It’s a bedrock principle of economics: Incentives matter. You’ll find it in the first chapter of any introductory textbook. And it is the animating principle of Republican economic policy, as we were reminded last week by Rep. Paul Ryan when he unveiled the latest House Republican budget.
In outlining his proposal for deep cuts in spending on Medicaid, food stamps and services for the unemployed, Ryan explained that Republicans “don’t want to turn the social safety net into a hammock that lulls able-bodied people to live lives of dependence and complacency, that drains them of their will and incentive to make the most of their lives.”
But for Ryan, fixing the economy isn’t just about eliminating the wrong incentives for the poor. It’s also about giving the right incentives to everyone else to work hard, invest and take entrepreneurial risk. So even in the face of massive budget deficits and incontrovertible evidence of rising income inequality, the Republican budget would also reduce taxes for those whose high incomes are proof not only of their superior productivity and job-creating prowess, but of their moral superiority as well. No hammocks for them.
As much as this parable of the undeserving poor and the deserving rich might offend our sense of justice, it carries a large kernel of economic truth. Economic systems that promise on equality of outcomes, whether of the communist or kibbutz variety, have repeatedly failed to deliver higher overall living standards than more market-based systems where significant gaps between rich and poor are tolerated.
In a society where incomes are made to be too equal, there is little reason to work harder or to defer current consumption in order to save and invest. There is no incentive to take the risk of launching a new enterprise or to spend hours in the lab or the garage dreaming up the next breakthrough technology. Without the prospect of earning more or getting ahead, there would be less reason for getting much beyond the most basic education and training. And it is precisely these factors — work effort, investment in human and physical capital, development of technology — that are key to determining how fast an economy grows.
In 1974, the late, great economist Arthur Okun gave a series of lectures in which he argued that there was a “nagging and pervasive trade-off” between economic equality and economic efficiency.
“We can’t have our cake of market efficiency and share it equally,” Okun told his Harvard audience. The hard questions in public policy, he argued, most often involved a balancing of these two priorities.
Four decades later, however, Okun’s “big trade-off” has been hijacked by Ryan Republicans eager to use it as a rationalization for tax cuts for the rich and service cuts for the poor. Ignoring Okun’s premise that society wants both fairness and economic growth, Republicans have not only elevated growth as the sole objective of economic policy, but declared that fairness is everywhere and always a deterrent to growth. For them, the relationship is perfectly linear: If some inequality is required to increase economic growth, as it surely is, then more inequality must always beget even more economic growth.
Or maybe not. What if the relationship between inequality and economic growth is more complicated than that? What if there is a diminishing return to inequality? What if we’ve reached the point where any additional increase in inequality results in less growth, not more?
There is, in fact, some empirical evidence of this. Last year, two economists at the International Monetary Fund, Andrew Berg and Jonathan Ostry, published a paper showing that countries that experienced longer periods of strong economic growth were significantly more likely to be characterized by more equality than less. Inequality, they speculated, might amplify the risk of financial crises, which are often followed by long periods of slow or negative growth. It might bring about political instability, which can discourage investment. Inequality might make it harder for ordinary citizens to invest in entrepreneurial activity, or even invest in their own training and education.
If that story sounds a bit familiar, it should.
It is hardly coincidence that the past 20 years — a period in which inequality has risen noticeably in the United States and around the world — has also been characterized by repeated and severe financial crises. There was the junk bond sell-off of 1987, the continuing savings-and-loan crisis of the early ’90s, the Asian financial crisis and the tech-and-telecom bust of the late ’90s, and the near meltdown of financial markets in 2008.
Surely one explanation for the most recent crisis is that too many households took on too much debt as they struggled to maintain their standard of living in the face of nearly three decades of stagnant wages and salaries. Another might be that with so much of the nation’s wealth accumulating in so few hands, it was inevitable that they would misallocate much of it by bidding up the price of “positional” goods such as houses in the Hamptons and seats at the best private schools.
It is worthy of note that this period of rising inequality also coincided with a dramatic slowdown in college graduation rates, particularly among men. More recently, it has also coincided in a decline in business startups and other measures of entrepreneurial activity.
And can anyone doubt the connection between rising inequality and the increasingly partisan and divisive nature of American politics, which has made it difficult, if not impossible, for government to respond quickly and intelligently to the major economic challenges facing the nation? Surely that can’t be good for growth.
I find it strange that Republicans assign such overriding importance to economic incentives for investors, executives and hedge-fund managers while remaining totally clueless about the economic incentives faced by everyone else. Over the past 30 years, the entire increase in the nation’s income has been captured by the 10 percent of households at the top of the income scale. Do you think that maybe, just maybe, the lack of a pay raise for the other 90 percent might have had any impact on their productivity, their work effort, their creativity or their willingness to take risk?
Paul Ryan was spot on last week when he warned that the country was approaching an “insidious moral tipping point.” Too bad he is too blinded by ideology to see what that tipping point it really is.