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Tyler Cowen - The Inequality That Matters

Must-read piece on rising income inequality by Tyler Cowen. Here’s one part that stuck out to me:

It is also the case that any society with a lot of “threshold earners” is likely to experience growing income inequality. A threshold earner is someone who seeks to earn a certain amount of money and no more. If wages go up, that person will respond by seeking less work or by working less hard or less often. That person simply wants to “get by” in terms of absolute earning power in order to experience other gains in the form of leisure—whether spending time with friends and family, walking in the woods and so on. Luck aside, that person’s income will never rise much above the threshold.

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The funny thing is this: For years, many cultural critics in and of the United States have been telling us that Americans should behave more like threshold earners. We should be less harried, more interested in nurturing friendships, and more interested in the non-commercial sphere of life. That may well be good advice. Many studies suggest that above a certain level more money brings only marginal increments of happiness. What isn’t so widely advertised is that those same critics have basically been telling us, without realizing it, that we should be acting in such a manner as to increase measured income inequality. Not only is high inequality an inevitable concomitant of human diversity, but growing income inequality may be, too, if lots of us take the kind of advice that will make us happier.

That is a very intriguing consideration. Another large part of the piece concern the hypertrophy of the financial sector and the world of too-big-to-fail.

What Ross Douthat took away from the piece is that we need to reign in the deficit and cap bank size, so that banks don’t have as much money to play with. Matt Yglesias on the other hand reads the piece even more pessimistically, noting that even without bailouts, the logic that lead up to the housing bubble will still hold. From Cowen’s original piece:

To understand how this strategy works, consider an example from sports betting. The NBA’s Washington Wizards are a perennially hapless team that rarely gets beyond the first round of the playoffs, if they make the playoffs at all. This year the odds of the Wizards winning the NBA title will likely clock in at longer than a hundred to one. I could, as a gambling strategy, bet against the Wizards and other low-quality teams each year. Most years I would earn a decent profit, and it would feel like I was earning money for virtually nothing. The Los Angeles Lakers or Boston Celtics or some other quality team would win the title again and I would collect some surplus from my bets. For many years I would earn excess returns relative to the market as a whole.

Yet such bets are not wise over the long run. Every now and then a surprise team does win the title and in those years I would lose a huge amount of money. Even the Washington Wizards (under their previous name, the Capital Bullets) won the title in 1977–78 despite compiling a so-so 44–38 record during the regular season, by marching through the playoffs in spectacular fashion. So if you bet against unlikely events, most of the time you will look smart and have the money to validate the appearance. Periodically, however, you will look very bad. Does that kind of pattern sound familiar? It happens in finance, too. Betting against a big decline in home prices is analogous to betting against the Wizards. Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs.

Thus, Yglesias notes,

It’s true that the possibility of bailouts somewhat exacerbates this tendency. But it would exist even in a totally bailout free world. Richard Fuld and other Lehman Brothers honchos didn’t get bailed out. But Fuld and other key Lehman executives still earned far more than most Americans during the good years, and even those who are still unemployed today are far richer than the average American. Looking back on the whole saga in retrospect, I’m sure they wish they’d gotten a bailout or somehow manipulated the situation a bit better. But if the alternative to getting rich and then going bust was to never get rich in the first place, then the alternative looks bad even without bailouts.

My own suspicion is that if bank hypertrophy is an inevitable by-product of the capitalist system, this is a bad thing for the long term viability of capitalism. Eventually, either the banks will win, in which case we have reverted to feudalism, or we find some method of restricting the bankers’ activities, in which case it might not be right to call it capitalism anymore. But perhaps I’m being pessimistic.