The great white whale of income inequality

My last Krugman post managed to generate a vigorous debate in the comments section while simultaneously confusing Donald Luskin. So it’s worth focusing more closely on one of the points where Krugman’s current analysis goes off the track — his Ahab-like obsession with income inequality. One of Krugman’s biggest complaints about the trajectory of the American economy is the rise in income inequality. This rise was particularly acute during the Clinton era, and a constant refrain of his writing is that Bush’s tax cuts will merely accelerate this trend, leading to more social frictions. There are three big ways in which Krugman is wrong — his emphasis on inequality in the first place, his failure to distinguish between the different causes for inequality, and his assumptions about the political effects of rising inequality. 1) Inequality is the wrong variable. I wrote a longish post over the summer about why the fears about income inequality are way overblown. To sum up — a focus on inequality overlooks the high degree of income mobility in the United States, as well as the absolute improvements over time in the lives of the poorest Americans. For another refresher on this, go check out Todd Bass‘ more recent analysis on this point (link via Instapundit). 2) The sources of inequality matter. Take Krugman’s concerns at face value. Are there moral reasons to oppose this rise in inequality? Anyone not completely blinded by ideology would at least acknowledge there are valid arguments against increasing inequality. However, a key question is the causes behind inequality. If the reason is increased social stratification due to the advantages accrued by inherited wealth, then I’m pretty sympathetic, since such stratification stifles growth. If the reason is increased opportunities for gain via entrepreneurial activity, then I’m pretty unsympathetic, because entrepreneurial activity promotes growth. In Saving Capitalism from the Capitalists (p. 92), Raghuram Rajan and Luigi Zingales make an important point about the changing origins of American wealth:

One statistic best sums up the changes that have taken place: in 1929, 70 percent of the income of the top .01 percent of income earners in the United States came from holding of capital — income such as dividends, interest, and rents. The rich were truly the idle rich. In 1998, wages and entrepreneurial income made up 80 percent of the income of the top .01 percent of income earners in the United States, and only 20 percent came from capital. Seen another way, in the 1890s the richest 10 percent of the population worked fewer hours than the poorest 10 percent. Today, the reverse is true. The idle rich have become the working rich! Instead of an aristocracy of the merely rich, we are moving to an aristocracy of the capable and the rich.

Americans will not begrudge the rich getting richer if it’s by dint of effort. [Krugman would respond by pointing to the astronomical rise in CEO pay–ed. No doubt, there are examples of malfeasance in matters of corporate governance. Suggesting a systemic problem, however, is a bit of an exaggeration, given the increase in asset prices of U.S. firms over the past twenty years. It’s telling that Rajan and Zingales, who are sensitive to the issue of income distribution, are far more afraid of overreegulation in response to Enron-like episodes than underregulation] For more on this, go read Thomas Piketty and Emmanuel Saez’s NBER paper, “Income Inequality in the United States, 1913-1998” (updated in 2000). 3) Rising inequality does not lead to a breakdown in social cohesion. This is Krugman’s core concern — that inequality will lead to political and social instability. To repeat what he told Kevin Drum:

Is this the same country that we had in 1970? I think we have a much more polarized political system, a much more polarized social climate.

Krugman’s reference to 1970 is interesting, since income inequality was much lower in 1970, the peak of the Great Society programs. Despite the reduced level of inequality, society was more polarized back then. Anyone who believes that the country currently has a more socially polarizing climate now than in 1970 is, well, either lying or lost their grip on reality. Does Krugman really think that the debates about Iraq or affirmative action today even approximate the division and discord that Vietnam, Kent State or school busing generated thirty years ago? Economic inequality has a far less significant effect on social instability relative to other factors — the rate of absolute poverty, the method of raising armed forces, and the rate of economic growth and labor productivity. Krugman needs to worry about it less.