Newsletter – A year of inequality debate

Inequality and poverty issues were big news this past year.

The English version of Thomas Piketty’s book, Capital in the Twenty-First Century, was published in April.  It provided an impressive collection of historical data on trends in wealth distribution. Much less impressive was the interpretation of the data and the theory that went with it.

The book was greeted with enormous enthusiasm by the political left. No surprise there. People – on both the left and right of politics – tend to accept uncritically information or views which align with their prior beliefs.

But one of the great virtues of a free and open country, and of the democratic process, is that your political opponents will scrutinise your arguments and you theirs. It’s a contest of ideas.

So how has Piketty’s book held up? A recent lengthy review by Deirdre McCloskey described the many problems with the book, and John Cochrane (University of Chicago Business School) has helpfully provided a condensed version. It is well worth a read.

Cochrane summarises McCloskey:  the book is “wrong as simple microeconomics ….and growth economics; the evidence is contrary to its thesis…. and it advocates policies – confiscatory taxation by a centralized world government – that would turn back the trade-based betterment (a better description than ‘capitalism’, as it is innovation that drives income growth) that has saved billions from grinding poverty.”

McCloskey notes that Piketty’s definition of wealth does not include human capital – the skills and education of the workers. Add back in human capital to the accounting, and you find that workers own most of the nation’s capital, “and Piketty’s drama from 1848 falls to the ground.”

The year ended with more publicity on academic work on inequality, with the Guardian newspaper featuring a working paper from the OECD. The headline was: Revealed: how the wealth gap holds back economic growth.  This headline was enough to excite those on the political left, but the subheading was even better:  OECD report rejects trickle-down economics, noting a ‘sizeable and statistically negative impact’ of income inequality.

The political cream on top was that the report identified NZ and Mexico as the two countries whose growth was most held back by rising inequality:

Does any of this stand up?

Let’s start with the Guardian’s subheading, where they ever so predictably reach for the notion of “trickle-down economics”. This expression is a pretty standard fantasy of the political left, not so much a straw man as the left’s imaginary friend.  There is no such academic theory.

What about the OECD report itself, rather than the overheated journalistic version?  Was Russel Norman’s excitement in the House justified?  Had he read it, or just the Guardian report?

As always with these matters, you need to wait a bit until other academics have tested the report – its methodology, its data analysis and conceptual coherence.

An economist at the NZ Initiative, Eric Crampton, has helpfully reviewed the OECD paper on his blog, Offsetting Behaviour. You can read it here.

Crampton notes several odd aspects of the report’s conclusions.

“They find that net inequality (after tax-and-transfer) hurts economic growth, that gross inequality (pre tax-and-transfer) doesn’t hurt growth, that changes in human capital (education) do not affect growth one way or another – there’s a slightly negative effect of education on growth in the set of specifications, but it’s not significant; and, investment doesn’t affect growth one way or another.”

As Crampton notes, these are strange results. Typically we would expect investment in capital equipment and in human capital to be important for growth.

But it gets weirder still.

Digging into the report, the results suggest that all that matters is the difference between the average income and the level just below – the 4th decile. The difference between incomes at the top (the 9th and 10th deciles) and average incomes have no influence on growth.

If you took that result seriously your policy recommendation would be to increase the tax on average earners to give money to people slightly poorer than them. An odd result. Nobody now seems to be defending the data analysis in this report.

But if you did, you would wonder what the mechanism might be for inequality to affect growth?

The report suggests it would be via reduced investment in education in the lower decile cohorts.  But remember, the report found no effect of education on growth.

The authors decided this result must be wrong, and instead made the case for increased spending on education. That judgement in turn is based on other OECD papers which do find a strong effect of education on growth. Awkwardly, many of those very papers also find that inequality increases growth.

Go figure.

Let’s be positive here. The authors cite OECD research that suggests that “across 21 OECD countries human capital has a robust, positive and significant impact on long run growth”.  Yes, it does, see the McCloskey comments on Piketty earlier.

Referring to that research the authors write:  “The evidence strongly suggests that high inequality hinders the ability of individuals from low economic background to invest in their human capital, both in terms of the level of education but even more importantly in terms of the quality of education. This would imply that education policy should focus on improving access by low-income groups, whose educational outcomes are not only worse on average from those of middle and top income groups, but also more sensitive to increases in inequality.”

Well, there is a policy that does just that. It is called Partnership Schools.

Ponder that over the holiday break, and wonder why the political left does not support this policy.

Merry Xmas!