Some thoughts on Inequality and Inefficiency (From Dr. Joseph Stiglitz’s lecture)

 

A few weeks ago, Davidson had the honor of having Dr. Joseph Stiglitz come visit campus to deliver the annual Cornelson lecture. Besides offering the opportunity to hear from one of the most respected and experienced economists in the world, one of the most exciting parts of Dr. Stiglitz’s speech was how his topics relates directly to what we’ve been talking about in Econversations lately. I guess Davidson students are smart, because we’re interested in the same stuff that is interesting a Nobel Laureate. So, I’d like to take a little bit of time looking back on how Dr. Stiglitz shed more light on some of the subjects that I’ve written on over the past couple of weeks.

 

Costs of Inequality

When I wrote about the “Lost Einsteins” paper, I commented on the massive waste of potential inequality causes as a universal economic consequence, over and above the inherent costs of inequality to the individual (and therefore, to those concerned with inequality as a purely social, and not economic, issue). Dr. Stiglitz spent a fair amount of time during his presentation expanding on the real damage inequality does to the overall macroeconomy.

 

Dr. Stiglitz referenced the book Efficiency and Equality: The Great Tradeoff, by well-known, and well-respected, economist Arthur Okun. The theory that Okun puts forward in the piece does hold water, or rather, in this case, aptly does not. Okun posits a “leaky bucket theory” that says that redistributive efforts bent on easing inequality automatically come at a cost of efficiency: administrative costs of redistributive agencies and regulatory activity, decreased incentive to work at higher income levels due to higher marginal tax rates, and an increase in effort to avoid taxation through creative tax shelters or deductible spending. At the very least, he’s certainly not long about the black hole of bureaucratic inefficiencies, and just last week Shyam mentioned that studies have documented the instinctual human behavior to begin gaming rules as soon as they are set. I have some qualms with the argument about deductible spending, because, ostensibly, we include tax deductions in an effort to encourage certain forms of spending (such as investment or charitable contribution), but nonetheless, Okun’s points are well taken.

 

However, what Okun fails to take into account is that, quite frankly, all the money in the world can’t buy you a solid bucket. To step away from the metaphor for a moment because I think we are starting to stray from the point, Okun’s theory assumes that the current state of affairs is more efficient than a more redistributive system. Dr. Stiglitz provided data and theory to demonstrate that inequality is not the consequence of efficiency, but rather inefficiency is the consequence of inequality.

 

The chart below shows that in the last 60 years, corporate profits as a percent of GDP peaked in 2013 at 11%. The chart below that shows that in the last 60 years, private business investment peaked in 1966 at 28%.

Plot of corporate profits over time

Plot of  business investment over time

 

Both charts are from Dr. Stiglitz’s powerpoint slides, which he was kind enough to share with me, and use data from the Federal Reserve Bank of St. Louis. I’m only taking into account the data from 1960 onwards, since that’s when the data for business investment starts.

 

For comparison, in 1966, corporate profits constituted 7% of GDP, and in 2013, business investment constituted 11% of GDP.

 

So, in the peak year of corporate profits as a percent of GDP, corporate investment as a percent of GDP was 17 percentage points lower than it was in its own peak year. In the peak year of corporate investment as a percentage of GDP, corporate profit as a percent of GDP was 4 percentage points lower than in its own peak year. Effectively, businesses are profiting more but they are investing not just slightly less but significantly less. Moreover, if you look at the data points surrounding 2008, things get even more interesting. First of all, I swear even on graphs recessions look scary. They get all pointy and so it looks either like a cliff you could fall into or something sharp and stabby. Which, you know, is really apt considering their exceptional ability to ruin lives and cause mass chaos. But secondly, by July of 2009, corporate profits constituted the same portion of GDP as in July of 2007. In 2009, business investments constituted 3% of GDP, compared to 13% in 2007. Business investments still have not yet returned to 2013 levels, reaching only 12% in 2015 before declining again.

 

These data points show that even though company profits are becoming a larger part of the economy as a whole, companies are sitting on their profits instead of spending them. Investment is a key driving force in the economy, not just because money firms invest is distributed throughout the economy, but also because investment increases production and, more often than not, increases efficiency.

Were Okun alive today, he might not even disagree with Stiglitz. For his leaky bucket theory, Okun is considered one of the leading supply side economists, subscribing to a central belief that high marginal tax rate “discourages income and output” which ultimately slows the economy. Importantly, the negative effects of high marginal tax rates happen at both ends of the spectrum. As I mentioned in my post on the UBI, certain welfare policies that specifically apply to certain income levels make the marginal tax rate at the threshold for the policy extremely high.

 

However, high levels of income are actually in and of themselves discouraging output. As Dr. Stiglitz explained, much of the current inequality is caused by rapidly increasing market power. Firms with a lot of market power have no incentive to invest because doing so would simply cannibalize their own business. Because they are already producing at, or close to, their profit maximizing point (see my post on social surplus for an explanation of why that is), any investment to increase output would make their marginal return less than their average return (effectively, the amount that they would make on producing the next unit is less than the amount they currently make per unit).

 

I’m actually reminded of one of the Juan Bobo stories my mother used to read me as a child. For those who don’t know, Juan Bobo is young boy who is a central figure in a lot of Puerto Rican folk tales and fables. This is the collection of retellings I had as a child.

In one of his stories, Juan Bobo’s mother instructs him to get water from the stream near their home. When Juan Bobo protests that the buckets his mother has given him will be too heavy when filled with water, she suggests that he find something else to carry the water. Juan Bobo selects two wicker baskets, and goes down to the stream as he has been instructed. When he returns to the house, he excitedly tells his mother that he believes he is getting stronger: the water seemed to grow lighter and lighter as he walked (this story also reminds me of last week at the gym when I thought a workout was getting easier and then I realized I was doing it wrong, so it just goes to show the power of fables in relating to your life I suppose).

 

Anyway, the story continues as follows:

 

“’That is odd,’ said Mama. Then she stepped into a big puddle!”

 

These rising corporate profits are giving the illusion that the economy is growing stronger, but the growth is so concentrated that the economy at large is not benefiting the way it could be were the resources more evenly distributed. Instead, the very wealthy have these wicker baskets that are refilled as fast as they are draining, and the rest of the country is left with a big puddle and no water for washing the dishes.

 

The only problem is, we aren’t dealing with water to wash the dishes. We’re dealing with the money that people need to fill the dishes with food in the first place. No matter how much I zoom out to say that even if you don’t consider the individual, inequality is bad for the economy, I want to make sure I’m zooming back in and reminding myself, and you, to think about the individual as well.

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