The inequality that matters

Here is a new and longish piece by me, on the inequality debates, in The American Interest.  It's about which kinds of inequality matter and which do not.  Most of them do not:

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.

Furthermore there is a natural rising inequality in a world of strivers and slackers.  But some forms of inequality are more dramatic and are associated with unstable incentives:

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…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.

An understanding of the Black-Scholes idea of synthetic positions drives home the point that such strategies are very hard to stop by regulatory means.  Furthermore politicians have incentives to play the very same socially risky strategies; if things are "good now" they will get reelected and they pay few penalties for the severity of their eventual mistakes.  The fight against excess leverage is probably a non-starter (who now wishes to "slow down" the recovery?).  It is possible that our current system of state capitalism is "Arrow-Hahn-Debreu gameable" and that the financial sector has opened a hole in the proverbial bathtub and is sucking on a very large straw.

There are many other points about inequality in this piece which I have not presented on MR.


neglected observation, too, is that envy is usually local.

really? how much experience do you have of living in a shitty neighbourhood with a badly paid job, struggling to get by, and looking enviously of the lifestyles of the non-local wealthy, with their big houses, nice clothes, eating out in fancy restaurants etc.?

this idea that objecting-to-inequality is a local phenomenon sounds truer for the comfortably off than for those at the bottom of the pile. If you have any evidence that those at the bottom of the pile are relatively troubled by the existence of the non-local wealthy, I'd be interested to see it.

addendum: how many of the poor work in jobs where the rich become 'local' because the job entails serving the rich? Say, delivering goods to their fine houses, or serving them fine food in restaurants, or laundering their shirts etc.

I'm envious of blogs like MR that get a lot more traffic than my blog.

There oughta be a law....

Nice piece, but I can't help but think that your "status quo" conclusion follows from an insufficiently broad concept of inequality. Wouldn't you say that global inequality has significant political ramifications for the US? Shouldn't we thus frame the inequality issue in global terms? But perhaps that's not within The American Interest's mandate...

You could restate this in terms of Zipf's law: most resentment over inequality is (mis)directed at people in the second and third quartile by others in the second and third quartile, even though the absolute difference in their positions is not great.

In the discussion on income of the top 1-2%, the comments focussed on the financial sector--which I can understand from the fact, as you pointed out, that 25 hedge fund manager made more than all the CEOs of the Fortune 500. If the hedge fund managers take their income as carried interest, effectively being taxed at 15% rates, then this leads to rapid wealth accumulation, even compared to CEOs. So, tax policy relates to disparate wealth accumulation, even for the same income earners.

Second, though, is the actual costs of corporate management. If you look at CEO and top tier management income increases since the 70's, in their own terms or relative to employees in the corporation, there has been growth that cannot be explained easily--were executives that bad in the 70's, were they lazy then? The problem is that we have separated ownership from control of corporations, so that managers and not shareholders, rule. Thus, excessive compensation. I do not attribute this growth of income to suddenly becoming better managers or worker harder than their 70's predecessors.

The problem with inequality isn't the mere fact that some folks have more than some other folks. The problem is that kids from poor families don't have the same opportunities as kids from rich families. Not only do they have worse schooling, they also have worse health care and nutrition. So we're letting a lot of our talent go to waste.

This is the problem with an aristocracy, and it's a problem we've been struggling against for 200 years. Our concern ought to be equality of opportunity, not necessarily equality of outcome.

This is the problem with an aristocracy, and it's a problem we've been struggling against for 200 years. Our concern ought to be equality of opportunity, not necessarily equality of outcome.

However, as long as goods are scarce, the only way to achieve this is to forbid good parents to try to give something to their own children...

Bring up inequality and all the socialists come out.

This is right. People do NOT sit around saying, "God I wish I could have been like Warren Buffet." Oh, we might bandy it about but we know it's unattainable. We usually set our sights and envy on what we reasonably consider attainable.

Beyond that, it takes severe hatemongering to develop a negative sense of class consciousness and the associated entitlement mentality.

I was a poor kid who roamed the wealthy neighborhoods staring at the large houses and wishing I could drive the car from Risky Business. Now I have a six-figure income and own a house - not a big one. I could easily afford a Porsche, but choose not to. I own a Rolex - a steel one.

I would like to earn double my income and think I can attain that. I could earn ten times my income, but really wouldn't want to work that hard.

It's telling that the people who dream of the most glorious riches are those who have close to nothing. Those who are moderately well off are far less envious.

Of all the kids wanting to be a star athlete or entertainer, only 1 in a hundred thousand makes it. The rest pass up an opportunity to take the slow and sure route I took over 25 years:

- Military
- Community College
- University
- Grad School
- Several job changes

Bundled with envy is a blindness of how to ethically achieve what you want, hatred for those who have, and destructive impatience.

To those who say the poor don't have opportunities, "Piss on you." We have public education, affordable colleges, and many ways to pay for it. It takes only hard work and perserverence. I'm your counterexample. Your belief people can't make it is condescending, defeatist, patronizing, and hatemongering.

CEO salary is EASILY justified by their marginal revenue products. What is not justified are the incetives which encourage them to take tail risk, insulating them from bad decisions. Kevin Hallock of Cornell wrote a good paper on CEO salary. But you don't need a paper to understand the CEOs today handle much more than their predecessors and are a much rarer breed.

Robert Frank argues that status-competition induces conspicuous consumption, and that trying to keep up with the super-rich causes spending by the semi-super-rich and so on down. I'm persuaded by Tabarrok's housing data that having wealthy neighbors is not a negative externality (people seem more willing to move to larger ponds than becoming the biggest fish in a smaller one) and the rat-race book might help explain why.

No, envy is not usually local. That's the petty stuff that is easily worked around. Your brother-in-law will share his expensive beer with you, and you'll see he's a nice guy, and you'll get over it.

Most envy comes from the idea that other people are living in an entirely different universe than you are. I own a big house in a crime-free town with great schools. No matter how nice a guy I am, this is a different universe for lots of people, and some of those people will never be able to say "Good for him." Likewise, people in my shoes can have a hard time with the John Kerrys of the world, who spend $7 million on a boat that they sail twice a year.

So you're wrong -- most economic resentment IS directed towards millionaires and billionaires -- but it is also directed at those who might as well be, because they are simply in a universe that you will never reach for yourself.

What worries me about concentrating wealth into fewer hands is that when this has happened in the past, they always have been able to buy the government among other things.

It really has nothing to do with envy.

The negative skew trade is in banks, where it can be hidden deep in the balance sheet, and in most cases even the management will have no clue where or what it is. Insurers have regulators and hedge funds have investors.

Even if their companies don't get government bailouts, individual hedge fund traders effectively do - they're using other people's money, and they take a cut of the gains in a good year but don't pay out in a disastrous year.

I notice resentment from low income private sector workers toward Government workers. They seem to feel that they deserving those jobs. I had one friend say "Yeah he does not care about us, he already has his safe good benefits Government job." It was directed at a friend who did not help him get a job with the state. He looks at a Government job as having it made.

Of course they resent Wall Street to but Wall Street people are just an idea to regular worker.

Another thing people seem to not mind an owner or inventor so much as they are bothered by high pay on Wall Street or of athletes.

Khoth, regardless of the other flaws in your statement, hedge fund managers with strategic decision making authority generally have the majority of their wealth invested in their funds. That is a main point of due diligence for institutional hedge fund investors.

Sigh. I agree with almost all of the larger arguments, but I cannot bring myself to embrace your conclusion, that "maybe that’s simply the price of modern society".

As a young person employed by big finance, it is quite clear that I have two optimal choices: 1) Work hard and watch my bank account grow, or 2) become a "threshold worker" and maximize my leisure. It is amazing how difficult that choice can be.

Some other points:
1) On the assertion that inequality in personal well-being is much lower versus 100 years ago, I am not convinced by your anecdotal claims. What does the data say?

2) The point on age/demographics affecting income inequality is well-taken, which is why I'd like to see this type of analysis refocus on consumption inequality (as Scott Sumner suggests). Perhaps we could include estimated value of leisure to control for the issue of threshold earners?

3) Need a discussion about the role of central banking in so-called modern society; would we be better off with more frequent and smaller financial crises vs. the large but less frequent ones that we get when central banks intervene?

4) What is the ultimate end-result of the "short volatility" pattern, if no change is made to the system? War? We need more discussion of downside scenarios based on historical examples.

It seems clear from your analysis that the only long term solution to the problems you discuss is to allow equity and bond holders to lose when they make bad bets.

This reminds me of negotiating with kidnappers. If you make it clear that your primary goal is the welfare of the hostages, the kidnappers have a great deal of leverage. This gives them an incentive to take more hostages and kidnap more people. On the other hand, if you make it clear that you will not negotiate with them, they lose this incentive. The hostages they currently hold may be killed which is tragic, but it removes the incentive for the hostage takers to take more hostages. This is a better outcome in the long run.

In your analysis, the financial sector holds the rest of the economy hostage. No one wants the hostage to be harmed, so the banks (and their lenders, owners and employees) get away with extortion. But if it were clear to the banks, the bond holders, and the shareholders, that regardless of what happens to the hostage, they will be wiped out if they
make bad bets, we would have many fewer bad bets - less selling of unhedged put options.

The question is, is it possible to make this threat credible, so that bond and equity holders really believe they will lose if they make bad bets? Germany seems to want to move in that direction, but it is having a hard time of it.

Doc Merlin, Robin makes a good point but competition could make things worse if your concern is the betting at the expense of society (rather than inequality).

Michael F. Martin, which parts of G.S limited the shorting of volatility?

From Tyler's piece: "Neither the Treasury nor the Fed allowed creditors to take any losses from the collapse of the major banks during the financial crisis."

This just isn't true. Washington Mutual bondholders were wiped out, and I believe the Lehman bondholders as well, and lots of others from smaller banks.

Bondholders from TARP banks JPMorgan, Citi, Goldman, etc. didn't take losses, but that makes sense because these banks weren't fundamentally insolvent, as evidenced by their ability to pay back the Treasury and Fed with generous profits. The stockholders of these banks took a major hit.

Luis Enrique:
really? how much experience do you have of living in a shitty neighbourhood with a badly paid job

I for one have lots of such experience. I like to say I have been low income (bottom 10%) and I am now high income (top 5%) and it is better to be high income but not that much better. Good family, friends and neighbors matter much more than income. Because I like my neighbors I still live the home that I bought when may income was 6x lower than it is now. The home that I live in is now worth less than half of my current annual income even at still too high bubble prices.

Most resentment about inequality I've observed comes from inequality in changes in standard of living during downturns -- think blue-collar workers losing jobs while Wall Street gets bailed out, or CEOs getting a big bonus in the face of massive layoffs. That's consistent with prospect theory, and you can't measure it simply by looking at the overall wage distribution. The lag in employment recovery relative to output (jobless recoveries) has been much longer for recent recessions.

"how many of the poor work in jobs where the rich become 'local' because the job entails serving the rich? Say, delivering goods to their fine houses, or serving them fine food in restaurants, or laundering their shirts etc."

This doesn't seem right at all. Waiters work on tips, so the finer the establishmnet the more money they make. The fancy organic dry cleaners where the elites get their Brooks Brothers shirts laundered is a probably a family-owned business that makes a decent profit. And there's a good chance that kid delivering pizza to the mcmansion is the teenage son of one of the neighboors.

There are a lot of people out there trying to stoke the fires of class warfare and it doesn't work precisely because the narrative they are selling just doesn't fit the reality that most people experience. Walk into a random home in a lower-middle class neighborhood and you're likely to find a stocked fridge, a flat-screen TV and an Xbox. The ways in which inequality manifests itself happen at a much different level.

Whoa. I'm just impressed by the consensus here about the fact that having issues with income inequality is just a matter of envy, with biblical references and all. Let me put my point of view forward: we are a family of three living on my $50k salary, which puts us pretty much at the median of the US household income distribution. Our living standard is ok, but not stellar either. After paying for everyday expenses, we can put a few $100 aside most months. Now I look at the American society, and tell myself: half of the people here make less than me, many significantly less. This includes many people who do work harder than me, i.e. longer hours and/or sh*t jobs. That is what worries me most. Not everything can be explained by self-interest, Tyler.

As for the distinction between equality of opportunity and equality of outcome, I'd like to kick in the idea that kids' opportunity is closely tied to their parent's outcomes, with the US having an income mobility among the lowest in the developed world. So much for the "American Dream".

If the streets are really paved with gold and there are so many ways to get by, maybe these should be advertised to the kid over in the ghetto whose sister works hard waiting tables and who thinks his best chance is to become a football star.

What about 37 years of stagnant wages? That ok too?

To, so you do not accept the possibility that someone's life prospects could be seriously damaged by an indoctrinated teacher? I know of at least one ex-Communist teacher here who does not miss an opportunity to preach class struggle and envy to 12-year olds. OK, this is Czechia, not the USA, but still. France is still worse, it is probably the only developed country in the world that still has sizable community of Trotskyites.

In western Europe, radical imams and teachers in Wahhabi-funded schools play similar role in Muslim communities. If a young Arab comes to the mosque on every Friday and, week after week, listens to the crap that Jews keep the world subjugated and infidels (read: native population) are dirty descendants of apes and pigs whose women are sluts. Then some of them start to believe it and suddenly you have a surge in antisemitic incidents and general street violence.

Maybe if my wages had risen in the last 37 years I'd be able to afford things like cable television, personal computing machines and portable telephonic devices by now. I guess I'll just sit here in my un-air conditioned library reading old Krugman articles and not understanding the nonstationarity of inflation data (even though the BLS includes a disclaimer about using their CPI data for long term comparisons at the bottom of every release).

Envy & covetousness are terrible. But then there's the unfair reality
because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

Nobody who supported the TARP and/or other bailouts for the rich should be complaining about income inequality now -- and the LTCM bailout previously mentioned was a moral hazard lesson stupidly not learned.

All the Big Banks should have gone belly up, with fast debt to equity bankruptcy. And, if necessary, the Fed should have made loans available to companies who "needed them", at some 1-2% higher than the "market rate" (that such companies were failing to get). Based on prior loans, etc.

I'm sick at the multi-millionaires who got bailed out despite their irresponsible housing bubble supporting bets.

On envy being "closer to home", I've long the local Jews, just a little bit richer, suffered from such local envy. But much of today's anger is based at unfair gov't support of the super-rich, more than the local irritation.

Does anyone know who wrote a response to this article in defence of finance, which argued that finance deserve the returns because it is becoming harder to allocate capital?

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