Economics 11: inequality

by George Hatjoullis

Inequality is one of the most difficult subjects to discuss because it is inevitably emotive. Perhaps it is for this reason that economics has studiously side-stepped the issue and economic theory has proceeded with the assumption (implicit or otherwise) that the size of the cake is independent of the distribution. The thrust of Economics 1-10 is that inequality is not independent of growth of potential output and the failure of economics to discuss adequately this interdependence is the source of many so-called ‘debates’. Inequality is the motivating force of the market system. It is the opportunity for profit that typically drives investment and innovation but not all succeed. Those that do are allowed to keep the fruits of their endeavour and thus inequality is born, sustained and idolised. It is worth noting that inequality is not unique to a market based system but in such a system it does serve a motivational purpose that is productive in terms of GDP. There is inequality in feudal and modern communist systems that merely sustains hierarchies and is patently unproductive. Perhaps this is why these systems failed to survive.

Inequality does come in many forms. In Economics 10 we noted that there is inequality in genetic and social inheritance. This may in turn in lead to inequality of opportunity. There is inequality in the distribution of claims on GDP; the share of labour and profits. There is inequality in the distribution of ownership of the means of production. Society at various points laments the existence of such inequalities and political pressure to reduce (and at times increase) inequality emerges. Such efforts have consequences and often discussion of the desirability of change does not adequately account for the unrecognised and unintended consequences. Economists may ignore the link between the size of the cake and its distribution but others try to have their cake and eat it.

Inequality is productive in terms of GDP but also contains a logical inconsistency that can lead to sustained periods of below potential GDP. This has been the thrust of Economics 1-10. The series has not introduced anything controversial but the characterisation of the source of the problem in terms of inequality is unusual and will make many uncomfortable. It is thus worth elaborating the characterisation. The key is the existence of money.

Money has the interesting feature that it can be accumulated ad infinitum. You can never be too rich. Indeed, for one very important player in the market system, money is a way of keeping score. This player is insatiable because he/she judges self-worth on how much is made during the last endeavour. It matters not whether they have enough accumulated claims on GDP to fund the most extravagant lifestyle for many generations. If the last endeavour (or this years income) yields gains below last years, he/she feels that he/she has failed. The accumulation of wealth is not the objective but a by-product of the use of money as a scoring system. The result is that he/she is always looking for ways to make more money. It is this scoring system that motivates much investment and innovation. The ‘he/she’ may be a group of individuals acting on behalf of others in a corporation, but the same drive is evident. The problem is that the endeavour must result in a realised profit. Unsold output is of no use and someone needs to buy it.

Problems arise, as we have seen, because those that have produced GDP in a period may not want to consume it all. They wish to sell or lend it to someone in return for monetary claims on future GDP. If there are enough people willing to spend from accumulated monetary claims or borrow, then all well and good. However, if aggregate desired saving by the producers of GDP exceeds that of dissavers then there will be unsold goods and this will lead to production cutbacks and unemployment and future GDP below potential. The producers of GDP are labour and the owners of the means of production. The two categories overlap. The distribution of GDP and ownership of the means of production will in part determine the likelihood that aggregate saving will exceed aggregate dissaving at any point. The reason is the propensity to consume differs with income and wealth. Poor people spend most if not all of their income (and thus struggle to accumulate wealth), and rich people spend very little as a % of total income. The lower the share of labour in GDP and the more inequality in the ownership of the means of production, the more likely is desired saving to exceed dissaving (other things being equal) and GDP to operate below potential. Eventually unemployment and losses will reduce desired saving and increase dissaving and the two will equate. However, this can occur at well below potential GDP and can remain at this level for a long period.

To keep the discussion topical (and not bore you too much) let us put this way of thinking to use in the present situation. The central banks seem to think their respective economies are operating below potential. The forward guidance  given is clear evidence that this is so. Yet government policy is targeting an increase in saving through private pension saving, deleveraging and fiscal austerity. Individuals are being forced to work longer at a time when employment prospects are poor owing to below potential GDP (cyclical unemployment). Technology is also making possible large economies in labour inputs and introducing a structural element to the lower demand for labour. The share of labour in GDP seems to be universally at the lower end of the historical spectrum and ownership of the means of production unevenly distributed judging by the evidence of inadequate saving for retirement. It is very difficult to conclude that saving will not exceed dissaving unless something changes.

One interesting theoretical question is whether there is an ‘optimal’ income distribution in the sense of maximizing GDP over time. This involves both growth of potential GDP and keeping the economy operating at close to potential. It is evident that, at some point, inequality can become a problem for a market system. The previous paragraph suggests present levels of inequality have already become a problem. However, complete equality is probably not the solution given social values. If everyone receives the same share of GDP irrespective, then motivation may become a problem and undermine the productivity of the system. Potential GDP may not grow as fast as it may have. The problem is how to replace the productive potential of the insatiable hunger for money. Alternatively, perhaps the solution is to downgrade GDP within the objective function and complement it with some other considerations e.g. CO2 emissions. Given the weather of late this might not be an unpopular direction.

To recap:

1. Inequality is not unique to market based economic systems but it is productive in such systems.

2. Adjusting the degree of inequality may have unintended consequences.

3. The productivity of inequality in market based systems arises from the ability to accumulate infinite monetary wealth and the use of wealth growth to keep score. However, wealth only grows if profitability is realised.

4. If desired saving in aggregate exceeds desired dissaving then GDP may settle below potential. This is more likely with wide inequality.

5. Is there an optimal level of inequality in the sense of maximizing GDP?

6. Perhaps GDP should not be the only consideration.