The Inequality Engine

Many social critics assail rising income inequality in America, but in the assessment of Tyler Cowen, a George Mason University economist and author of the new book The Great Stagnation, it’s what is causing the inequality that is truly troubling: namely, an unwieldy financial industry whose core practices undermine the stability of the economy and the prosperity it provides.

There is no question that income inequality has increased over the last couple of decades. The share of pre-tax income earned by the richest one percent of Americans went from about eight percent in 1974 to more than 18 percent in 2007. But the real drama is at the apex of the pyramid: The richest 0.01 percent (about 15,000 families) claimed less than one percent of pre-tax earnings in 1974, but more than six percent in 2007.

What’s fueling the gargantuan income increases of the megarich? It’s not manufacturing, which once propelled men such as Henry Ford into the stratosphere of wealth. It’s the world of finance. In 2004, the top 25 hedge fund managers together earned more than all the CEOs of the companies listed in the S&P 500. Among people earning more than $100 million a year, Wall Street investors outnumbered executives of publicly traded companies nine to one.

Two practices central to the financial industry drive the skyrocketing incomes: “going short on volatility” (betting against unlikely swings in market prices) and “moving first” (being faster than the competition when new information emerges, sometimes by seconds or less, in a winner-take-all system).

Going short on volatility involves betting against unlikely events—such as a collapse of the mortgage bond market. The returns can be steady and unspectacular, until one starts using other people’s money and taking riskier bets. And if you bet wrong, “what’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton.” Add the safety net of government bailouts, and you've got an industry in which many of the top earners do not have much to lose.

It’s worrisome “from a social point of view,” Cowen argues. In normal times, society suffers as many of the most talented people choose the financial sector over fields such as medicine or education. But more dangerous, says Cowen, is that when their bets flop, as they did during 2007–09, “everyone else pays the price”—particularly those lower on the income ladder, who can spend months unemployed in the wake of a financial crisis and don’t have a fancy degree and valuable social network to fall back on.

Cowen says we must “find a way to prevent or limit major banks from repeatedly going short on volatility at social expense.” The catch? No one knows how to do so. It remains to be seen whether the new financial regulation law will have a positive effect.

“For the time being, we need to accept the possibility that the financial sector has learned how to game the American (and UK-based) system of state capitalism,” Cowen writes. “It’s no longer obvious that the system is stable at a macro level.”

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The Source: "The Inequality that Matters" by Tyler Cowen, in The American Interest, January-February 2011. 

Photo courtesy of Flickr/CafeCredit.com