Steve Waldman: "Inequality and the Credit Crisis"

Steve Waldman has a great little post on how the end of the consumer credit bubble is going to expose rifts papered over by the illusion of rising living standards for all. In fact, average real wages have been stagnant since the mid-1970s; the gains in income have accrued entirely to those at the top of the food chain.

Thomas Palley has made a similar argument with a different emphasis. He contends that policy-makers retreated from full employment as a goal, since it allows workers to demand higher wages, which in turn causes inflation. Reducing worker bargaining power led to disinflation, lower interest rates led to rising asset prices, which in combination with financial innovation, created an until-recently reinforcing cycle whereby rising asset prices funded consumption. Palley noted that that cycle was at its limits, and Waldman discusses the implications.

My favorite section:

Credit was the means by which we reconciled the social ideals of America with an economic reality that increasingly resembles a "banana republic". We are making a choice, in how we respond to this crisis, and so far I'd say we are making the wrong choice. We are bailing out creditors and going all personal-responsibility on debtors. We are coddling large institutions of prestige and power, despite their having made allocative errors that would put a Soviet 5-year plan to shame. We applaud the fact that "wage pressures are contained", protecting the macroeconomy of the wealthy from the microeconomy of the middle class.

Go read it here.

Voters Around the World Unhappy With Income Disparity

The Financial Times reports on a FT/Harris survey found a surprising consensus across eight countries in Europe and Asia, as well as in the US, that increasing income disparity was undesirable. Not surprisingly, respondents favored increasing taxes on the rich.

Of course, this poses an interesting conundrum for politicians, given the sway of multinational corporations and Big Finance. As Jean Colbert observed, "The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing." And those at the top of the food chain know to hiss loudly. So unless the public at large figures out how to get more vocal, any moves to address these sentiments are likely to be symbolic.

And the survey participants appear to understand that dynamic well. For the most part, they expect inequality to worsen in the next five years.

From the Financial Times:

Income inequality has emerged as a highly contentious political issue in many countries as the latest wave of globalisation has created a “superclass” of rich people...

According to the latest FT/Harris poll, strong majorities in five European countries – ranging from 76 per cent in Spain to 87 per cent in Germany – consider that income inequality is too great.

But 78 per cent of respondents in the US, traditionally seen as more tolerant of income inequality, also think the gap is too wide....

For the first time, the FT/Harris poll surveyed opinion in Asia. In China, which has experienced three decades of helter-skelter development, 80 per cent of respondents think income inequality is too great.

However, Japan recorded the lowest figure of all countries surveyed, with 64 per cent....

Clear majorities in all countries agree that taxes should be raised on the rich and lowered on the poor. In Britain, 74 per cent of respondents think that those on low incomes should be taxed less, helping to explain the furore that surrounded the Labour government’s decision to abolish the 10p income tax rate...

US respondents were the most resistant to the idea of lowering taxes on the poor, with 27 per cent agreeing with the proposition that taxes should be kept at current levels.

Note that Japan has one of the most equal distributions of income, if you believe the UN Gini coefficient ranking, although the CIA Factbook Gini points to a very different conclusion. But the Japanese are keen observers of very small status differences (the legacy of having once had extremely strict sumptuary laws), so their sensitivity to income disparity is considerable.

Why So Little Interest in Danish "Flexicurity"? (Income Inequality/Labor Inefficiency Edition)

Why is it that some ideas capture the popular imagination and others die on the vine? A lot has to do with timing, getting noticed by opinion leaders, having a pithy turn of phrase. Yet I've seen articles and books that (at least to me) make fundamentally important observations and go nowhere, and others which seemed by comparison lightweight, get a great deal of attention.

Now the object lesson isn't in the earthshaking category, yet it's sufficiently interesting and instructive to warrant more attention than it appears to have gotten.

Robert Kuttner wrote an article for Foreign Affairs (subscription required) on the Danish economic model. The summary:

Denmark has forged a social and economic model that couples the best of the free market with the best of the welfare state, transcending tradeoffs between dynamism and security, efficiency and equality. Other countries may not be able to simply copy the Danish model of social democracy, but it nonetheless offers important lessons for governments confronting the dilemmas of globalization.

Given that we have Larry Summers, Martin Wolf, and plenty of others regularly hand-wringing about the growing backlash against free trade, a country, particularly a little country that of necessity has to trade, has managed to reach not merely workable, but successful and robust mix of safety nets and market mechanisms is noteworthy, precisely because it flies in the face of the popular prejudice that you have to have one or the other. Conventional wisdom holds that you have either lots of social welfare and sclerotic, rigid economies, or you have laissez faire capitalism which (allegedly) produces higher growth rates, although it increasingly appears that the main beneficiaries are those at the top, and the average guy gets left behind, sometimes in a dustheap.

But look at what we get in Denmark. According to Kuttner, trade unions call on industry to do more outsourcing! Mirable dictu! That alone should stir interest.

Yes, the piece was deemed interesting enough to have run in Foreign Affairs, so presumably some serious policy wonks took note. But if the level of comment in blogland is any indicator, it appears to have been largely ignored by the Serious Economist cohort. Dani Rodrick gave it a very nice writeup last week, but a quick search shows that it went nowhere.
And this is an article that appeared in the March/April issue, mind you.

[Update: Mark Thoma provided this and this link, along with two others, to some older discussions of fliexicurity].

So what's afoot? I can make a few quick guesses:

1. Kuttner works as a journalist. Those outside the academy are not held in high esteem.

2. That name "flexicurity" stinks.

3. Recall the Swedish miracle? I wonder if the fact that Sweden eventually fizzled makes the experts loath to get on any Scandinavian bandwagons.

4. As discussed below, even if you accept that the Danish model can't be readily exported, it nevertheless has some uncomfortable implications for the US.

Let's get to the basics according to Kuttner:

.....the Danes are passionate free traders. They score well in the ratings constructed by pro-market organizations. The World Economic Forum's Global Competitiveness Index ranks Denmark third, just behind the United States and Switzerland. Denmark's financial markets are clean and transparent, its barriers to imports minimal, its labor markets the most flexible in Europe, its multinational corporations dynamic and largely unmolested by industrial policies, and its unemployment rate of 2.8 percent the second lowest in the OECD (the Organization for Economic Cooperation and Development).

On the other hand, Denmark spends about 50 percent of its GDP on public outlays and has the world's second-highest tax rate, after Sweden; strong trade unions; and one of the world's most equal income distributions. For the half of GDP that they pay in taxes, the Danes get not just universal health insurance but also generous child-care and family-leave arrangements, unemployment compensation that typically covers around 95 percent of lost wages, free higher education, secure pensions in old age, and the world's most creative system of worker retraining.

Aside: would you mind paying that much in taxes if you got all those bennies, plus clean streets and nice public transportation? (Note I am unaware of what individuals pay in taxes versus corporations, but one has to assume the effective rate is pretty high). And remember, since the income distribution is so even, it's not like some people are paying disproportionately for public services.

Kuttner gives us his caveats:

Yet Denmark's social compact is the result of a century of political conflict and accommodation that produced a consensual style of problem solving that is uniquely Danish. It cannot be understood merely as a technical policy fix to be swallowed whole in a different cultural or political context. Those who would learn from Denmark must first appreciate that social models have to grow in their own political soil.

Danish "flexicurity" means no labor rigidity. Like the US, you have employment at will; the only restriction on firing workers is that you give them advance notice. The key elements:

[F]ull employment; strong unions recognized as social partners; fairly equal wages among different sectors, so that a shift from manufacturing to service-sector work does not typically entail a pay cut; a comprehensive income floor; and a set of labor-market programs that spend an astonishing 4.5 percent of Danish GDP on initiatives such as transitional unemployment assistance, wage subsidies, and highly customized retraining.

As Rodrik notes:

In the U.S. by contrast, "spending on all forms of government labor-market subsidies -- of which meager and strictly time-limited unemployment compensation makes up the most part -- is about 0.3 percent of GDP.

What Kuttner stresses, and this is hard for Americans to swallow, are two elements:

1. The large degree of government intervention, even if it is to promote better functioning labor markets and more economic efficiency

2. The commitment to economic equality

And there are not obvious reinforcements between 1. and 2.

As for 1, the US has (unfortunately) come to associate large scale government programs with wealth transfer (as in the New Deal and Great Society programs) or (occasionally) showcases that are assumed to produce useful side benefits (NASA, the national labs such as Sandia, the national park system). Somehow most people don't include our massive defense apparatus on this list.

Yet we tend to forget our own government support of business (the official kind, not the pork or regulatory capture variety), such as the federal funding, particularly by the National Institutes of Health, of drug research (estimates range from 40% to 55% of total outlays). Japan in its heyday benefited from the guidance of the Ministry of Trade and Industry. Australia has its Commonwealth Scientific and Industrial Research Organization, a highly government funded applied science think tank focused on industries deemed economically important.

But the Anglo-Saxon countries don't have much in the way of models for buffering labor market dislocation. We tend to see it as welfare, but that line of thinking is fatally flawed.

Consider: as societies become more advanced, economic roles become more specialized. Everyone is a hunter-gatherer in a primitive society. In a pre-industrial society, you will see specialization (farmers versus tailors versus smiths), but these economies features little or no growth, and everyone's fate tended to rise and fall together, depending on the vagaries of weather, wars, and pestilence. There wasn't a scenario under which the smith would make a killing and the rest of the village would go begging.

Industrialization brought growth but also greatly increased uncertainty. As Adam Smith pointed out, even greater labor specialization becomes the norm. And that has increased over time not just in factories but in all walks of life. 100 years ago, a doctor was a doctor was a doctor. No more. You see it even in economics: trade economists versus macroeconomists versus financial markets specialists. Yes, they are often familiar with the work in other areas (teaching will force that on them), but they tend to publish more narrowly.

But if society demands increasingly specialized skills, and these skills in turn require the investment of time (education, considerable on the job training, or both) that creates labor market inefficiencies due to skill imbalances as demand and technologies change. This is a drag I don't see well recognized in conventional theories. It seems to be assumed that when trade or technological advances lead to certain industries, like buggy whips, to die off, labor and capital will automatically adjust. It isn't so simple and no where near so frictionless.

We thus have the highly visible problem of individuals suffering job losses, which can lead to long term un and under-employment, and/or not finding work only at considerably lower pay. That tends to be treated as a Darwinian outcome in the US, and we miss the fact that many of the people really could be redeployed in other fields if they had real training, not the half-hearted variety on offer here. Too often, the proposals to retrain workers to soften the blow of globalization sound more like a ruse to placate voters than serious policy.

Now of course, that view, as far as America is concerned, has some big shortcomings. First is the uneven and often substandard public education. It's hard to retrain people if they lack an adequate foundation. Second is labor mobility. As far as I can tell, you can drive from one end of Denmark to another in just over five hours. Thus if one had to move to find work, it would not be as wrenching as in the US (although changing communities is never easy).

But Denmark's biggest secret weapon is its even income distribution. That makes no only makes labor highly fungible, but is also facilitates people taking the jobs that suit them best (to the extent they have choices) rather than basing their decisions primarily or significantly on the size of their paychecks.

One thing that has quietly distressed me is how much US talent has been sucked up by Wall Street. I doubt that having a good bit of our top mathematical talent work on making better derivative models is the best use of their skills as far as society as a whole is concerned (and they don't even appear to have been hugely successful at that). A high proportion of the best and the brightest of Ivy League schools have also gone into finance; in earlier generations, they would have gone into a much broader range of occupations. Would Dean Richardson, the top veterinary surgeon who attempted to save the racehorse Barbaro, ever have gone that route had he graduated from Dartmouth in the 1980s? (Richardson was class of '74). Highly doubtful. Multiply Richardson by 10,000, maybe even 100,000. And that's just counting the elite schools. The same pattern holds at middlling to good but less celebrated schools (and of course, the other sad fact is America is due to the vagaries of primary and secondary education, plenty of smart, hardworking people don't have a shot at the best schools. Even in my very limited personal sample, I've seen way too many examples).

Consider further: in societies with more even income distribution, you can have higher caliber public servants (is the problem with government the institutions per se, or the difficulty in getting good people in the rank and file?) and teachers. And within organizations, people may be less resistant to change if the worst possible outcome, job loss, really isn't so terrible.

Yet economic competitiveness seems to have become inextricably enmeshed with our notions of the American Dream. It once meant that poor immigrants could come here, better themselves, and have a shot at middle class life. And even if they did not attain it, if their children applied themselves, almost certainly would.

But the American Dream seems to have morphed into something different. It no longer seems to stand for "if you work hard and play by the rules, you can have a comfortable and productive life." It feels as if it has become bound up with ever-increasing consumption, no matter what your economic cohort. Yet that new version of the dream now appears to be accessible only to those in the top echelons. So the fact of stagnant incomes for the bulk of the population has been exacerbated by the gap between the lifestyle aspirations pushed in media and the life most people lead.

And per the Danish example, the hidden costs of income inequality may be far higher than anyone wants to admit. To me, that it the inconvenient truth of Kuttner's piece which is leading it to be less popular than it deserves to be.

Did Increased Income Disparity Help Cause the Depression?

I've been meaning to discuss how increased income disparity is bad for economic growth, because in the end you wind up with insufficient labor income to fund consumption (note that America's high consumption rate has been achieved by lowering its already low savings rate to zero) and too much capital chasing too few investment opportunities (even a sound bet will produce a bad return if you pay too much for it).

It turns out I was beaten to the punch by nearly 50 years, as Robert Reich tells us in his latest post, invoking former Fed chairman Marriner Eccles . Insufficient consumption is one theory of the roots of the Depression (the monetarist version has gained ascendance), but Eccles links the consumption shortfall directly to a shift in wealth towards the top. And some of the other patterns of the Twenties, such as debt-fueled growth, are worryingly familiar.

While I wouldn't go as far as seeing this shift as the cause of the Depression or our current woes, it plausible that it was a culprit then and now.

From Reich's "Are We Headed for Another Great Depression?":

Probably not. But go back 75 years and you'll find eerie similarities. Marriner S. Eccles who served as Franklin D. Roosevelt’s Chairman of the Federal Reserve from November, 1934 to February, 1948 gave his view of what caused the Depression in his memoirs, "Beckoning Frontiers" (New York, Alfred A. Knopf, 1951):

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth -- not of existing wealth, but of wealth as it is currently produced -- to provide men with buying power equal to the amount of goods and services offered by the nation s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.

That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low. Private debt outside of the banking system increased about fifty per cent. This debt, which was at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer installment debt, brokers' loans, and foreign debt. The stimulation to spending by debt-creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time. Had there been a better distribution of the current income from the national product -- in other words, had there been less savings by business and the higher-income groups and more income in the lower groups -- we should have had far greater stability in our economy. Had the six billion dollars, for instance, that were loaned by corporations and wealthy individuals for stock-market speculation been distributed to the public as lower prices or higher wages and with less profits to the corporations and the well-to-do, it would have prevented or greatly moderated the economic collapse that began at the end of 1929.

The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality underconsumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment.

Unemployment further decreased the consumption of goods, which further increased unemployment, thus closing the circle in a continuing decline of prices. Earnings began to disappear, requiring economies of all kinds in the wages, salaries, and time of those employed. And thus again the vicious circle of deflation was closed until one third of the entire working population was unemployed, with our national income reduced by fifty per cent, and with the aggregate debt burden greater than ever before, not in dollars, but measured by current values and income that represented the ability to pay. Fixed charges, such as taxes, railroad and other utility rates, insurance and interest charges, clung close to the 1929 level and required such a portion of the national income to meet them that the amount left for consumption of goods was not sufficient to support the population.

This then, was my reading of what brought on the depression.

Krugman: Trade Data Not Good Enough to Analyze Impact on Wages

Quite often, policy debates get mired in superficial, outdated, manipulated, or simply incomplete understandings of the facts. Getting relevant data is vital to coming up with intelligent approaches.

Unfortunately, Paul Krugman, who has tried getting to the bottom of whether trade has increased income inequality in the US, concludes that we don't have the right information to do the needed analysis.

The corollary, of course, is that you can spout whatever you believe and no one will be able to disprove it....

The concluding section of a draft of Krugman's paper, "Trade and Wages, Reconsidered" (hat tip Mark Thoma):

The starting point of this paper was the observation that the consensus that trade has only modest effects on inequality rests on relatively old data – that there has been a dramatic increase in manufactured imports from developing countries since the early 1990s. And it is probably true that this increase has been a force for greater inequality in the United States and other advanced countries.

What really comes through from the analysis here, however, is the extent to which the changing nature of world trade has outpaced our ability to engage in secure quantitative analysis—even though this paper sets to one side the growth in service outsourcing, which has created so much anxiety in recent years. Plain old trade in physical goods has become remarkably exotic.

In particular, the surge in developing-country exports of manufactures involves a peculiar concentration on apparently sophisticated products, which seems at first to put worries about distributional effects to rest. Yet there is good reason to believe that the apparent sophistication of developing country exports is, in reality, largely a statistical illusion, created by the phenomenon of vertical specialization in a world of low trade costs.

How can we quantify the actual effect of rising trade on wages? The answer, given the current state of the data, is that we can’t. As I’ve said, it’s likely that the rapid growth of trade since the early 1990s has had significant distributional effects. To put numbers to these effects, however, we need a much better understanding of the increasingly fine-grained nature of international specialization and trade.

"Why America needs a little less laissez-faire"

Barney Frank, chairman of the House Financial Services Committee, has the reputation of having a sharp mind (and occasionally sharp tongue) and it shows in this Financial Times comment piece. The article makes a two pronged attack against the rightward economic drift of the last 30 years, noting that deregulation has not been the panacea it was promised to be, and similarly, that tax policies favoring the wealthy have not produced the much-hyped trickle down.

Interestingly, Frank does not choose to say that income redistribution or regulation to more growth; he merely says that economic expansion has been achieved under a wider range of tax and regulatory regimes than conservatives would lead us to believe is possible.

From the Financial Times:

As we prepare for this autumn’s election, the results are in on America’s 30-year experiment  with radical economic deregulation. Income inequality has risen to levels not seen since the 1920s and the collapse of the unregulated portion of the mortgage and secondary markets threatens the health of the overall economy.

These two economic failures will be major issues in the forthcoming presidential election, and, importantly, there is an emerging Democratic consensus standing in sharp contrast to the laisser faire Republican approach.

There are two central elements of this consensus. Democrats believe that government’s role as regulator is essential in maintaining confidence in the integrity and fairness of markets, and we believe that economic growth alone is not enough to reverse unacceptable levels of income inequality. In the wake of the subprime mortgage crisis, credit markets round the world contracted sharply in response to concerns among market participants about the value of exotic and opaque securities being offered in largely unregulated secondary markets. This staggering implosion and its damaging and widespread reverberations make it clear that a mature capitalist economy is as likely to suffer from too little regulation as from too much.

With respect to income inequality, since the end of the last recession – a period of steady economic growth – average earnings for the vast majority of workers have fallen in real terms. During this period, after-tax incomes of the top 1 per cent nearly doubled.

Whether because of globalisation, technology or other factors, it is clear that market forces have produced too much inequality and government has not adequately used its capacity to mitigate the impact of these forces.

Conservatives have long argued that government efforts to address these issues would damage the economy. They are, of course, the same people who predicted that there would be an economic disaster after Bill Clinton and the Democratic Congress raised marginal tax rates in 1993, and who opposed other tax increases on upper-income people. Economic growth in the ensuing years was among the strongest in the postwar era. It is now clear that growth in the private sector is consistent with a far greater variation in many aspects of public policy – including taxation and regulation – than conservatives claim. In fact, appropriate intervention with respect to prudential market regulation is necessary to promote growth, and its absence – as we have learned – can retard it.

As recently as a year ago, one often heard the argument that US financial activity would migrate offshore unless we moved to further deregulate markets. There is little evidence to support this claim. In fact, it is now clear that what has been migrating to the rest of the world are the problems associated with securities based on bad loans – often originated by unregulated institutions in the US. Banks in the UK and Germany were forced to close, either as a result of holding large portfolios of these securities or because they could not roll over debt backed by them.

Widespread securitisation, and use of the “originate to distribute” model, has turned out to be far less than the unmitigated boon it had once appeared.

The market did its job with great efficiency in exploiting the benefits of securitisation but government failed to make good on its responsibilities. The failure of regulation to keep pace with innovation left us with no replacement for the discipline provided by the lender-borrower relationship that securitisation dissolves. Increasing and largely unregulated leverage multiplies the corrosive effect of this change.

In response to the current crisis, it appears that the regulatory tide may, at long last, be turning.

In 1994 a Democratic Congress – the last before the Republican takeover marked the arrival of the deregulators – passed the homeowners equity protection act, giving the Federal Reserve the power to regulate all home mortgage loans. The avatar of deregulation, Alan Greenspan, then Fed chairman, flatly refused to use any of that authority.

In contrast, today’s Fed will soon issue rules using that authority. That represents a significant repudiation of the previous view. While the proposals made by the Democratic presidential candidates differ in detail, they are to a substantial extent consistent with the argument I have made here. Their Republican counterparts continue to advocate the hands-off approach pursued by the Bush administration. As a result, we are likely to have a healthy debate about the role of government in supporting a robust capitalist economy in the 21st century. It is important to note that this debate is not about policy details but represents fundamentally different views about the nature of our modern economy.

I believe the American people will decide that we should enact policies that seek to curb growing inequality and provide some check on market excesses.

Why the Weak Relationship Between Income Inequality and Redistribution Efforts?

Asking good questions is half the battle in advancing knowledge, and a clever and timely piece by Andreas Georgiadis and Alan Manning of the London School of Economics does just that.

The post looks into why rising income inequality isn't strongly correlated in democracies with more concerted efforts at redistribution. After all, as wealth becomes concentrated in fewer hands, the have nots, who outnumber the top echelon in considerable numbers, will have both the incentive and the means to vote for policies that make the after-tax distribution of income less skewed.

The post by Georgiadis and Manning makes an interesting first cut into the problem. It looks at the relationship between income inequality in the UK from 1974 to 2004, a period during which the disparity in earnings grew sharply, and social attitudes towards redistribution. Although there was a time from the mid 1980s to the mid 1990s when the desire for redistribution increased, over the long haul it has declined dramatically. The authors offer some theories, the most persuasive being that rising inequality give the rich the means to fight off demands for reallocation (ie, they are better able to manipulate public opinion).

From VoxEU:

The standard framework for thinking about inequality and redistribution – the median voter approach – predicts that rising inequality should produce more redistribution. The facts reject this prediction for the UK and suggest that beliefs may be an important missing factor.

"I warn you that there are going to be howls of anguish from those rich enough to pay over 75% on their last slice of earnings", a gleeful Denis Healey, Labour Party Shadow Chancellor, 1973.

"The justice for me is concentrated on lifting incomes of those that don't have a decent income. It's not my burning ambition to make sure that David Beckham earns less money", Tony Blair, Labour Party Leader, 2001 Election Campaign.

One of the main activities of the state in democracies is to redistribute resources. The most common explanation for why the state gets involved in this activity is that the distribution of income is skewed with small numbers of large incomes so that average income is above median income. In simple models of democracy, it is the median voter who is decisive and the government effectively does what they want, and they will typically want to redistribute resources from the rich to themselves. More sophisticated models of democracy also tend to have the same prediction. According to this view, a rise in income inequality will lead to more redistribution as the median voter tries to get a slice of the extra pie going to the rich.

However this prediction about the relationship between inequality and redistribution does not fare so well when confronted with data. Perhaps the starkest comparison is between the United States and Europe. The United States has higher levels of inequality than Europe and less redistribution, the opposite of the views sketched above. (See Alesina, Glaeser and Sacerdote, 2001, for a good discussion of this comparison).

However, there are many other potential differences (e.g. racial divisions and the political system) between countries that muddy the link between income inequality and redistribution. While the existing studies do make serious attempts to control for these confounding factors, it is very difficult to do this in a way that is beyond reasonable criticism.

However, it is not just across countries but also over time that we see changes in inequality. Looking at how redistribution in a country responds to changes in inequality has the potential advantage that many factors that might be thought to be relevant to redistribution (e.g. the political system) are held constant so we might hope to get a better estimate of the impact of inequality on redistribution. That was the purpose of our research on the relationship between inequality and redistribution in the UK.1

The UK is a good country to consider because it has had large rises in pre-tax income inequality that are generally thought to be the result of the exogenous forces of technological change and globalisation. In particular, there has been a large rise in the share of pre-tax income going to those at the top of the income distribution. As discussed above, most models of the political process used by economists would predict that the political response to this would take the form of rising redistribution with rising marginal tax rates on the rich. But we show that this has not happened. In our research, we use a sophisticated way to arrive at this conclusion but the simplest way to see it is that the top rate of income tax fell from 83% in the late 1970s to 40% in 1988 since when it has not changed. There is now no major political party proposing rises in the top marginal rate of income tax.

Why has the rise in UK inequality been met with so little demand to increasing taxes on the rich? One possibility is that the models of the political process used by economists are all wrong. For example, if our democracy is closer to ‘one pound, one vote’ instead of ‘one person, one vote’ then a rise in the share of income going to the rich will also lead to a rise in their share of political power, hence potentially explaining the lack of a redistributory response. But it is also possible that other factors have been changing.

To investigate this we used data from the British Social Attitudes Survey to see whether attitudes towards redistributive taxation have been changing. The answer is that they have. The figure below shows the average response of individuals to the statement “government should redistribute income from the better-off to those that are less well-off” where a 1 represents strongly disagree and 5 strongly agree so that higher average values represent a greater demand for redistribution.


From the figure it can be seen that the demand for redistribution fell in the early 1980s but then rose from the mid 1980s to the mid 1990s. This was the period in which inequality grew fastest and it seems plausible to argue that the lack of redistribution by the Thatcher and Major governments was not particularly popular. Hence Tony Blair would seem to have inherited in 1997 a large unmet demand for redistribution. But, little happened to actual inequality or redistribution but the support for redistribution plummeted to the lowest level available. The bottom line is that inequality now is much higher than in the 1970s but the demand for redistribution is much lower.

Why the change?

Why might people’s attitudes to redistribution have changed so much? There are a number of possible explanations. First, if you care a lot about the poor or are very envious of the rich, it is quite likely that you support a lot of redistribution. Secondly, if you believe that high taxes discourage work then you are not likely to support much redistribution. If you think the government cannot be trusted you are less likely to support redistribution. We find evidence for all these predictions using the British Social Attitudes Survey as well as the standard prediction that the rich favour less redistribution than the poor.

But have any of these attitudes been changing over time? Our conclusion is over the last 10 years that changing attitudes towards incentives and changing attitudes towards the rich (fewer people now believe there is one law for the poor and one for the rich or that big business benefits owners at the expense of workers) can explain almost two-thirds of the decline in the demand for redistribution in the UK.

One way to summarise this conclusion is that what people believe is as important as the objective economic circumstances in explaining people’s attitudes to political issues like redistribution. And these beliefs can change fast. Such a conclusion is perhaps only a potential surprise to economists as it simply says that politics is a battle for ‘hearts and minds’. But where those beliefs come from is itself an interesting question that we cannot answer very easily – it may be that they themselves are a product of the economic fundamentals. For example it could be that the rise in inequality gives the rich more power to fight off demands for redistribution and the way in which they do this is to put resources into persuading people that incentives are very important or that big business is not all bad. The determinants of what people believe is an area where economists are only beginning to focus their attentions.

Mirabile Dictu: Wall Street Journal Says Income Inequality is Rising

After denying the existence of rising disparities in income and wealth on it editorial pages, the Wall Street tells us that income inequality is indeed on the rise. It's a refreshing change from January, when the Journal misrepresented a speech by New York Fed President Timothy Geithner in which he said that the growing concentration of wealth at the top was undermining support for free trade. The Journal's coverage focused on the opposition to free trade and barely acknowledged that Geithner described income inequality as the proximate cause, despite the fact that the discussion of rising inequality took up roughly half of his remarks.

One peculiar aspect of this story by Greg Ip is that it cites IRS data and "scholars," but the only researchers mentioned by name are Steven Kaplan, Joshua Rauh, and Jason Furman. Tthe failure to mention the work of Thomas Piketty of École Normale Supérieure in Paris and Emmanuel Saez of the University of California at Berkeley, whose work in this area is generally regarded as the most thorough is a glaring omission.

This is yet another instance of the Journal being late to treat a well-recognized development as a news item. I am no expert, yet increasing inequality of income and wealth was such an obvious trend that I recommended that a major financial services company focus on the super wealthy as a growth market back in 2004. Where has the Journal been?

One small consolation: the efforts to separate the rich from their wealth have also escalated. A high-end jewelry designer (he uses the same workshops as Cartier) paid a rare visit to some retailers. At Bergdorf Goodman, a typical item he saw was an admittedly beautiful bracelet made of Kevlar and perhaps 4 carats of micro-pave diamonds.

Sales price? $125,000. Value of materials? At the very most (and this is a stretch) $15,000.

This is significant because in the old days, the markup on fine jewelry was two to three times. Now it is being marked up to the same degree as costume jewelry.

From the Journal:

The richest Americans' share of national income has hit a postwar record, surpassing the highs reached in the 1990s bull market, and underlining the divergence of economic fortunes blamed for fueling anxiety among American workers.

The wealthiest 1% of Americans earned 21.2% of all income in 2005, according to new data from the Internal Revenue Service. That is up sharply from 19% in 2004, and surpasses the previous high of 20.8% set in 2000, at the peak of the previous bull market in stocks.

The IRS data, based on a large sample of tax returns, are for "adjusted gross income," which is income after some deductions, such as for alimony and contributions to individual retirement accounts. While dated, many scholars prefer it to timelier data from other agencies because it provides details of the very richest -- for example, the top 0.1% and the top 1%, not just the top 10% -- and includes capital gains, an important, though volatile, source of income for the affluent.

The IRS data go back only to 1986, but academic research suggests the rich last had this high a share of total income in the 1920s.

Scholars attribute rising inequality to several factors, including technological change that favors those with more skills, and globalization and advances in communications that enlarge the rewards available to "superstar" performers whether in business, sports or entertainment.....

Jason Furman, a scholar at the Brookings Institution and an adviser to Democratic politicians, said: "We've had a 30-year trend of increasing inequality. There was an artificial reduction in that trend following the bursting of the stock-market bubble in 2000."

The IRS data don't identify the source of increased income for the affluent, but the boom on Wall Street has likely played a part, just as the last stock boom fueled the late-1990s surge. Until this summer, soaring stock prices and buoyant credit markets had produced spectacular payouts for private-equity and hedge-fund managers, and investment bankers.

One study by University of Chicago academics Steven Kaplan and Joshua Rauh concludes that in 2004 there were more than twice as many such Wall Street professionals in the top 0.5% of all earners as there are executives from nonfinancial companies.

Mr. Rauh said "it's hard to escape the notion" that the rising share of income going to the very richest is, in part, "a Wall Street, financial industry-based story." The study shows that the highest-earning hedge-fund manager earned double in 2005 what the top earner made in 2003, and top 25 hedge-fund managers earned more in 2004 than the chief executives of all the companies in the Standard & Poor's 500-stock index, combined. It also shows profits per equity partner at the top 100 law firms doubling between 1994 and 2004, to over $1 million in 2004 dollars

Update, 11/12, 2:40 PM: Trader Magazine focused on a tidbit in the story that was apparently added after the initial posting of the article, namely, what the bottom half makes:

The bottom 50% earned 12.8% of all income, down from 13.4% in 2004 and a bit less than their 13% share in 2000.

Income Disparity Growing in Asia

Back at my desk after over two weeks of holiday and wanted to get at least one post out before responding to some comments that seemed to call for a reply and getting back in touch with news and commentary.

The Asian Development Bank issued a report that found that income inequality is on the upswing in Asia. 15 countries showed a rise in the difference in incomes of the rich and poor, while only 7 saw a decline. And the countries with the largest populations, namely China and India, are among those exhibiting a larger gap.

While the report noted that the level of poverty was declining, in many countries the gulf between the haves and have-nots is getting so large as to have the potential to lead to political instability.

From the BBC:

The gap between rich and poor has widened sharply in China and many other Asian countries as their economies have boomed, research has suggested. The Asian Development Bank (ADB) found that relative inequality had widened more substantially in China than any other Asian country except for Nepal.

Other countries with rising wealth gaps include India, Cambodia and Sri Lanka.

More spending was needed on education, training and healthcare to alleviate the situation, the ADB argued.

The bank said the main reason for widening wealth gaps in recent years was the discrepancy in investment between urban and rural areas which favoured better-educated, better-off urban populations.

Improvements in rural infrastructure were being held back by government policies which deterred private investment.

Relative inequality, measured as the change in proportionate differences in income between the richest and poorest in society, has risen in 15 countries studied since the early 1990s, according to the bank's Key Indicators 2007 report.

In only six - Indonesia, Mongolia, Malaysia, Kazakhstan, Armenia and Thailand - did it narrow over the period in question.

Although basic poverty levels have fallen as Asian economies have expanded, the living standards of the wealthiest in society have improved at a much faster rate, leaving the poorest lagging even further behind.

While increased income disparities were not unusual in countries such as China experiencing rapid economic growth, the ADB said such extreme differences were socially harmful.

"In a region as dynamic and vibrant as developing Asia, low growth in incomes of the poor is reflective of weakness in the pattern of growth," said Ifzal Ali, the ADB's chief economist.

"Growing inequalities can weaken social cohesion."

Urban-dominated growth in China and India has caused social friction as a result of the high levels of migration to cities and a shortage of foreign investment in more isolated areas.

But the ADB said the answer was not to try and turn back the tide of globalisation but to ensure employment opportunities were made more widely available.

"Inequalities in life start early and they begin with extreme circumstances that deny millions the opportunity to have adequate nutrition, health and basic education," it noted.

Governments must ensure their health and education programmes were "targeted" and implemented in a way which did not destabilize the overall economy, the bank added.

The report in Forbes.com focused on China and was more pointed in discussing social and political implications:

China has had Asia's second-biggest and second-fastest-growing wealth gap since the 1990s, exceeded only by war-wracked Nepal on both counts, the bank said in an annual survey.

China has seen thousands of protests in recent years, some of them violent, over land seizures and other economic grievances blamed on the growing gap. The communist government has made improving incomes for the poor a priority, warning last year that inequality has reached "alarming and unacceptable" levels.

"High inequality, particularly high absolute levels of inequality, leads to a disruption in social cohesion. You could have street demonstrations which could lead to violent civil wars," Ifzal Ali, the bank's chief economist, said at a news conference.

Ali said it was inappropriate to speculate when asked whether China should expect worse unrest. But he cited the experience of Nepal, where he said a recently ended, decade-long civil war was most intense in areas with highest inequality.

Tensions over China's growing gap between an urban elite, who have profited most from two decades of economic reform, and the poor majority are a key political issue for communist leaders. They have promised to spread prosperity by spending more on social programs for the countryside and the urban poor.

Ali said China's poorest people have benefited from its boom - which saw the economy expand by 11.9 percent last quarter - but incomes for the richest 20 percent have grown much faster.

Cambodia, Sri Lanka and Bangladesh also saw rapid growth in the gap between rich and poor, the bank's report said.

China's Gini coefficient, a measurement of inequality in income distribution, was 47 in 2004, the most recent year for which figures were available, up from 40.7 in 1993, according to the bank.

That brought China close to the levels of Africa and Latin America, which have the greatest inequality, Ali said....

[T]he gap could slow the spread of prosperity, because the poorest people have less access to education, health care, bank loans and other things needed to benefit from economic growth.

"Increasing inequality lowers the impact of economic growth on poverty reduction," said Ali

Is the Public Wrong to be Anti-Globalization and Income Inequality?

Apologies to be somewhat late to this item and more terse (and spare on links for some of the arguments) than I'd normally be (I'm at sea and the satellite connection is pricey).

Monday, the Financial Times reported that a poll it commissioned jointly with Harris found widespread international opposition to globalization, as well as rising income inequality (I haven't done my usual checking around the logical suspects in the US media, but I have a sneaking suspicion this item went underreported in the US):
A popular backlash against globalisation and the leaders of the world's largest companies is sweeping all rich countries, an

FT/Harris poll today shows.

The British have the least admiration of any national group for the leaders of their country's largest companies, and a large majority believes the government should impose a pay cap on the heads of companies to limit their rewards.

Large majorities of people in the US and across Europe want higher taxation for the rich to counter a widespread belief that rewards are unjustified.

Believing that globalisation is an overwhelmingly negative force, citizens of rich countries are looking to government to cushion the blows they perceive have come from the liberalisation of their economies to trade with emerging countries.

Those polled in the UK, France, the US and Spain were about three times more likely to say globalisation was having a negative rather than a positive effect on their countries. The majority against globalisation was smaller in Germany, with its large export base.

Corporate leaders fared little better with only 5 per cent or fewer people in the US and all large European economies, except Italy, saying they had a great deal of admiration for those who run large companies.

In the UK, nearly 80 per cent of those polled thought corporate executives earned too much,60 per cent said they should be taxed more and the same proportion thought the government should limit their pay directly.

In response to fears of globalisation and rising inequality, the public in all six rich countries surveyed wanted their governments to increase taxation on those with the highest incomes.

Europeans overwhelmingly support the principle of free competition within the EU, contrary to Nicolas Sarkozy's wishes at the recent European summit, but in France, Germany and Spain the populations want their political leaders to play a larger role in managing their economies.

The depth of anti-globalisation feeling in the FT/Harris online poll, which surveyed more than 1,000 people in each of the six countries, will dismay policymakers and corporate executives. Their view that opening economies to freer trade is beneficial to poor and rich countries alike is not shared by the citizens of rich countries.

Now one can quibble with the methodology of the survey. Online surveys probably have a bigger element of self-selection, since there isn't a live human being to arm-twist the hesitant into participating. However, the fact that the survey may have gotten a higher proportion of cranks than in the population at large was probably partially, if not entirely offset by the fact that Internet users (at least in the US) are more educated and affluent than the population at large and therefore one would assume they'd look more favorably upon free trade and income inequality (they would be presumed to come out ahead on both counts).

Now doubtless many pundits will bemoan how dumb the public is, how they are taking positions that are contrary to their economic interests (we will leave aside for the moment that people are not merely economic automatons and might have other priorities in life than simply maximizing lifetime income and consumption). As an aside, I'm often amused that the same people who see free markets as virtuous because they provide a mechanism for netting out various views as to price and quantity will take exception to polls when they produce results they don't like. If the public is smart enough to express its economic views intelligently in one forum, why are they not trusted in another?

In fact, in a bit of synchroncity, David Brooks, in an op-ed column, "A Reality Based Economy," in the New York Times, attempted to dispute many popular beliefs about the current state of play. I would very much like to address this largely wrongheaded piece point by point, but let's limit ourselves to the most germane bit:

The fourth complicating fact is that recent rises in inequality have less to do with the grinding unfairness of globalization than with the reality that the market increasingly rewards education and hard work.

A few years ago, the rewards for people earning college degrees seemed to flatten out. But more recent data from the Bureau of Labor Statistics suggests that the education premium is again on the rise.

Fifth, companies are getting more efficient at singling out and rewarding productive workers. A study by the economists Thomas Lemieux, Daniel Parent and W. Bentley MacLeod suggests that as much as 24 percent of the increase in male wage inequality is due to performance pay.

On Brooks' point four, Paul Krugman has discussed ad naseum that most of the glaring increase in inequality is at the very top, the top 1% and even more dramatic in the top .1%. It is this group of super rich that is contributing heavily to the skew in incomes, and the specter of a group of people at the top having not only exorbitant incomes, but likely exorbitant influence, that creates a gnawing sense of unease. And the performance of this group cannot be explained by education.

On point 5, the belief that pay and promotion is meritocratic is a necessary fiction of corporate life. Our colleague Susan Webber addressed this point at length in her Conference Board Review article, "Fit vs Fitness", which cited research not available on line on the inherent defects of performance appraisal systems.

In fairness, Brooks does acknowledge that, "Inequality is obviously increasing. There’s evidence that global trade is producing more losers."

In addition to Brooks' argument, the classic response is that more open trade produces gains for all participating countries, and that what these countries need to do is to implement more progressive taxation and stronger education and retraining programs to assure that the gains of globalization are shared. (Elsewhere, Dani Rodrik has pointed out that commonly cited level of income gains attributed to trade are methodologically bogus, and the benefits are much more modest. Rodrik has also provided a list of conditions that have to hold for free trade to produce its expected benefits. They differ in very significant regards from the real world. Yet most advocates keep invoking theory rather than trying to examining the facts on the ground to see what benefits "more open" trade produces.

Now the mysterious knzn has pointed to an interesting paper in progress by Karl Smith (no relation), a professor of economics and government at Chapel Hill. knzn gives this intro:

Karl Smith has an interesting idea about trade, explained here discursively and with a link to his paper in progress here. The traditional Ricardian theory of gains from trade applies in the case of certainty: those who benefit from liberalized trade will have sufficient benefits that they could (theoretically) compensate the losers and still end up better off, so trade is Kaldor-Hicks efficient ex post. But in a world with uncertainty (and with incomplete insurance markets), liberalization of trade can be Pareto inefficient ex ante. That is, the increased risk to everyone could be such a disadvantage that it outweighs the average expected gains and makes the contemplated liberalization a net disadvantage to everyone involved.

Karl Smith has posted a preview on his blog:

Kaldor-Hicks tends to overestimate the net benefits of a policy whose distribution is uncertain.

That is, when we think about whether a policy is a good idea we do a cost-benefit analysis. We add up all the costs to whomever they occur and all of the benefits to whomever they accrue. If the benefits are greater than the costs we declare the policy to be efficient.

Perhaps, the policy is not equitable but it is efficient. The winners could compensate the losers and be better off.

Now the problem is that the winners don’t compensate the losers. And, that’s not just a problem for the reason you think it is. We all admit that the distribution of the gains may be such that the winners don’t personally value their gains as much as the losers personally value their losses. However, without the ability to do interpersonal comparisons we are stuck.

Yet, there is another problem. If the distribution of the gains is not certain then the individual agents will value them at less than their face value. Likewise if the distribution of the losses is not certain than the individual agents will value them at more than there face value.

This means that even if the total benefits outweigh the total losses with certainty, uncertain distribution can lead to individual agents preferring not to make the trade.

To drive the point home I create the following example:

There is a policy were the gains to the winners outweigh the losses to the losers with certainty but NO AGENT wants to see the policy enacted. That is, there is a policy which passes cost-benefit analysis but is uniformly rejected by each person affected by it.

The simplest example is easy. Suppose that the benevolent government is offered the following deal. One million of your residents will be selected and given $100,000. Another one million of your residents will be selected and charged $99,999.

To make matters simple only residents who have at least $99,999 will participate in this program. However, whether the resident is a winner or loser is chosen at random.

This program seems like an economic free lunch. The gains are guaranteed to outweigh the losses by $1 million. The selection process is completely random, so there are no economic distortions. In fact, there is no a priori reason to expect that the winners will have lower marginal utilities of income than the losers.

Yet, we could expect that every single agent will reject this program. Why? They reject it because the program exposes them to risk. The cost of that risk outweighs the expected benefit of program.

Perhaps, the agents could insure against the risk. Since the expected gains are positive they should be able to write a contract that splits the expected gains with an insurer so that everyone winds with more than what they started with.

However, what if I said that I am not going to announce the winners and the losers? I am simply going to subtract the losses from the losers net worth and add the gains to the winners net worth with no record of the transaction. How could one insure that?

If this seems a little far fetched and unrelated to real world issues, allow me to change the offer again. Rather than simply adding $100,000 or subtracting $99,999 I am going to do this.

The winners will receive an increase in the demand for their services and a pay raise. The losers will see their jobs outsourced to Asia. The winners won’t know for sure why they lost they received a raise. The losers won’t know for sure why they lost their job.

To add another layer of realism lets change the terms a little. I won’t change any of the expected values but this time instead of selecting 1 million winners and giving them each raises worth $100,000, I will select 100 million winners and give them each raises worth $1000.

The expected gains from this deal are still $1 million. Does anyone want to go for it?

There are two insights that I draw from this thought experiment.

1) That distributional risk is a real concern in policy. If the winners don’t know they will be winners and the losers don’t know if they will be losers the policy will seem better than it really is.

This was the idea that I started with. Workers I talked to disliked outsourcing not just because some people did loose there jobs but because they felt like any of them could loose their jobs. The difference is subtle but important. The first is just about direct costs; the second includes a notion of risk.

2) The second insight I take away is that just as Von Neumann / Morgenstern risk comparisons allow us to define cardinal rather than simply ordinal utility. Who-will-gain risk comparisons allow us to define a sort of interpersonal utility comparison. If you had an equal shot of being on any end of this policy would you still support it? Its not exactly interpersonal comparisons but it carries much of the intuition we want to gain from it.

Smith will need to tighten his argument a bit( (his discussion about uncertainty are mixing the notion of lack of information with the not surprising observation from behavioral finance that people are very risk averse if exposed to the possibility of non-trivial losses) but this is a useful advance in the debate.

An Economist Argues That Single-Payer Healthcare is Inevitable

Stephen Cecchetti, professor of finance at Brandeis' business school and former director of research for the Federal Reserve Bank of New York, makes an elegant and persuasive argument at VoxEU in favor of a single payer medical system: it's inevitable.

Why? Cecchetti starts from the premise that improved genetic testing will provide foreknowledge of an individual's health prospects. Those with robust constitutions will seek only accident insurance; the sickly rest will be rejected by private insurers. Hence the government will have to step in. This is the core of his argument:

The fact that private insurers can accurately compute customer premiums to reflect expected future payouts means that the insurance market will break down. Insurance is about shifting risk, pooling large groups of undifferentiated individuals. When either the insurer or the insured can forecast future events, and accurately distinguish one person from another, the rationale for insurance disappears.

I doubt that genetic testing will become accurate and comprehensive enough to have the forecasting accuracy that Cecchetti anticipates any time soon. However, if we had good genetic tests that could predict the predisposition to develop even a few costly and common ailments, say type 2 diabetes, cancer, and Alzheimers, the dynamics that Cecchetti describes would come into play.

From VoxEU:

Technology will force private health insurance to disappear; social pressure to provide equal access to care will remain. The inevitable result will be that health care systems everywhere will provide universal coverage and be publicly run.

Economists believe in markets. Market-determined prices allocate scarce resources efficiently, encouraging individuals to put them to their best possible uses. This improves everyone’s welfare. But there are times when private markets break down, and insurance is one of them. When markets fail, the government inevitably has to step in and provide insurance. That’s the case with deposit insurance as well as with insurance against the devastation from natural disasters. The future is one in which health care will fall into this same category. Even in countries like the United States, the government, not the market, will ultimately control the level and cost of the medical care we will receive.[1]

A single-payer, publicly run, health-care system is the inevitable consequence of the nearly continuous scientific revolution in molecular genetics that began a half century ago. One day it is James Watson, one of the discoverers of the structure of DNA, being handed the complete genetic code inside his own cells. The next day, researchers tie yet another chronic disease to the presence of specific patterns on individual chromosomes. And then, a few days after that, we learn that scientists are learning to make stem cells from skin cells.

The time is fast approaching when we will have an inexpensive test that is capable of revealing a person’s genetic propensity to contract a broad array of chronic diseases. That means that we will be able to accurately assess the cost of medical treatment over their lifetime.

I grant that there are a number of things about my medical future that I would rather not know. For example, I am not anxious to learn about my genetic predisposition to develop Alzheimer’s disease or my propensity to contract heart disease or type 2 diabetes.

While I may shy away from knowing the details, I am interested in the medical equivalent of my credit score – call this my “health score.” Without revealing the specifics of any future diseases I am likely to contract, a health score will summarise my overall health-care risks. And, each year, with new information on my weight, blood-pressure, and the like, my score will be refined.

The fact that we will all have health scores has profound implication for insurance; or, more accurately, for the failure of market-based insurance.[2] If I have the information revealing that I am likely to be healthy, living a long and low-medical-care-cost life, this knowledge alone will create adverse selection, causing me to forgo insurance for everything except treatments arising from accidents, which can never be forecasted.

To understand the problem, think about a simple case in which there are only two kinds of people, those with high and low expected future medical-care-costs lives. Imagine that the insurance company can’t distinguish the two types, so it charges all comers the average cost across the entire population. For the healthy people, the cost of the insurance will look very high, so they won’t buy it. That means that the only people who will buy the insurance are the unhealthy. Realising this, the insurance company will have to raise their price further to compensate for the fact that only the high cost people are willing to buy insurance. This is the classic “lemons” problem that causes markets to fail and was first described by George Akerlof.[3]

Alternatively, if my insurance company can obtain my health score, then, in the same way that lenders use my credit score to calibrate the interest rate they offer on a loan, they will adjust my health insurance premium based on their precise estimate of the cost of my future medical care. And, importantly, a clever insurance company that is precluded from learning my health score directly will find a pricing scheme that leads me to reveal it to them through the choices that I make.[4]

The fact that private insurers can accurately compute customer premiums to reflect expected future payouts means that the insurance market will break down. Insurance is about shifting risk, pooling large groups of undifferentiated individuals. When either the insurer or the insured can forecast future events, and accurately distinguish one person from another, the rationale for insurance disappears.

In thinking about the provision of medical care, it is important to realise that we view it differently from other goods and services. When it comes to housing, cars, vacations, and the like, we are fairly tolerant of disparities between rich and poor. Our focus is on equal opportunities, not equal outcomes.

Granted, Americans accept greater inequality than the citizens of many other countries do. Not so for health care. Members of wealthy societies share the view that their members are entitled to high quality medical care. Social justice demands that the rich and poor among all of us receive roughly comparable treatment.

Over the past decade, there have been several attempts to reform the American health care system. The US spends nearly 15½% percent of our GDP on medical care, roughly 50% more than countries like France, Germany and the Netherlands. And, as measured by life expectancy and infant mortality, Americans’ health outcomes are worse than those in much of the industrialised world. Something has to change. But change is politically and socially difficult, so in designing the new system we should make changes that are likely to last.

Looking into the future, we see that technology will force private health insurance to disappear at the same time that the social pressure to provide equal access to care will remain. This makes it inevitable that health care systems everywhere will provide universal coverage and be publicly run. Governments will replace markets, insuring that the poor and uninsurable receive medical treatment at the same time that the healthy are forced to participate in a comprehensive system.

Unfortunately, we will be forced to restrict access to the most expensive treatments, but even so, everyone is going to receive adequate health care. The operation replacing my disintegrating brain and over-worked liver with the new ones grown from my skin cells may not be covered; but then again, maybe it will. Regardless, I’m off to my wine cellar to ponder the best way to design a publicly run, single-payer health care system.

[1] For a description of how the U.S. health care system operates today see Jonathan Gruber, “Health Insurance I: Health Economics and Private Health Insurance,” Chapter 15 in Public Finance and Public Policy, New York, N.Y.: Worth Publishing, 2005.
[2] Insurance problems are discussed in most intermediate microeconomics textbooks. One example is Robert Frank’s Microeconomics and Behavior, 6th edition, New York, N.Y., 2006, pages 208—214.
[3] See “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics (August 1970).
[4] Insurance companies can create pricing schemes in which differing individuals signal their type through the choice of what they choose to purchase.

Now It's Official: Politicians Favor the Wealthy

Mind you, the headline above doesn't mean that politicians curry favor of wealthy donors, but wealthy people in general. Mark Thoma provides this tidbit from Ezra Klein at the LA Times who in turn cites the abstract of a paper by Larry Bartels, Economic Inequality and Political Representation:

I examine the differential responsiveness of U.S. senators to the preferences of wealthy, middle-class, and poor constituents. My analysis includes broad summary measures of senators’ voting behavior as well as specific votes on the minimum wage, civil rights, government spending, and abortion. In almost every instance, senators appear to be considerably more responsive to the opinions of affluent constituents than to the opinions of middle-class constituents, while the opinions of constituents in the bottom third of the income distribution have no apparent statistical effect on their senators’ roll call votes. Disparities in representation are especially pronounced for