Economics Nobel laureate Joseph Stiglitz is the chief alarmist warning that income and wealth inequality in the U.S. is a very serious threat to the economy. So it comes as a surprise that his fellow Nobelist Paul Krugman – Stiglitz’s intellectual comrade-in-arms – disagrees with him. Their disagreement goes to the heart of today’s economic problem.
We frequently read about inequality, and the statistics often take the same form. Reports try to shock us by showing how unequal a particular society is. A recent article I saw described South Africa’s continuing problems, including economic inequality. To demonstrate how unequal South Africa’s society is, the article said: “The top 10% of the population takes home 58% of the country’s annual income, while the bottom half receives less than 8%.”
When I read statements like that, I wonder, “How bad is that?” Of course the upper percentage of income earners or wealth holders will have more than that percent of the money. The only way the upper 10% could have exactly 10% of the money, for example, is if everybody’s income or wealth were the same.
That, of course, is highly unlikely – unless equality were forced on society by the government, as Communist governments tried to do. But even then, inequality persists.
Given that we know that the upper x% will have more than x% of money – say it has y% – how big does y% have to be before our jaws should drop? And how big does y% have to be before it becomes a problem?
And what, exactly, is the problem?
Inequality from the bottom up
Italian statistician and sociologist Corrado Gini invented the Gini coefficient, a handy device for making comparisons in wealth inequality, a century ago. It may have lain dormant for a while, but suddenly we are hearing about it everywhere. (For a brief explanation of the Gini coefficient and the Lorenz curve on which it is based, see the Appendix.)
Imagine a country with 10 million people – call it Equalia – where everyone has the same amount of money, $10,000. Its wealth distribution curve (its “Lorenz curve” – see Appendix) looks like the straight dashed green line in Figure 1. The Gini coefficient is zero – perfect equality.
Now suppose that Clyde, one of the denizens of Equalia, stumbles on a vein of 2,000 tons of pure gold. He stakes a claim. The gold is worth $100 billion. So now the wealth of Equalia has doubled, but Clyde has half of it, while everyone else has an equal amount. The Lorenz curve looks like the solid blue line in Figure 2.
Now the Gini coefficient is 0.5, because the areas of the two triangles are the same. (If Clyde had come into an infinite amount of wealth instead of only $100 billion, the Gini coefficient would approach its maximum value of one.)
That 0.5 is a rather high Gini coefficient, about the same as Zimbabwe’s, but not as high as Hong Kong’s. Is that bad?
First of all, it won’t stay that way. Clyde will spend some of his new wealth, which means other people in Equalia will get it – and the Gini coefficient will decrease.
This leads us to Krugman’s disagreement with Stiglitz. But first, let’s recap Stiglitz’s arguments.
Krugman’s problems with Stiglitz
Stiglitz argued in a New York Timesop-ed that inequality in the U.S. is holding back economic recovery. “Our middle class is too weak to support the consumer spending that has historically driven our economic growth,” he wrote. “While the top 1% of income earners took home 93% of the growth in incomes in 2010, the households in the middle — who are most likely to spend their incomes rather than save them and who are, in a sense, the true job creators — have lower household incomes, adjusted for inflation, than they did in 1996.”
In a blog entry in which he expressed enormous respect for and general agreement with Stiglitz, Krugman countered Stiglitz’s main point. Citing research by Milton Friedman, Krugman said he was not sure that households in the middle are more likely to spend their money than top earners.
It sounds logical that the richer you are, the smaller percentage of your wealth or income you spend. But the evidence is mixed. Empirical evidence suggesting that the rich save more is complicated by the fact – as Friedman showed – that people with a temporary upturn in earnings will save it, while those with a temporary downturn may spend savings down.
Krugman concludes:
So am I saying that you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs? Well, yes. You don’t have to like it, but economics is not a morality play, and I’ve yet to see a macroeconomic argument about why it isn’t possible.
Before Clyde’s big find, he lived exactly like anyone else in the Equalian “middle class” – which was everyone. Any spending of his newfound wealth will be on luxuries. That spending is likely to increase other people’s employment and promote economic growth.
The political argument against inequality
Stiglitz thinks the problem is not only economic inequality in the U.S. (which can be measured by a Gini coefficient, in this case 0.45), but the fact that median income hasn’t risen in 20 years, and that equality of opportunity has sagged alarmingly. Economic upward mobility is now more difficult in the U.S. than in Scandinavia.
Stiglitz could be right – economic certainty on this, as on so many economic issues, is elusive. But his political argument carries more weight. Stiglitz, among others, argues that a state of inequality like that prevailing in the U.S. today creates a privileged and highly influential class that is completely out of touch with 99% of the people and their living conditions. The top 1% has no idea what it is like to live as ordinary citizens, he claims, without access to the kind of amenities and conveniences that are automatic for them. As a result, they are ill-suited to make or even philosophize policy affecting the vast majority of the population. Yet because of the influence of money in politics, they have an outsized effect.
The political divide in the U.S. today is surely exacerbated by the economic divide. Republican presidential candidate Mitt Romney, in his secretly recorded May 2012 address at a private fundraiser to a group of wealthy constituents, drew the line of the divide at 47%:
There are 47% of the people who will vote for the president no matter what. All right, there are 47% who are with him, who are dependent upon government, who believe that they are victims, who believe that government has a responsibility to care for them, who believe that they are entitled to healthcare, to food, to housing, to you-name-it.
Romney’s invited audience, none of whom commented, nor indignantly took exception to Romney’s statement, was probably composed solely of the 1% – indeed, of a much smaller percentage than that. It may be correct to perceive them as isolated, unaware. The implication of Romney’s message was that the remaining 53% would agree with his assessment. Some of them do, certainly, but not a majority. It shows how detached from political reality the 1% is. That level of detachment, it could be argued, lost the election for the Republicans.
Inequality in the United States may or may not contribute to economic turmoil, but it does contribute to political turmoil.
The international economic argument for inequality in the U.S.
Another group of economists has recently floated the argument that America’s cutthroat inequality is actually a boon to the rest of the world’s economy. Noting that other countries such as Norway, Sweden, Denmark and Finland have much lower levels of inequality than the U.S. (income Ginis 0.25, 0.23, 0.25 and 0.27, respectively) but have thriving economies, they ask whether the U.S. couldn’t be like those countries. Wouldn’t it be nice for the U.S. to have the same or nearly the same level of growth but with less economic inequality and a better safety net, like the Scandinavian countries?
Daren Acemoglu of MIT, James A. Robinson of Harvard and Thierry Verdier of the Paris School of Economics make some hefty assumptions, but their thesis has a ring of truth to it. They say that the U.S. needs the exaggerated incentives presented by high levels of inequality to fuel its innovation engine. That engine provides a constant flow of new innovations. If America became more laid back, other countries would be deprived of the steady stream of ideas and innovations that their economies need to develop.
Why was hydraulic fracturing (fracking) invented in the U.S., along with smartphones, the Internet, Google, Facebook and so many other frontier developments? Many people in the U.S. would like to believe that it is America’s cowboy vitality, chutzpah and cutthroat capitalism that keep it strong and vibrant – and there is something to that. They might also like to believe that other countries, like those in Europe, are the U.S.’s economic wards. Acemoglu’s, Robinson’s and Verdier’s thesis provides nourishment for that belief.
The moral dimension
Of course, many people believe there is a moral failing inherent in economic inequality. That is less clear than it seems. Does Equalia suddenly become immoral because Clyde discovered a gold mine? His find – and the inequality it brings – will cause a wave of activity that could awaken a sleepy economy and promote commerce. Would it have been more moral for Clyde to immediately redistribute all of his gold so as to restore Equalia’s Gini coefficient to zero and not bring a ripple to commerce?
The moral dimension, I think, has a different focus. New York Times columnist David Brooks began to get at it in a recent column. Brooks’ point was that in the past, there were competing status hierarchies. There was a wealth hierarchy, but there was also a strong moral hierarchy, which was often the wealth hierarchy’s equal and opposite. Brooks used an anecdote from early in the last century of a young man who succeeded by washing dishes to work his way through college, to show that “people then were more likely to assume that jobs at the bottom of the status ladder were ennobling and that jobs at the top were morally perilous. That is to say, the moral status system was likely to be the inverse of the worldly status system. The working classes were self-controlled, while the rich and the professionals could get away with things.”
Brooks concluded that “The culture was probably more dynamic when there were competing status hierarchies. When there is one hegemonic hierarchy, as there is today, the successful are less haunted by their own status and the less successful have nowhere to hide.”
This may be the lesson of economic inequality. When we are obsessed with one hierarchy and one only, that hierarchy will come to dominate too much of public life.
A curve of cumulative percentage wealth or income is called a Lorenz curve.
Appendix
The Lorenz curve and the Gini coefficient – a brief tutorial.
The Gini coefficient can be used as a measure of wealth inequality or income inequality. A country’s Gini coefficients for wealth inequality and income inequality can be quite different, but the method of calculation is the same.
Those statistics about South Africa’s income inequality in the article I read could be plotted on a graph, like this:
Figure A1. Cumulative percentage income – South Africa (rough estimate)
The diamond symbols represent the points that the article mentioned: 50% receive 8% of the income, and the top 10% receives 58% of the income (so the bottom 90% receives 100% minus 58%, or 42% of the income). Of course, the bottom 0% receives zero income and the bottom 100% (everyone) receives 100% of the income. That adds two more points at (0%, 0%) and (100%, 100%).
In Figure A1 I’ve connected the dots with lines to hint at what the percentages in between might be. Normally, though, the lines would be more curved, as in Figure A2.
Figure A2. Cumulative percentage income – South Africa (estimated)
The Gini coefficient
If everybody had the same wealth, then x% of the population would have x% of the wealth. The dashed green line in Figure A3 shows what the Lorenz curve would look like if everybody had the same wealth (or income).
Figure A3. The Gini coefficient
The ratio of Area A to the whole triangular area – the sum of Area A and area B – is the Gini coefficient. The larger the ratio – that is, the larger is area A – the larger the inequality.
If everybody had the same wealth, the Gini coefficient would be zero (the solid blue curve would coincide with the dashed green curve). But if wealth ownership is as skewed as possible, the Gini coefficient will approach one.
Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment and sustainable development fields. He is a senior research fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong and a project consultant at the Fung Global Institute, as well as a partner and chief investment officer of Denver-based Fair Advisors. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.
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