In recent years, income inequality in the US has increased despite significant increases in overall wealth. Some lament this development as an inherent flaw in need of correction. Others see income inequality as largely the result of the relative worth of some members of society. In my opinion, both of these common views are partly right and partly wrong . . .
It is a bit unusual that income inequality would increase during times of increasing output. Most left-leaning business cycle theories rest on the belief that booms are a natural product of capitalist "excess" where businesses produce accelerating amounts of new goods while paying lower wages culminating in a crisis where no one can afford the new products. This theory is flawed in that it doesn't deal with the critical question of where the capital comes from to build the "excess" products to begin with.
Marx contended that this capital comes from underpaying the workers. But this doesn't make sense because it fails to explain how the capitalist can pay his workers at all. Where do wages come from when the products are still being manufactured, shipped and marketed (i.e. during start-up)? These wages would have to be paid out of prior savings, and the only way to have these savings would be to either a) be a very thrifty worker or b) to have previously sold products that people were able to buy. So there doesn't seem to be any way for the system to get unbalanced. Sure, businesses succeed and fail all the time -- but why do business cycles see a large number of business successes followed by an unusually large number of failures? Why aren't the successes and failures uniformly distributed in time? Why do they cluster up like that?
The missing factor here is debt.
Most businesses borrow in order to pay the bills until profit materializes. Theoretically, banks get their loanable funds from prior savings as well. However, since banks in all industrialized countries use fractional reserve banking their loanable funds are actually a multiple of the amount of savings present in society. As a result, loans are a more attractive means of providing capital for large projects and there is an apparent increase in the amount of capital available. The key word there is "apparent" -- since the available loans do not reflect the actual amount of savings available to fund new projects.
The result is that businesses will pursue many projects that are ill-advised and unsustainable. When these projects begin to fail, they will seek new capital to keep the project going in the hopes that profits are right around the corner. Banks compete for the interest paid on these loans and thus there is a race to the bottom to provide cheaper and cheaper loans. Eventually, the banks cannot keep up, interest rates level out and the prior chain of events unravels in the familiar process of recession.
Causes of Present Inequality
Since the early 70s income inequality has largely increased in the US. While recessions have occassionally reversed this trend, income equality has never returned to pre-boom levels. I regard inequality as an indicator of how much the capital structure has become divorced from the actual pool of savings. Some inequality will be present no matter what, but the long term historical trend (at least until the 70s) seems to be toward decreasing income inequality. So what went wrong in the 70s that caused America (and much of the West) to swing against the trend?
All modern developed countries have central banks. Central banks provide governments with an enhanced ability to spend money. Whenever a government overspends, they produce securities (a promise of future tax revenues with interest) which the central bank "buys" by creating new currency. The securities are then bought by commercial banks and become assets which provide reserves out of which new loan money appears. Thus a government that overspends and has a central bank will serve to amplify the business cycle process.
In 1971, President Nixon unilaterally ended the Bretton Woods gold exchange system that had existed since the end of WWII. The U.S. was being drained of its gold reserves because it was increasingly apparent that the government defined price of gold was not reflective of its actual worth in dollar terms. This was because the US had inflated its currency at a rapid rate to pay for Vietnam and the Great Society programs. Before this, there was at least some tenuous link between the money printed by various Western governments and underlying economic reality (in this case the gold price). But since then, the only important restraining factors on money supply expansion have been investor confidence (willingness to take on new loans) and the ability of banks to spread out the risks of their aggressive lending.
I don't think I have to go into much detail about how aggressively banks are looking for new people to loan to. These days, unsolicited credit card offers and mortgage ads are about 50% of my mail by weight. I'm sure many people have similar experiences. Does anyone really think there is so much available capital that it is reasonable to give credit cards to anyone with a pulse?
No, what we are experiencing here is a credit system gone berserk. Eventually we will reach a breaking point and 35 years of mostly unimpeded credit expansion will come to a crashing halt. With that readjustment, one of two things will happen. Either income inequality will decrease as many of our wealthiest citizens suffer serious financial loss or such inequality will remain in place because of a permanent drop in our standard of living.
It is often asked, how can there be such poverty in a nation so rich? The answer is that we're really not that rich. Much of our wealth is an illusion -- an inflated stock market, ridiculous housing prices, cheap credit. Moreover, consider all of the capital that has been expended chasing business ventures that long ago became unprofitable. Those are wasted savings.
When the crunch comes, there will be some (especially those at the top) who will demand relief. They will demand bailouts. They will ask that the government "save jobs" and protect them from years of error. We must resist that temptation. To the degree that we help these failed industries capital will be permanently destroyed. The only way to prop up these industries will be through taxes and those taxes aren't going to come from the failing industries -- they're going to come from succesful ones that are still generating profits.
It's true that many will lose their jobs (as always happens in a recession) but that dislocation is a side effect of a far more important process -- the redistribution of capital to more profitable industries. The more dynamic this process is, the less roadblocks there are to this process, the faster that new jobs will be created. But if the government protects favored interests and embarks on infrastructure projects to "create" jobs then we will end up with a permanent loss of living standards and corruption that will make the current government seem quaint by comparison.
There's no way to stop the recession. It's already bought and paid for. What matters is how the collapse is handled.
In short, the liberal of view of inequality is correct in that concern is warranted but mistakenly considers inequality a cause of problems rather than a symptom of them. The conservative view of inequality is confused as well. Those who gain during a boom are not necessarily deserving and those that fail during the bust must not be allowed to avoid the results of their mistakes.
(This article was inspired by the article Wealth, Unrelenting Disparities.)