…or How I Learned to Stop Worrying and Love Inequality.
David R. Henderson is a research fellow at Stanford University’s Hoover Institution, and a professor of economics at the Graduate School of Business and Public Policy, Naval Postgraduate School, in Monterey, California.
Thomas Piketty’s Capital in the 21st Century managed to do something unprecedented among equation-dense economic tomes, it became the #1 selling book on Amazon.com. The book tapped in to a hot topic among politicians and the general public: the high (and possibly rising) wealth and income shares of the top 1%. However, David points out that although the book was a best-seller, it wasn’t actually a best-reader. Amazon logs the sentences people highlight, and the top five most-highlighted sentences in Capital all appear in the first 26 pages. It seems that, at least among kindle readers, most people didn’t make it past the introduction. It appears that people buy the book to back up the views they already hold.
David thinks that the huge interest in economic inequality in general and the wealth of the 1% in particular was sparked in the 1990s by politicians, including Al Gore, and picked up by journalists like Sylvia Nasar, before influencing the economics debate. Piketty has been able to ride this wave of public interest at what appears to be its crest.
David distinguishes between inequality of wealth, inequality of income, and inequality of power. Income inequality is the difference in the amount of income we each take in in wages, interest, dividends, and government transfers (e.g. welfare or social security payments), the four main sources of income for most people. Wealth should ideally include the total value of a person’s assets in addition to the stream of income he is likely to earn in the future, though this stream is more often ignored in wealth statistics. Wealth inequality is not the same as income inequality. Critically, since people earn variable income throughout their lives, income inequality doesn’t capture what we think of as the gap between “rich” and “poor.” Retired people who own two-million-dollar homes might have low incomes, but they certainly aren’t poor. Or, to use an example that’s relevant to myself, as a PhD student my income probably sits in the bottom quintile, and yet I can expect a much higher income after I graduate.
The major factor in both income inequality and wealth inequality (measured by current assets and not expected earnings) is age. Teenagers earn little or nothing, but they grow into adults and gain skills and education, their incomes rise, and they gain wealth through savings. Even if everyone had the same lifetime earnings, there would still be significant inequality in any given year since some people would be young low-earners, while others would be older, wealthier high-earners. And since the older people would have had the chance to accumulate wealth over a lifetime, they would have twenty times the wealth of their younger counterparts.
While there is a correlation between wealth and power, that correlation is by no means perfect. David gives the example of Bill Gates who discovered the hard way that when you have too little political influence, it can be costly. Gates was hit with a long and costly antitrust suit, after which he greatly expanded his lobbying efforts; he had learned his lesson. David agrees with Joseph Stiglitz’ argument, to some extent, that large accumulations of wealth are the result of rent seeking. Local governments restrict the building of new homes and developments that could expand the supply of housing. Thus, they keep real estate prices artificially high to the benefit of those who already own their homes. This is an example of successful rent seeking by homeowners to the detriment of non-homeowners. However, while Stiglitz would argue that this justifies a higher tax rate on the wealthy, David prefers the more direct solution of simply reducing or removing these restrictions.
The following are also mentioned in this episode:
- Wealth Inequality in America
- Piketty and Saez vs. Burkhauser and Cornell: Who’s right on income inequality and stagnation?
- Income and Wealth by Alan Reynolds
- The Boskin Commission
- Myths of Rich and Poor by W. Michael Cox and Richard Alm
- Mark J. Perry on individual income inequality
- Greg Mankiw’s favourite textbook
- Bernie Madoff
- The McCulloch chainsaw
- Lyndon B. Johnson
- David’s review of Capital in the 21st Century for Regulation
- David’s (unexpectedly) controversial EconLog post about ordinal utility
- Robert Solow’s review of Capital in the 21st Century
- Matthew Rognlie’s response to Piketty and Randal O’Toole’s comment on Rognlie’s response
- Branko Milanovic’s blog on global inequality
- David’s article on The Bottom One Percent
- Peter Jaworski
- Is Government the Source of Monopoly? by Yale Brozen
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Brilliant interview, David. Well done. Also, Garrett, great show. This is the first I have heard of your program and I loved it. Thanks so much.
Your discussion provided much to think about:
Around 18:45 David Henderson said, “If you could tax people in the 1% and not badly distort their incentives and give it to people below that then, yeah, people below that would be better off. I think you would distort the incentives…”
This statement appears true at first blush, and probably is true in the very short term, but in the medium and long term it is false. The distortion of incentives of the top 1% [which is what I think he was referring too] is real but I suspect is the smaller concern. It is the distortion of incentives of the BOTTOM 99% created by the “redistribution” that chiefly undermines any positive outcomes created by redistribution. Changes in behavior of the top 1% are unlikely to matter much given that they are such a small group–even if you assume they have an influence on the economy greater than their size implies. Furthermore, taking from the few to give to the many is theft, regardless of how small or wealthy the minority being robbed or how large or “poor” the majority benefiting. Theft is always unjust—which is to say, someone is getting hurt. Adam Smith argued that Justice was the minimum level of morality required to maintain a society. So however good the outcomes predicted for the bottom 99% from redistribution, could it possibly be worth degrading or even destroying society? No! Injustice means someone is being harmed. Harm without recourse implies the victims are outside the citizenship agreement. Only those included in the citizenship agreement are restrained from violence against other citizens by the citizenship agreement. Injustice on such as scale is the first move in a game that ends in war. Violence, especially war, has such negative economic outcomes as to guarantee a profoundly negative economic calculation even when balanced against the improvement in income experienced by the “bottom 99%” over any length of time.
Separately, I want to thank David for mentioning the bottom 1% in this discussion. I did not realize that there was an 80% correlation between the bottom 1% and being in prison. It makes me wonder if they are in the bottom 1% because they are in prison or they are in prison because they are in the bottom 1% or perhaps the two conditions are only randomly correlated and instead caused by some other factor. He seemed to be arguing that the drug war was that causal factor. That is a really interesting idea which drawn from another correlation that more than 50% of the prisoners were sentenced for drug law violations. I would like to add some complexity to that assertion. I will argue that the incentives created by “redistribution” for poor people are causally associated with their drug use. After all, Society assumes most of the risks from drug use by guaranteeing medical care for the health complications associated with drug use. Lungs don’t work from smoking—welcome to disability. Can’t hold a job because your brain got fried—welcome to the unemployment system, Medicaid, and disability. Overdose–no worries, the ER will save you free of charge. Additionally, redistribution payments free up time for drug users. They don’t need to spend 8 hours a day working, so they can instead spend that time in a never ending search for stimulation, entertainment, and meaning. In many cases, the government even supplies the drugs directly in the form of cigarettes to military servicemen several decades ago, addictive pain medications for “pain” to their the people covered under their “insurance”, and marijuana—in some places—for pain and appetite stimulation and depression and anxiety and, well, there does not seem to be a limit on what it gets prescribed for. Anyway, these points–I think–compliment David’s concern without contradicting it, though they imply a different causal chain. He said his number one effort to help the poorest of the poor would be to end the drug war. I got the impression that he was arguing to make drug use legal. I don’t disagree, but I think the picture is more complex. I think we would get even better outcomes by removing the redistributive institutions that directly and indirectly encourage drug use and the institutions that transplant the down-side of using drugs on to the rest of society. Once those absurd institutions are gone, legalizing drugs might actually lead to the beneficial outcomes he implied. Without removing the redistribution system first, however, I predict that legalizing drugs would increase poverty, not lessen it.
Finally, David’s thoughts on the prison population and its relationship to the bottom 1% is hugely important given that the USA has the largest prison population in the world yet considers itself the freest society in the world (http://www.nytimes.com/2008/04/23/world/americas/23iht-23prison.12253738.html?pagewanted=all&_r=0). Both cannot be true.
Thanks, glad you’re enjoying the show! You’re right that the bottom 99% face distortionary incentives from redistribution, and we didn’t talk about it in the episode.
The welfare system probably does subsidize drug use to some extent, but I would favour legalizing drugs even if welfare couldn’t be reformed. The fact that poor people are drawn into the production and distribution of drugs only to be thrown into prison is beyond the pale. Yes, it would be better if we could fix welfare too, but I’d legalize drugs either way.
Garrett
I appreciate your thoughts. Your comment, “the fact that poor people are drawn
into the production and distribution of drugs only to be thrown into prison is
beyond the pale,” suggests you would legalize drugs on moral
grounds. When I was younger I probably would have said the same. However, there is a precedent for my concern that legalization would lead to unexpected,
enormous, negative outcomes.
If you recall, the financial crisis in the USA around 2007–which subsequently led to worldwide recession– was preceded by de-regulation of the banking and finance industry. This made no sense to me as an ideal-market advocate. An increase in Freedom should lead to improved output and innovation, not collapse. So I did some research. Before the de-regulation, the United States Government wrote legislation that encouraged—even required—the Fannie Mae and Freddie Mac lending agencies to make enormous numbers of loans to people who were blatantly high risk of default. The Government assured the lending giants that, should those high risk loans ever fail, they would be bailed out. Thus the benefits of making loans and the risks of making loans fell on different groups of people. That’s bad. Additionally there was a low interest rate on home loans–due to Federal Reserve Policy and the emerging Asian Tigers’ high savings rate–, and an overestimation of the FDIC’s ability to handle widespread bank failure, plus a steady relaxing of bank capital requirements–money banks set aside as a hedge against disaster.
The final straw that unleashed the public-good monster was the de-regulation of the banking and finance industry. When left free to act on the incentives outlined
above, banks raced to loan money to everyone they could and borrowers raced to get as much of the free money as possible. When an enormous number of the risky loans failed, the whole financial system collapsed, and the American public—and later the whole world—paid the price.
I hear the term “Moral Hazard” used to explain this kind of scenario where risks are born by one group of people and benefits are realized by a different group of people. However, I think that is a lousy term because it makes it sound like the bad outcomes might happen but they also might not. I think that is false. The bad outcomes are guaranteed. I prefer to call this an artificially manufactured public-good scenario. Artificially manufactured because it is not natural. Public-good scenario because–it just so happens–ANYTIME the costs of a decision are born by someone other than the beneficiary, you see outcomes identical to those produced in natural public-good scenarios, even when the goods in questions do not meet the definition of a public-good [non-excludable and non-rivalrous].
The point of this narrative is that there is a time when increasing Freedom is exactly the wrong thing to do. That is why I say legalization of drugs without first addressing the aberrant institutions of redistribution will not give you the outcome you expect or desire.
Has there been research on how much of current inequality of income derives from governmental subsidies and other rent-seeking? Much of current economic inequality may well be due to explicit and implicit subsidies rather than entrepreneurship. Also, there is probably no way of knowing how much wealth generation has been prevented by taxes, restrictions, and mandates, which would have enabled lower-income families to rise.
I found this book chapter on rent seeking’s impact on Chinese inequality. It is unfortunately behind a paywall.