Inequality is a Problem for Capitalism

“It is but equity, besides, that they who feed, clothe, and lodge the whole body of the people, should have such a share of the produce of their own labour as to be themselves tolerably well fed, clothed, and lodged.” 

Whose statement was this? John Maynard Keynes? Or Karl Marx, perhaps? No. This is a quote by Adam Smith, the “Father of Economics,” also known as the “Father of Capitalism.” It’s from the Wealth of Nations, the foundational book published in 1776 that we all remember for its statements on the benefits of rational self-interest and free markets. 

The pro-development aspect of Smith often goes ignored, as does the impact of wealth inequality on the macroeconomy. It is common to hear from political campaigns that eight billionaires control the same amount of wealth as the poorest 50% of the world’s population. However, this is not just a moral injustice. Income inequality over a period of time slows down economic growth and, ultimately, disrupts the very functioning of the capitalist system. The economic system of our time is not working as Adam Smith envisioned; it has resulted in excesses for some, and shortages for others. In a truly perfect market, where information is accessible to all without barriers to exercise one’s self-interest, equilibrium is achieved where ultimately every group’s utility is met. This is the classical notion of capitalism. Therefore, if the goals of capitalism are to be met, essentially, there should be no inequality of opportunity.

Joseph Stiglitz is a Nobel Laureate in Economics who is well-known for his work on the relationship between economic inequality and growth. He accurately points out in his work that despite the effort in the 1980’s towards creating a perfect market by lowering government intervention through slashing regulations, decreasing social spending, and providing tax cuts to businesses, the rate of growth in the United States slowed. Instead of achieving a perfect market condition, these policy changes led to a market failure. Economic growth and shared prosperity were not realized. Instead of achieving a perfect market condition, these policy changes led to a market failure. The nation neither achieved economic growth, nor shared prosperity. Rather, during this same period, the country experienced a sharp rise in income inequality.

In economics, inequality is most commonly displayed through the Lorenz curve, a graphical depiction of the cumulative income of the bottom x% of a nation’s population. In order to encapsulate the income inequality between members of the population, the data in the Lorenz curve is used for developing a measure known as the Gini coefficient. This coefficient is calculated by measuring the deviation of the Lorenz curve from the line of perfect equality. A Gini coefficient of 1 would imply that one person holds all the wealth, while 0 means perfect equality. All nations in the real world fall somewhere in between.

U.S. income inequality has been on the rise since the mid-1980’s and is currently at its highest level in 50 years, with a Gini coefficient of 0.485 in 2018, according to the US Census Bureau. To put this in perspective, America’s Gini coefficient is close to that of a developing country, such as Rwanda or Nigeria; no Scandinavian nation in 2017 had a Gini higher than 0.286, by the World Bank’s measure. It won’t be long before economic inequality eventually becomes a serious drag on economic growth, to the dismay of the powerful American interest groups who don’t see inequality as a problem. Don’t take my word for it: even economists within pro-market institutions, such as the International Monetary Fund (IMF), are starting to recognize the threat that inequality poses to national economies around the world. 

According to a 2019 IMF Working Paper that did a time-series statistical analysis of 166 countries over a 65 year period, intergenerational wealth disparities that arise due to inequality of opportunity eventually become a long-term burden on a nation’s economy. The new findings are intriguing because past statistical models have not been able to establish any significant correlation between income inequality and growth. However, the paper finds that when growth is measured in nations where inequality has been displayed over time through “intergenerational immobility,”  economic growth has slowed down significantly in these nations. For example, in countries where the education level (i.e. human capital) of one generation does not improve over the previous generation, growth in those countries slows down. In this context, the study reveals that as the Gini coefficient of a nation increases by 0.1 annually, in the next five years 0.5 percentage points will be knocked off the average growth of that nation. 

 The IMF study establishes that the growth slowdown is because of “intergenerational immobility,” usually produced as a result of what the paper labels as “unequal opportunities.” What does that mean? Suppose all students are receiving winter jackets from their school to be offered equal opportunity to be protected from the cold, but they all receive coats of the same size because they are the same age, even though they all have different heights. This leaves some students feeling cold in smaller coats. Equal opportunity ideally means that each student will receive a coat that fits their unique size – giving them all the same level of freedom and capability to walk to school without any hindrance. In the IMF study, they have measured inequality of opportunity by measuring unequal access to education, the job market, and the financial market due to several socioeconomic barriers in several countries. 

Why exactly would unequal opportunity translate into income inequality and inhibit growth? Think of this in the context of the United States, founded by the Declaration of Independence on the principles of “Life, Liberty, and the pursuit of Happiness” – the ideal of equal opportunity. Yet today’s America is failing miserably in respect to offering opportunities to all. College enrollment, for example, has been steadily falling in the U.S., usually attributed to the skyrocketing cost of higher education. Equal access to the job market is not guaranteed; studies have been conducted that show racial discrimination to be prominent in the labor market, where resumes with “white-sounding” names were much more likely to result in call-backs for interviews than applicants with “black-sounding” names. Is this equal opportunity? Barriers to getting a good-paying job because of unaffordable higher education? Barriers to being employed because of corporate racial preferences? These are not drivers of economic growth, even under a pure capitalist model. The IMF research points specifically to reductions in human capital, caused initially by unequal access to opportunities, then translating into increases in income inequality, thus “retarding future growth disproportionately.”

When an inordinate portion of the American population remains without a college degree or attains a degree in a less expensive field that they are not suited for, the result is a less productive economy. People with the potential to become doctors, for example, might be driven away from the profession because of unreasonably high medical school tuition. The outcome of skill misallocation is no longer hypothetical. America has fewer young entrepreneurs than ever as their student debt is preventing them from investing in start-ups. This nation will not have enough doctors to deal with a rapidly aging population as students cannot afford medical education, and high-poverty school districts in America without enough teachers are leaving young students unequipped to compete in the future job market. If it is accepted that the primary goal of American capitalism is to maximize economic growth, then it’s time to recognize the long-term dangers of decreasing human capital that is exacerbating inequality.

It is also imperative that we reevaluate our understanding of Adam Smith and the basis of our economic system. In his book On Ethics and Economics, Nobel Laureate Amartya Sen points out that Adam Smith himself did not separate societal well-being from economic success. Notably, Smith wrote that “man…ought to regard himself…as a citizen of the world…[and] to the interest of this great community, he ought at all times to be willing that his own little interest should be sacrificed.” It is the job of the state on behalf of its citizens to spend on public programs in a very targeted manner with the goal of expanding access to opportunities tailored to the specific needs of different communities. Spending on education, healthcare, and childcare are areas where specific government action can help increase human capital among lower-income citizens. This would not only create new jobs, but reduce underemployment through better skill allocation as well as improve worker productivity in existing jobs, thus boosting economic growth. An economy where citizens are well-educated, healthy, and are able to work without struggling to afford childcare will be a productive economy. Instead, we are seeing an unfettered American casino capitalism with unprecedented levels of wealth concentration, corporate consolidation, and unequal opportunity – results that would have made Adam Smith’s stomach churn. However, if we want the best of capitalism, with the freedom to have a perfect flow of information, freedom to start businesses and spur innovation with a skilled and productive labor force, and freedom for consumers to make their choices, then it is critical that the government steps in to make our markets work for everybody, to knock down barriers for low-income communities to reach success, and to tackle economic inequality head-on.

The founding fathers of America envisioned a country that rested on the ideal of meritocracy. In modern economics, such as in the work of Amartya Sen and many others, the “capability approach” means that people can compete based on their merit only when the resources at their starting point are the same from birth, thus allowing them the freedom to use their capabilities to the fullest. Based on the same understanding, the founding fathers believed that it was the role of the United States government to “promote the general Welfare,” as written in the American Constitution. Yet the country today remains in denial about this vision of the common good over concentrated success. There are a plethora of proposals to increase human capital and decrease inequality that is holding too many Americans back, such as universal prekindergarten, tuition-free public four-year college, and a federal jobs guarantee, just to name a few. Whether one believes in capitalism, socialism, welfarism, or not, it is time to accept across the ideological spectrum that inequality is an issue that needs to be addressed, if shared prosperity is really the goal. It is of course a separate debate whether the success of a nation should only be measured through prosperity and not through other measures, such as justice and happiness. The fact that capitalism as a model is being revisited by pro-market economists is what is being highlighted here, not taking away from the fact that the notion of success is not limited by growth and shared wealth only.