Why Do We Have Income Inequality? Part I

After my exhausting "Mother of All Economics Blogs", it was/is hard to imagine going on a massive economics tirade for a while... But one of the sections of that blog - on income inequality - is something that deserves its own post, and definitely could stand a re-write or two, so I took up the challenge none-the-less.

First. I should make the crucially important note that while it is true that the gap between rich & poor has grown in monetary terms, it is also true that the real wealth for the poor in the US is substantially higher today than at any time in the past. One of my favorite economists, Steve Horwitz explains this point perfectly:



However... I don't think it's fair to write off the the growing nominal income disparity. It isn't as "bad" as many people on the "left" would like everyone to believe, and it doesn't - on its own - preclude poorer individuals from becoming rich over time. However, there are a lot of institutional impediments to the advancement of the poor, and I do want to talk about them.

In general, my main thesis is that income inequality has more to do with monetary policy, central banks and a legal/political system that favors big businesses at the expense of a free and competitive market place than it has to do with anything else - and it is most certainly not a feature of a "free market" in the way most people think it is.

There are many different words for the type of system we have in America, but in short, the word that seems to fit the best is also one of the oldest: Mercantilism. The second post in this series will explain more of my views on the topic..

But first, there are many alternate theories floating around out there explaining income inequality and I want to deal with them now.

The basic narrative goes that "capitalism", "deregulation" or "greed" and in some tellings, "tax-cuts" have produced America's presumably growing inequality in earned income. I am no vulgar libertarian, as Kevin Carson would over-zealously label it - and so I won't sit here denying that the inequality exists... Although I will point out, as I did in the monster-blog, that the term "wealth gap" is mistaken. Money & wealth are not identical concepts... I covered that already though, so go read some of my other blogs if you want more on that topic.

Given that income inequality exists, and given that I think there is an extent to which it is a legitimate problem, I think it's remarkably important to accurately assess the causes and put down the inaccurate assessments promoted by countless others. So let's start there...

The Bad Arguments

1. "Tax-cuts"

As noted, I already dealt with this one... But just for the record, the idea that reductions in top marginal income tax rates - specifically between the late 1970s and today - are responsible for the growing income inequality is quite false for two major reasons.

• Increased spending on anti-poverty programs does not help poverty: The tax-cut argument in part requires the assumption those taxes fund programs that actually help the poor - rather than the reality that they fund programs which help the designers & organizers of anti-poverty programs but which have done very little to fix poverty in America. See the graph to the left showing poverty rates and compare that to the increase of spending from under $9,000,000,000 (9 Billion) in the first decade of Johnson's "War on Poverty" to over $10,300,000,000,000 (10.3 trillion) in the past decade - in real dollars. 
• Higher taxes don't result in higher government revenue: Changes in the top-marginal rate - that is, "taxes on the rich" - have not substantially raised or lowered government revenue as a percentage of GDP by one iota over the last 60+ years. The average is 17.9%, and it's never really broken 19%... Top tax rates have been 90% and 35%. No benefit... One major reason for this is because rich people change their behavior under high-tax regimes and reduce their taxable income in favor of other forms of income. Additionally, because of the negative economic consequences to high tax rates, GDP tends to decline leaving government with a smaller pie from which to collect that 17.9%.

^Old, common sense idea^

Thus, even if we raised taxes substantially, government revenue wouldn't actually be increased - and even if government revenue was increased, by no means does that mean the money flowing out of the pockets of the rich would go into the pockets of the poor. The best you can really hope for is basically "punishing" the rich for earning high salaries... And frankly, you can't even do that because above a certain threshold, there are dozens of ways to re-configure one's income in ways that allow you to retain your overall net-worth without being taxed so heavily. 

The further problem is that high tax regimes are really bad for the middle class & poor in the long run because rich people tend to engage in capital flight and that tends to result in fewer opportunities & jobs as a general consequence of there being less available money used for investment in business development in the unfriendly country... Though I guess if you were to consider all of these factors, the high taxes of the 60s-80s probably contributed in some ways to the decline of the middle class as investors & business owners worked pretty hard during those years to find ways to automate jobs & reduce labor costs, or move their investments over-seas. But then... That's certainly not the fault of tax "cuts", is it?

So it should be clear. Raising taxes not only won't solve the problem of income inequality, it can actively make everyone substantially poorer in real terms.

2. "Greed"

This is a common one among people who don't really care to get into the details, or think in more depth about philosophy or economics. It's not surprising as it's kind of imbued in big parts of our culture to abhor "greed", being one of the 7 deadly sins and all that. Honestly... It's kind of a catch-all... But it also doesn't explain anything, first because it is a constant feature of human nature, and secondly because it's not an action. Thomas Sowell always summed it up the best:

"Think about it: I could become so greedy that I wanted a fortune twice the size of Bill Gates' -- but this greed would not increase my income by one cent. If you want to explain why some people have astronomical incomes, it cannot be simply because of their own desires -- whether "greedy" or not -- but because of what other people are willing to pay them."

It's kind of obvious, isn't it?

To expand on Sowell's point... I'm a multimedia producer. If I am really greedy, but I have nothing to offer a potential employer or client, they will not only be likely to not hire me to create media for them, they're also very likely to walk away from interacting with me considering that I am not a very good person to do business with in the future.

There's no doubt that there are many people out there, rich & poor, who are extremely greedy individuals - and there's no doubt that under the right circumstances, greedy motivations can propel those people to ask for or take more than they "deserve"... But greed alone doesn't - and can't - make anyone rich or poor.

3. "Deregulation"


This one is a bit trickier... But on the scale of things, I have to point out that the gap in incomes between rich & poor has been widening since the 1970's, and in that time there have been a few instances of what some people call "deregulation" which were truly deregulation and many instances in which we had changes in regulation, and far more instances where regulation was massively increased.

The further problem with the "deregulation" theory is that the areas that experienced the most deregulation have largely benefited the poor disproportionate to the rich.

Let's take the case of airline deregulation. The Airline Deregulation Act of 1978 changed the airline industry from a de facto public union to a (slightly) more "free market" in air travel. As much as people have a tendency to whinge about the high costs of air travel, the results of this deregulation have been overwhelmingly positive:

"Airfares, when adjusted for inflation, have fallen 25 percent since 1991, and, according to Clifford Winston and Steven Morrison of the Brookings Institution, are 22 percent lower than they would have been had regulation continued (Morrison and Winston 2000). Since passenger deregulation in 1978, airline prices have fallen 44.9 percent in real terms according to the Air Transport Association. Robert Crandall and Jerry Ellig (1997) estimated that when figures are adjusted for changes in quality and amenities, passengers save $19.4 billion dollars per year from airline deregulation. These savings have been passed on to 80 percent of passengers accounting for 85 percent of passenger miles. The real benefits of airline deregulation are being felt today as never before, with LCCs increasingly gaining market share."

Now... Of course, there were transitional problems, and competition has changed a lot about air travel in ways that some people don't like. However... This is a frequent side effect of making goods & services which were once only available to the wealthiest people available to the masses. The trade-off for providing a relatively inexpensive means of transportation to 750+ million passengers a year is that a lot of those people opt only for lowest-cost. As a result, many airlines cater to that desire instead of towards providing all the fancy luxuries like decent food and bigger seats that they used to provide when only the richest people could afford to fly.

Of course, the fancy meals and comfy seats (in fact, seats which now fold into beds and have privacy shields) are still available. Only... They cost more.

One real casualty of deregulation... and of,
you know... a culture better to women.

But then, the first commercially available air travel opened up to "the common man" in the 1950s, and cost around $100 a ticket, which is equivalent to almost $900 today. Yet.......... The average ticket price for air travel in 2010, according to the Bureau of Transportation Statistics was about $329, not including baggage fees (so... plus $20-50 for certain passengers).

And that 2010 price is up almost 5% from 2009, which isn't too bad of an increase considering that for the first time in about 20 years, airlines are marginally profitable again with positively blistering 5-6% margins.

Anyway, the point is, if you judge the success or failure of airline deregulation by the standard of lowered prices, increased safety and improved access for travelers of all income brackets, it's been a spectacular success for consumers. And this is a case - like nearly all such cases - where we're not even talking about full on "deregulation"... The industry is still heavily regulated and controlled in all sorts of ways, and obviously since 9/11 there has been a dramatic up-tick in relevant regulation and costs imposed by government (which rest assured wind up getting passed on to passengers).

So in real terms, I hope I've made the point that deregulation of at least some industries has contributed significantly to the increased prosperity of average Americans - and that in turn acts counter to the growing gap in incomes and improves real wealth for most people. Of course... Markets do this all the time, and we see it all over the world... and not just in transportation - in all areas: Deregulation of telecoms has likewise produced cheaper, better forms of communication for hundreds of millions of people in the US and around the world and the lack of regulation (up until recently anyway) of the internet has contributed to its unqualified, outrageous success.

Now, don't mistake Airline "deregulation" (or most certainly that of telecoms) for a real free-market in air travel. It's not... But it's still better than air travel being treated like a public utility - at least, if you're poor and want to see family across the country.

But what about financial "deregulation"? Welllllllllllll.... That's a different thing, for a few reasons, but its safe to say that deregulation really has not contributed to the problems facing America.

Why? Because, first off... It never really happened...

At least, it hasn't happened to any meaningful degree and not in a way that substantially effects the income gap or the current financial crisis. What's the proof, you say? Well... It's relatively ample, but I like the following passage from economic historian Niall Ferguson (author of "The Ascent of Money"):

"There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we're in now. Third, the continental Europeans - who supposedly have much better-regulated financial sectors than the United States - have even worse problems in their banking sector than we do. The German government likes to wag its finger disapprovingly at the "Anglo Saxon" financial model, but last year average bank leverage was four times higher in Germany than in the United States. Schadenfreude will be in order when the German banking crisis strikes.

We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street. New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers. And the globalization of finance played a crucial role in raising growth rates in emerging markets, particularly in Asia, propelling hundreds of millions of people out of poverty."

The first paragraph does a pretty excellent job about explaining why deregulation is a bad "answer" to the current financial crisis... and the second paragraph is a great start on explaining why lower costs and more options benefited regular people substantially.

Additionally, and perhaps much more obviously, there were only 3 major de-regulatory bills in the last 30 years. There was:

1. As Ferguson noted, the Depository Institutions Deregulation & Monetary Control Act of 1980, which allowed banks to merge, and allowed credit unions & savings and loan banks to offer checking accounts - which I would think anyone would recognize as a fabulous thing for most consumers... But, it also forced banks to abide by Federal Reserve rules and gave the Fed more power over non-member banks... And... It raised the FDIC insurance for banks & credit unions to $100,000 per depositor. Note the double-edged sword here? Some deregulation + more centralized control + more moral hazard introduced with implicit "too big to fail" guarantees. On net... Maybe not the best thing ever.
2. The Garn-St. Germain Depository Institutions Act of 1982, which allowed adjustable rate mortgages. The full name of the act, FYI, was: "An Act to revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans".
3. The Gramm-Leach-Bliley Act in 1999, which repealed parts of the Glass-Steagall Act and allowed commercial banks to compete with investment banks.

I should note here that the Garn-St. Germain act is often blamed for - or considered a contributor to - the Savings & Loan Crisis in the 80s, but as Anthony Randazzo pointed out:

"Garn-St. Germain should have allowed banks more freedom to compete while also clarifying the role of the FDIC. But it failed, along with other regulations, to outline the role of the government in the case of financial institution failure. As a result, the implicit government guarantee for firms "too big to fail" skewed the risk assessment process that aids market efficiency. The promise of rescue was much more damaging than loosened lending standards."

Likewise, in spite of the fact that many people place the bulk of the blame for the current economic crisis on the repeal of the "barriers" between commercial & investment banking, the truth is that had the provisions from Glass-Steagall still been in effect, it wouldn't have made a damn bit of difference.

Investment banks like Bear Stearns, Lehman Brothers, and Merrill Lynch all tanked, but none of them had commercial bank divisions. AIG is an insurance company... So also; no commercial banking division. So the repeal of the restrictions on commercial banking was irrelevant to all of those major "too big to fail" failures. Likewise, Fannie Mae and Freddie Mac - as GSE's - were never effected by Glass-Steagall to begin with. 

Furthermore, under the Bush administration, 13,652 new pages of financial regulation were added to the Federal Register, and as Mercatus Center economist Veronique de Rugy pointed out in her excellent article, "Bush's Regulatory Kiss-Off":

"Since Bush took office in 2001, there has been a 13 percent decrease in the annual number of new rules. But the new regulations' cost to the economy will be much higher than it was before 2001. Of the new rules, 159 are "economically significant," meaning they will cost at least $100 million a year. That's a 10 percent increase in the number of high-cost rules since 2006, and a 70 percent increase since 2001. And at the end of 2007, another 3,882 rules were already at different stages of implementation, 757 of them targeting small businesses."

So, that whole line of deregulation myth reasoning is kind of a massive failure when it comes to explaining the roots of America's current financial problems. The truth is that there are nearly 50,000 people who work for the government regulating the economy... and there are around 80,000 pages of Federal regulations on the books. Plus, I mean... There are many more sources to debunk the idea of deregulation as cause of the financial crisis.

But again, staying on point... What about its role in the income gap?

That's much harder to assess, but as I've noted above, much of the banking deregulation was helpful to consumers and provided gains to the average man's investments that were previously only available to the rich. But to an extent that's just the the vulgar libertarian aspect of my argument rearing its ugly head. The great bulk of financial regulation is designed by people in banking and in government who benefit from ties to people in banking.

Regulation does come into play with respect to the income gap, but "deregulation" generally speaking, does not... At least not in the sense people think it does. Perhaps I should say "free markets", which don't exist by any stretch of the imagination in banking, are not at all culpable for the growing income gap.

More on the non-vulgar libertarian point at the end.

4. Capitalism itself is the problem


Well... Again... Complicated.

But this time, it's complicated not by the massive pile of competing incentives produced by an overly-complex and cumbersome regulatory scheme largely written and captured by the banks & investors supposedly being "regulated"... But, instead this point is complicated by the confused and varied use of the term "capitalism" itself.

The dictionary definition is:

: an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market

But the dictionary definition is naturally lacking in context and explanation.

A bad idea that earns losses does not survive
very long at all in a free market.

"Capitalism" [PDF - for those who want a truly detailed explanation of the system] needs to be a system of private ownership, that's true. As such it is supposed to be a profit and loss system. It is not a system where profits are privatized & losses are borne by the community or "socialized"... But that is precisely what happens in America, where some of our biggest industries - banking, auto-manufacturing, railroads, etc. get bailouts from the tax-payers after making objectively bad (as determined by financial losses) market decisions.

In an actually capitalist system, or at least, in a free market system companies making decisions and offering products consumers do not want or are not willing to pay for at the prices asked lose money and either change course or go out of business. This is a good thing! It spurs innovation, holds companies accountable to their consumers and helps direct the world's scarce resources towards the uses which are most highly valued by the ordinary man. This is what Joseph Schumpeter (1883-1950) called, "Creative Destruction".

Likewise, private ownership can't just mean private in terms of the written "title" on pieces of paper, but it has to mean ownership in the sense of a person's right to control access & use. But, yet again, here in the United States, that's all it means in many ways. If there are numerous regulations, licenses and other controls on how I use my property; whether or not I can sell my property, to whom, what I can use it for, who I can allow access to it, etc., then I do not have private control over my property in any real ore meaningful sense.

These are important distinctions to make - because in the case of America, the dictionary definition of capitalism just isn't at all applicable. Take note:

• You are not free in America to do what you please with the land you supposedly "own" - there are numerous zoning laws and other regulations that control your use. 
• You are not free to decide the best use of many of the possessions that you supposedly "own" - government imposes numerous licenses & restrictions on the use of goods, especially in terms of their use in business or production.
• You are not free to buy or sell whatever you want with whomever you choose to associate with - laws restrict the sale of many goods and pose restrictions on sellers of goods.
• You are not free to set your own prices, at least certainly not in all industries and not at all if you're trying to buy or sell labor - thanks to tariffs, price controls and restrictions on wages and benefit payment requirements.
• You are not free to legitimately control your own investment or banking decisions - 78,000 pages of financial regulation prevent that.
• You are not free to openly or honestly compete with other businesses in a free market - regulations, subsidies, bail-outs, tariffs and licensing all control access to the market and erect new barriers to entry that didn't exist in America before.

Example: This is NOT "capitalism".

This list goes on and on... And while it's true that each of these economic limitations is perhaps not as severe in America as it is in some other nations, the limitations that do exist are far more than one would need to have in order to accept the conclusion that the dictionary definition of "capitalism" is not the system at work in the United States. And if you accept that what evidence I provided above for the immense regulations imposed on the market is true, you really have no choice but to recognize this fact.

However... When people typically use the term, "capitalism" they fail to properly parse the difference between the reality of our economy and the provided definition which they were told in elementary school.

In many minds, the syllogism goes something like this:

Premise 1: The United States is "Capitalist" (because everyone says it is)
Premise 2: Capitalism is a system of private property and free markets (because my teachers said so)
Conclusion: Ergo, the United States has a free market (because I accept Premises 1 & 2 as true)

But... If you have even the slightest respect for the English language, you should easily understand that we don't have a free market at all - and it's getting less free by the day.

And that's why this isn't a purely semantic discussion.

The word capitalism is being used by ordinary people to include all the ideas that academically define the term (such as free markets), even though none of those ideas are actually in practice in the American economy.

This is ultimately a huge problem working backwards, because when propositions to expand the role of individual choice & free markets occasionally crop up, people mistakenly believe that "free market" → "capitalism" → pro-big business & Wall Street → economic problems they're currently facing today.

The incorrect label inevitably results in people incorrectly blaming the wrong ideas for their problems. And unfortunately, this mistake is frequently perpetuated by two groups.

1. Politicians: Politicians benefit from using the language of capitalism and economic freedom. Make no mistake here, in spite of the hatred some people spew against the idea of capitalism itself, the language of personal & economic liberty remains astoundingly popular. For instance, politicians will say that a giant agricultural subsidy to corn producers is an act done to support the market and thus is for "capitalism"... But subsidies, which overwrite consumers' voluntary decisions by force and distort the information about supply & demand provided by the voluntarily arranged prices, have no place in truly free markets! In short: Politicians...well, umm... they lie. Surprise!!
2. College Professors: Lazy intellectuals who don't bother to make proper distinctions in terms, often - at least in my opinion - because they are both ignorant of economics and (not coincidentally) tend to be big fans of the idea of centrally planned societies. How surprising is it really, after all, to find that many "smart" people fancy the idea of being able to effectively design society the way they think is best? I'm not surprised at all.

Markets like this just... happen... Everywhere.
This IS basically capitalism. Private individuals trade
their private property with each other to mutual gain.

Free markets are - by definition - not designed. They are simply the name we ascribe to the results of producers & consumers uninhibited by restrictions. They are examples of spontaneous order. But I think the whole idea that there isn't some brilliant mastermind at the helm scares a lot of people, even though plenty of spontaneously organized systems have benefited everyone in enormous ways over the course of human history - like language, culture and even biological evolution itself!

Furthermore, from a historical standpoint, the points in US history when we actually had a much freer market - the periods where there were fewer regulations, no/minimal licenses required for market entry, low taxes and limited/no tariffs & subsidies - real wages for everyone increased substantially, and during those periods the middle class exploded and flourished.

So if you want to blame "capitalism" for economic inequality, I must first ask you: What do you mean?

• Do you mean free markets; limited government, profits and losses borne by private owners & entrepreneurs competing without special privileges or subsidies? 
• If so... Then you are empirically incorrect. 
• Do you mean the highly regulated system we actually have in America in which there are immense barriers to entry limiting market-competition, a tax and subsidy system tilted towards well-connected big businesses, and thousands upon thousands of pages of regulations & rules dictating each and every aspect of your economic life? 
• If so... Then you probably have a good point.

Interestingly enough, some Marxists and other "leftists" are, ironically, better about understanding the distinction between free markets and what exists in the US. Many of them will instead use the term "State Capitalism" or "Crony Capitalism" to highlight what system they're really referring to.

But... I really don't know why they do this since there are ALREADY a few perfectly excellent words for the economic system America currently employs. And by suggesting these better words, I can now segue into the second main part of this essay, which is about the correct arguments.

Read Part II, HERE.