Sir,

In your leader on the increasing inequality in recent decades you argue forcefully against redistribution by taxation but completely ignore the much more insidious and pernicious redistribution by inflation. Inflation represents an alternative to the consensus explanations of technology and globalization for the rapid rise in incomes of the top fraction of the population. Since the early 1980s the financial sector has grown much more rapidly than the rest of the economy in sympathy with accelerated growth in credit and the supply of money. The managers and financiers whose pay packets have soared in recent years are the gatekeepers of newly issued money and have been diverting an increasing proportion of it to themselves at the expense of the rest of the world’s savers and labourers, whose incomes are devalued. Wealth accrued by such means is no more a reflection of free market forces and returns to value added than is wealth accrued through taxation.

bsetser — (blushing) I’m just flattered that you dropped by to read, let alone to agree. You’re my original econoblogging hero.

Andy — So, Yellowstone is the kind of public good for which there are not, exactly, superior private substitutes. I’d guess that Yellowstone might not be harmed by inequality. But despite your hopeful conjecture about public transportation, my sense is that in the real world, it just doesn’t work that way. People with cars quickly cease to support public transportation spending (except on roads), and become actively hostile if they find that buses cause them any sort of inconvenience. I’ve done no empirical study, but I’d be willing to wager on the overall direction. In less developed countries with, as often happens, very many poor people and a wealthy class rich even by Davos standards, it is an sad though amusing, and very observable, phenomenon that rural and mountain roads are poorly maintained while wealthy people with vacation homes travel in comfort with SUVs. If the SUVs cold not be purchased, my guess is that the roads (at least to the lovelier places) would be better maintained. I’m willing to hold to my general proposition: the availability of public goods for which superior private substitues can be purchased is nearly always diminished with increasing inequality.

Nels — Interesting point. I love economics and spend much of my free time reading what economists have to say. But the word hubris should not be lost to the dismal science. As an epistemological matter, it remains an open issue to what degree progress is possible in the social sciences. No theory or prescription of economics is so certain that we should accept its imposition without a lot of cross-checks and smell tests, and not only the sort of tests performed by econometricians. Sometimes even that oldest of charnel houses, the parliament, has something valid to say, despite anybody’s t-tests. Power corrupts academics as easily as men of politics, and no man was ever more corruptible than the one with an ideology or science proclaiming what happens to be his own interest just and right.

Aaron — So, we agree on many things, but we’re likely to argue on technicalities. I stand by my claim that “there’s no such thing as a Pareto improvement” in any system in which two preconditions hold: 1) relative wealth has nonzero positive utility; and 2) the benefits of absolute or relative wealth are incommensurable. If this is true, then the private exchange you describe — which makes both parties richer — is not a Pareto improvement because it harms the relative wealth of others. Now of course, as Tyler Cowen argued and I wholeheatedly agree, I’ve set up this game badly. I’ve made life into a zero-sum game when it needn’t be. By construction, there is no such thing as a Pareto improvement, thanks to my preconditions. (Technically, there is one possible Pareto improvement — a proportionate increase in the wealth of all players.) I agree with this criticism, and see no point in making life more zero-sum than it has to be. So what was wrong with my preconditions? Precondition 1 is absolutely true: In real life, relative wealth matters, as a matter of real-world expected outcomes as well as the fuzzy psychological stuff. I give no quarter with respect to Precondition 1. Precondition 2, however, is not necessarily true. If you get rich by inventing a better nose-hair clipper, I might lose out in terms of my relative wealth, but my absolute gains in nose-clipping utility (I have hairy-ass nostrils, let me tell you) might in some sense overwhelm that relative demotion. If we let absolute and relative gains be commensurable, and define a conversion to common units (dollars? utils?) such that the cost of the fall in relative stature is less than the gain in easy nose clipping, then your invention (and the subsequent voluntary private transactions whose result in your fortune) might indeed represent a Pareto improvement (at least in a society in which all people have hairy noses). But note how many assumptions and definitions we have to make to find a Pareto improvement: we have to define the cost of relative loss, the gain of the general “increase in wealth”, and some transmission mechanism whereby that increase is general (that is, not only the hairy-nosed benefit).

In practice, I agree with you that there are many activities that “add real value”, and for which secondary costs (like changes in relative status) should not be much considered, and that societies that support the “production of real wealth” will be better societies than those that do not (and especially better societies that place too high a weighting on relative wealth compared to some measure of “absolute wealth”). Therefore, in practice I both agree with you, and support a the generation of a great deal of economic inequality, so long as the unequal wealth is somehow tethered to “real value creation”.

But that doesn’t mean that economics professors who pull fairy tales out of game theory textbooks and try to claim inequality is nothing to worry about because it’s all Pareto improvement should be treated as though they are authorities on the matter. Perhaps it is an overstatement to say there is no such thing as a Pareto improvement. But I can confidently claim that no occurrence in the real world can be identified as a Pareto improvement without a lot of judgement calls between the event and the identification.

Pareto increase is founded on the injection of new value into society, not specific transfers and allocations of money, which are secondary. A transaction in which both parties benefit — which is the kind of transaction most common in a free market — generally produces such a Pareto increase. I genuinely believe that. I think the proof is essentially that gradual deflation will be produced in a society with no upwards liquidity bias; all the Pareto increases accumulate and you end up with increasing value relative to money.

Now, all things go out of whack when you mess with credit and money. Money is supposed to track this injection of wealth and value into society, but in our system it often does not. You are quite likely to get more money purely because you already had money, and get it without producing at least that much value, which means you’re getting the money at someone else’s expense (even if the money/credit is created ab initio, the expense on society is precisely that much more inflation or asset-bubbling).

To me this is a more dominant phenomenon than “classical” redistributive transfers of the extant money around society, of the kind lacking in the Pareto property. Instead we’ve got an out of whack money and credit system, which causes another kind of decoupling of money from value creation. The lack of Pareto-type benefit isn’t the problem here; it’s the lack of tracking such benefit closely with monetary reward.

Furthermore,I will add that the high standing among economists of hypotheses which are important in economic history and which have been rejected by the data is one of the reasons many current debates in economics are so insane and reinforces my low level of expectations from the majority of professional economists.

In my freshmen economics course “The Worldly Philosophers” by Robert Heilbroner was required reading. He updated the book some years ago and therein called on the economics profession to reformulate “the economic problem.” In the updated edition he said: “We live in a period in which much of the conventional wisdom of the past has been tried and found wanting. Economics is in a state of self-scrutiny, dissatisfied with its established premises, not yet ready to formulate new ones. Indeed, perhaps the search for a new vision of economics, a vision that will highlight new elements of reality and suggest new modes of analysis, is the most pressing economic task of our time… Perhaps in a different society of the future, another hypothesis about behavior would have us serve as our starting point. People might be driven by the desire to better the condition of others rather than themselves… A story about heaven and hell is to the point. Hell has been described as a place where people sit at tables laden with sumptuous food, unable to eat because they have three-foot long forks and spoons strapped to their hands. Heaven is described as the very same place. There, people feed one another.”

Also, it’s not likely that the market for cheap cars will be cut in half — more likely that it will be just slightly reduced, probably not enough to cut down on economies of scale. In fact, spending on services probably goes up much more than spending on goods, and services are labor-intensive. What about the Baumol effect? All of a sudden, there’s a market for $200 haircuts, expensive massages, restaurants, and all sorts of other personal services.