Economics and politics - comment and analysis

Is inequality our destiny?

Two weeks ago, one of the most well-known and most respected inequality researchers, Branko Milanović, gave an interview to Der Zeit (see here). As I observed many times before, researchers on inequality seem to know all the facts, but they lack proper understanding about the relevant relationships.

When asked about the reasons for inequality that is increasing worldwide at fast pace, Milanović replies:

“Most economists agree that the increase in inequality is due to three independent developments: technological progress, the policy of deregulation and growing competition from countries like China or India. I am convinced that all three developments have something to do with globalization” (see also here).

As an unprejudiced reader, I wonder why he mentions technical progress in the first place. There has been technical progress for much longer than rising inequality, which only became a problem during the last thirty or so years. When asked to elaborate, Milanović gave the following answer:

“Take technical progress. It raised inequality, because due to the falling prices of production, it became cheaper for companies to replace people with machines. Take laptops for example. A couple of years ago, a portable computer might cost $ 6.000, nowadays its costs a mere $ 400.“

This answer is surprising, to say the least. Clearly, people are being replaced by machines because of falling prices of production technology. It is called productivity gains. But what happens next? Then, obviously, wages do not grow? Why not? This is what needs to be explained if you want to say something substantial about inequality. It has nothing to do with productivity gains, which are nowadays particularly weak worldwide (see my short series on this here). If real wages follow the evolution of productivity, the result of this income distribution on ‚the market‘ is called the primary distribution and it does not lead to increasing inequality.

A neoclassical economist will immediately argue that today wages do not rise as much as would be necessary to prevent inequality, because unemployment in the Western world, eight years after the outbreak of the great crisis, is still high.  Fine, but why did inequality also rise before the crisis of 2008/2009, when unemployment was much lower? According to neoclassical theory, there must have been a sharp increase in wages which caused unemployment before the eruption of the crisis. This is nothing more than the iron consequence of neoclassical labour market theory. It is their only ‚explanation‘ of unemployment. But it makes no sense: if real wages grew faster than productivity growth before the outbreak of the financial crisis, how is it then possible that researchers find increasing inequality over many decades?

One can see very well that a little bit of logic takes one much further than the most advanced models or the most amazing empirical research, at least on the condition that one puts aside his prejudices for just a moment. The next deductive step is clear: if inequality increased consistently over several decades (as it did), although unemployment rose sharply due to the major financial crisis, then the rise of unemployment during this crisis may have nothing to do with wages. It is obviously entirely possible that there has been a stark rise in new and more unemployment regardless of whether wages rose excessively or not in the period that preceded the crisis.

Any reasonable person who is seriously concerned with what has happened during the financial crisis knows that unemployment is an inevitable consequence of such crises. My Japanese colleague Richard Koo explained this thoroughly last week in Der Spiegel. Friederike Spiecker and I have argued the same at Flassbeck-economics over and over again from day one (see here for our first contribution on this).

However, if unemployment can rise when wages do not rise faster than productivity gains or do not rise slower than these gains (or at a very low wage rate, see the figure in the link above), then unemployment undoubtedly has a devastating impact on inequality.  Any unemployment, no matter how it comes about, changes the balance of power in the labour market at the expense of workers. Employers will always try to use the ‚reserve army‘ of the unemployed to drive down wages. Of course, the downward pressure on wages is especially strong where many are seeking employment and this is especially outspoken in areas with many low-skilled and low-paid workers (see here for an example of this mechanism in the USA).

This is the kind of argument that an inequality researcher would definitely make when she or he would think a little outside to the neoclassical straightjacket. It may be difficult to let neoclassical theory go because the above-described power mechanism seems to confirm that the neoclassical ratios are at work in all countries.  But that is not correct. The shift in the balance of power is taking place and it is happens in a market, as the neoclassicists say, but which sort of a market is it? It is one which is characterised by extremely unequal power relations. This is a fact that neoclassical economists should question and criticise and it is a problem that cannot be resolved without government intervention.
The pressure on wages which emanates from these power relations is not only morally reprehensible, it is also directly harmful to the economy.  It destabilises the economy because it stifles domestic demand.  However, it is exactly this demand that is needed in a closed economy in order to reduce unemployment (evidently, it is not possible for all to export their unemployment). If wages do not rise when productivity increases, the labour market causes unemployment because it prevents the economy from creating new employment. The pressure on wages reduces employment and opportunities to create new jobs. Anyone who wants to reduce inequality has to start with these simple but fundamental relationships. And, of course, governments can do a lot in the so-called secondary distribution. They can impose taxes and duties in order to improve real incomes, to redistribute the social product and to flatten out inequality.

In the USA, the understanding of these relationships is much more advanced than in Europe. It is my impression that the American administration and the Council of Economic Advisors under Jason Furman fully understand that nowadays low and insufficiently rising wages are the real bottlenecks of the US economy. In Europe, we are infinitely far away from this and every American movement in the right direction triggers an angry snarl in the German press. But this is for future posts.