July 17, 2014

Real Inequality: Why Things Are Better Than They Seem and Will Almost Surely Get Worse

John Nye

Frederic Bastiat Chair in Political Economy, Mercatus Center

Thanks to the bestselling book by French economist Thomas Piketty — “Capital in the Twenty-First Century” — income inequality remains a hot topic of discussion. (Did it ever go away?) Dozens of pundits, scholars and bloggers have already weighed in on this issue, either to support his policy proposals or to denounce his ideas.

Thanks to the bestselling book by French economist Thomas Piketty — “Capital in the Twenty-First Century” — income inequality remains a hot topic of discussion. (Did it ever go away?) Dozens of pundits, scholars and bloggers have already weighed in on this issue, either to support his policy proposals or to denounce his ideas. I want to muddy the waters a bit further by getting us to think more about what it is we’re trying to measure. In so doing, I bring both good news and bad news.

I make two claims: that in a very fundamental sense, real inequality has almost certainly declined over the last few decades, despite the problems brought on by the financial crisis, but that improvements due to stronger growth, productivity, and higher incomes will only alleviate some of our concerns while exacerbating the perceptions of inequality — perceptions that I predict will surely grow in the coming decades.

“Because the areas with the highest wages tend to have higher costs, our measures of both wealth and income exaggerate perceived inequality.”

First, the (somewhat) good news. Dollar measures of income inequality always exaggerate differences because what matters to people is what they can buy for their money and how much value they derive from what they have purchased. Are you really richer if you must spend $40,000 per year for a two-bedroom flat in Brooklyn, New York, than someone earning a bit less who spends $20,000 on a nice three-bedroom house in Brooklyn, Wisconsin?

In other words, our measures of inequality are imperfect and rely to a great extent on our ability to obtain good prices with which to compare nominal incomes over time. For example, if we simply take people’s dollar incomes (or wealth, the point is the same) we need to deflate this by the cost of living. But whose cost of living? If we measure income inequality using average prices for the U.S. as a whole, we will be exaggerating differences in inequality between high-cost and low-cost areas. Whether $50,000 a year is a good salary depends a lot on whether you live in the urban Northeast or rural Midwest. Because the areas with the highest wages tend to have higher costs, our measures of both wealth and income exaggerate perceived inequality.

Consumption inequality

But ultimately, income is not a question of how many zeroes are in your bank account, but how much you can buy in goods and services. People have tried to circumvent this by measuring not just income but consumption. The data on consumption, derived from the government’s Consumer Expenditure Surveys, shows that consumption inequality has not matched the rise in income inequality over the last two to three decades.

Moreover, even consumption, as measured by dollars spent, overstates inequality. Thus if I spent $400 a month on food and you spent $200 per month, my food consumption is double yours even if we bought exactly the same things at different prices. Measures of consumption expenditure ignore differences in the prices of what we consume. This is true even when statisticians leave out rural areas to make comparability easier. But even within urban areas, if those with lower incomes are concentrated in lower-cost areas relative to higher-income areas, then using an expenditure measure is likely to overstate the differences in actual consumption. If you buy the exact same sandwich or haircut as I do but at a higher price, in what sense is your consumption greater than mine?

Many researchers feel that consumption inequality is understated and that true measures of consumption expenditure show much greater inequality. But these adjustments focus on dollar expenditures that aren’t corrected for cost differences. They just assume if you spend more, you’ve consumed more. But to assess real inequality, we care about how different the mix of goods and services is that different people consume.

There is an even deeper problem that causes us to exaggerate differences in consumption between the rich and the poor: changes in the quality of goods are not properly accounted. The march of technology means the good becomes commonplace and the best is often only incrementally better, but usually costs a lot more money.

Doubling the price of an item doesn’t give you twice as much. As technology progresses, the price differences between low-end and high-end goods conceal relatively small differences in functionality. To take a simple example: If a good 25-inch cathode ray tube color TV cost $500 in 1990 and a larger flat screen TV cost about $2,000 in the same year, would you think that someone buying a TV today would get as much of a jump in quality for the equivalent price difference? For $500 today, you could get a flat screen TV not that much worse and only somewhat smaller than you could buy for $2,000. Some of the differences, such as 3-D capability, might not even matter to most consumers. Yet in both cases, statisticians treat the higher spending person as having consumed four times as much as the one buying the cheaper TV.

Or think of coffee. That one person spends less than a dollar a day on coffee and another spends $5 may reflect differences in quantity or the fact that one brews at home and the other goes to Starbucks. That’s not the kind of difference that would have been felt much earlier in the 20th century, when having regular coffee of any grade was itself a small luxury.

“Technology has turned many luxuries into commodities and made it much harder for the rich to distinguish what they consume from the cheaper but functionally similar products used by the average person.”

Likewise, sugar and salt were historically expensive goods, yet in our time, they cost so little that the average family does not rush to stock up if salt falls in price by 50 percent. Or think of watches: Fifty years ago, a $1,000 Swiss watch was functionally superior to one that you might have bought for $100. Today, a $10,000 Swiss watch might be no better and, if it has a spring-driven mechanism, would actually tell time worse than a $10 Quartz wristwatch.

A better way to see how ignoring the relatively small differences in quality and functionality between many, even most, cheap and expensive goods distorts inequality comparisons is to do a thought experiment. Take two families. Family A lives in a distant suburb on take-home pay of $30,000 a year in a small two-bedroom apartment. Family B lives on $150,000 a year in the big city in a similarly sized two-bedroom flat. Despite the similarity in flat sizes, we would agree that the first family will be much more constrained in its choices than the second one. Family B gets to buy mostly more and better goods than Family A.

Now pretend that a magical box is invented so that for pennies, either family can produce any material item they desire of any arbitrary quality. Want clothes? Punch in the design, and for a nickel, you have the latest fashions. Need a computer? That too will pop out cheaply. Ditto for food and drugs. We would all agree that no matter what their dollar incomes, the families with that technology would be more equal than Families A and B are today.

So imagine that in this futuristic scenario, the two families are essentially equal on most margins with this magical box, but Family B earns 10 times as much as Family A ($300,000 versus $30,000) and both have to spend most of their money on a two-bedroom flat. The statistics would show a net increase in inequality, even though most would agree that by any reasonable reckoning the two are in fact more equal now in terms of what they can consume and how similar their consumption patterns would be. Of course, this is fantasy, but the general trend in material progress is well captured by this hypothetical. Technology has turned many luxuries into commodities and made it much harder for the rich to distinguish what they consume from the cheaper but functionally similar products used by the average person.

It is in this sense that no matter the measured gap in inequality, real welfare inequality is much less than earlier in our history. That the poor and the rich are not living so differently is perhaps more readily seen in the convergence in mortality rates between the rich and the poor and the fact that the largest parts of the remaining differences are heavily driven by behavior (smoking, obesity, accidents) and from having intact families — and not by lack of access to basic health care. The fact that it is hard to do these comparisons does not change the fact that it is these differences in outcomes, given similar behavior and family, that should be the ideal measures of changing health inequality.

“It is in this sense that no matter the measured gap in inequality, real welfare inequality is much less than earlier in our history.”

Thus in the long run, technology tends to favor the poor. Contrary to common wisdom, current research suggests that the 19th century saw a decrease in inequality when measured in consumption terms. Before industrialization, the rich had silks, where the poor might not have had underwear at all. Cheap cotton and then wool and then synthetics made it possible for all to have more than ample clothing. Today, companies such as Uniqlo have gotten rich off their ability to mimic more expensive fashions at more modest prices. Though differences persist, they are smaller or more subtle than before. In fact, the rise in average wages hurt the rich in one very noticeable way: As the rich tended to consume labor in the form of household workers or personal services, the rise in incomes disproportionately increased the cost of goods that the rich tended to buy (otherwise known as the “servant problem.”)

So much for overstated inequality

But now here comes the bad news. There are important dimensions on which inequality persists and worse yet, will loom larger in the coming years, even if technological progress rebounds to increase prosperity for all. In fact, the more we are able to overcome the plagues of hunger and want, the more likely the inequalities that remain will sting and be sources of conflict.

It is not a surprise that when people worry about the cost of living, the item that looms large in comparisons is housing. But is housing just about housing? A four-bedroom McMansion that might cost $1 to $4 million to purchase in a highly desirable area might only cost $200,000 or $300,000 to build in a remote rural area. In that case, are we really complaining about inequality of housing or of where the house is located?

And this constitutes the nub of the problem. People live to be nearer to work and to people like themselves, to find safe neighborhoods, and to ensure quality schools for their children. But all of these things depend heavily on what other people are doing, not on absolute income per se. Moreover, other factors such as desirable views of the lake or mountains or proximity to the nicest clubs and theaters downtown are inherently limited, “positional” goods that are not easy to replicate even with the best technology. To oversimplify, if there is one area in the city that everyone agrees is the “best” location to live in, then by definition, no amount of economic growth will make it possible for all to live in that location. Economist Fred Hirsch made this argument back in 1978 with his book “The Social Limits to Growth.” Inequality, and therefore the social value of positional goods, has been growing ever since.

Similarly, technology may lift the educational value of almost all universities, but so long as there is a benefit to going to the top 20 universities, no matter how those are defined, then by construction, there will always only be 20 top schools — and that is independent of wealth or demand (though they can weakly accommodate this through growth, while in the process diluting their desirability as selective institutions).

These are called positional goods in the sense that their value depends greatly on their relative status. Some goods, such as housing, could be a combination of material aspects (construction, amenities) and positional goods (location). Others might be mostly positional, as is the case with top universities. Technology cannot do anything to produce such goods, or at any rate produce them in ways that would easily match overall growth.

While it is imaginable that highly desirable new cities will emerge in the future, their desirability in the overall pecking order will likely either constrain demand or else displace a “cooler” city in attracting the wealthiest inhabitants and most skilled workers. In fact, economic growth makes this problem even worse. To the extent that technology and growth alleviate those inequalities that are purely material (e.g. access to initially rare drugs or expensive new electronics), the remaining inequalities will by definition be those that are more intractable. For example, if powerful people’s capacity to obtain more goods and services than us comes not from their wealth but from their political influence, social position, fame, beauty or charm, then it becomes much harder for the rest of us to attain equality. Just think of clubs with “face control” or restaurants that seat customers at desirable tables on the basis of their fame or attractiveness. If you can’t pay for better service and must rely on the discretion or whims of the staff, then the inequalities that persist will most likely be insurmountable for most people. A world that eliminated disparities in wealth but still maintained vast disparities in power or influence would effectively replicate those aristocracies liberal nations sought to overturn.

Some writers — such the economist Robert Frank — have used the positional goods race to argue for higher taxation of consumption; the idea would be to discourage destructive positional competition, which he likens to an arms race. But all this will do is reduce competition in dollar terms. Competition will shift to other dimensions (such as the aforementioned political power, persuasive ability or physical attractiveness) that are even less fungible and often more inegalitarian than income.

“Our fixation on income inequality (which I am certain will not disappear under any feasible policies) will obscure the fact that trying to tax away or regulate those inequalities will give more play to inequalities that are even less tractable, like social or political connections.”

Communist nations such as the Soviet Union were not more equal than Western nations, they had simply suppressed income disparities. Moreover, the assumption that positional competition is inherently wasteful is unfounded. The need of many to one-up their neighbors has often led to productive innovation. Without early adopters who first fought to get Blackberries, and then iPhones, would the mobile market be as well developed? And status-seeking has allowed for socially valuable charitable giving on the part of plutocrats who might otherwise focus exclusively on enriching their descendants.

Our fixation on income inequality (which I am certain will not disappear under any feasible policies) will obscure the fact that trying to tax away or regulate those inequalities will give more play to inequalities that are even less tractable, like social or political connections.

Zoning restrictions and rent control, for example, have not made Manhattan’s housing affordable. If anything, rent control has led to the spectacle of wealthy or influential people occupying luxury accommodations at bargain basement prices. (In the 1980s, because of rent control, New York City Mayor Ed Koch was famously paying about $475 for an apartment worth $1,200 a month.) When transparent market pricing is not allowed to hold sway in a market with high demand, other forms of influence – as well as money – will play a much larger role in distributing desirable resources.

Consider just one example from France: the Socialist leader and former managing director of the International Monetary Fund Dominique Strauss-Kahn did not receive an unusually high salary but had benefits which included the right to fly first class on Air France at any time, including the right to arrive at the last minute and be guaranteed a seat even if the plane was full. No billionaire has those rights, which cannot simply be purchased.

Schooling is especially positional – and especially resistant to solutions like Frank’s consumption tax (although that policy might be good for other reasons). That’s because school is a mix of absolute learning and of access to good or elite students. Consider that the number of Ivy League schools won’t increase as population increases. So while the median state school is vastly better than it used to be and the gap in what you can study has shrunk between the average and the elite schools, the social benefits of going to the top few universities have grown to the point where admission committees wield extraordinary influence and can make arbitrary decisions as to which sets of characteristics give kids a leg up. Large donations help, but so does coming from a well-connected political family or being a Hollywood celebrity. If taxing wealth made it harder to buy one’s way into these schools (e.g. by restricting donations), it would substantially increase the arbitrary power of admissions committees, which would promote different types of inequality. It would make competition from the use of family connections, for example, even more significant.

Examples in Greg Clark’s recent book “The Son Also Rises” also show that efforts to tackle income inequality do little to eradicate other, more persistent inequalities like the social mobility gap. Despite progressive taxation, egalitarian Sweden seems to have about the same degree of long-term social mobility as the United States. And the presence of elite families in China’s top universities seems no different than elsewhere despite the Cultural Revolution and half a century of Communism.

Indeed, focusing on wealth inequality can obscure situations in which social inequality is being improved by allowing larger income inequality. Just consider a CEO of a protected industry that is not threatened by takeovers or foreign competition. That CEO can enjoy many untaxed perks, and therefore, will need a lower salary, all else equal, than someone in a more open, transparent market where the most desirable managers are still paid more than ordinary workers. Traditionally, their compensation partly came in the form of various perks, as well as social prestige and influence. But the fewer the perks, the fairer the rules, and the greater the competition for those slots, the higher the salaries one would have to pay to those who really are on top.

Indeed, to the extent that the U.S. and a few other countries have been moving to more transparent compensation, greater taxation of perks, less deference from subordinates, and greater rights of shareholders, we should expect that the measured compensation of CEOs and managers will only increase, holding all else constant.

It is likely, for example, that if countries such as Japan were to play by the more open competitive rules of the U.S. economy, with greater restrictions on perks, less acceptance of collusive arrangements, and were more subject to foreign competition and threats of takeovers at home, we would shortly see that leading firms would end up having to pay even more for the CEOs or managers that firms wanted to retain, aside from the vexed question of whether these managers “deserved” their high pay. Paying them more would certainly increase measured income inequality while possibly reducing true inequality both within and across firms. Even in the U.S., how many top managers would accept lower salaries if women and foreigners were not allowed to compete for their positions, office perks were untaxed, and hostile takeovers were illegal?

Humans care about goods and humans care about relative status and that means that no matter how much progress we make in providing for all, we will undoubtedly see even more vicious conflicts about positional inequality in the years ahead, even if they are couched in such terms as “good schools” or “affordable housing.”