Is inequality inefficient?

It depends, of course. In my recent article, Inefficient Inequality, I argue that it very well could be. I am wary of making sweeping generalizations, but I believe it is important to point out the ways in which certain levels and types of inequality can, in theory, lead to inefficient outcomes. In my view, there is far too much made of the idea that wealth accumulation provides the only incentive for hard work and ambition that drive economies forward. I don’t personally doubt that it does, only that the other side – that super-wealth also creates pathologies – does not get enough play.

Here are some of my points about how inequality may be allocatively inefficient:

Inequality may suppress capital investment.

It could be the case that increasing wealth inequality merely changes the number of people with capital to invest: the amount of money invested stays the same, only concentrated in fewer individuals. But in addition to investment, there is a consumption side: fewer individuals with less disposable income spend less money, reducing the incentive to invest in products that then won’t get off the shelves. Whether a recovery should be investment-led or consumption-led is a complicated matter, and among macroeconomists often more about ideology than empiricism, but in my view the latter has gotten insufficient attention.

The same-amount-of-money argument also overlooks the fact that a huge amount of the capital held in a society is human capital, the formal and informal learning undertaken by individuals. Concentrating wealth can have the negative effect of narrowing the breadth of access to education. A lessening of human capital is particularly harmful because human capital builds on itself: broader human capital makes the best human capital even better.

Inequality may erode social trust.

Inequality has always existed, but at times it has driven a social wedge between haves and have-nots. Growing inequality means that wedge is getting deeper. It was shocking when, in a 2014 Pew survey, respondents in the top 40% by financial security agreed with the statement “[p]oor people today have it easy because they can get government benefits without doing anything in return.” It was never easy for people to cross the empathy gap between rich and poor, but it seems to be even harder now. Without any sense of a shared society, trust becomes more scarce.

Inequality can lead to bad policy.

Much of my work draws on Thomas Piketty’s Capital. It has been widely criticized, and my colleague Samuel Hammond joins many others in doubting the usefulness of Piketty’s r > g relation. I cede the empirical arguments to Piketty’s critics, but I want to suggest that the relation retains a useful heuristic role. Historically and broadly, legal rules and institutions have done a much better job of protecting returns to capital than in promoting economic growth.

Mancur Olson wrote decades ago about why nations rise and then decline in a downward one-way ratchet of unemployment and stagflation. Over time, Olson argues, a country with a stable political environment allows special interest groups to develop. Special interest groups exist only to engage in rent-seeking – why else would members of special interest group join and pay dues, unless they expect the group to obtain benefits they could not obtain themselves as individuals? Over time, special interest groups form, they gain influence and secure above-normal wealth, and what is left over is below-normal wealth for everybody else. While Olson is primarily concerned with allocative inefficiency and Piketty with distributive effects, they are both sides of the same coin: the real problem with inequality is that it produces inefficiency. Both see a one-way ratchet, not a cycle. Both see their stories as mostly inevitable, checked only by random, infrequent, exogenous shocks.

Even this modest deployment of r > g may be too much for some, who might blanch at the thought of Olson being associated with the likes of Piketty. But I want to suggest that Olson and Piketty are talking about the same mechanism: inequality seeking to perpetuate itself, and it cannot be done unless legal rules and institutions are bent to that purpose. Take finance. Tyler Cowen has argued that there is one form of inequality that is truly pernicious and inefficient: the propensity of the finance sector to leverage its wealth to get government to insure its risky bets. The result is higher returns, with the downside losses inefficiently borne by the taxpayer. Eric Posner and Glen Weyl have also argued this, though they might resist the connection to inequality, even as they acknowledge that compensation for finance workers has been inordinately and, they seem to suggest, inefficiently high.

Would the finance industry be able to gamble with other people’s’ money without this recent (decades-long) growth in inequality? It is hard to say without a counterfactual, and it is also hard to make a generalization about “law,” or “legal rules and institutions.” But as a law professor, I look around and see numerous other legal analogs to the finance industry’s gambling with other people’s’ money, with resultant inequality and concomitant inefficiency. The law plays a central role in enabling this social pathology. Need I even mention climate change? Why is there such a rush to restore coal leasing on federal lands, given that the social costs are nearly ten times the mine mouth price? Climate change will of course produce harms, but in vastly unequal ways. Giving those with the least to lose the power to ignore social costs and let climate change proceed apace is one more way inequality can be inefficient.

With so much discussion around the trade-off between reducing equality and promoting efficiency, it is worth keeping in mind the many ways inequality may be inefficient, as well.

Shi-Ling Hsu is the D’Alemberte Professor and Associate Dean for Environmental Programs at Florida State University’s College of Law.