Of all the economic problems of the Western world in our day and age, the rise of inequality is undoubtedly the most pressing one to solve. Even if one chooses to ignore the dimensions of social justice and fairness that inevitably accompany the debate (and which are not the focus of this piece), there are plenty of concrete, measurable reasons why more egalitarian societies are better off. Egalitarian societies tend to be happier, healthier (both physically and mentally), better educated, and more cohesive. They often work less and produce more. The fact that many of them consistently beat out some of the more unequal societies in areas such as competitiveness and productivity trump the argument that inequality is inevitably needed for economic progress. Boris Johnson, the clown-haired Conservative major of London, summarized this perverse view best when he claimed a few months back that inequality was essential to fostering “the spirit of envy” and that greed was “a valuable spur to economic activity”. Clearly he wasn’t speaking to a German or a South Korean crowd.
Unfortunately, despite the near consensus on addressing the issue of inequality by anyone other than full blooded Reagan/Thatcherites, Chicago School economists or libertarians, there is nothing even remotely approximating a set of universally shared public policy recommendations to achieve this. Occasionally, hardcore leftist proposals come to the fore on the op-ed pages of major newspapers but these are often hard to take seriously. And even the more sensible of the lot are brought down by the inevitable broadside from an indignant Right, which immediately lambasts them for not having market logic, or for villainizing the rich, or for any other excuse that comes to mind. Just a wee bit of extra regulation here and there at the margins, coupled with a dash of redistribution (but not too much!) and markets will take care of things in the long run (Lawrence Summers, one of the intellectual architects of deregulation, dixit).
Oh, if only things were so simple.
To address inequality in the West, one must first understand where it comes from. The two major sources of inequality are inequality within the workplace (as represented by the income gap between the lowest or median workers versus upper management), and inequality between industries (as represented by the disproportionate share of aggregate corporate profits obtained by certain industries, in excess of their actual contribution to national prosperity and growth). A third element is the effect of national redistribution systems; in fact, many egalitarian societies are actually quite structurally unequal when observing their pre-tax and transfers income. Unsurprisingly the countries that let these three sources of inequality behave by the whims of the market the most (the US being the most notorious case), are the most unequal. Note that I have purposely left aside other sources of inequality such as gender and race as these are a different topic altogether, and require different policies to address.
Inequality within the workplace
This aspect of inequality is probably the easiest to identify and to fix. At risk of sounding like a red-blooded Marxist, the fundamental problem lies in the fact that the capitalist enterprise is fundamentally undemocratic and therefore, there is no need for management to be accountable to their workers in setting their compensation levels. Exacerbating the problem is that the body that management has to account to, the Board of Directors, is generally composed of other managers from other firms; a massive conflict of interest if there ever was one. Why would anyone vote down the same privileges they hold in their own firms? Until the 1970s, unions were largely responsible for ensuring that these pay gaps remained narrower but the general trend towards declining union membership has essentially left workers in many countries, particularly the Anglo-Saxon ones, with little or no representative power whatsoever.
The solution, therefore, is to democratize the workplace, and the easiest and less controversial way possible is to allow employees to have a seat on the company’s board. This may sound like a radical concept to Anglo-Saxon ears but believe it or not, it is very much the norm in Europe. Furthermore, the argument given that such systems of corporate government are less efficient falls flat against the evidence that some of the world’s most technically advanced and profitable firms come from countries with strong levels of employer representation (ehem, Germany). Looking at the numbers, among 16 countries covered by the European Industrial Relations Observatory (EIRO), only three lack board-level employee representation: Belgium, Italy and Britain. Additionally, Portugal has the legal framework but doesn’t implement it in practice, and in Spain this is limited to a small number of former state-owned enterprises. Not surprisingly, the countries without representation (either legally or in practice) happen to be among the more unequal in Europe. It is true that correlation does not necessarily involve causality but given that inequality in the workplace is one of the most socially and politically sensitive aspects of the inequality epidemic in the West, it needs to be addressed.
Of course, other more “radical” proposals need to be considered as well. And I say radical sarcastically because to solve a radical problem, half-baked proposals that have been dumbed down to please those who benefit from the current status quo just won’t cut it. One hardly controversial fix is to tax capital gains as much as ordinary income. It’s a no-brainer and I find it hard to find a single argument against it. There should also be limits to the ability of management to see its compensation rise in excess of some standard of company performance and in excess to the average rise in pay of all the firm’s employees. This would avoid the messier alternative of permanently capping executive-to-median pay, although this probably needs to be done as an initial one-off in those firms where the gap is stratospherically high. Let’s also ban golden parachutes and other ridiculous rewards for mediocrity (most CEOs are not Steve Jobs), and stop arguing that the policies that generate inequality in the workplace are necessary to “retain talent”. They’re not. They’re only retaining a generation of executives who care more about their own compensation and the company’s short-term profits than anything else.
Inequality between industries
It’s no secret that certain industries are better paid than others, and among these finance towers above all others like a modern colossus. The problem of the excessive pay in the finance sector over the past 30 years is not so shocking because of its rise in absolute terms but in a relative sense against the rest of the economy, proving therefore that the wealth doesn’t really trickle down. For example, a recent report by the New York State Comptroller showed that salaries in the securities industry was a scandalous six times higher than in all other private sector industries in 2010; in 1982 is was only around twice. Then there’s the fact that over 30% of corporate profits in the US (and probably a similar share in Britain) go to the finance sector despite the fact it represents just 5% of employment and 8% of GDP. There’s no escaping the fact that finance, particularly the type practiced by the large investment banks and alternative finance firms (hedge funds, private equity, et al) has extracted too large a share of income and wealth, and kept most of it for itself. All the time doing it without adding a sustainable boot to the economy which, if anything, has been rendered more vulnerable due to the systemic risks created.
How did the finance sector get so big? There’s one simple answer: deregulation. Which means the solution is also quite simple: re-regulation. First, there needs to be a serious attempt to reassess the need for many financial products and services with respect to their potential for creating systemic risk and whether they are contributing to adequately fulfilling the basic functions of a financial sector; namely, to channel savings into investments in the most efficient manner and to adequately price risk (neither of which it has done particularly well over the past decade). It seems to me that many of these new financial products, mainly exotic derivatives, serve no function whatsoever to achieve these basic goals. These not only make the markets more systemically vulnerable, but result in a trickle up of profits between less sophisticate investors that buy them (often by being lied to), to the big investment banks that create them, sell them, and trade them. If Say’s Law (supply creates its own demand) ever needed any sort of proof, modern finance is probably the best example.
The second aspect of this is the liberalization of capital flows across borders. It is questionable whether this has made life better for the average person; if anything, it has increased the external vulnerabilities of these economies that now have to defend against situations such as a sudden outflow of short-term speculative capital which has caused many a developing economy to crash in the past 30 years (including my own in 1994). You don’t need to be a WTO-hating anti-globalist to accept this: one of the main defenders of free trade, economist Jagdish Bhagwati, just so happens to be an ardent opponent of the free flow of international capital precisely because of the reasons mentioned above. Trade and capital liberalization do not necessarily go together: you can have free trade and still keep some natural barriers to destabilizing capital flows. Anyone who argues that it’s impossible to separate the two needs just a quick reminder that in that case, labor flows (i.e. immigration) should also be free to have all factors of production truly globalized.
An alternative, but in my view complementary, policy to addressing the risks of free global capital movements is to tax them. This is the so-called Tobin tax. The classic argument against it is that you need all countries to adopt it; if not, it just takes a few Tobin tax-free countries to have all the big banks channel their operations through them. With a little twist, this argument is overcome: tax both the transactions undertaken by banks located in the country as well as transactions involving all domestic assets, regardless of where they are traded. With this you only need a small number of countries or regions imposing a Tobin tax to have the bulk of global transactions covered. And if the tax isn’t paid, then the holder of the asset loses legal protection over it. Example: a bank in Luxembourg could not sell a US Treasury bond to a bank in the Cayman Islands without it being taxed, or else the US government would not be legally obliged to pay back the bondholder. It’s that simple. While we’re at it, government could also threaten removing legal protection over assets held in tax havens. Problem solved.
So, when you stop the flow from fees and trading, you stop the profits, and banks will have no choice but to reduce their compensation levels to adjust to the new reality. This is already happening, although banks are responding by shedding staff in order to keep increasing their own compensation for those who remain. This is a shrewd tactic, obviously, but one that is unsustainable in the long-run: at some point bankers will have to take less money for themselves. The beauty of this approach is that you don’t need to enact policies such as caps on bonuses: this will happen on its own once the profits of the banking sector dwindle to a more respectable volume. The question remains: can we live in a world without CDOs, CDSs and other overly-complex acronyms? Can we live with barriers to unrestricted capital flows across borders? Of course we can. We have during decades, when financial systems worked to serve the economy and not the other way around. Re-regulating will not be the disaster that the free marketeers fear.
Effect of national redistribution systems
I will not dwell too much on this for two reasons: 1) it’s a topic for discussion in itself and 2) most countries in the EU already do a relatively decent job of reducing inequality through fiscal transfers. According to data from the OECD, the average member country reduced its pre-transfers Gini coefficient by 0.16 points, from an average of 0.47 (which approximates Latin American standards) to just 0.31. Of course, some countries did much better than others. Countries like France, Germany and Finland achieved reductions of over 0.2. Other countries like Korea, just managed 0.03 but their pre-transfers Gini of 0.34 is also absurdly low (the lowest, in fact, of the group) which means that it’s as close as one can get to a structurally egalitarian society. The US fares pretty badly, with a reduction of 0.12, below the OECD average and makes it obvious that limitations in the country’s social service provisioning has an important role to play in why inequality is so entrenched in the world’s largest economy.
Then of course there’s a uniquely American penchant for accepting inequality as a fact of life: no other society on Earth places such a premium on economic success as the ultimate measure of human value and is therefore so merciless to those that don’t make the cut. There’s not much one can do about this, when any sensible argument for, say, universal healthcare is met with cries of “socialism!” and any public intervention to support the poor is evidence of “big government”. There are few things more frustrating than being an American progressive, because the uphill struggle to improve the lot of its less fortunate is so much steeper than that in Europe where welfare is not treated as such a political stigma or in the Far East where societies are more egalitarian by nature. But the fact is, there is no single better policy for addressing inequality than redistribution. For the past 30 years, governments have – by intent and by ignorance – created policies that have made the wealth of the Western world trickle up. It’s about time governments made a proper effort to reverse that trend. What emerges will be fairer, more equal societies, and ones that in all likelihood will economically outperform the plutocracies we have today.