Money is Power; The consequences of economic inequality

This is my second post in a series of blog posts about income inequality. This post (again, an essay written for a thesis that never materialized) discusses why income inequality matters, from both a political and economic perspective. You can read the first post in the series here.

Thomas Piketty’s book Capital in the 21st Century surprised many when it entered and lead the New York Times’ bestseller’s list in 2014, when the English translation was released. It is an unapologetically academic book intended for a literate (though not necessarily specialist) audience, yet nonetheless managed to tap a nerve. Paul Krugman called the book “… the most important economics book of the year — and maybe of the decade.”

Piketty’s book says wealth is becoming increasingly concentrated in the hands of a few, and this trend is likely to continue throughout the rest of the century, reaching (if not surpassing) the inegalitarian concentration of wealth saw in the Belle Époque. But his book is missing a crucial element, which Martin Wolf observed: “ [Piketty] does not deal with why soaring inequality – while more than adequately demonstrated – matters.” His criticism is a valid one. Why should I care if my neighbor has $100 or $100 million balance in his bank accounts if his balance does not affect my economic well-being?

In truth, I do not think Piketty is completely silent on why inequality matters. Piketty does say that high levels of inequality are politically troublesome and lead to political and social strife, simply because people do not see high levels of inequality as being fair. He does suggest that growing income inequality in the United States has been associated with skyrocketing salaries for the “supermanagers” and stagnant wages for everyone else, which is problematic not only in its own right but also because it demands some sort of government response, one of which was the degradation of credit that resulted in a housing bubble in the United States and ended in the 2008 financial crisis (see Pickety and Rajan). And the idea that high levels of inequality simply are not fair lurks in the background of the text, written between the lines. Nonetheless, I do not feel that these ideas alone truly address Wolf’s concern. Fairness is a tricky idea, hardly objective, and does not always warrant a response, and Piketty does not provide evidence for his hypothesis meant to explain the rise of “supermanagers.” I believe more is needed to warrant the discussion on income and wealth inequality.

With that said, reasons to be concerned about growing levels of inequality do exist. Piketty said we should be concerned about oligarchs owning and controlling an increasing share of the world’s wealth. He observed that stocks of wealth possess inertia that results in the larger stocks growing faster than the smaller ones, how the past consumes the future. He explains this by citing the ability of larger stocks of wealth to hire better talent to grow it. But this is not the only way the rich can get richer. Wealth can buy not only better management but political influence, be it through bribery, campaign contributions, or the ability to influence the discussion that produces policy. The wealthy gain political power while the rest lose it and the vision of the affluent for not only the economy but society in general dominates, with the potential to inflict harm on everyone else.

The 2008 financial crisis and the power of the financial sector make for a good case study for the consequences of economic inequality, and I believe that lessons learned there can be generalized to other issues. Calorimis and Haber, in their book Fragile by design; The political origins of banking crises and scarce credit, presented a model in which political coalitions are responsible for the creation of banking systems with varying stability. They make an excellent case for their model, though I do not agree with some of their conclusions. In particular, they argue that “populist” democracies can produce banking systems that, while providing ample credit, are unstable. They cite the United States as being such a democracy, that banks teamed up with populist organizations (namely activist groups such as ACORN) to degrade the quality of mortgages and create a credit bubble. Supposedly, a government with more checks against populism (which they call a “liberal” democracy) produces more stable banking systems that are still able to provide abundant credit. Their narrative suggests that the United States’ banking woes are partially to blame on U.S. populism.

Unfortunately, Calorimis and Haber assume that the United States is a populist democracy without providing evidence to make this assumption credible (at least with regard to American democracy today). The strongest reason for doubt of Calorimis and Haber’s assumption is a study by Martin Gilens and Benjamin Page that provides evidence against it. They studied policy issues from 1981-2002 and found that the opinion of the economically affluent had much more influence on policy outcomes than the “average citizen.” In fact, the latter have almost no independent ability to impact policy outcomes. While not perfect, Gilens and Page’s empirical evidence makes Calorimis and Haber’s assumption a very dubious one.

Nevertheless, Calorimis and Haber’s Game of Bank Bargains model can still explain why the American banking system is what it is. Johnson and Kwak’s book 13 bankers; The Wall Street takeover and the next financial meltdown describes how the U.S. banking system became so unstable. Through the 1980s and 1990s, American banking experienced a transformation. The financial sector began to amass political power and favor with both parties. Wall Street gave donations to both political parties and created a revolving door between policy makers and the industry. Policy makers favorable to the industry could earn a plush job after their career in politics, and decision-making positions were often given to those with a previous career in finance. In addition to this, an ideology developed in academia, think tanks, and other policy-making circles in Washington that believed the industry knows best and policy makers should simply let the markets work their magic. This ideology, with a large helping of lobbying, made Washington pliant to the financial industry’s desires.

It is true that some of those who championed the deregulation that lead to the housing bubble did so for reasons that could be considered “populist”; that is, they wanted to expand credit availability to those who otherwise could not obtain it, those with lower income (see Calomiris and Haber and Rajan). But this hardly means that those individuals were the ones leading the deregulatory charge, or even had an equal hand in the process, as Calorimis and Haber suggest. Instead, these “allies” of the financial sector helped to make deregulation easier to swallow. The coalition in charge, though, was not an alliance between bankers and populists but bankers alone. The financial sector has acquired so much political influence, it can create most of its own rules.

The financial sector represents a new elite in the United States, a part of the powerful class of supermanagers that emerged in the United States since the 198os (see Piketty, Johnson and Kwak). Their incomes are many times the average. Fairness aside, why should this be concerning? Giles and Page found that policy outcomes were not responsive at all to the opinion of citizens who are not economically affluent. Instead, they respond more to the interests of the affluent and interest groups, especially pro-business groups.1

Giles and Page’s study does not provide any evidence for a causal relationship that explains their results. I believe there are a few hypotheses to consider. One obvious explanation is that politicians simply want the money the affluent can provide, for a variety of reasons. Another is that, because most politicians come from a wealthy background, their ideas, opinions, knowledge, and interests already line up with those of the affluent. But I am particularly interested in the power of the affluent via interest groups. Gilens and Page observed that each individual interest group appear to have roughly equal “sway” in terms of policy outcomes; pro-business interest groups wield more influence than other interest groups because they are more numerous, not because politicians listen to these groups more than others on a case-by-case basis. The influence of interest groups in general may be due to how policy in Washington is made. When legislation or regulatory rules are being formed, interest groups are the most involved, writing letters and sending representatives to hearings, making their opinion known. Policy makers seek out the opinion of interest groups when drafting rules or legislation. Nonaffiliated citizens rarely participate, in comparison.

With this observation in mind, more explanations for the influence of the affluent can be generated. Because the affluent class is smaller than the rest of society, it may be easier to overcome the free-rider problem that any attempt for collective action must face. In addition, the affluent can provide more financially to a cause, allowing it to obtain the lobbyists necessary to influence action. Consider this: wealthy organizations can hire lobbyists with close connections to key policy makers, who can present their clients’ case to said policy makers sometimes on a face-to-face basis. Ordinary citizens, who cannot afford even a mediocre lobbyist, express their opinion to politicians via direct letters or phone calls to congressional offices, where an overworked, underpaid intern reads them and makes a small note (if any at all) of their opinion.

The interest groups are also much more likely to represent the interests of the affluent than those of ordinary citizens. The capacity for collective action by ordinary citizens is very limited. Low or mid-income persons must use more of their income on personal expenses, so a small portion of their income would consist of contributions to organizations, while affluent patrons can afford to give a greater share of their income to causes they support. Any interest group relying on outside support must consist of a large number of small donors (which is difficult to achieve, although easier now thanks to the Internet) or a few large donors (which I believe is much more common). In either case, the opinion of a small donor matters little compared to that of a large donor, and the organization will think much more carefully before offending the latter compared to the former. Thus, I believe that interest groups are much more likely to reflect the opinion of the affluent rather than the average citizen.

This is a direct consequence of income inequality. Consider a perfectly egalitarian society, where everyone makes the same income. In such a society, assuming everyone’s preference for donations to interest groups is the same, every individual would have the same “budget” for contributions. When an interest group is making decisions, there would be no large donors that they must consider; every donor would have equal financial influence and therefore equal say in the group’s decision. But give some members a bigger budget, and keeping those members’ donations will be a greater concern for the organization. The larger the inequality, the greater the share of an organizations’ budget consists of a minority of wealthy donors. Thus the organization will be more considerate of the affluent minority’s opinion.

Gilens and Page’s research does have something to say about how closely the opinion of interest groups and the opinion of the affluent and the “average” citizens agree. They found that the opinion of interest groups in general does not correlate with the opinion of either the affluent or the average citizen. This result could be because minorities (as in numerical minorities, which includes the wealthy, not necessarily ethnic minorities) may have the upper hand when faced with the problem for collective action, not only because the size of their group is smaller but also because they may be more motivated to take action to promote their agenda. Nonetheless, their study found that interest groups do wield considerable sway over policy outcomes, though not as much as that of affluent citizens.

Thus the consequences of inequality are both political and economic. Specifically, the affluent cash in their political power for favorable policies. Sometimes, they may use their political power to effectively expropriate taxpayers. Consider the financial sector: up until the financial crisis, the financial sector was calling for less government involvement in their activities, claiming that markets did not need regulation. When the financial crisis came, though, they ceased to be proponents of laissez-faire capitalism; now they needed the government to bail out the banks, as the consequences of their reckless actions had come home to roost. After the government gave the financial sector what they wanted and began to consider rules for preventing another crisis from occurring, they returned to resisting government involvement in their activities (see Johnson and Kwak). The hypocrisy is sickening, but business does not care for ideology. They will be libertarians one day or Keynesians the next, depending on which ideology benefits them the most. The more politically influential these organizations are, the easier expropriation of taxpayers becomes, and dollars lost to this expropriation are dollars not spent on projects benefitting more than the affluent.

Korkut Ertürk considers another source of instability: the need for capitalists to show self-restraint in their activities. Economic theories will often assume that economic agents are “rational,” yet this assumption often tells little about what decision an economic agent will make, one reason being that sometimes “rational” decisions point in opposite directions (see Foley). Ertürk considers specifically the need for an agent to consider both her short-term self-interest and what he calls her “enlightened” self-interest, which is a more forward-thinking self-interest that may call for self-restraint. Following her short-term self-interest and following her enlightened self-interest are both rational choices, and can lead to different decisions being made. Ertürk believes that one way that economic agents were disciplined to follow their “enlightened” self-interest in the past was by the threat of mass retaliation by the numerous yet individually weak stakeholders. He speculates that a consequence of the weak losing their capacity to retaliate (because of losing political power, for example) is the inability of the strong to maintain the discipline necessary to pursue their enlightened self-interest, which results in bad long-term outcomes.

Admittedly, many of these consequences of inequality via political power are speculatory. Gilens and Page’s study covers only a limited period of time which was dominated by pro-market politics on both sides of the aisle. Laissez-faire was the vogue from 1980-2002. I am curious how their results would change if they studied policy issues from other historical periods. A longer study could also account for changing levels of inequality; in fact, considering how slowly those variables change, a long study may be necessary in order to say anything useful about how political power and inequality are associated.2

With that said, the question is an important one. Piketty’s forecast is disturbing. If I doubt it, that is because I cannot assume that events like the World Wars will not happen in the 21st century, helping prevent large accumulation of capital (at the expense of human lives).3 The question of how to solve the problem of inequality is still open, despite Piketty’s “utopian” recommendation of a global tax on wealth. Better solutions may come when people begin to consider it a threat to be addressed rather than populist whining.

  1. Gilens and Page found that the opinion of average citizens and the affluent are correlated. Their results could be threatened by the statistical phenomenon of multicollinearity, but given how much greater the impact of the elite’s opinion is far higher than that of average citizens, I believe their results are still valid. 
  2. Unfortunately, obtaining useful data (if it even exists) would be very difficult, and data prior to 1950 may not be trustworthy due to statistical techniques not yet being honed (see Seife). 
  3. According to Piketty, the capital stock collapsed in Europe during the World Wars, due to destruction and wartime economic policies. 

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