How Big of a Deal Is Income Inequality? A Guest Post

Retired neurologist William Bernstein is probably known for his investment books The Intelligent Asset Allocator and The Four Pillars of Investing. His two latest books, A Splendid Exchange: How Trade Shaped the World and The Birth of Plenty, deal with the history of world trade and economic growth, subjects he has agreed to blog about here.

How Big of a Deal Is Income Inequality?

by William Bernstein

A Guest Post

For nearly all of human history, the lot of the average person improved not at all. Then, about two hundred years ago, the material well-being of the planet’s inhabitants began to grow at about 2 percent per year.

Although this may not sound like much, it means that the life of a child is nearly twice as prosperous as that of its parent; over a century, the standard of living increases sevenfold. Today, per capita G.D.P. is higher in Mexico than in the world’s wealthiest nation in 1900, Great Britain.

The paradox of economic growth is that the same mechanisms that create great wealth –secure property rights and rule of law guaranteed by an independent judiciary — also give rise to great inequalities in its distribution. Private property provides a powerful incentive to produce wealth for oneself while simultaneously denying that same wealth to others. Wealth does trickle down to the rest of the population, but often not fast enough to avoid political strife and worse.

The reason for this is simple: if individuals cannot keep enough of what they earn then they will not produce. If, on the other hand, the most productive do keep what they earn, significant inequalities inevitably result.

Further, in a technologically driven world where an individual’s unique talents can be scaled up to an almost infinite degree, inequality increases dramatically.

For example, researchers Thomas Piketty and Emmanuel Saez calculated that between 1972 and 2006, the portion of income earned by the top 10 percent of the population rose by half; for the top 1 percent, meanwhile, it doubled; and it quadrupled for the top 0.1 percent. For the top 0.01 percent, it rose sevenfold. The current disparities are nearly identical to those of early 20th-century American robber-baron capitalism.

Economic libertarians argue that this growing inequality is unimportant: aren’t the poor of 2008 still far better off in terms of real income, health, life expectancy, and material comfort than even the richest citizen in 1900?

The fallacy of this argument is that human beings do not measure their well-being by absolute real income or longevity — but rather in relative terms. To paraphrase H.L. Mencken, a wealthy man is one who earns more than his wife’s brother-in-law.

Further, a growing body of research reveals that the social and medical costs of inequality are high. Here is the tiniest of samplings:

• Among both American states and Canadian provinces, homicide rates closely track income inequality, even after the absolute level of income itself is carefully controlled for. That homicide is not driven by poverty alone is demonstrated by Canada, where, because of aggressive redistributive policies, the poorest provinces have the lowest inequalities and also the lowest number of violent deaths.

• It is becoming increasingly obvious among obesity researchers that the primary underlying factors in this epidemic are social class and income inequality.

It is no accident that the U.S., with the highest income inequality among the world’s developed nations, also has the highest incidence of obesity and its attendant comorbidities: diabetes, hypertension, and vascular disease.

Obesity may also be the reason that the U.S., ostensibly the world’s wealthiest nation, ranks 29th in life expectancy, right behind Jordan and Bosnia. Those who think that these problems are primarily the result of voluntary lifestyle choices should reflect on the difficulty of providing a family of four with fresh fruits and vegetables on a minimum wage salary.

Worse, extreme income and wealth inequality alone may hinder growth. After all “respect for property rights” is really, in most cases, shorthand for “respect by the have-nots for the property rights of the haves.” If those on the bottom rungs do not feel that they are getting a fair shake, the very bedrock of our prosperity crumbles into social and economic apartheid as millions of Americans flee to gated communities, millions more are required to staff the burgeoning private security industry, and yet more millions fill our prisons.

This is likely the reason why supply-side economics fails in the real world. Cross national comparisons in developed nations, for example, show no correlation between tax rates and economic growth. Further, the “golden period” of growth in the years before 1973 occurred in an environment of higher tax rates than in the lower-growth 1980’s and 1990’s.

More ominously, several data sets now connect high national income inequality with low growth. Correlation is not causation, and clearly, much more research is called for.

But these data should give pause to those who are complacent about increasing income and wealth disparities, and who further believe that reducing the top marginal income-tax rates and eliminating the “death tax” leads to economic Valhalla.