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Joseph Stiglitz Explains How to Grow the Economy: Reduce Inequality and Unearned Income
Joseph E. Stiglitz, recipient of the Nobel Memorial Prize in Economic Sciences in 2001 and the John Bates Clark Medal in 1979, is University Professor at Columbia University, and Chief Economist of the Roosevelt Institute
How to rewrite the rules governing the market economy
By Joseph Stiglitz
In the middle of the twentieth century, it came to be believed that ‘a rising tide lifts all boats’: economic growth would bring increasing wealth and higher living standards to all sections of society. At the time, there was some evidence behind that claim. In industrialised countries in the 1950s and 1960s every group was advancing, and those with lower incomes were rising most rapidly.
In the ensuing economic and political debate, this ‘rising-tide hypothesis’ evolved into a much more specific idea, according to which regressive economic policies— policies that favour the richer classes— would end up benefiting everyone. Resources given to the rich would inevitably ‘trickle down’ to the rest. It is important to clarify that this version of old-fashioned ‘trickle-down economics’ did not follow from the postwar evidence. The ‘rising-tide hypothesis’ was equally consistent with a ‘trickle-up’ theory— give more money to those at the bottom and everyone will benefit; or with a ‘build-out from the middle’ theory— help those at the centre, and both those above and below will benefit.
Today the trend to greater equality of incomes which characterised the postwar period has been reversed. Inequality is now rising rapidly. Contrary to the rising-tide hypothesis, the rising tide has only lifted the large yachts, and many of the smaller boats have been left dashed on the rocks. This is partly because the extraordinary growth in top incomes has coincided with an economic slowdown.
The trickle-down notion— along with its theoretical justification, marginal productivity theory— needs urgent rethinking. That theory attempts both to explain inequality— why it occurs— and to justify it— why it would be beneficial for the economy as a whole. This essay looks critically at both claims. It argues in favour of alternative explanations of inequality, with particular reference to the theory of rent-seeking and to the influence of institutional and political factors, which have shaped labour markets and patterns of remuneration. And it shows that, far from being either necessary or good for economic growth, excessive inequality tends to lead to weaker economic performance. In light of this, it argues for a range of policies that would increase both equity and economic well-being.
Explaining inequality
How can we explain these worrying trends? Traditionally, there has been little consensus among economists and social thinkers on what causes inequality. In the nineteenth century, they strived to explain and either justify or criticise the evident high levels of disparity. Marx talked about exploitation. Nassau Senior, the first holder of the first chair in economics, the Drummond Professorship at All Souls College, Oxford, talked about the returns to capital as a payment for capitalists’ abstinence, for their not consuming. It was not exploitation of labour, but the just rewards for their forgoing consumption. Neoclassical economists developed the marginal productivity theory, which argued that compensation more broadly reflected different individuals’ contributions to society.
While exploitation suggests that those at the top get what they get by taking away from those at the bottom, marginal productivity theory suggests that those at the top only get what they add. The advocates of this view have gone further: they have suggested that in a competitive market, exploitation (e.g. as a result of monopoly power or discrimination) simply couldn’t persist, and that additions to capital would cause wages to increase, so workers would be better off thanks to the savings and innovation of those at the top.
More specifically, marginal productivity theory maintains that, due to competition, everyone participating in the production process earns remuneration equal to her or his marginal productivity. This theory associates higher incomes with a greater contribution to society. This can justify, for instance, preferential tax treatment for the rich: by taxing high incomes we would deprive them of the ‘just deserts’ for their contribution to society, and, even more importantly, we would discourage them from expressing their talent. Moreover, the more they contribute— the harder they work and the more they save— the better it is for workers, whose wages will rise as a result.
The reason why these ideas justifying inequality have endured is that they have a grain of truth in them. Some of those who have made large amounts of money have contributed greatly to our society, and in some cases what they have appropriated for themselves is but a fraction of what they have contributed to society. But this is only a part of the story: there are other possible causes of inequality. Disparity can result from exploitation, discrimination and exercise of monopoly power. Moreover, in general, inequality is heavily influenced by many institutional and political factors— industrial relations, labour market institutions, welfare and tax systems, for example— which can both work independently of productivity and affect productivity.
That the distribution of income cannot be explained just by standard economic theory is suggested by the fact that the before-tax and transfer distribution of income differs markedly across countries. France and Norway are examples of OECD countries that have managed by and large to resist the trend of increasing inequality. The Scandinavian countries have a much higher level of equality of opportunity, regardless of how that is assessed. Marginal productivity theory is meant to have universal application. Neoclassical theory taught that one could explain economic outcomes without reference, for instance, to institutions. It held that a society’s institutions are simply a facade; economic behaviour is driven by the underlying laws of demand and supply, and the economist’s job is to understand these underlying forces. Thus, the standard theory cannot explain how countries with similar technology, productivity and per capita income can differ so much in their before-tax distribution.
The evidence, though, is that institutions do matter. Not only can the effect of institutions be analysed, but institutions can themselves often be explained, sometimes by history, sometimes by power relations and sometimes by economic forces (like information asymmetries) left out of the standard analysis. Thus, a major thrust of modern economics is to understand the role of institutions in creating and shaping markets. The question then is: what is the relative role and importance of these alternative hypotheses? There is no easy way of providing a neat quantitative answer, but recent events and studies have lent persuasive weight to theories putting greater focus on rent-seeking and exploitation.
Rent-seeking and top incomes
The term ‘rent’ was originally used to describe the returns to land, since the owner of the land receives these payments by virtue of his or his ownership and not because of anything he or she does. The term was then extended to include monopoly profits (or monopoly rents)— the income that one receives simply from control of a monopoly— and in general returns due to similar ownership claims. Thus, rent-seeking means getting an income not as a reward for creating wealth but by grabbing a larger share of the wealth that would have been produced anyway. Indeed, rent-seekers typically destroy wealth, as a by-product of their taking away from others. A monopolist who overcharges for her or his product takes money from those whom she or he is overcharging and at the same time destroys value. To get her or his monopoly price, she or he has to restrict production.
Growth in top incomes in the past three decades has been driven mainly in two occupational categories: those in the financial sector (both executives and professionals) and non-financial executives. Evidence suggests that rents have contributed on a large scale to the strong increase in the incomes of both.
Let us first consider executives in general. That the rise in their compensation has not reflected productivity is indicated by the lack of correlation between managerial pay and firm performance. As early as 1990 Jensen and Murphy, by studying a sample of 2,505 CEOs in 1,400 companies, found that annual changes in executive compensation did not reflect changes in corporate performance. Since then, the work of Bebchuk, Fried and Grinstein has shown that the huge increase in US executive compensation since 1993 cannot be explained by firm performance or industrial structure and that, instead, it has mainly resulted from flaws in corporate governance, which enabled managers in practice to set their own pay. Mishel and Sabadish examined 350 firms, showing that growth in the compensation of their CEOs largely outpaced the increase in their stock market value. Most strikingly, executive compensation displayed substantial positive growth even during periods when stock market values decreased....MORE
