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The Inefficiency of Inequality

Why America's staggering wealth disparity is an economic problem -- not just a moral one.

The debate about inequality inflames many passions because of its moral and philosophical trappings. But inequality is also an economic phenomenon with enormous consequences that we are just beginning to understand. In fact, inequality's impairment of economic growth may dwarf its more apparent social costs.

To understand why, consider what happens when economic opportunities are in short supply. When any market has a shortage, not everyone gets the things they want. But who does get them also matters, because it's not always the people who value those things the most.

Economists Edward Glaeser and Erzo Luttmer made this point in a 2003 paper about rent control. "The standard analysis of price controls assumes that goods are efficiently allocated, even when there are shortages," they wrote. "But if shortages mean that goods are randomly allocated across the consumers that want them, the welfare costs from misallocation may be greater than the undersupply costs." In other words, letting the wrong people buy the scarce goods can be even worse for society than the scarcity itself.

This problem, which economists call inefficient allocation, is present in the market for opportunities as well. It's best for the economy when the person best able to exploit an opportunity is the one who gets it. By giving opportunities to these people, we make the economic pie as big as possible. But sometimes, the allocation of opportunity is not determined solely by effort or ability.

To a great degree, access to opportunity in the United States depends on wealth. Discrimination based on race, religion, gender, and sexual discrimination may be on the wane in many countries, but discrimination based on wealth is still a powerful force. It opens doors, especially for people who may not boast the strongest talents or work ethic.

Country club memberships, charity dinners, and other platforms for economic networking come with high price tags decided by existing elites. Their exclusion of a whole swath of society because of something other than human potential automatically creates scope for inefficient allocation. But it's not always people who do the discriminating; sometimes it's just the system.

For instance, consider elected office. It's a tremendous opportunity, both for the implementation of a person's ideas and, sad to say, for financial enrichment as well. Yet running for office takes money -- lots of it -- and there are no restrictions on how much a candidate may spend. As a result, the people who win have tended to be very wealthy.

Of course, political life isn't the only economic opportunity with a limited number of spots. In the United States, places at top universities are so scant that many accept fewer than 10 percent of applicants. Even with need-blind admissions, kids from wealthy backgrounds have huge advantages; they apply having received better schooling, tutoring if they needed it, enrichment through travel, and good nutrition and healthcare throughout their youth.

The fact that money affects access to these opportunities, even in part, implies some seats in Congress and Ivy League lecture halls would have been used more productively by poorer people of greater gifts. These two cases are particularly important, because they imply that fighting poverty alone is not enough to correct inefficient allocations. With a limited number of places at stake, what matters is relative wealth, or who can outspend whom. And when inequality rises, this gap grows.

And rise it has. According to the Federal Reserve's Survey of Consumer Finances, the share of American wealth held by the top 10 percent of families (ranked by net worth) climbed from 67 percent in 1992 to 75 percent in 2010. In the 2010 survey, the average net worth of the bottom half of families was $11,400. For the next quarter of families, the average was $168,900. Clearly, these two groups face vastly different economic opportunities in our society, regardless of their raw aptitude.

If you believe that poor people are poor because they are stupid or lazy -- and that their children probably will be as well -- then the issue of inefficient allocation disappears. But if you think that a smart and hardworking child could be born into a poor household, then inefficient allocation is a serious problem. Solving it would enhance economic growth and boost the value of American assets.

There are two options. The first is to remove wealth from every process that doles out economic opportunities: take money out of politics, give all children equal schooling and college prep, base country club admissions on anonymous interviews, etc. This will be difficult, especially since our society is moving rapidly in the other direction. Election campaigns are flooded with more money than ever, and the net price of a college education -- after loans and grants -- has jumped even as increases in list prices have finally slowed. Poor kids who do make it to college will have to spend more time scrubbing toilets and dinner trays and less time studying.

The other option is to reduce inequality of wealth. Giving poor children a leg up through early childhood education or other interventions might help, but it would also take decades. So would deepening the progressivity of the income tax, which only affects flows of new wealth and not existing stocks. In the meantime, a huge amount of economic activity might be lost to inefficient allocation.

The easiest way to redistribute wealth continues to be the estate tax, yet it is politically unpopular and applies to only about 10,000 households a year. All of this might change, however, as more research estimates the harm caused by inequality through the inefficient allocation of opportunities.

This kind of research is not always straightforward, since it measures things that didn't happen as well as those that did. Nevertheless, some economists have already shown how value can be destroyed through inheritance and cronyism among the wealthy. Scaled up to the entire economy, the numbers are on the order of billions of dollars.

These costs are not unique to the United States. Even as globalization has reduced inequality between countries, it has often increased inequality within them; the rich are better able to capitalize on its opportunities. Where nepotism and privilege are prevalent, the costs are amplified.

The Occupy protestors were on to something, but the economic damage caused by unmitigated inequality of wealth is at least as salient as their moral objections. This is an urgent challenge to the prosperity of the United States and the global economy. Ignoring inequality makes us all poorer.

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Daniel Altman

The Bad Bargain

Is the declining value of labor behind the dangerous rise in income inequality?

What explains the growing levels of income and wealth inequality inside rich countries? Data provide at least one answer: the share of income earned by investors has been steadily cutting into the share earned by workers. There are several factors behind this shift, but they all come down to one thing: bargaining power. That's where the problem is -- the question is whether it can also be the solution.  

Labor's share of national income has been falling slowly since the 1970s in rich countries around the world. A measure of labor's share called "real unit labor cost" -- in plain English, the total wages and benefits paid to all workers, divided by total output in an economy -- used to range from about 50 percent to 75 percent for countries in the Organization for Economic Cooperation and Development; now it's down to roughly 40 percent to 70 percent. What happened?

Economists like to tell three stories. The first is about union membership, which dropped steadily in the 1970s and 1980s before flattening out in the 1990s. Without unions, workers were in a weaker position to bargain with investors -- represented by corporate boards -- for their share of the profits from selling goods and services. Second is a story about the integration of the global economy. With new sources of labor coming online around the world, especially in Asia and Eastern Europe, workers' bargaining power in rich countries shrank still further. Finally, there were changes in technology. With more sophisticated machines and ways of doing business, it became easier to replace labor with capital. This was especially true in low-skill industries.

All three of these stories are really about bargaining power. As the influence of unions began to decline, workers had to compete against each other: myriad sellers of labor negotiating with just a few buyers. And with the onset of globalization, workers also had to compete with their counterparts overseas. Finally, with technological change, workers had to compete with machines. In each case, the bargaining power of individual workers slipped.

There's also a fourth story, and it has to do with the other side of the bargaining table. In the United States, the average size of firms rose from just over 15 employees in 1977 to about 23 at the end of the 1990s and stayed above 22 through 2009. In other words, the average number of potential employers for each worker sank, and fewer options for each worker meant even less bargaining power.

With these four forces in play, it's not hard to see why workers saw little increase in purchasing power despite their rising productivity. Yes, companies still wanted to hire them; unemployment rates in the 1990s and 2000s were some of the lowest on record in rich countries. But in retrospect, this was partly because labor was available on the cheap. Even with low unemployment, inequality grew.

Despite the ugly consequences for society of the decline in labor's bargaining power, some pundits have suggested that the trend is not a bad thing. For them, the solution is simply to turn workers into bigger investors.

In the United States, this notion is risible. Ranked by net worth, the lowest three quarters of families received less than 2 percent of their income directly from financial assets over the past decade, versus close to 80 percent from wages. Only half of families had indirect holdings of financial assets through pension funds, trusts, or other assets. To make any sort of dent in their dependence on labor income, you'd have to increase their holdings of capital by an order of magnitude at least. But as no one is just going to give financial assets to workers, you'd have to pay them with assets rather than regular salaries -- the same way many companies pay their top executives.

Yet then you'd be forcing millions of low-income people to rely on the volatile returns of stocks and bonds instead of the steady flow of wages. You could smooth out the returns through some sort of insurance scheme, but you'd essentially be punishing low-income people for being risk-averse -- a natural tendency when putting food on the table is the main concern.

Education may be a better answer. Bargaining power has eroded much less in high-skilled occupations that can't easily be sent offshore or replaced by machines, whether in factories or on farms. It's not easy for everyone to climb the skills ladder, though, and doing so takes time, especially with a U.S. educational system that's struggling to keep up with foreign competition.

A quicker fix might be for workers to take some of their bargaining power back. One way is for governments to negotiate for them, by raising minimum wages. Some states and municipalities have being doing this, but they risk companies relocating to lower-wage jurisdictions. Meanwhile, the percent of workers represented by unions actually dropped from 13.7 percent in 2008 to 12.5 percent in 2012.

Here in the United States, competition from abroad would remain even if Washington increased the minimum wage nationwide. The same would be true if American workers unionized en masse. The truth is that to stop the erosion of labor's bargaining power, action at home would not be enough; workers would have to act at the global level.

In other words, if you can't beat ‘em, join ‘em. To wrest income back from investors, workers would have to join together to limit companies' labor options all over the world. It may seem farfetched to imagine call center workers from Idaho negotiating alongside those from India, but it might also be the only way for the ones in Idaho to regain what they've lost. The question is whether the ones from India will go along.

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