Inequality Might Matter

James Taranto forwarded an article by Arthur C. Brooks of Syracuse University's Maxwell School. Professor Brooks makes several good arguments against the left's misguided obsession with income equality. In his research, Professor Brooks has found that inequality does not make poor people miserable and that:

"...the evidence reveals that it is not economic inequality that frustrates Americans. Rather, it is a perceived lack of opportunity. To focus our policies on inequality, instead of opportunity, is to make a serious error..."

Professor Brooks notes that some left wing academics hold that the wealthy should be taxed so that they will not work. The proponents of this theory believe that the only significance of high incomes is high earners' ability to make whoopee and spend money. This, of course, fails to grasp that high earners create consumer surplus, so that discouraging the productive wealthy from working would devastate national welfare.

Think of it this way. Let's say Albert Sabin and Jonas Salk had become wealthy as scientists. The left would argue that because they had made money in prior work, they should have been discouraged from doing further work because their high incomes might have been irritating to low-income Americans. However, the low-income Americans who would otherwise have suffered from polio might have been more irritated at the economists than at Sabin's and Salk's high incomes. Advocacy of broad policies based on narrow findings about reactions to income inequality puts academics making such generalizations into the quack category.

Brooks adds that the general level of happiness has not changed since 1972 and that economic mobility rather than equality creates happiness among Americans:

"An accurate and constructive vision of America sees a land of both inequality and opportunity, in which hard work and perseverance are the keys to jumping from the ranks of the have-nots to those of the haves. This vision promotes policies focused not on wiping out economic inequality, but rather on enhancing economic mobility."

Amen. But there are reasons to be concerned about inequality. Increasing income inequality may not result from free market sources. Rather, increasing income inequality may result from federal policies that liberal economists have previously advocated. These include (1) indirect effects of the income tax and (2) credit policies of the Federal Reserve Bank.

Marginal tax rates may discourage effort of low-wage workers, increasing inequality. Because income taxes discourage saving, they reduce capital formation. Capital formation increases wages, especially for blue collar workers.

Federal Reserve Bank policy may be the ultimate source of increasing income inequality. Professor Brooks ought to ask whether wages of low-wage workers relative to high-wage workers are increasing at the rate they did before the Fed was established in 1913. They likely are not. Since the 1970s there has been a flattening in real wage growth.

The reason the Fed's credit policies might result in more rapid income increases at the upper end of the distribution is that cheap credit increases the available investment opportunity set. Low interest rates increase profits. Increased profits help the wealthy. They may hurt low-income Americans if low interest rates expand the expected present value of returns on cost-strategy type investments such as moving plants overseas, reducing demand for domestic labor. Such investments might not be made in a high interest rate environment if they do not impact the expected present value of future earnings sufficiently. This could easily be the case.

An error that the American Enterprise Institute makes in its various media statements is the claim that credit expansion and interest rates are costless to the public. This is not true. Low-income workers may pay twice. First, because they do not participate in profit growth due to low interest rates because they are less likely to hold assets (stocks and real estate, for example). Second, if high earners are not like Sabin and Salk and are earning their high incomes because of Federal Reserve policy rather than because they create of consumer value. If easy money has resulted in extraction of wealth through "malinvestment", credit expansion may cause inequality and also result in inflation. Credit expansion is not free--it results in a declining dollar, high import costs, economic dislocation, and likely ultimately inflation. In the 1970s the sum of unemployment and inflation was called the "misery index".

In order to gauge the effects of increasing income inequality, Professor Brooks would need to look dynamically into the future, when Americans are confronted with inflation and economic dislocation due to the same Fed policies that have contributed to increasing income inequality. Although the claim that taxation is the solution to this problem is preposterous, the issue is more important than the American Enterprise Institute would like us to believe.