Why inequality matters?

This is the question that I am often asked and will be asked in two days. So I decided to write my answers down.

The argument why inequality should not matter is almost always couched in the following way: if everybody is getting better-off, why should we care if somebody is becoming extremely rich? Perhaps he deserves to be rich—or whatever the case, even if he does not deserve, we need not worry about his wealth. If we do that implies envy and other moral  flaws. I have dealt with the misplaced issue of envy here (in response to points made by Martin Feldstein) and here (in response to Harry Frankfurt), and do not want to repeat it. So, let’s leave envy out and focus on the reasons why we should be concerned about high inequality.

The reasons can be formally broken down into three groups: instrumental reasons having to do with economic growth, reasons of fairness, and reasons of politics.

The relationship between inequality and economic growth is one of the oldest relationships studied by economists. A very strong presumption was that without high profits there will be no growth, and high profits imply substantial inequality. We find this argument already in Ricardo where profit is the engine of economic growth. We find it also in Keynes and Schumpeter, and then in standard models of economic growth. We find it even in the Soviet industrialization debates. To invest you have to have profits (that is, surplus above subsistence); in a privately-owned economy it means that some people have to be wealthy enough to save and invest, and in a state-directed economy, it means that the state should take all the surplus.  

But notice that throughout the argument is not one in favor of inequality as such. If it were, we would not be concerned about the use of the surplus. The argument is about a seemingly paradoxical behavior of the wealthy: they should be sufficiently rich but should not use that money to live well and consume but to invest. This point is quite nicely, and famously, made by Keynes in the opening paragraphs of his “The Economic Consequence of the Peace”. For us, it is sufficient to note that this is an argument in favor of inequality provided wealth is not used for private pleasure.

The empirical work conducted in the past twenty years has failed to uncover a positive relationship between inequality and growth. The data were not sufficiently good, especially regarding inequality where the typical measure used was the Gini coefficient which is too aggregate and inert to capture changes in the distribution; also the relationship itself may vary in function of other variables, or the level of development. This has led economists to a cul-de-sac and discouragement so much so that since the late 1990s and early 2000s such empirical literature has almost ceased to be produced. It is reviewed in more detail in the Section 2 of this paper.

More recently, with much better data on income distribution, the argument that inequality and growth are negatively correlated has gained ground. In a joint paper Roy van der Weide and I show this using forty years of US micro data. With better data and somewhat more sophisticated thinking about inequality, the argument becomes much more nuanced:  inequality may be good for future incomes of the rich (that is, they become even richer) but it may be bad for future incomes of the poor (that is, they fall further behind). In this dynamic framework, growth rate itself is no longer something homogeneous as indeed it is not in the real life. When we say that the American economy is growing at 3% per year, it simply means that the overall income increased at that rate, it tells us nothing about how much better off, or worse off, individuals at different points of income distribution are getting.

Why would inequality have a bad effect on the growth of the lower deciles of the distribution as Roy and I find? Because it leads to low educational (and even health) achievements among the poor who become excluded from meaningful jobs and from meaningful contributions they could make to their own and society’s  improvement. Excluding a certain group of people from good education, be it because of their insufficient income or gender or race, can never be good for the economy, or at least it can never be preferable to their inclusion.

High inequality which effectively debars some people from full participation translates into an issue of fairness or justice. It does so because it affects inter-generational mobility. People who are relatively poor (which is what high inequality means) are not able, even if they are not poor in an absolute sense, to provide for their children a fraction of benefits, from education and inheritance to social capital, that the rich provide to their offspring. This implies that inequality tends to persist across generations which in turns means that opportunities are vastly different for those at the top of the pyramid and those on the bottom. We have the two factors joining forces here: on the one hand, the negative effect of exclusion on growth that carries over generations (which is our instrumental reason for not liking high inequality), and on the other, lack of equality of opportunity (which is an issue of justice).

High inequality has also political effects. The rich have more political power and they use that political power to promote own interests and to entrench their relative position in the society. This means that all the negative effects due to exclusion and lack of equality of opportunity are reinforced and made permanent (at least, until a big social earthquake destroys them). In order to fight off the advent of such an earthquake, the rich must make themselves safe and unassailable from “conquest”. This leads to adversarial politics and destroys social cohesion. Ironically, social instability which then results discourages investments of the rich, that is it undermines the very action that was at the beginning  adduced as the key reason why high wealth and inequality may be  socially desirable.

We therefore reach the end point where the unfolding of actions that were at the first supposed to produce beneficent outcome destroys by its own logic the original rationale. We have to go back to the beginning and instead of seeing high inequality as promoting investments and growth, we begin to see it, over time, as producing exactly the opposite effects: reducing investments and growth.

In the footsteps of Mr. Nye-Powell: inequity and creativity*

When you read VS Naipaul for the first time, it is like when you have tasted ice for the first time (to use another of my favorite writers). You never forget it. I read VS for the first time when I travelled to India in the early 1980s. I made a mistake of taking his book “The Wounded Civilization”. I cannot remember if my  Indian friends suggested it, or I just read about it in newspapers, or perhaps I simply ran into it in a bookstore and bought it. I do know however that I had never heard of Naipaul’s name before.

I read the book while in Delhi and Bombay and it filled me with fear and despair. I was not naïve (even when I was young). I was not a do-gooder. But I just felt reading through the book that detailed all the failings of India, to be riding, or rather to have been submerged, under an enormous wave of hopelessness. Nothing could be done to make peoples’ lives better regardless of how much you wanted to do so: every effort was doomed to fail, to come to naught, even turn into its opposite. It was a miracle that India existed at all: so hopeless it was. Naipaul would later change his views (in “A Million Mutinies Now”), but my point is no whether he was right or wrong on India then—but that he was a writer of uncommon ability to pack in words the emotions that would not leave you for days.

Eventually, I had to quit reading the book while I was in India. It happened to me only once again. When I was in Djibouti in the early 1990s, I, not suspecting anything, bought in Belgrade, a short booklet that was Ivo Andric’s Ph D dissertation about the Ottoman rule in Bosnia. The bleakness of the description of that rule in a non-fiction book (Andric’s only non-fiction) was so powerful that I decided to stop reading since I feared that it might influence my relations with people in Djibouti, overwhelming majority of them Muslim.

I continued reading Naipaul after India. I think I read most of his non-fiction, but  not much of his fiction (“A house for Mr. Biswas” and “Half a Life” being the only ones). I loved all his books; long after I have forgotten the details, a sharp observation would still be with me. I can declaim a number of them even now. When Naipaul died last August I thought the world had lost perhaps its greatest writer.

But I did not think much about him, nor was I planning to read more of his books. However: a couple of weeks ago, in Washington, I saw in a used bookstore a well-preserved copy of Paul Theroux’s “Sir Vidia’s Shadow: A Friendship Across Five Continents”. The book attracted my attention also because inside the book there was a photograph of the youthfully-looking Paul Theroux with a caption the like of which I have never seen before. It said that the photo could be used only if writing reviews of the book and that all other uses were prohibited. I do not think any weirder injunction to the book readers is easy to imagine.

Theroux’s book is excellent. Theroux, whose wittings were largely unknown to me (I read many years ago one or two of his short pieces in The New Yorker or in the NYRB), had written a sympathetic (yes, I think so) and riveting book on his friendship with, and the strange individual that was, VS Naipaul. The book led to the break-up of their relationship. Still it is difficult, for even an admirer of Naipaul, to say that the book was unfair to him--with the exception of one chapter where Theroux, quite unnnecessarily, repeats the gossip about Naipaul that he did not witness. Theroux describes himself multiple times as disciple of Naipaul’s, having benefited enormously from his literary comments and knowledge, even after both men have achieved a measure of fame and when the difference in their age (less than ten years) had become rather negligible compared to what it was when then first met in Kenya, and when Theroux was in the early 20s.

From a very bourgeois morality standpoint, one can criticize Theroux for revealing thoughts that were said in privacy or in confidence and that one does not wish to see repeated, especially not in print. (Although with VS who obviously had an exhibitionist streak one is not even sure that he really did not want these things reported.)

But the rules for ordinary mortals are different from the rules for great men. What might be considered a breach of confidence in an ordinary relationship, was in this case (perhaps) driven by the need to describe one of the foremost writers of the era, the way he was. And the singular character of Naipaul, the solitary, often child-like, complex, utterly egocentric and selfish man, provides a great literary subject—so much so that the book can be read as much as a work of fiction as a description of an actual  friendship.

For Naipaul himself can appeal to us on the same grounds: that the private actions of great people cannot be judged by the same yardstick we use in everyday life. His treatment of his two wives/partners is nothing but heartless and  egotistic insensitivity. But when we read Tolstoy’s “Anna  Karenina” do we think about how he treated Sophie?  When we read Kafka do we think about the day when after the engagement party to Felice Bauer, with her entire family present, he abruptly cancelled the wedding? When we read Naipaul we no more think about how he treated Pat Naipaul and Margaret Gooding. It is a gender inequity issue for which Naipaul is not the only example. Who cooked Adam Smith’s dinner? And who took care of Karl Marx’s kids, including the one that he conceived with the family maid? Moreover, it could be thought not only that without his two wives Naipaul would not have become what he did (which is a pretty conventional way), but—more extremely—that without him treating them in such an awful way he wouldn’t have written the books that he did.

Towards the end of his life Naipaul had become a caricature of everything that he despised in his youth. He was an OBE, Sir Vidia; he moved in the company of ambassadors, politicians and tycoons; he travelled not as on ordinary person, but as the president of the Republic of Letters; he was feted, wined and dined for free. He did not need even to pretend not to have noticed restaurant bills as when he was younger, poorer and associated with Theroux.

But he was also one of the most powerful writers of the second half of the 20^th century, a man who set out from deep poverty and the world periphery to reach the top. Like Kafka, Naipaul is impossible to classify in any of our ordinary niches, for he was neither Trinidadian, nor Indian, nor British, nor Hindu, nor religious, nor an atheist. A perfect citizen of nowhere. A real globalist.

* Nye-Powell, with the appropriately exaggerated pronunciation, is Naipaul's own mocking of his name, of the Anglicized gentleman that he would become in his old age, and of his fame, which he never doubted would come, whether during his life or posthumously. 

How Adam Smith proposed to have his cake and eat it too

It is this deception which rouses and keeps in continual motion the industry of mankind. It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and arts, which ennoble and embellish human life; which have entirely changed the whole face of the globe, have turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth… It is to no purpose, that the proud and unfeeling landlord views his extensive fields, and without a thought for the wants of his brethren, in imagination consumes himself the whole harvest that grows upon them. The homely and vulgar proverb, that the eye is larger than the belly, never was more fully verified than with regard to him. The capacity of his stomach bears no proportion to the immensity of his desires, and will receive no more than that of the meanest peasant. The rest he is obliged to distribute among those, who prepare, in the nicest manner, that little which he himself makes use of, among those who fit up the palace in which this little is to be consumed, among those who provide and keep in order all the different baubles and trinkets, which are employed in the oeconomy of greatness; all of whom thus derive from his luxury and caprice, that share of the necessaries of life, which they would in vain have expected from his humanity or his justice. The produce of the soil maintains at all times nearly that number of inhabitants which it is capable of maintaining. The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species. When Providence divided the earth among a few lordly masters, it neither forgot nor abandoned those who seemed to have been left out in the partition. These last too enjoy their share of all that it produces. In what constitutes the real happiness of human life, they are in no respect inferior to those who would seem so much above them. In ease of body and peace of mind, all the different ranks of life are nearly upon a level, and the beggar, who suns himself by the side of the highway, possesses that security which kings are fighting for. (emphasis mine)

Who has not read this long, and famous, paragraph in Smith’s “Theory of Moral Sentiments”, and been left absolutely speechless? Not only because it is the first (of only three) mentions of the invisible hand, but because after the most eloquent critique and even ridicule piled upon the rich landlords, it ends with a Panglossian conclusion that everything, in this world of inequity, is actually done in the best possible manner. Who, but the most stone-hearted writer, would seriously aspire to defend a distribution of whose injustice he is so aware and critical, and to do this by using the threadbare excuse that the rich really overestimate the worth of their wealth and comforts, and that the poor, “sun[ing]…by the side of the  highway” may be as happy as the rich? It seems so presumptuous a statement that our facilities of reacting to it appear, for a moment, to have been stunted.

David Wootton in a new book “Power, Pleasureand Profit: Insatiable Appetites from Machiavelli to Madison“ opens his chapter dedicated to Smith with this long quote. He relates it to the discussion (of which I wrote here) about the two Adam Smiths, the one of the TMS (a moralist) and another of the WoN (a realist). Wootton argues that Smith’s introduction of  self-delusion among the rich is crucial to downgrade the moral significance of acquisition of wealth. Smith needs people to believe that wealth will give them happiness so that they work hard, take risks, and invest, and thus make us all better off as the society gets wealthier. But he also needs self-delusion to make sure that there is equality in the space of happiness, in other words that the rich never attain the happiness after which they strive.  

The self-delusion is thus the key link that ensures that there is no trade-off between growth and equity. Self-delusion acts as a deflator of all actual wealth: yes, I have a big house, but if I use a delusion deflator of 100, the happiness that it gives me makes it feel like a hut. The social order  which produces such inequitable outcomes in the space of actual incomes and wealth, is not impugned: actually existing inequality is immaterial.

But did not Smith really delude himself about that delusion? Wootton writes: “Thus Smith failed to acknowledge the amorality of market forces…He failed to recognize that speculators and gamblers, thieves and fraudsters often flourished while people of industry, prudence, and circumspection were broken by forces outside their control” (p. 279).

Had Smith accepted that amoral and often immoral ways in which wealth is acquired (mentioned in innumerable examples in his two books) can lead to greater happiness of those who engage in such acts, he would have validated the rationality of such behavior.  A commercial society could be seen  not only as producing a visible hierarchy in which fraudsters are on the top but allowing them to live happier lives than the rest. How could then such a society be morally justified? Religion came with the answer that such riches are ephemeral: the real riches lie beyond. For Smith, the delusion does the job: it comes in to erase the importance of undeserved gains. Adam Smith can have his cake and eat it.

I do not think that anyone would have defended this point of view today because it relies on something that is manifestly false: the argument that higher income or wealth do not (at a given point in time and in a given society) lead to greater happiness. This opposite is true empirically (as the studies on happiness show), and it is revealed in our daily behavior through permanent striving for more. Thus the argument which denies the relevance of massive inequality in the distribution of “earthy” goods by minimizing their importance—or by claiming that in the end, we would all be dead—is indeed one of the most brazenly dishonest arguments. For if the authors of this kind of arguments seriously believed them, they should have nothing against the poor and the rich changing places. But they have seldom proposed to proceed to such a swap.