social mobility across the income ladder in the US.

Some of the arguments are factually incorrect or amazingly ignorant in its conclusions. It finds a silver-lining in the way people are becoming rich today. Consider this

"... to become rich in the first place, they typically have to do something extraordinary. Some inherit their money, of course, but most build a better mousetrap, finance someone else’s good idea or at least run a chain of hairdressers in a way that keeps customers coming back. And because they are mostly self-made, today’s rich are restless, dynamic and much keener on change than the aristocrats of old."

This is plain factually incorrect. There is enough evidence to suggest that the major share of the super-rich increasingly inherit their wealth, either directly (by direct inheritance of massive wealth) or indirectly (by accessing privileged education). The examples of Larry Page and Mark Zuckerberg stand out precisely because they are exceptions than the norm.

The lengthy discourse in the header article on the stress and hormonal imbalances created by inequality is a classic case of diverting attention from important issues. This is all the more surprising given the complete avoidance of the almost commonplace political economy failings that inequality generates.

The arguments to debunk the work of Richard Wilkinson and Kate Pickett (the authors of "The Spirit Level: Why Equality is Better for Everyone") - who attributes all manner of social ills to inequality - is plain specious. Consider this rebuttal by Peter Saunders of Policy Exchange,

"Factors other than inequality are often more strongly correlated with the problems described in the book. In American states, for example, race is a far more accurate predictor of murder, imprisonment and infant-mortality rates... He also chides the authors... for glossing over social problems, such as divorce and suicide, that are worse in more equal countries."

This argument overlooks the role of widening income inequality in exacerbating the pre-existing fault-lines. In simple terms, prevailing racial and other social inequalities are one more entry-barrier that those populations face in the race to access the opportunities that enable people to sit at the top of the income table. The already disadvantaged groups face even greater hurdles in this race today.