Chapter Three - Markets and Inequality
The preceding chapter emphasized the role of rent seeking in creating America’s high level of inequality. Another approach to explaining inequality emphasizes abstract market forces. In this view, it’s just the bad luck of those in the middle and at the bottom that market forces have played out the way they have—with ordinary workers seeing their wages decline, and skilled bankers seeing their incomes soar. Implicit in this perspective is the notion that one interferes with the wonders of the market at one’s peril: be cautious in any attempt to “correct” the market.
The view I take is somewhat different. I begin with the observation made in chapters 1 and 2: other advanced industrial countries with similar technology and per capita income differ greatly from the United States in inequality of pretax income (before transfers), in inequality of after tax and transfer income, in inequality of wealth, and in economic mobility. These countries also differ greatly from the United States in the trends in these four variables over time. If markets were the principal driving force, why do seemingly similar advanced industrial countries differ so much? Our hypothesis is that market forces are real, but that they are shaped by political processes. Markets are shaped by laws, regulations, and institutions. Every law, every regulation, every institutional arrangement has distributive consequences—and the way we have been shaping America’s market economy works to the advantage of those at the top and to the disadvantage of the rest.
There is another factor determining societal inequality, one that we discuss in this chapter. Government, as we have seen, shapes market forces. But so do societal norms and social institutions. Indeed, politics, to a large extent, reflects and amplifies societal norms. In many societies, those at the bottom consist disproportionately of groups that suffer, in one way or another, from discrimination. The extent of such discrimination is a matter of societal norms. We’ll see how changes in social norms—concerning, for instance, what is fair compensation—and in institutions, like unions, have helped shape America’s distribution of income and wealth. But these social norms and institutions, like markets, don’t exist in a vacuum: they too are shaped, in part, by the 1 percent.
The Laws of Supply and Demand
Standard economic analysis looks to demand and supply to explain wages and wage differences and to shifts in demand and supply curves to explain changing patterns of wages and income inequality. In standard economic theory, wages of unskilled workers, for example, are determined so as to equate demand and supply. If demand increases more slowly than supply,1 then wages fall. The analysis of changes in inequality then focuses on two questions: (a) What determines shifts in demand and supply curves? and (b) What determines individuals’ endowments, that is, the fraction of the population with high skills or large amounts of wealth?
Immigration, legal and illegal alike, can increase the supply. Increasing the availability of education may reduce the supply of unskilled labor and increase the supply of skilled labor. Changes in technology can lead to reduced demands for labor in some sectors, or reduced demands for some types of labor, and increases in the demand for labor of other types.
In the background of the global financial crisis were major structural changes in the economy. One was a shift in the U.S. job market structures over some twenty years, especially the destruction of millions of jobs in manufacturing,2 the very sector that had helped create a broad middle class in the years after World War II. This was partly a result of technological change, advances in productivity that outpaced increases in demand. Shifting comparative advantages compounded the problem, as the emerging markets, especially China, gained competencies and invested heavily in education, technology, and infrastructure. The U.S. share of global manufacturing shrank in response. Of course, in a dynamic economy jobs are always being destroyed and created. But this time it was different: the new jobs typically were often not as well-paying or as long-lasting as the old. Skills that made workers valuable—and highly paid—in manufacturing were of little value in their new jobs (if they could get new jobs), and, not surprisingly, their wages reflected the changed status, as they went from being a skilled manufacturing worker to being an unskilled worker in some other sector of the economy. American workers were, in a sense, victims of their own success: their increased productivity did them in. As the displaced manufacturing workers fought for jobs elsewhere, wages in other sectors suffered.
The stock market boom and the housing bubble of the early twenty-first century helped to hide the structural dislocation that America was going through. The real estate bubble offered work for some of those who lost their jobs, but it was a temporary palliative. The bubble fueled a consumption boom that allowed Americans to live beyond their means: without this bubble, the weakening of incomes of so many in the middle class would have been readily apparent.
This sectoral shift was one of the key factors in the increase in inequality in the United States. It helps explain why ordinary workers are doing so badly. With their wages so low, it’s not a surprise that those at the top, who get the lion’s share of the profits, are doing so well.
A second structural shift stemmed from changes in technology that increased the demand for skilled workers, and replaced many unskilled workers with machines. This was called skill-biased technological change. It should be obvious that innovations or investments that reduce the need for unskilled labor (for example, investments in robots) weaken the demand for unskilled labor and lead to lower unskilled wages.
Those who attribute the decline of wages at the bottom and in the middle to market forces then see it as the normal working of the balance of these forces. And, unfortunately, if technological change continues as it has, these trends may persist.
Market forces haven’t always played out this way, and there is no theory that says that they necessarily should. Over the past sixty years, supply and demand for skilled and unskilled labor have shifted in ways that at first decreased, and then increased, wage disparities.3 In the aftermath of World War II, large numbers of Americans received a higher education thanks to the GI Bill. (College graduates formed only 6.4 percent of the labor force in 1940, but the percentage had doubled, to 13.8 percent, by 1970.)4 But the growth of the economy and the demand for high-skill jobs kept pace with the increase in supply, so the return to education remained strong. Workers with a college education still received 1.59 times what a high school graduate received, almost unchanged from the ratio in 1940 (1.65). The diminished relative supply of unskilled workers meant that even these workers benefited, so wages across the board increased. America enjoyed broadly shared prosperity, and in fact at times incomes at the bottom increased faster than those at the top.
But then U.S. educational attainment stopped improving, especially relative to the rest of the world. The fraction of the U.S. population graduating from college increased much more slowly, which meant the relative supply of skilled workers, which had increased at an average annual rate of almost 4 percent from 1960 to 1980, instead increased at the much smaller rate of 2.25 percent over the next quarter century.5 By 2008 the U.S. high school graduation rate was 76 percent, compared with 85 percent for the EU.6 Among the advanced industrial countries, the United States is only average in college completion; thirteen other countries surpass it.7 And average scores of American high school students, especially in science and mathematics, were at best mediocre.8
In the past quarter century, technological advances, particularly in computerization, enabled machines to replace jobs that could be routinized. This increased the demand for those who mastered the technology and reduced the demand for those who did not, leading to higher relative wages for those who had mastered the skills required by the new technologies.9 Globalization compounded the effects of technology’s advances: jobs that could be routinized were sent abroad, where labor that could handle the work cost a fraction of what it cost in the United States.10
At first, the balance of supply and demand kept wages in the middle rising, but those at the bottom stagnated or even fell. Eventually, the deskilling and outsourcing effects dominated. Over the past fifteen years, wages in the middle have not fared well.11
The result has been what we described in chapter 1 as the “polarization” of America’s labor force. Low-paying jobs that cannot be easily computerized have continued to grow—including “care” and other service sectors jobs—and so have high-skilled jobs at the top.
This skill-biased technological change has obviously played a role in shaping the labor market—increasing the premium on workers with skills, deskilling other jobs, eliminating still others. However, skill-biased technological change has little to do with the enormous increase in wealth at the very top. Its relative importance remains a subject of debate, upon which we will comment later in this chapter.
There is one more important market force at play. Earlier in the chapter, we described how increases in productivity in manufacturing—
outpacing the increase in demand for manufactured goods—led to higher unemployment in that sector. Normally, when markets work well, the workers displaced easily move to another sector. The economy as a whole benefits from the productivity increase, even if the displaced worker doesn’t. But moving to other sectors may not be so easy. The new jobs may be in another location or require different skills. At the bottom, some workers may be “trapped” in sectors with declining employment, unable to find alternative employment.
A phenomenon akin to what happened in agriculture in the Great Depression may be happening in large swaths of today’s job market. Then increases in agricultural productivity raised the supply of agricultural products, driving down prices and farm incomes relentlessly, year after year, with an occasional exception from a bad harvest. At points, and especially at the beginning of the Depression, the fall was precipitous—a decline of half or more in farmers’ income in three years. When incomes were declining more gradually, workers migrated to new jobs in the cities, and the economy went through an orderly, if difficult, transition. But when prices fell precipitously—and the value of housing and other assets that the farmers owned fell concomitantly—people were suddenly trapped on their farms. They couldn’t afford to move, and their decreased demand for goods made in urban factories caused unemployment in the cities as well.
Today America’s manufacturing workers have been experiencing something similar.12 I recently visited a steel mill near where I was born, in Gary, Indiana, and although it produces the same amount of steel that it did several decades ago, it does so with one-sixth the labor. And once again there is neither the push nor the pull to move people to new sectors: higher costs of education make it difficult for people to obtain the skills they need for jobs that would pay a wage comparable to their old wage; and among the sectors where there might have been growth, low demand from the recession creates few vacancies. The result is stagnant, or even declining, real wages. As recently as 2007, the base wage of an autoworker was around $28 an hour. Now, under a two-tier wage system agreed upon with the United Automobile Workers union, new hires can expect to earn only about $15 an hour.13
Back to the role of government
This broad narrative of what has happened to the market and the contribution of market forces to increasing inequality ignores the role that government plays in shaping the market. Many of the jobs that have not been mechanized, and are not likely to be soon, are public-sector jobs in teaching, public hospitals, and so on. If we had decided to pay our teachers more, we might have attracted and retained better teachers, and that might have improved overall long-term economic performance. It was a public decision to allow public-sector wages to sink below those of comparable private-sector workers.14
The most important role of government, however, is setting the basic rules of the game, through laws such as those that encourage or discourage unionization, corporate governance laws that determine the discretion of management, and competition laws that should limit the extent of monopoly rents. As we have already noted, almost every law has distributive consequences, with some groups benefiting, typically at the expense of others.15 And these distributive consequences are often the most important effects of the policy or program.16
Bankruptcy laws provide an example. Later, in chapter 7, I describe how “reforms” in our bankruptcy laws are creating partially indentured servants. That reform, together with the law prohibiting the discharge of student debt in bankruptcy,17 is causing immiseration for large parts of America. Like the effects on distribution, the effects on efficiency have been adverse. The bankruptcy “reform” reduced the incentives of creditors to assess creditworthiness, or to ascertain whether the individual is likely to get a return from the education commensurate with its costs. It increased the incentives for predatory lending, since lenders could be more certain of recovering the loans, no matter how onerous the terms and how unproductive the uses to which the money was put.18
In later chapters, we’ll also see other examples of how government helps shape market forces—in ways that help some, at the expense of others. And too often, the ones who are helped are those at the top.
It is, of course, not just laws that have large distributive effects, but also policies. We’ve considered several policies in the previous chapter—for example, on the enforcement of laws against anticompetitive practices. In chapter 9 we’ll look at monetary policies, which affect the level of employment and the stability of the economy. We’ll see how they have been set in ways that weakened the income of workers and enhanced that of capital.
Finally, public policy affects the direction of innovation. It is not inevitable that innovation be skill biased. Innovation could, for instance, be biased toward the saving of natural resources. Later in this book, we’ll describe alternative policies that might succeed in redirecting innovation.
One aspect of the “market forces” theory has been the center of attention now for more than a decade: globalization, or the closer integration of the economies of the world. Nowhere do politics shape market forces more than in the globalization arena. Much as the lowering of transportation and communication costs has promoted globalization, changes in the rules of the game have been equally important: these include reducing impediments to the flow of capital across borders and trade barriers (for instance, reducing tariffs on imported Chinese goods that allow them to compete with American ones on an almost even playing field).
Both trade globalization (the movement of goods and services) and capital markets globalization (international financial market integration) have contributed to growing inequality, but in different ways.
Over the past three decades, U.S. financial institutions have argued strongly for the free mobility of capital. Indeed, they have become the champions of the rights of capital—over the rights of workers or even political rights.19 Rights simply specify what various economic players are entitled to: the rights workers have sought include, for instance, the right to band together, to unionize, to engage in collective bargaining, and to strike. Many nondemocratic governments severely restrict these rights, but even democratic governments circumscribe them. So too, the owners of capital may have rights. The most fundamental right of the owners of capital is that they not be deprived of their property. But again, even in a democratic society, these rights are restricted; under the right of eminent domain, the state can take away somebody’s property for public purpose, but there must be “due process” and appropriate compensation. In recent years, the owners of capital have demanded more rights, like the right to move freely into or out of countries. Simultaneously, they’ve argued against laws that might make them more accountable for human rights abuses in other countries, such as the Alien Torts Statute, which enables victims of those abuses to bring suit in the United States.
As a matter of simple economics, the efficiency gains for world output from the free mobility of labor are much, much larger than the efficiency gains from the free mobility of capital. The differences in the return to capital are minuscule compared with those on the return to labor.20 But the financial markets have been driving globalization, and while those who work in financial markets constantly talk about efficiency gains, what they really have in mind is something else—a set of rules that benefits them and increases their advantage over workers. The threat of capital outflow, should workers get too demanding about rights and wages, keeps workers’ wages low.21 Competition across countries for investment takes on many forms—not just lowering wages and weakening worker protections. There is a broader “race to the bottom,” trying to ensure that business regulations are weak and taxes are low. In one arena, finance, this has proven especially costly and especially critical to the growth in inequality. Countries raced to have the least-regulated financial system for fear that financial firms might decamp for other markets. Some in the U.S. Congress worried about the consequences of this deregulation, but they felt helpless: America would lose jobs and a major industry if it didn’t comply. In retrospect, however, this was a mistake. The loss to the country from the crisis that resulted from inadequate regulation was orders of magnitude larger than the number of jobs in finance that were saved.
Not surprisingly, whereas a decade ago it was part of conventional wisdom that everyone would benefit from free capital movements, in the aftermath of the Great Recession many observers have their doubts. These concerns are coming not just from those in developing countries but also from some of globalization’s strongest advocates. Indeed, even the IMF (the International Monetary Fund, the international agency responsible for ensuring global financial stability) has now recognized the dangers of unencumbered and excessive financial integration:22 a problem in one country can rapidly spread to another. In fact, fears of contagion have motivated bailouts of banks in the magnitude of tens and hundreds of billions of dollars. The response to contagious diseases is “quarantine,” and finally, in the spring of 2011, the IMF recognized the desirability of the analogous response in the financial markets. This takes the form of capital controls, or limiting the volatile movement of capital across borders, especially during a crisis.23
The irony is that in the crises that finance brings about, workers and small businesses bear the brunt of the costs. Crises are accompanied by high unemployment that drives down wages, so workers are hurt doubly. In earlier crises, not only did the IMF (typically with the support of the U.S. Treasury) insist on huge budget cuts from troubled nations, converting downturns into recessions and depressions, but it also demanded the fire sales of assets, and the financiers then swooped in to make a killing. In my earlier book Globalization and Its Discontents, I described how Goldman Sachs was one of the winners in the 1997 East Asia crisis, as it was in the 2008 crisis. When we wonder how it is that the financiers get so much wealth, part of the answer is simple: they’ve helped write a set of rules that allows them to do well, even in the crises that they help create.24
The effects of trade globalization have not been as dramatic as those of the crises associated with capital and financial market liberalization, but they have nonetheless been operating slowly and steadily. The basic idea is simple: the movement of goods is a substitute for the movement of people. If the United States imports goods that require unskilled workers, it reduces the demand for unskilled workers to make those goods in the United States, and that drives down unskilled workers’ wages. American workers can compete by accepting lower and lower wages—or by getting more and more skilled.25 This effect would arise no matter how we managed globalization, so long as it led to more trade.
The way globalization has been managed, however, has itself led to still lower wages because workers’ bargaining power has been eviscerated. With capital highly mobile—and with tariffs low—firms can simply tell workers that if they don’t accept lower wages and worse working conditions, the company will move elsewhere. To see how asymmetric globalization can affect bargaining power, imagine, for a moment, what the world would be like if there was free mobility of labor, but no mobility of capital.26 Countries would compete to attract workers. They would promise good schools and a good environment, as well as low taxes on workers. This could be financed by high taxes on capital. But that’s not the world we live in, and that’s partly because the 1 percent doesn’t want it to be that way.
Having succeeded in getting governments to set the rules of globalization in ways that enhance their bargaining power vis-à-vis labor, corporations can then work the political levers and demand lower taxation. They threaten the country: unless you lower our taxes, we will go elsewhere, where we are taxed at lower rates. As corporations have pushed a political agenda that shapes market forces to work for them, they have not, of course, revealed their hand. They don’t argue for globalization—for free capital mobility and investment protections—saying that doing so will enrich them at the expense of the rest of society. Rather, they make specious arguments about how all will benefit.
There are two critical aspects to this contention. The first is that globalization will increase the country’s overall output as measured, for instance, by GDP. The second is that if GDP is increased, trickle-down economics will ensure that all will benefit. Neither argument is correct. It is true that when markets work perfectly, free trade allows people to move from protected sectors to more efficient unprotected export sectors. There can be, as a result, an increase in GDP. But markets often don’t work so nicely. For example, workers displaced by imports often can’t find another job. They become unemployed. Moving from a low-productivity job in a protected sector to unemployment lowers national output. This is what has been happening in the United States. It happens when there is bad macroeconomic management, so the economy faces a high unemployment rate, and it happens when financial sectors don’t do their jobs, so new businesses aren’t created to replace the old businesses that are destroyed.
There is another reason why globalization may lower overall output; it typically increases the risks that countries face.27 Opening up a country can expose it to all kinds of risks, from the volatility of capital markets to that of commodity markets. Greater volatility will induce firms to move to less risky activities, and these safer activities often have a lower return. In some cases, the risk-avoidance effect can be so large that everyone is made worse-off.28
But even if trade liberalization leads to a higher overall output for a given economy, large groups in the population can still be worse off. Consider for a moment what a fully integrated global economy (with both knowledge and capital moving freely around the world) would entail: all workers (of a given skill) would get the same wage everywhere in the world. America’s unskilled workers would get the same wage that an unskilled worker gets in China. And that would mean, in turn, that America’s workers’ wages would fall precipitously. The prevailing wage would be the average of that of America and the rest of the world and, unfortunately, much closer to the lower wage prevailing elsewhere. Not surprisingly, advocates of full liberalization, who typically believe that markets function well, don’t advertise this outcome. In fact, unskilled workers in the United States have already taken a beating. As globalization proceeds, there will be further downward pressures on their wages. I don’t think markets work so well that wages will be fully equalized, but they will move in that direction, and far enough to be of serious concern.29 The problem is particularly severe today in the United States and Europe: at the same time that labor-saving technological change has reduced the demand for many of the “good” middle-class blue-collar jobs, globalization has created a global marketplace, putting the same workers in direct competition with comparable workers abroad. Both factors depress wages.
How, then, can globalization’s advocates claim that everybody will be better-off? What the theory says is that everybody could be better off. That is, the winners could compensate the losers. But it doesn’t say that they will—and they usually don’t. In fact, globalization’s advocates often claim that globalization means that they can’t and shouldn’t do this. The taxes that would have to be levied to help the losers would, they claim, make the country less competitive, and in our highly competitive globalized world countries simply can’t afford that. In effect, globalization hurts those at the bottom not only directly but also indirectly, because of the induced cutbacks in social expenditures and progressive taxation.
The result is that in many countries, including the United States, globalization is almost surely contributing significantly to our growing inequality. I have emphasized that the problems concern globalization as it has been managed. Countries in Asia benefited enormously through export-led growth, and some (such as China) took measures to ensure that significant portions of that increased output went to the poor, some went to provide for public education, and much was reinvested in the economy, to provide more jobs. In other countries, there have been big losers as well as winners—poor corn farmers in Mexico have seen their incomes decline as subsidized American corn drives down prices on world markets.
In many countries, poorly functioning macroeconomies have meant that the pace of job destruction has exceeded that of job creation. And that’s been the case in the United States and Europe since the financial crisis.
Among the winners from globalization in the United States and some European countries, as it’s been managed, are the people at the top. Among the losers are those at the bottom, and increasingly even those in the middle.