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.


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