Illegitimate Inequality

In the wake of increasing inequality across the OECD area, public debate over policies of redistribution has become more intensive. Large parts of the populations affected feel uneasy about widening gaps, even groups that have been favoured by this development, but few arguments beyond the moral one are advanced. To right-wing opinion-makers, the distribution of incomes and assets is largely a matter of taste, or is simply irrelevant. In their view, calls for redistributive policies at worst simply stem from jealousy.

Differences in income or assets that are based on differences in capabilities or effort are widely considered to be legitimate, but it is easy to verify that all observed differences cannot be explained in this way. In its 2016 report on the global distribution of wealth, Oxfam International reported that the richest 62 persons in the world own as much as the poorer half of the world’s population, about 3.5 billion people. Clearly, one person cannot be 100 million times as productive as another healthy and reasonably well-educated person. After all, a day and night comprises only 24 hours for all of us, rich or poor.

In a seminal paper on the drivers of inequality, Robert and Ricardo Fernholz have analysed the long-term distribution of wealth in an abstract growing market economy. They assume that the economy generates a surplus which is invested in a financial market. Even assuming that all individuals in this society are identical as far as capabilities, efforts, preferences, and initial assets are concerned, the distribution of assets will become increasingly skewed over time. In the long run, one household will own all the assets. The explanation for this is simple: small variations in return on assets will be magnified over time, because those who are lucky can afford to take somewhat higher risks and will be rewarded with even higher returns, and so on.

Simple as this mechanism may be, it has far-reaching consequences. Even in an imagined world of perfect equals, inequality will develop as a result of our innate tendency towards risk aversion – wealthy individuals can afford to take risks, whereas the less wealthy have to be more cautious. Equality is inherently unstable; even the slightest perturbation of a perfectly egalitarian equilibrium will cause it to degrade into a highly unequal society, where only the self-interest of the richer strata will set the limits.

History confirms this general tendency of inequality to grow. In a broad study of inequality in pre-industrial and modern societies, Branko Milanovic, Peter Lindert and Jeffrey Williamson have shown that there is a general tendency for inequality to rise as the economic potential of a country grows. Growth increases the room for inequality, and this room for manoeuvre is normally best exploited by those who are already wealthy.

In real societies, individuals differ in both capabilities and efforts. But, because of the self-reinforcing effect of differences, the inequalities that we observe will be completely out of proportion with differences in effort or capabilities. Inequality is largely a market failure. This is what makes the case for redistribution.

At first sight, this inherent instability of egalitarian distributions would seem to strengthen the right-wing case, where the futility of trying to affect the income distribution has often been used as an argument for abandoning the project altogether. But if history confirms a general tendency towards inequality, it also indicates a way out of this impasse. Just as unstable mechanical and technical equipment can be stabilised using appropriate feedback mechanisms, the development of per-capita wealth and inequality in the long run can be affected by political decisions and judicious design of institutions.

There is an important historical exception from the general drift towards increasing inequality – the period from the second half of the 19^th century till around 1970, during which per capita income in industrialising countries grew in parallel with decreasing inequality. It is natural to couple this deviation from the general pattern with the development of trade unions and universal suffrage. A quick glance at today’s differences between OECD countries shows that the distribution of disposable income and wealth varies widely. These countries are very similar in their basic economic and social structures, so the differences that we observe have political origin. Politics matter.

But, it must be recognised that feedback from the outcomes is a precondition for this program to succeed; creating the right institutions is not sufficient. A policy that aims at combining equality with efficiency must rely on a varied toolbox, equalising opportunities via education and labour market policy as well as outcomes via taxes and transfers.

A conclusion which is somewhat more philosophical by nature is that the idea of the perfect social contract à la Robert Nozick’s Anarchy, State and Utopia, which lays down the rules once and for all and thereby legitimises all future outcomes, is doomed to fail. This is precisely because of the inherent instability of equality. There is simply no set of a priori rules that can protect society from drifting into a state of inequality that cannot be defended by efficiency arguments, and which would in fact be considered unacceptable by everyone when the social contract is negotiated. Constant policy adjustments in the form of redistributive policies – feedback from the outcomes – are necessary to keep inequalities within civilised bounds.