Friday, 21 October 2016

Inequality- What's It All About?

by Georgia McKirgan

Since about 2010, everyone has been talking about inequality. President Obama has described it as "the challenge of our times" and the Davos conference this year described it as one of the key threats to the global economy. How did we get here, is it a bad thing and what can we do about it? 

Firstly, the statistics are clear. Around the world, income inequality has grown to levels not seen since the 1920s. If we look at the share of total US income going to the top 1% of the population, the graph below shows that this declined from 23.9% in 1924 to 8.9% in 1974 and has climbed back up to 21.2% in 2014. The increase in income inequality is probably more pronounced in the US but similar statistics can be seen in the UK. 

While this has been going on, average earnings have not really moved. Real average earnings are back to where they were in 2001. If you want to find a reason for the increasing levels of dissatisfaction among the electorate, look no further. Most people feel they have not really progressed economically while they see that the top 1% have taken virtually all the spoils of economic growth. For generations, increases in productivity fed through to growing average wages. People would experience growing living standards through their lives and each generation would be better off than the last. This model has broken down and people are not happy. So we can see that income inequality has increased significantly and many people are not happy with this situation. How did it happen? As you analyse the reasons for this increase in income inequality, the reasons can be roughly split into two groups: market driven and rent seeking.

(1) Market-driven reasons

Globalisation and technology have been responsible for the loss of millions of relatively well-paid, skilled manual jobs. The result of this is that a larger and larger share of company profits are going to the people that design, control and manage this automated process rather than to workers on the factory floor. The wages of college-educated people versus non college-educated people are a good proxy for this. The ratio between average college-educated and non college-educated pay was relatively stable for many years but this ratio started to increase in the 1980s and has now doubled over the last 30 years. Changes in the global economy mean that people with skills are increasingly more valuable than those without. Many people who used to hold relatively well-paid skilled manual jobs are now doing minimum wage jobs in the service sector with little hope that their wages will rise significantly.

Another market-based reason for increased income inequality is the response by central banks to the financial crisis. Low interest rates and quantitative easing have boosted the prices of financial assets and property. These assets are disproportionately held by better-off people, either directly or through pension schemes. The FTSE 100 index has risen from 3,500 in 2009 to 7,000 today. Anyone holding UK equities over that period has doubled their money. House prices in the South-East are also now higher than before the crisis.

So, changes in the global economy and monetary policy are responsible for some of the increase in income inequality, but that is not the full story.

(2) Rent-seeking reasons

Rent-seeking was defined by Gordon Tullock in 1967 as "an attempt to obtain economic rent (i.e. the portion of income paid to a factor of production in excess of what is needed to keep it employed in its current use) by manipulating the social or political environment in which economic activities occur, rather than by creating new wealth."

Executive pay is a perfect example of this phenomenon. Economic theory suggests that the pay for a job should be just high enough to attract enough people with the requisite skills and experience for the job. Any more and there would be an excess of applicants and the companies, being economically rational, would lower the wage offered until there were just enough applicants. You would also expect to see a correlation between executive pay and company performance. Neither of these things happen. The people who should control the situation are the owners of the shares in the company (whose money is being wasted) and the boards of the companies acting on the owners' behalf. Most shares are held by large asset managers and the managers of these funds and the  members of the boards benefit if the executives at the companies they own and manage receive high salaries. They use these levels to justify their own salaries, so (surprise, surprise) they are happy to support ever-higher executive compensation. In 1998, the ratio between average pay and CEO pay for FTSE100 companies was 47. In 2015 this ratio was 130. The worst example is the advertising company, WPP, where Sir Martin Sorrell gets paid 780 times the average employee. Executives have been indulging in rent-seeking behaviour.

Rent-seeking behaviour also happens at the bottom of the pay scale, but the extent of this has been substantially reduced. Through collective bargaining, unions are able to negotiate higher wages for their members than the members could negotiate on their own. These wages represent rent-seeking, but the membership of trade unions has been in decline for many years. In 1979, there were 13 million members of trade unions but by 2014 this had fallen to 6.4 million, with the majority of these being in the public sector (civil servants, NHS and schools).

So market changes, monetary policy and increased rent-seeking at the top of the pay scale have resulted in a significant increase in income inequality. Is this a problem? Apart from creating a growing sense of dissatisfaction, there is evidence that this level of inequality is economically inefficient. Put simply: rich people don't spend enough of their income. If you took £1,000 away from a millionaire, it wouldn't really do much to their spending. If you gave this £1,000 to someone in a minimum wage job, a large percentage of it would be spent, which would increase economic activity. Many economist talk about chronic weakness of demand in the economy and the skewed distribution of income may be part of the problem.

How much inequality is good?

A certain amount of inequality can spur economic activity, but how much is good? Professor Richard Freeman of Harvard conducted a simple experiment. He took a group of 6 people and asked them to solve a number of picture puzzles. In the first experiment, he told them that however many puzzles each person completed, they would receive $5 each. At the end of the experiment, the number of puzzles completed was very low as everyone knew that however many they completed they would each receive the same money.

In the second experiment, he told people that the person that completed the most puzzles would get $30 and everyone else would get zero. The people who thought they were quite good at puzzles tried hard, but everyone else did nothing as they didn't think they would win and only the winner would get any money. Again, the number of puzzles completed was quite low.

In the third experiment, the people were told that the person who completed the most puzzles would get paid the most, the next person a bit less, the third person a bit less, etc, with the total prize money adding up to $30. Therefore, at any level of skill the more puzzles you completed, the more you would get paid. The number of puzzles completed in this test was significantly higher than the first two tests. No inequality of income or extreme inequality of income are much less economically efficient than a moderate level of inequality.

So far, so easy. Pointing out that inequality has risen and that this is bad for the economy is the easy bit. What can be done? I've not heard much from politicians, but I have got a few suggestions:

(1) limit executive pay: as a multiple of average pay in each company

(2) gradually increase the minimum wage

(3) massively expand employee share ownership

There are issues with all three of these proposals, but if we do nothing the situation is only going to get worse.

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