The welfare state in the age of globalization

In my previous post that looked at policies to reduce inequality in the 21^st century, I mentioned that I will next discuss the welfare state. Here it is.

It has become a truism to say that the welfare state is under stress from the effects of globalization and migration. It will help to understand the origin of this stress if we go back to the origins of the welfare state.

 

As Avner Offer has recently reminded us in his excellent book (co-authored with Daniel Söderberg), the origin of social democracy and the welfare state is in the realization (and financial ability to deal with it) that all people in their lives go through periods where they are not earning anything, but have to consume: this applies to the young (hence children’s benefits), to the sick (health care and sick pay), to those who had a misfortune to get injured at work (worker’s accident insurance), to mothers when they give birth (parental leave), to people who lose jobs (unemployment benefits), and to the elderly (pensions).  The welfare state was created to provide these benefits, delivered in the form of insurance, for either unavoidable or very common conditions. It was built on the assumed commonality of behavior or, differently put, cultural and often ethnic homogeneity. It is no accident that the prototypical welfare state born in Sweden in the 1930s, had many elements of (not used here in a pejorative sense) national socialism.

In addition to commonality of behavior and experiences, the welfare state, in order to be sustainable, required mass participation. Social insurance cannot work over small parts of the workforce because it then naturally leads to adverse selection, a point well illustrated by the endless wrangles over US health care. The rich, or those who are unlikely to be unemployed, or the healthy ones, do not want to subsidize the “others” and opt out.  The system that would rely only on the “others” is unsustainable because of huge premiums it would require. Thus  the welfare state can work only when it covers all, or almost all, labor force, i.e. when it is (1) massive and (2) includes people with similar conditions.

Globalization erodes both requirements. Trade globalization has led to the well-documented decline in the share of the middle class in most western countries and income polarization. With income polarization the rich realize that they are better off creating their own private systems because sharing the systems with those who are substantially poorer implies sizeable income transfers. This leads to “social separatism” of the rich, reflected in the growing importance of private health plans, private pensions, and private education. The bottom line is that a very unequal, or polarized, society cannot maintain an extensive welfare state.

Economic migration to which most of the rich societies have been newly exposed in the past fifty years (especially so in Europe) also undercuts the support for the welfare state. This happens through inclusion of people with actual or perceived differences in social norms or lifecycle experiences.  It is the same phenomenon as dubbed by Peter Lindert lack of “affinity” between the white majority and African Americans in the US which rendered the US welfare state historically smaller than its European counterparts.  The same process is now taking place in Europe where large pockets of immigrants have not been assimilated and where the native population believes that the migrants are  getting an unfair share of the benefits. Lack of affinity need  not be construed as some sinister discrimination. Sometimes it could be indeed that, but more often it may be grounded in correct thinking that one is unlikely experience the lifecycle events of the same nature or frequency as the others, and is hence unwilling to contribute to such an insurance. In the US, the underlying fact that African Americans are more likely to be unemployed probably led to less generous unemployment benefits; similarly, the underlying fact that migrants are likely to have more children than the natives might lead to the curtailment of children’s benefits. In any case, the difference in expected lifetime experiences undermines the homogeneity necessary for a sustainable welfare state.

In addition, in the era of globalization more developed welfare states might experience a perverse effect of attracting less skilled or less ambitious migrants. Under “everything being the same” conditions, a decision of a migrant where to emigrate will depend on the expected income in one country vs. another. In principle, that would favor richer countries. But we have also to include migrant’s expectation regarding where in the income distribution of the recipient country she expects to end up. If she expects to be in the low income deciles, then a more egalitarian country with a larger welfare state will be more attractive. An opposite calculation will be made by the migrants who expect to end up in the higher ends of recipient countries’ income distributions.  If the former migrants are either less skilled or less ambitious than the latter (which is reasonable to assume), then the less skilled will tend to choose countries with more developed welfare states. Hence the adverse selection.

In very abstract terms, the countries that would be exposed to the sharpest adverse selection will be those with large welfare states and low income mobility. Migrants going to such countries cannot expect, even in the next generation, to have children who would climb up the income ladder. In a destructive feedback, such countries will attract the least skilled or the least ambitious migrants and once they create an underclass, the upward mobility of their children will be limited. The system then works like a self-fulfilling prophecy: it attracts ever more unskilled migrants who fail to assimilate. The natives tend to see migrants as generally lacking in skills and ambition (which may be true because these are the kinds of people their country attracts) and hence as “different”. At the same time,  failure to be accepted will be seen by the migrants as confirmation of natives’ anti-migrant prejudices, or, even worse, as religious or ethnic discrimination.

There is no easy solution to the vicious circle faced by developed welfare states in the era of globalization. This is why I argued in my previous blog for (1) policies that would lead toward equalization of endowments so that eventually taxation of current income can be reduced and the size of the welfare state be brought down, and (2) that the nature of migration be changed so that it be much more akin to temporary labor without automatic access to citizenship and the entire gamut of welfare benefits. This last point in discussed in Chapter 3 of my “Global inequality” as well as here and here.

Why 20th century tools cannot be used to address 21st century income inequality?

The remarkable  period of reduced income and wealth inequality in the rich countries, roughly from the end of the Second World War to the early 1980s, relied on four pillars: strong trade unions, mass education, high taxes, large government transfers. Since the increase of inequality twenty or more years ago, the failed attempts to stem its further rise have relied on trying, or at least advocating, the expansion of all or some of the four pillars. But neither of them will do the job in the 21^st century.

            Why? Consider trade unions first. The decline of trade union density, present in all rich countries and especially strong in the private sector, is not the product of more inimical government policies   only. They might have contributed to the decline but are not the main cause of it.  The underlying organization of labor changed. The shift from manufacturing to services and from enforced presence on factory floors or offices to remote work implied a multiplication of relatively small work units, often not located physically in the same place. Organizing dispersed workforce is much more difficult than organizing workers who work in a single huge plant and share a single interest. In addition, the declining role of the unions is a reflection of diminished power of labor vis-à-vis capital which  is due  to the massive expansion of wage labor (that is, labor working under capitalist system) since the end of the Cold War and China’s re-integration into the world economy. While the latter was a one-off shock, its effects will persist for at least several decades, and may be reinforced by future high population growth rates in  Africa, thus keeping the relative abundance of labor undiminished.

            Mass education was a tool for reduction of inequality in the West in the period when the average number of years of schooling went up from 4 or 6 in the 1950s to 13 or more today. This led to a reduction in the skill premium, the gap between college educated and those with only high or elementary school, so much so that the famous Dutch economist Jan Tinbergen believed in the mid-1970s that by the turn of the century the skill premium will be zero. But mass expansion of education is impossible when a country has reached 13 or 14 years of education on average simply because the maximum level of education is bounded from above. Thus we cannot expect small increases in the average education levels to provide the equalizing effect on wages that the mass education once did.

            High taxation of current income and high social transfers were crucial to reduce income inequality. But their further increases are politically difficult. The main reason may be a much more skeptical view of the role of government and of tax-and-transfer policies that is now shared by the middle classes in many countries compared to their predecessors half a century ago. This is not saying that people just want lower taxation or are unaware that without high taxes the systems of social security, free education, modern infrastructure etc. would  collapse. But it is saying that the electorate is more skeptical about the gains to be achieved from additional increases in taxes imposed on current income and that such increases are unlikely to be voted in.

            So if the high underlying inequality is a threat to social homogeneity and democracy, what tools should be used to fight it? It is where I think we need to think not only out of the box in purely instrumental fashion, but to set ourselves a new objective: an egalitarian capitalism based on approximately equal endowments of both capital and skills across the population. Such capitalism generates egalitarian outcomes even without a large redistributionist state. To put it in simple terms:  If the rich have only twice as many units of capital and twice as many units of skill than the poor, and if the returns per unit of capital and skill are approximately equal, then overall inequality cannot be more than 2 to 1.

            How can endowments be equalized? As far as capital is concerned, by deconcentration of ownership of assets. As far as labor is concerned, mostly through equalization of returns to the approximately same skill levels. In one case, it passes through equalization of the stock of endowments, in the other through equalization of the returns to the stocks (of education).

            Let us start with capital. It is a remarkable fact, to which little attention has been paid, that the concentration of wealth and income from property has remained at the incredibly high level of about 90 Gini points or more since the 1970s in all rich countries. This is to a large extent the key reason why the change in the relative power of capital over labor and the increase in the capital share in net output was directly translated into a higher inter-personal inequality. This obvious fact was overlooked simply because it is so…obvious. We are used to thinking that as the capital share goes up, so must income inequality. Yes, this is true—but it is true because capital is extremely concentrated and thus an increase in a very unequal source of income must push overall inequality up.

            But if capital ownership becomes less concentrated then an increase in the share of capital that may be (let’s suppose) inevitable because of international forces such as Chinese move to capitalism, does not need to lead to higher inequality within individual rich countries.   

            The methods to reduce capital concentration are not new or unknown. They were just never used seriously and consistently. We can divide them into three groups. First, favorable tax policies (including a guaranteed minimum rate of return) to make equity ownership more attractive  to small and medium shareholders (and less attractive to big shareholders, that is, a policy exactly the opposite of what exists today in the United States). Second, increased worker ownership through  Employee Stock Ownership Plans or other company-level incentives. Third, use of inheritance or wealth tax as a means to even out access to capital by using the tax proceeds to give every young adult a capital grant (as  recently proposed by Tony Atkinson).

            What to do with labor? There, in a rich and well-educated society, the issue is not just to make education more accessible to those who did not have a chance to study (although that too is obviously important) but to equalize the returns to education between equally educated people.  Significant source of wage inequality is not any longer the difference in the years of schooling (as it was in the past), but the difference in wages (for the same number of years of education) based either on the perceived or actual difference in school qualities.  The way to reduce this inequality is to equalize the quality of schools. This, in the US, and increasingly in Europe as well, implies improvement in the quality of public schools (a point argued by Bernie Sanders in the recent US election). This can be achieved only by large investments in improved public education and by withdrawals of numerous advantages (including tax-free status) enjoyed by private universities that command huge financial endowments. Without the leveling of the playing field between private and public schools, a mere increase in the number of years of schooling or the ability of a rare child of lower middle class status to attend elite colleges (that increasingly serve only the rich), will not reduce inequality in labor incomes.

            In my next post I will address the issue of the welfare state in the era of globalization and migration.  

How I “met” Samuelson and Friedman

Several weeks ago, a Belgrade weekly asked me to write a free-form piece with some reminiscences  of how intellectual life was for a student of economics like myself in the 1970s Belgrade. I am not a big fan of personal memoirs (of people whose lives, like mine, have no greater resonance) so I dithered until yesterday when I read this interview by Paul Samuelson. This brought back the memories of how I first “encountered” Samuelson.

I was then in my sophomore or junior year, studying economics and statistics. We knew of Samuelson vs. Friedman, one who was a kind of a social-democrat, the other a rightist. A very simplified version of  Samuelson’s Economics (just up to the Keynesian cross) was taught in our macro class. But his book was mentioned repeatedly and so students knew of him. I never took any finance classes, and I do not know if Friedman was ever taught there or not. (Yugoslavia was a market economy with predominantly non-private ownership of companies and persistently high inflation, so teaching both had some obvious policy meaning too.)

One day as I was waiting for my haircut, a copy of Newsweek laying around attracted my attention. This was unusual because foreign papers (few people spoke English) would not be normally found lying around in barber shops. (They still do not: I have never seen a foreign-language publication except for fashion magazines since.) It was also politically a bit suspicious. But my barber must have been quite pro-American because he had there also a propaganda monthly published in Serbo-Croatian by the American Embassy in Yugoslavia. I took the Newsweek (my English was quite good by then) and read a column by Samuelson. Afterwards, I  continued buying for perhaps a year every single issue of Newsweek where alternatively Samuelson and Friedman were writing their columns.

Gradually I became more and more disillusioned. Their articles were exceedingly narrowly US-based, dealt with (what I considered) tiny and unimportant topics, and were boring. For somebody brought up on the grandiosity of Marxist economics where economics is about the development of social formations, their columns dealing with (I remember that quite well) busing, housing rents in New York and similar topics were incredibly petty. I was expecting discourses about the future of mankind, and was offered a write-up on rent subsidies and cost of education. It was also difficult (America being a very different world from Europe), to understand many of their columns. I just couldn’t follow what is the big fuss about busing. I then had no idea how the American school system was organized and although I broadly guessed what were the issues, the whole problem was entirely alien to me. I did not know about the extreme decentralization of US school system, the huge variability of school quality and importance of going to the “right” school, nor did I realize fully the long physical distances between homes and schools.

So, after a year, I tired of both Samuelson and Friedman.

But then Samuelson reappeared a year or so later when I prepared for my GRE. I bought his beautifully-crafted and illustrated Economics (I still have the book, paperback edition) and I loved it. It just opened up for me an entirely new world where both the grand themes of economics and chicken-feed issues from his columns coexisted and enlightened each other. I read I think every word of the book: I still have my notes on the margins, my numerous one-pagers explaining this or that. The book was absolutely right for me as I was then at 21. It was neither too easy nor impossibly hard. It had challenging parts but such that  I knew I would, with effort, figure out.

Economics was not  an exceedingly expensive book (perhaps $10), although it was some 4-5% of the average after-tax salary. I have to say though that I was then, compared to most of my friends, quite “well-off”. I was earning money, mostly through consecutive translation but also from tutoring and other odd jobs, since I was 18. As I lived (like almost everybody else) with my parents and had zero living expenses, and also had a girlfriend who lived outside the country and so I was practically not going out, I spent most of my time either with friends at home, or reading and reading and reading. Both were cheap occupations and most of my money was spent on books and soccer games (and later on records).

There were however several small things in Economics that—I still remember this  40 years later--irritated me.  The first was Samuelson’s frequent exhortation to readers which would end with “Bon appetit!” (in French), and a similarly vulgar “the proof of the pudding is in the eating”. And then there was his parochialism where, other than for the classics, all other citations were from professors from about four or five top US universities. I found this annoying: was not there anyone else in this wide world who has done something worth mentioning? Constant references to person’s university were also silly because people would change universities. (I suppose Samuelson had then, in the next edition, to revise their provenance.) Also I did not like Samuelson’s use of possessives like “Harvard’s Johnson” (rather than “A. Johnson from Harvard University”) as if people were slaves of universities. But it was a great book, and I remember it warmly.

Fast forward to 1990, when I was already in the United States. A group of university friends who were then in the economic commission of the Democratic Party (that was the time when the multi-party system in Yugoslavia/Serbia was just born) suggested that we ask Milton Friedman for privatization advice. (I must say that I liked a lot his unfinished Price Theory and never cared for The Theory of the Consumption Function which I think was tautological.)

I wrote a nice letter. What was our surprise when a week or so later, we received a three-page detailed, nicely typed (this was before word processors) reply from Friedman! Unfortunately, I do not think I have kept it: it must have gotten lost in my many moves. It was friendly, substantive, used both UK and British Columbia privatization examples, and if I recall correctly, advised a free voucher privatization. Friedman never came to Yugoslavia (in the letter he said he would come to Belgrade if we could also arrange for him to visit Dubrovnik; but this was said in a very amiable way), and privatization went much worse than anyone expected. I read later that Friedman said how he, like everybody else, was wrong in underestimating the difficulties of transition and privatization.

Thus without ever meeting any of these two giants, they did influence a bit my economics. On a more serious note, I think that Samuelson may be remembered in the longer-term much less well than deserved by his intellectual capacities perhaps because he had a too narrow and too technical view of economics. Unlike Keynes, Pareto, Walras or Marx, for example, his interests were narrow and he was not a great writer.  Friedman may be different as he got closely associated with one big idea (as Nassim Taleb says, one should have only one big idea) and that idea will be around as long as economics exists.