economy

THE WASHINGTON POST: Can We Ever Do Better Than the Toilet?

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This article originally appeared in The Washington Post

The cover story for this week’s Economist is on one of our favorite topics: the debate over the state of innovation — whether its slowing down, speeding up and what it means for economic growth. In the grand tradition of the magazine, the authors are anonymous, but there are two pieces on the debate over whether innovation has slowed. The shorter of the two asserts that we have yet to develop “an invention half as useful as” the toilet, going on to state that “the biggest danger” to the fast-flowing juices of innovation in the 21st century is government. The second, longer piece is a tour of the current debate over whether innovation and new technology have stopped fueling growth. The conclusion: take claims that innovation and new technology are no longer fueling economic growth with a grain of salt. The innovation engine continues to churn, just not in the way it once did.

“There will be more innovation,” writes the cover-story’s author, “but it will not change the way the world works in the way electricity, internal combustion engines, plumbing, petrochemicals and the telephone have.”

The longer piece also addresses the work of George Mason University professor and economist Tyler Cowen, mostly from his 2011 book titled “The Great Stagnation.” Asked what he thought of the piece, Cowen said via an e-mail Friday that he thought it was “excellent.”

He went on to say that a “key distinction” needed to be made between ”whether we have had lots of recent innovation” — he thinks we have — and “whether those innovations have much raised typical standards of living for Americans,” which he says is “much less clear.”

“Looking forward, I am optimistic actually,” Cowen said. ”Science has not stopped, it simply gets turned into practical products at a very uneven rate.  The new question will be who is poised to benefit from the forthcoming stream of advances.”

The debate over whether innovation has stalled will very likely continue well after this and many other pieces are written. That said, at least in so far as the toilet is concerned, the Gates Foundation already has an initiative to fund inventions to improve that particular technology. The Foundation’s work, however, did not make an appearance in either piece. So, while they may not be inventing something new, different and completely earth-shattering, at least there are people trying to improve on our existing commode technology.

Notable in the longer cover story, although perhaps not central to it, was this drawing of a thick line between innovation and technology:

Innovation and technology, though talked of almost interchangeably, are not the same thing. Innovation is what people newly know how to do. Technology is what they are actually doing; and that is what matters to the economy.

It’s an important distinction to consider, particularly as the consumer electronics show winds down — an event that was greeted with arelatively loud, collective yawn on the part of tech writers. The next, great, industry-transforming invention may not have been unveiled in Las Vegas this week, but an absence of new technology, as outlined above, doesn’t necessarily mean a slowing of innovation.

 

NATIONAL JOURNAL: Technology Is the Way Out of Economic Doldrums

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This article originally appeared in National Journal

FAIRFAX, Va.—Tyler Cowen says he’s a “small-l libertarian,” but as the prolific George Mason University economics professor talks about jump-starting the economy, it’s clear his ideology isn’t easy to pigeonhole. Cowen says he believes government can spur innovation, but he’s skeptical of regulations and would slash 80 percent of them. In his 2011 book, The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better, he argues that we can fix things. The United States, he says, hasn’t lost its greatness.

Cowen, 50, earned a Ph.D. in economics at Harvard but has further-flung interests. After watching the legendary Spassky–Fischer chess match in 1972, the 10-year-old Cowen started playing the game and, five years later, became the youngest state champion in New Jersey history. He gave up chess for economics. “More interesting,” he says. “And it pays better.”

His curiosity is eclectic. His most recent book, An Economist Gets Lunch: New Rules for Everyday Foodies,explores the food marketplace, which has interested him since age 20, when he first lived abroad in Germany.

“Food is about innovation, small business and big business, entrepreneurship. How do you judge quality? Globalization. Key themes for the world.”

Edited excerpts from an interview follow.

How big an economic fix are we in?

COWEN: It depends on relative to what. We’re still one of the richest countries in the world. A lot of the nonmaterial aspects of our life have gotten a lot better, including social tolerance. So it’s hardly dystopia. But it is still the case we’re planning and spending as if we’ll grow 2 to 3 percent [annually], and we might just grow 1½ percent. That is a disaster. We are not adjusting our expectations to the reality. That said, I do think we will get out of the great stagnation. A lot of the stuff that will get us out of it, we’ve already done. 

Such as?

COWEN: The Internet. The Internet is still [a] somewhat immature technology, and you’ll see education, health care, and retail all fundamentally restructured for the better through the Internet. The Internet and smart machines, software, artificial intelligence—that conjunction of concepts is getting better rapidly. 

Can we return to economic greatness?

COWEN: We have never left greatness. In some ways, you could argue we are the only great country in the world—though Canada and Australia have good claims. In absolute terms, this country has never been better. It’s just the rate of economic improvement has slowed.

Does government have a role in spurring innovation?

COWEN: If you turn on a TV show from, say, the early 1970s, it is remarkable how much life looks familiar. You could take the people from that show and put them [here and now]. Except for computer Internet stuff, they could operate everything. That suggests progress has been slower than [since] earlier in the 20th century. But Internet, computers, artificial intelligence, smartphones—all that has been phenomenal. The government should fund science much, much more—basic research. 

Must we change our expectations of what government will do for people?

COWEN: In terms of spending and borrowing, our expectations have been out of whack with reality since the end of the Clinton administration. Now, these forthcoming technological breakthroughs will help, but we shouldn’t always assume they will translate into tax revenue. You can see a lot of great things coming and still worry about the budget. Take the music sector, which for listeners is better now than it ever has been by a lot. But the revenue in that sector has kind of collapsed. Journalism, too: A lot of stuff is great for readers, not good for revenue. It’s because of technology. We need to be very careful about equating progress with more revenue. For now, this connection between revenue and well-being is a much bigger disconnect than in the past. I sometimes say I am a “happiness optimist” but a “revenue pessimist.”        

The New York Times: World Hunger, The Problem Left Behind

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This article originally appeared in The New York Times

The drought-induced run-up in corn prices is a reminder that we’re nowhere near solving the problem of feeding the world. The price surge, the third major international food price spike in the last five years, casts more doubt on the assumption that widespread economic development leads to corresponding gains in agriculture.

The green revolution has slowed since the early 1990s, and it has become harder to bolster crop yields, as I have discussed in my book, “An Economist Gets Lunch.” And recent research by Dani Rodrik, a professorof international political economy at Harvard, indicates that agricultural productivity improvements are among the hardest to transmit from one nation to another.

For all its importance to human well-being, agriculture seems to be one of the lagging economic sectors of the last two decades. That means the problem of hunger is flaring up again, as the World Bank and several United Nations agencies have recently warned.

Consider Africa, which is often considered to have turned a corner and to be headed toward steady growth. The expansion of the African middle class and the decline in child mortality rates are both quite real, but the advances have not been balanced — and agriculture lags behind.

In a recent address, Michael Lipton, an economist and research professor at Sussex University in Britain, offered a sobering look at Africa’s agricultural productivity. He suggests that Rwanda and Ghana are gaining, but that most of the continent is not. Production and calorie intake per capita don’t seem to be higher today than they were in the early 1960s. It remains an issue how Africa’s growing population will be fed.

One huge problem is that the price of fertilizer in Africa is often two to four times the world price. Yet African soil and rainfall make much of the continent subpar for growing food. In other words, the region that probably needs fertilizer the most also has to pay the most for it, and much of Africa doesn’t have the prosperity to make this an easy stretch. The high prices result in large part from infrastructure and trade networks that aren’t developed enough to create a low-cost and competitive market. And the problem could worsen if economic troubles in China distract it from its beneficial investments in African roads and harbors.

On top of all that, many African nations have unhelpful policies toward agriculture. Malawi, for instance, subjects corn to periodic export and import restrictions as well as to price controls, all of which thwart development of a well-functioning market. When market speculators save corn in anticipation of greater scarcity, they may be punished by law. These restrictions of market incentives exacerbate the basic supply problems.

Such bottlenecks are a challenge for the future of the African economies. For comparison, the rapid expansions of economic growth in Japan, South Korea, and Taiwan were all preceded by significant progress in agricultural productivity. In these countries, higher yields created a domestic surplus for savings and investment, encouraged small-scale entrepreneurship, fostered a sense of economic security and helped the middle class expand.

In contrast, much of Africa’s growth has come from resource wealth — such as oil, diamonds, gold and strategic minerals — and, unfortunately, resource prices are notoriously volatile. Resource wealth is less well-suited to supporting sustainable democracies, because it tends to be connected with state-backed privileges and other legally entrenched entities. The Norwegian government manages its oil wealth just fine, for example, but autocracies and fledgling democracies are more likely to be corrupted.

There is no shortage of writing — often from a locavore point of view — in support of more organic methods of farming, for both developed and developing countries. These opinions recognize that current farming methods bring serious environmental problems involving water supplies, fertilizer runoff and energy use. Yet organic farming typically involves smaller yields — 5 to 34 percent lower, as estimated in a recent studyin the journal Nature, depending on the crop and the context. For all the virtues of organic approaches, it’s hard to see how global food problems can be solved by starting with a cut in yields. Claims in this area are often based on wishful thinking rather than a hard-nosed sense of what’s practical.

WHAT to do? First, put food problems higher on the agenda. In the United States, there is no general consciousness of the precarious state of global agriculture. Even in the economics profession, the field of agricultural economics is often viewed as secondary in status.

Second, the United States government should stop subsidizing its own corn-based biofuels, mainly ethanol. Today, about 40 percent of America’s field corn goes into biofuels, thanks to a subsidy and regulatory policy dating from 2005. With virtual unanimity, experts condemn these subsidies as driving up food prices, damaging land use and costing the taxpayers money. Once the energy costs of producing the biofuels are taken into account, it doesn’t even appear that this policy helps slow climate change. It has become a form of crony capitalism, at great global expense.

Today, we have two presidential candidates who both look a bit short on grand vision and transformational change. Perhaps they could look to helping solve the food problem — and making a big dent in global hunger — as America’s next beneficial legacy.

The world is not yet in that happy situation where “what’s for dinner?” is a boring question.

BusinessWorld: Philippines Could Be ‘Next Rising Star’

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This article originally appeared in The Washington Post


THE PHILIPPINES could be the “world’s next rising star” because it is relatively insulated from the turbulent global environment, economists said on Friday, but the country’s ascent will depend on finding solutions to key constraints.

When you look for countries that could be the world’s next rising star, you look for increasing growth, a stable fiscal deficit, strong English skills and a belief in education,” said Tyler Cowen, an economist at George Mason University, at the inaugural conference of the Angara Centre for Law and Economics.

“The Philippines has all of those things. It has the best chance,” he added.

Exposure to Europe’s ongoing debt woes and the slowdown in China is limited, Mr. Cowen explained as he lumped the Philippines along with Indonesia, Ghana and Nigeria as among the countries expected to be resilient amid the global downturn.

Mr. Cowen stressed, though, that this was not an “absolute prediction,” with much depending on how the government makes the most its opportunities.

“The discussions must begin with structural transformation,” added John Nye, a fellow economist at George Mason University.

One of the main issues that needs to be resolved is how to move people from poor agriculture jobs to better-paying ones in industry, Mr. Nye said, adding that more often than not, this also involves physically moving people to the urban centers.

“However, there are so many laws that make this difficult — laws on zoning, taxation, competition, labor, trade. This network of policies adds up,” Mr. he said. No single law — not even the often-blamed foreign ownership limits in the 1987 Philippine Constitution — is to blame, he added.

Changes must be made to these “redundant,” “misguided” and “contradictory” laws so that more businesses and investments can come into the Philippines and generate much-needed employment.

“The fact that we have so many overseas Filipino workers only means that we have a lot of highly-skilled people willing to work. Why are they so employable abroad but not here? Clearly, there are obstacles to creating employment,” Mr. Nye said.

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The New York Times: A Power Vacuum Is Killing the Euro Zone

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This article originally appeared in The New York Times

As problems mount in the euro zone, it’s increasingly evident that we’ve been witnessing an institutional failure of monumental proportions.

What is to be done about Greece? Simply keeping it in the euro zone won’t help much, even if it’s possible.  The continuing crisis has sapped confidence in banks not only in Greece, but also in Spain, Italy, Portugal and Ireland, though to varying degrees.  Unless there are explicit guarantees to these banks soon, the market will likely take a further turn for the worse.

An absence of guarantees could prompt a broader chain reaction of capital flight and bank collapses across several countries.

The basic problem is that many people won’t keep their euros in a Greek bank, and perhaps not in a Spanish bank, either, when those euros can be moved to Germany or some other haven.

Yet German citizens do not appear ready to guarantee Spanish banks or, by extension, the whole credit system of Spain and the other periphery nations. Guarantees of that scope are probably impossible and may also require constitutional changes in some nations.

We thus face the danger that the euro, the world’s No. 2 reserve currency, could implode.  Such an event wouldn’t be just another depreciation or collapse of a currency peg; instead, it would mean that one of the world’s major economic units doesn’t work as currently constituted.

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences.  For historical reasons, Germany isn’t up to playing the role formerly held by Britain and, to some extent, still held today by the United States.  (But when it comes to the euro zone, the United States is on the sidelines.)

There appears to be a power vacuum, and the implications are alarming. We may be entering a new world where international cooperative arrangements, in environmental areas as well as finance, are commonly recognized as impossible.  If the core European nations cannot coordinate effectively, what can we expect in dealings with China, Russia and other countries that have less of a common background and understanding?

In the euro zone, we are seeing two refusals to cooperate: Germany won’t renew financial pledges to Greece without Greek compliance on previous agreements, and Greece doesn’t want Germany to control its national budget.  Both seem reasonable positions, and maybe they are, but reasonable positions can apparently destroy an international agreement rather easily.

Is there a way out?  To seek a binge of pro-growth government spending, in the hope of stimulating economies, is to assume what already stands in doubt. The crisis has reached a head partly because the market already lacks trust in the periphery governments to invest money for sustainable economic growth.

There is also talk of forming a true fiscal union, but that seems to be doubling down on a bad idea.  If the euro zone cannot summon enough cooperation now, how is any union requiring tighter cooperation supposed to work?  How would national budgets be set and approved?  A credit collapse remains a real possibility.

Is it too late for monetary policy to make a difference?  The other euro-zone nations might allow Greece to leave, while guaranteeing payments for food and fuel, both of which Greece imports, for a reasonable period.  Higher price inflation might then depreciate the euro, limit the need for difficult downward wage adjustments, and help Spain and Italy improve their competitiveness.  The inflation could come through central bank bond purchases from the troubled nations, thus easing their debt problems.  That may be the only useful option still on the table.

But that’s also not easy.  First, economically healthier nations may be reluctant to accept the inflation, which would represent a rather direct, continuing redistribution of wealth to the troubled debtor countries.

The second problem is that some of the banking systems in the periphery nations may be too broken for monetary policy to take hold.  Imagine the European Central Bank trying to infuse new money and credit into Spain, while bank deposits move quickly to Germany, Switzerland and other safer places.  Again, why would anyone want to keep money in the bank of a fiscally troubled nation?  That loss of confidence will not be easily repaired.

Since December, the European Central Bank has lent more than a trillion euros to euro-zone banks, but that has bought no more than a few months of peace.  It isn’t clear how much more can be done.  It probably is about time to judge the euro zone as a failed idea — and rarely is it wise to double down on failed ideas.

What is most disturbing is that the euro-zone nations are democratic, protective of basic liberties, and have advanced intellectual and research communities. The final lesson of this debacle is that smart nations with noble motives can make very big mistakes.  And that should concern us all.

New York Times: Democracy Is Having Its Say

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Tyler Cowenwrote this column for The New York Times’ Room for Debate on April 23, 2012.

Today, very few countries in the euro zone are capable of making credible commitments or binding agreements with the others.

Quite simply, democracy is having its say. The French soon may elect a left-wing candidate who, in essence, wants to exempt France from fiscal rules and place more fiscal risk on Germany. The Dutch can no longer form a governmental consensus on the budget. The Irish will be putting the fiscal compact up for a referendum, and the Greeks are holding an election in May. Even in Germany there could be problems holding together the ruling coalition.

In general, voters are unwilling to give up their say over policy, or to regard the European Union or euro zone as necessarily superior to national interests. When it comes to the specifics, it appears increasingly likely that at least one national electorate will pull the plug on the entire set of bailouts and austerity programs.

There is no way to pull off the required cross-national agreements. Resources are being drained from euro zone banks, which are contracting their lending to business. This will make the current recession worse, which in turn will necessitate further unpopular policies, including cuts in government spending. Euro zone countries will become more nationalistic in hard times, and more likely to vote against incumbent governments, no matter what the specific issue at stake. It is hard to see a stabilizing outcome, so the best bet is on a crack-up of some of Europe’s major economies, including Spain and Italy.

There is an old saying in economics, namely “no monetary union without a corresponding fiscal union.” It could be added “no fiscal union without a corresponding electoral union.” In the longer run, we will probably end up with none of these institutions.

The euro zone probably was unworkable from the beginning, and now we are seeing why.

The Inequality That Matters

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This article was originally published in the January/February issue of The American Interest

Does growing wealth and income inequality in the United States presage the downfall of the American republic? Will we evolve into a new Gilded Age plutocracy, irrevocably split between the competing interests of rich and poor? Or is growing inequality a mere bump in the road, a statistical blip along the path to greater wealth for virtually every American? Or is income inequality partially desirable, reflecting the greater productivity of society’s stars?

There is plenty of speculation on these possibilities, but a lot of it has been aimed at elevating one political agenda over another rather than elevating our understanding. As a result, there’s more confusion about this issue than just about any other in contemporary American political discourse. The reality is that most of the worries about income inequality are bogus, but some are probably better grounded and even more serious than even many of their heralds realize. If our economic churn is bound to throw off political sparks, whether alarums about plutocracy or something else, we owe it to ourselves to seek out an accurate picture of what is really going on. Let’s start with the subset of worries about inequality that are significantly overblown.

In terms of immediate political stability, there is less to the income inequality issue than meets the eye. Most analyses of income inequality neglect two major points. First, the inequality of personal well-being is sharply down over the past hundred years and perhaps over the past twenty years as well. Bill Gates is much, much richer than I am, yet it is not obvious that he is much happier if, indeed, he is happier at all. I have access to penicillin, air travel, good cheap food, the Internet and virtually all of the technical innovations that Gates does. Like the vast majority of Americans, I have access to some important new pharmaceuticals, such as statins to protect against heart disease. To be sure, Gates receives the very best care from the world’s top doctors, but our health outcomes are in the same ballpark. I don’t have a private jet or take luxury vacations, and—I think it is fair to say—my house is much smaller than his. I can’t meet with the world’s elite on demand. Still, by broad historical standards, what I share with Bill Gates is far more significant than what I don’t share with him.

Compare these circumstances to those of 1911, a century ago. Even in the wealthier countries, the average person had little formal education, worked six days a week or more, often at hard physical labor, never took vacations, and could not access most of the world’s culture. The living standards of Carnegie and Rockefeller towered above those of typical Americans, not just in terms of money but also in terms of comfort. Most people today may not articulate this truth to themselves in so many words, but they sense it keenly enough. So when average people read about or see income inequality, they don’t feel the moral outrage that radiates from the more passionate egalitarian quarters of society. Instead, they think their lives are pretty good and that they either earned through hard work or lucked into a healthy share of the American dream. (The persistently unemployed, of course, are a different matter, and I will return to them later.) It is pretty easy to convince a lot of Americans that unemployment and poverty are social problems because discrete examples of both are visible on the evening news, or maybe even in or at the periphery of one’s own life. It’s much harder to get those same people worked up about generalized measures of inequality.

This is why, for example, large numbers of Americans oppose the idea of an estate tax even though the current form of the tax, slated to return in 2011, is very unlikely to affect them or their estates. In narrowly self-interested terms, that view may be irrational, but most Americans are unwilling to frame national issues in terms of rich versus poor. There’s a great deal of hostility toward various government bailouts, but the idea of “undeserving” recipients is the key factor in those feelings. Resentment against Wall Street gamesters hasn’t spilled over much into resentment against the wealthy more generally. The bailout for General Motors’ labor unions wasn’t so popular either—again, obviously not because of any bias against the wealthy but because a basic sense of fairness was violated. As of November 2010, congressional Democrats are of a mixed mind as to whether the Bush tax cuts should expire for those whose annual income exceeds $250,000; that is in large part because their constituents bear no animus toward rich people, only toward undeservedly rich people.

A neglected observation, too, is that envy is usually local. At least in the United States, most economic resentment is not directed toward billionaires or high-roller financiers—not even corrupt ones. It’s directed at the guy down the hall who got a bigger raise. It’s directed at the husband of your wife’s sister, because the brand of beer he stocks costs $3 a case more than yours, and so on. That’s another reason why a lot of people aren’t so bothered by income or wealth inequality at the macro level. Most of us don’t compare ourselves to billionaires. Gore Vidal put it honestly: “Whenever a friend succeeds, a little something in me dies.”

Occasionally the cynic in me wonders why so many relatively well-off intellectuals lead the egalitarian charge against the privileges of the wealthy. One group has the status currency of money and the other has the status currency of intellect, so might they be competing for overall social regard? The high status of the wealthy in America, or for that matter the high status of celebrities, seems to bother our intellectual class most. That class composes a very small group, however, so the upshot is that growing income inequality won’t necessarily have major political implications at the macro level.

What Matters, What Doesn’t

All that said, income inequality does matter—for both politics and the economy. To see how, we must distinguish between inequality itself and what causes it. But first let’s review the trends in more detail.

The numbers are clear: Income inequality has been rising in the United States, especially at the very top. The data show a big difference between two quite separate issues, namely income growth at the very top of the distribution and greater inequality throughout the distribution. The first trend is much more pronounced than the second, although the two are often confused.

When it comes to the first trend, the share of pre-tax income earned by the richest 1 percent of earners has increased from about 8 percent in 1974 to more than 18 percent in 2007. Furthermore, the richest 0.01 percent (the 15,000 or so richest families) had a share of less than 1 percent in 1974 but more than 6 percent of national income in 2007. As noted, those figures are from pre-tax income, so don’t look to the George W. Bush tax cuts to explain the pattern. Furthermore, these gains have been sustained and have evolved over many years, rather than coming in one or two small bursts between 1974 and today.[1]

These numbers have been challenged on the grounds that, since various tax reforms have kicked in, individuals now receive their incomes in different and harder to measure ways, namely through corporate forms, stock options and fringe benefits. Caution is in order, but the overall trend seems robust. Similar broad patterns are indicated by different sources, such as studies of executive compensation. Anecdotal observation suggests extreme and unprecedented returns earned by investment bankers, fired CEOs, J.K. Rowling and Tiger Woods.

At the same time, wage growth for the median earner has slowed since 1973. But that slower wage growth has afflicted large numbers of Americans, and it is conceptually distinct from the higher relative share of top income earners. For instance, if you take the 1979–2005 period, the average incomes of the bottom fifth of households increased only 6 percent while the incomes of the middle quintile rose by 21 percent. That’s a widening of the spread of incomes, but it’s not so drastic compared to the explosive gains at the very top.

The broader change in income distribution, the one occurring beneath the very top earners, can be deconstructed in a manner that makes nearly all of it look harmless. For instance, there is usually greater inequality of income among both older people and the more highly educated, if only because there is more time and more room for fortunes to vary. Since America is becoming both older and more highly educated, our measured income inequality will increase pretty much by demographic fiat. Economist Thomas Lemieux at the University of British Columbia estimates that these demographic effects explain three-quarters of the observed rise in income inequality for men, and even more for women.[2]

Attacking the problem from a different angle, other economists are challenging whether there is much growth in inequality at all below the super-rich. For instance, real incomes are measured using a common price index, yet poorer people are more likely to shop at discount outlets like Wal-Mart, which have seen big price drops over the past twenty years.[3] Once we take this behavior into account, it is unclear whether the real income gaps between the poor and middle class have been widening much at all. Robert J. Gordon, an economist from Northwestern University who is hardly known as a right-wing apologist, wrote in a recent paper that “there was no increase of inequality after 1993 in the bottom 99 percent of the population”, and that whatever overall change there was “can be entirely explained by the behavior of income in the top 1 percent.”[4]

And so we come again to the gains of the top earners, clearly the big story told by the data. It’s worth noting that over this same period of time, inequality of work hours increased too. The top earners worked a lot more and most other Americans worked somewhat less. That’s another reason why high earners don’t occasion more resentment: Many people understand how hard they have to work to get there. It also seems that most of the income gains of the top earners were related to performance pay—bonuses, in other words—and not wildly out-of-whack yearly salaries.[5]

It is also the case that any society with a lot of “threshold earners” is likely to experience growing income inequality. A threshold earner is someone who seeks to earn a certain amount of money and no more. If wages go up, that person will respond by seeking less work or by working less hard or less often. That person simply wants to “get by” in terms of absolute earning power in order to experience other gains in the form of leisure—whether spending time with friends and family, walking in the woods and so on. Luck aside, that person’s income will never rise much above the threshold.

It’s not obvious what causes the percentage of threshold earners to rise or fall, but it seems reasonable to suppose that the more single-occupancy households there are, the more threshold earners there will be, since a major incentive for earning money is to use it to take care of other people with whom one lives. For a variety of reasons, single-occupancy households in the United States are at an all-time high. There are also a growing number of late odyssey years graduate students who try to cover their own expenses but otherwise devote their time to study. If the percentage of threshold earners rises for whatever reasons, however, the aggregate gap between them and the more financially ambitious will widen. There is nothing morally or practically wrong with an increase in inequality from a source such as that.

The funny thing is this: For years, many cultural critics in and of the United States have been telling us that Americans should behave more like threshold earners. We should be less harried, more interested in nurturing friendships, and more interested in the non-commercial sphere of life. That may well be good advice. Many studies suggest that above a certain level more money brings only marginal increments of happiness. What isn’t so widely advertised is that those same critics have basically been telling us, without realizing it, that we should be acting in such a manner as to increase measured income inequality. Not only is high inequality an inevitable concomitant of human diversity, but growing income inequality may be, too, if lots of us take the kind of advice that will make us happier.

Lonely at the Top?

Why is the top 1 percent doing so well? The use of micro-data now makes it possible to trace some high earners by income and thus construct a partial picture of what is going on among the upper echelons of the distribution. Steven N. Kaplan and Joshua Rauh have recently provided a detailed estimation of particular American incomes.[6] Their data do not comprise the entire U.S. population, but from partial financial records they find a very strong role for the financial sector in driving the trend toward income concentration at the top. For instance, for 2004, nonfinancial executives of publicly traded companies accounted for less than 6 percent of the top 0.01 percent income bracket. In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning more than $100 million a year was nine times higher than the public company executives earning that amount. The authors also relate that they shared their estimates with a former U.S. Secretary of the Treasury, one who also has a Wall Street background. He thought their estimates of earnings in the financial sector were, if anything, understated.

Many of the other high earners are also connected to finance. After Wall Street, Kaplan and Rauh identify the legal sector as a contributor to the growing spread in earnings at the top. Yet many high-earning lawyers are doing financial deals, so a lot of the income generated through legal activity is rooted in finance. Other lawyers are defending corporations against lawsuits, filing lawsuits or helping corporations deal with complex regulations. The returns to these activities are an artifact of the growing complexity of the law and government growth rather than a tale of markets per se. Finance aside, there isn’t much of a story of market failure here, even if we don’t find the results aesthetically appealing.

When it comes to professional athletes and celebrities, there isn’t much of a mystery as to what has happened. Tiger Woods earns much more, even adjusting for inflation, than Arnold Palmer ever did. J.K. Rowling, the first billionaire author, earns much more than did Charles Dickens. These high incomes come, on balance, from the greater reach of modern communications and marketing. Kids all over the world read about Harry Potter. There is more purchasing power to spend on children’s books and, indeed, on culture and celebrities more generally. For high-earning celebrities, hardly anyone finds these earnings so morally objectionable as to suggest that they be politically actionable. Cultural critics can complain that good schoolteachers earn too little, and they may be right, but that does not make celebrities into political targets. They’re too popular. It’s also pretty clear that most of them work hard to earn their money, by persuading fans to buy or otherwise support their product. Most of these individuals do not come from elite or extremely privileged backgrounds, either. They worked their way to the top, and even if Rowling is not an author for the ages, her books tapped into the spirit of their time in a special way. We may or may not wish to tax the wealthy, including wealthy celebrities, at higher rates, but there is no need to “cure” the structural causes of higher celebrity incomes.

If we are looking for objectionable problems in the top 1 percent of income earners, much of it boils down to finance and activities related to financial markets. And to be sure, the high incomes in finance should give us all pause.

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks.

Moreover, smart shareholders will acquiesce to or even encourage these gambles. They gain on the upside, while the downside, past the point of bankruptcy, is borne by the firm’s creditors. And will the bondholders object? Well, they might have a difficult time monitoring the internal trading operations of financial institutions. Of course, the firm’s trading book cannot be open to competitors, and that means it cannot be open to bondholders (or even most shareholders) either. So what, exactly, will they have in hand to object to?

Perhaps more important, government bailouts minimize the damage to creditors on the downside. Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis. The U.S. government guaranteed these loans, either explicitly or implicitly.

Guaranteeing the debt also encourages equity holders to take more risk. While current bailouts have not in general maintained equity values, and while share prices have often fallen to near zero following the bust of a major bank, the bailouts still give the bank a lifeline. Instead of the bank being destroyed, sometimes those equity prices do climb back out of the hole. This is true of the major surviving banks in the United States, and even AIG is paying back its bailout. For better or worse, we’re handing out free options on recovery, and that encourages banks to take more risk in the first place.

In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.

And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. This type of implicit bailout brings high social costs by slowing down economic recovery (the interest rate spreads require tight monetary policy) and by redistributing income from the Treasury to the major banks.

The more one studies financial theory, the more one realizes how many different ways there are to construct a “going short on volatility” investment position. To an outsider, even to seasoned bank regulators, the net position of a bank or hedge fund may well be impossible to discern. It’s not easy to unpack a balance sheet with hundreds of billions of dollars on it and with numerous hedged, offsetting, leveraged, or off-balance-sheet positions. Those who pack it usually know what’s inside, but not always. In some cases, traders may not even know they are going short on volatility. They just do what they have seen others do. Their peers who try such strategies very often have Jaguars and homes in the Hamptons. What’s not to like?

The upshot of all this for our purposes is that the “going short on volatility” strategy increases income inequality. In normal years the financial sector is flush with cash and high earnings. In implosion years a lot of the losses are borne by other sectors of society. In other words, financial crisis begets income inequality. Despite being conceptually distinct phenomena, the political economy of income inequality is, in part, the political economy of finance. Simon Johnson tabulates the numbers:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.[7]

If you’re wondering, right before the Great Depression of the 1930s, bank profits and finance-related earnings were also especially high.[8]

There’s a second reason why the financial sector abets income inequality: the “moving first” issue. Let’s say that some news hits the market and that traders interpret this news at different speeds. One trader figures out what the news means in a second, while the other traders require five seconds. Still other traders require an entire day or maybe even a month to figure things out. The early traders earn the extra money. They buy the proper assets early, at the lower prices, and reap most of the gains when the other, later traders pile on. Similarly, if you buy into a successful tech company in the early stages, you are “moving first” in a very effective manner, and you will capture most of the gains if that company hits it big.

The moving-first phenomenon sums to a “winner-take-all” market. Only some relatively small number of traders, sometimes just one trader, can be first. Those who are first will make far more than those who are fourth or fifth. This difference will persist, even if those who are fourth come pretty close to competing with those who are first. In this context, first is first and it doesn’t matter much whether those who come in fourth pile on a month, a minute or a fraction of a second later. Those who bought (or sold, as the case may be) first have captured and locked in most of the available gains. Since gains are concentrated among the early winners, and the closeness of the runner-ups doesn’t so much matter for income distribution, asset-market trading thus encourages the ongoing concentration of wealth. Many investors make lots of mistakes and lose their money, but each year brings a new bunch of projects that can turn the early investors and traders into very wealthy individuals.

These two features of the problem—“going short on volatility” and “getting there first”—are related. Let’s say that Goldman Sachs regularly secures a lot of the best and quickest trades, whether because of its quality analysis, inside connections or high-frequency trading apparatus (it has all three). It builds up a treasure chest of profits and continues to hire very sharp traders and to receive valuable information. Those profits allow it to make “short on volatility” bets faster than anyone else, because if it messes up, it still has a large enough buffer to pad losses. This increases the odds that Goldman will repeatedly pull in spectacular profits.

Still, every now and then Goldman will go bust, or would go bust if not for government bailouts. But the odds are in any given year that it won’t because of the advantages it and other big banks have. It’s as if the major banks have tapped a hole in the social till and they are drinking from it with a straw. In any given year, this practice may seem tolerable—didn’t the bank earn the money fair and square by a series of fairly normal looking trades? Yet over time this situation will corrode productivity, because what the banks do bears almost no resemblance to a process of getting capital into the hands of those who can make most efficient use of it. And it leads to periodic financial explosions. That, in short, is the real problem of income inequality we face today. It’s what causes the inequality at the very top of the earning pyramid that has dangerous implications for the economy as a whole.

A Fix That Fits?

A key lesson to take from all of this is that simply railing against income inequality doesn’t get us very far. We have to find a way to prevent or limit major banks from repeatedly going short on volatility at social expense. No one has figured out how to do that yet.

It remains to be seen whether the new financial regulation bill signed into law this past summer will help. The bill does have positive features. First, it forces banks to put up more of their own capital, and thus shareholders will have more skin in the game, inducing them to curtail their risky investments. Second, it also limits the trading activities of banks, although to a currently undetermined extent (many key decisions were kicked into the hands of future regulators). Third, the new “resolution authority” allows financial regulators to impose selective losses, for instance, to punish bondholders if they wish.

We’ll see if these reforms constrain excess risk-taking in the long run. There are reasons for skepticism. Most of all, the required capital cushions simply aren’t that high, so a big enough bet against unexpected outcomes still will yield more financial upside than downside. Furthermore, high capital reserve requirements insulate bank managers from the pressures of both shareholders and bondholders. That could encourage risk-taking and make the underlying problem worse. Autonomous managers often push for risk-taking rather than constrain it.

What about controlling bank risk-taking directly with tight government oversight? That is not practical. There are more ways for banks to take risks than even knowledgeable regulators can possibly control; it just isn’t that easy to oversee a balance sheet with hundreds of billions of dollars on it, especially when short-term positions are wound down before quarterly inspections. It’s also not clear how well regulators can identify risky assets. Some of the worst excesses of the financial crisis were grounded in mortgage-backed assets—a very traditional function of banks—not exotic derivatives trading strategies. Virtually any asset position can be used to bet long odds, one way or another. It is naive to think that underpaid, undertrained regulators can keep up with financial traders, especially when the latter stand to earn billions by circumventing the intent of regulations while remaining within the letter of the law.

It’s a familiar story, repeated many times in the past. If one recalls the Basel I capital agreements for banks, the view was that we would make banks safer by inducing them to hold a lot of AAA-rated mortgage-backed assets. How well did that work out? So, with no disrespect to the regulators or the sponsors of the recent bill, it is hardly clear that enhanced regulation will solve the basic problem.

For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism. It’s no longer obvious that the system is stable at a macro level, and extreme income inequality at the top has been one result of that imbalance. Income inequality is a symptom, however, rather than a cause of the real problem. The root cause of income inequality, viewed in the most general terms, is extreme human ingenuity, albeit of a perverse kind. That is why it is so hard to control.

Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world.

That’s an underappreciated way to think about our modern, wealthy economy: Smart people have greater reach than ever before, and nothing really can go so wrong for them. As a broad-based portrait of the new world, that sounds pretty good, and usually it is. Just keep in mind that every now and then those smart people will be making—collectively—some pretty big mistakes.

How about a world with no bailouts? Why don’t we simply eliminate the safety net for clueless or unlucky risk-takers so that losses equal gains overall? That’s a good idea in principle, but it is hard to put into practice. Once a financial crisis arrives, politicians will seek to limit the damage, and that means they will bail out major financial institutions. Had we not passed TARP and related policies, the United States probably would have faced unemployment rates of 25 percent of higher, as in the Great Depression. The political consequences would not have been pretty. Bank bailouts may sound quite interventionist, and indeed they are, but in relative terms they probably were the most libertarian policy we had on tap. It meant big one-time expenses, but, for the most part, it kept government out of the real economy (the General Motors bailout aside).

So what will happen next? One worry is that banks are currently undercapitalized and will seek out or create a new bubble within the next few years, again pursuing the upside risk without so much equity to lose. A second perspective is that banks are sufficiently chastened for the time being but that economic turmoil in Europe and China has not yet played itself out, so perhaps we still have seen only the early stages of what will prove to be an even bigger international financial crisis. Adherents of this view often analogize 2009–10 to 1929–32, when many people thought that negative economic shocks had stopped and recovery was underway. In 2006, banks were gambling on the housing market, and maybe today they are, as the result of earlier decisions, gambling on China and Europe staying in one economic piece.

A third view is perhaps most likely. We probably don’t have any solution to the hazards created by our financial sector, not because plutocrats are preventing our political system from adopting appropriate remedies, but because we don’t know what those remedies are. Yet neither is another crisis immediately upon us. The underlying dynamic favors excess risk-taking, but banks at the current moment fear the scrutiny of regulators and the public and so are playing it fairly safe. They are sitting on money rather than lending it out. The biggest risk today is how few parties will take risks, and, in part, the caution of banks is driving our current protracted economic slowdown. According to this view, the long run will bring another financial crisis once moods pick up and external scrutiny weakens, but that day of reckoning is still some ways off.

Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.

 Footnotes

1. See Jacob S. Hacker and Paul Pierson, “Winner-Take-All Politics: Public Policy, Political Organization, and the Precipitous Rise of Top Incomes in the United States”, Politics & Society (June 2010). For one criticism of those numbers, see Scott Winship, “Hacker-mania!”, ScottWinshipWeb, September 19, 2010.

2. Lemieux, “Increasing Residual Wage Inequality: Composition Effects, Noisy Data, or Rising Demand for Skill?” American Economic Review, June 2006.

3. See Christian Broda and John Romalis, “Shattering the Conventional Wisdom on Growing Inequality”, New York Times Freakonomics blog, May 19, 2008.

4. Gordon, “Misperceptions About the Magnitude and Timing of Changes in American Income Inequality”, National Bureau of Economic Research, NBER Working Paper No. 15351 (September 2009).

5. See Thomas Lemieux, W. Bentley Macleod and Daniel Parent, “Performance Pay and Wage Inequality”, Quarterly Journal of Economics (February 2009).

6. Kaplan and Rauh, “Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?” Review of Financial Studies (March 2010).

7. Johnson, “The Quiet Coup”, The Atlantic (May 2009).

8. See “Wages and Human Capital in the U.S. Financial Industry”, Thomas Philippon and Ariell Reshef, National Bureau of Economic Research, NBER Working Paper No. 14644 (January 2009).

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