IT IS IMPORTANT TO DISTINGUISH BETWEEN DIFFERENT TYPES OF INEQUALITY and different causes. This chapter looks at both.
Different types of inequality1
There are many different concepts of equality and inequality, and the previous chapter showed how Hayek argued that some concepts preclude others. So it is important to distinguish between the different concepts before we start to analyse causes.
The first concept of inequality to be considered is that promoted by Hayek. This is essentially that each is equal in his or her legal and human rights. Hayek argues that the most important form of equality is equality under the law, giving equal legal protection for everyone. At the same time he argues that as people are different, equality of such rights is likely to lead to unequal outcomes for people.
Equality under the law is part of the constitution of most democratic countries. It is enshrined in Article 7 of the Universal Declaration of Human Rights and in Article 14 of the International Covenant on Civil and Political Rights and is part of the 14th Amendment to the US Constitution.
It is important to note that this type of equality is an equality of process. It does not guarantee equal outcomes or even equal access. Lawyers often argue that equal access cannot be guaranteed without freely available access to legal advice.
However, although equality under the law is important and most people would support it, this is not the concept of equality that is the focus of this book.
A second concept of equality is equality of opportunity. This concept is that people should be given equal chances of succeeding but whether they do in fact succeed or not is up to them. The economists Milton and Rose Friedman describe this concept in their book Free To Choose:2 equality of opportunity is ‘not to be interpreted literally’ since some children are born blind while others are born sighted; ‘its real meaning is … a career open to the talents’. This means that there should be ‘no arbitrary obstacles’ blocking a person from realising their ambitions, and that ‘Not birth, nationality, colour, religion, sex, nor any other irrelevant characteristic should determine the opportunities that are open to a person – only his abilities.’
Many people instinctively support equality of opportunity, but it is hard to generate in practice. There are interesting questions about the extent to which differences in health and education can be incorporated into the concept. Moreover, since different people have different genetic endowments, the equality of opportunity argument does not really handle how to compensate for this. Finally, luck plays a major role in life and again this is not dealt with in the equality of opportunity theory. But this book is not concerned with equality of opportunity.
The third concept is equality of outcomes, meaning that whatever people do in the economic sphere they should accept the same levels of income or expenditure. For a long time this concept was seen as an ideal held only by a minority. But as inequality of outcomes has increased in Western economies especially, support for equalising outcomes has grown.
This book mainly concerns itself with this last concept of equality, equality of outcome for income and wealth, and how to move towards it without damaging the economy or other appropriate objectives, such as reducing poverty.
This brings us to four different potential causes of the recent rise in inequality.
Type 1 Inequality
The first potential cause of the recent rise in inequality which we shall consider is the concept advanced by Piketty – increased inequality caused by increased exploitation.
It is unlikely that anyone will deny that this has happened, although there is plenty of scope for debate about how important it has been. Even if Piketty is wrong about it being the main cause, it certainly has had a role to play in these developments.
The formal definition of Type 1 Inequality is that it is the form of inequality that results when some people or groups abuse their power to extract wealth or income from the rest of society involuntarily. The simplest form is a protection racket. A more sophisticated form might come from the creation of an exploitative monopoly. A third form might be the abuse of political power to divert income and wealth to specific groups through the granting of state supported privileges.
Chapter 9 looks at this concept in more detail in the context of high pay for so-called crony capitalists, bankers and CEOs. It notes that some of the excessive pay might be a function of the disequilibrium phenomenon of a slowly adjusting labour market and that the problem of excessive pay for some might sort itself out naturally. Certainly bankers are now paid much less in London than was once the case (though in my view still far too much) and US CEOs earn less in cash terms than they did in the year 2000.
Type 1 Inequality is generally considered the most offensive form. Not only is income or wealth taken from poorer groups and given to richer groups effectively through force without creating any added value, leaving both the rich richer and the poor poorer, but in practice the existence of this type of inequality generally creates a negative sum game. The monopolies and rackets associated with it actually reduce economic activity, so the worse off suffer twice over.
In some cases tax cuts for wealthier groups might be expected to lead to increased Type 1 Inequality. This, in effect, is one of Piketty’s arguments: that increased social acceptability of greed led the rich to push for tax cuts which in turn made greed more profitable. Although he does not describe them in detail, it seems clear that he is referring to the Thatcher and Reagan tax cuts mainly in this context.
Yet it is possible to argue that, particularly in the UK context, the pre-Thatcher rates of tax were so excessive that the reductions in top rates from 83% for directly earned income and 98% for investment income were merely allowing wealthier people to keep a fairer share of what they had earned. Certainly the yields from higher rates of tax actually increased when the rates were reduced.
But the question of what rate of tax maximises revenue has long been debated. One suspects that it may vary between different societies with different cultural norms.
Type 2 Inequality
Type 2 Inequality is that caused by the early stages of globalisation. As emerging economies develop, typically they initially compete most with the developed economies in the more poorly paid jobs. At the same time global growth offers increased opportunities for those with scarce skills – especially from the more developed economies – to market their skills in a bigger market. Even if this process reduces poverty in the emerging economies (which it generally does) it might mean both more poverty and more inequality in the developed economies.
To understand the process it is worth looking at economic history, starting before the so-called ‘Great Divergence’ between the West and the East.
The Great Divergence
It was the political scientist Samuel Huntington who named the sharp widening of the gap in technology and incomes between a few selected European nations and some later offshoots of these nations on the one hand, and the rest of the world on the other, the Great Divergence.3
Table 2. The Great Divergence. Growth of GDP per capita in selected European and Asian Nations, 1000-1950 (in 1990 Geary-Khamis $)4
| Year | France | Germany | Italy | UK | USA | China | India | Japan |
| 1000 | 425 | 410 | 450 | 400 | 400 | 466 | 450 | 425 |
| 1500 | 727 | 688 | 1,100 | 714 | 400 | 600 | 550 | 500 |
| 1600 | 841 | 791 | 1,100 | 974 | 400 | 600 | 550 | 520 |
| 1700 | 910 | 910 | 1,100 | 1,250 | 527 | 600 | 550 | 570 |
| 1820 | 1,135 | 1,077 | 1,117 | 1,706 | 1,257 | 600 | 533 | 669 |
| 1850 | 1,597 | 1,428 | 1,350 | 2,330 | 1,806 | 600 | 533 | 679 |
| 1900 | 2,876 | 2,985 | 1,785 | 4,492 | 4,091 | 545 | 599 | 1,180 |
| 1950 | 5,186 | 3,881 | 3,502 | 6,939 | 9,561 | 448 | 619 | 1,921 |
Source: Maddison Data Archive, Groningen University
In 1450 a betting person would probably have been at least as likely to bet that Mughal India, China or the Ottoman Empire would grow rich and accelerate clear of the rest of the world as that the European countries would do so. Because my parents lived in the Malaysian town of Malacca when I was a small boy, one of the historical figures who has always intrigued me is the Chinese admiral Cheng Ho (now in Pinyin normally called Zheng He) who if he didn’t discover Malacca (there was already a Sultan when he first arrived) certainly did a lot to develop it. He visited Malacca at least five times on his seven great voyages (on one of which he may possibly have reached the Americas,5 though professional historians think he got only as far as the Mozambique Channel). Malacca’s best museum is the Cheng Ho Cultural Museum.6
In Cheng Ho’s time, the late 14th/early 15th century, China seemed to many to be the most technologically advanced nation in the world (although GDP per capita is estimated to have been slightly lower than in most European countries).7 His ships were many times larger and more advanced than those in which the great Spanish, Italian and especially Portuguese navigators discovered the world half a century later. (His biggest ships were about 400 feet long and 180 feet wide whereas Columbus’s Santa Maria was 60 feet long and about 20 feet wide.) Chinese nutritional standards and life expectancy at that time were significantly higher than those in Europe.
If you go to the Maritime Museum in Lisbon (in many ways, for those of us interested in globalisation, one of the great museums of the world) you can see how tiny and how technologically backward were the ships in which the daring adventurers from Portugal and elsewhere visited much of the world. Where they had an advantage was that their navigational skills were more advanced than others so they could cross oceans while others did not sail far away from the coast.
One of the most readable accounts of the Great Divergence is by the former BBC Economics Correspondent Peter Jay.8 One of the reasons that he writes so well about the voyages of discovery is that he is himself, as well as a distinguished economist, a highly competent sailor who has personally undertaken epic voyages (including returning from his stint as UK Ambassador in the US by sailing the Atlantic himself in a race).9
During the 15th century the Ottoman Empire conquered Constantinople, besieged Vienna, fought the battle of Lepanto, captured Hungary and raided Moscow as well as conquering many parts of Central and Eastern Europe. Technologically it too looked well ahead of the European nations who were hard pressed to hold it off militarily.
So how did Europe get ahead?
The main theories explain the Great Divergence as to do with the competition for ideas spurred by the Reformation in Europe (a slight problem for me having been brought up as a Catholic in various Jesuit monasteries) compared with the generally anti-business attitudes of the Chinese and the Muslim empires10 as well as of those parts of Europe that remained most heavily Catholic. Indeed the arrival of French Huguenots in Holland and England were major spurs to growth. Ironically, immigrants to London today working in Spitalfields and the area nearby, the same area colonised by the Huguenots, have created the new ‘Flat White Economy’ which has done so much to push the UK economy forward in the past ten years.11
Trade was considered by the Confucians to be ‘unproductive, uncultured and preoccupied with profit rather than the good of society’12 – they obviously hadn’t yet made the discovery of Adam Smith’s ‘invisible hand’.
Exploitation of the New World and, sadly, of slaves from Africa, were also probable contributory factors to the Great Divergence. If we ever think of ourselves in the West as somehow intrinsically superior to other peoples, it is sobering to think of the deception and violence that accompanied these processes. Although many others might have behaved just as badly had they had the resources to do so, it remains a fact that the West did have the resources and initiated the violence and deception.
It is arguable that persistent warfare in Europe during most of the next 300 years from 1500 also stimulated technological development. It certainly helped develop the weapons technology which enabled European nations to conquer and colonise much of the world.
Eventually the growth in per capita incomes created a world with a sufficient surplus over subsistence to finance an industrial takeoff. The combination of technology and capital generated the industrial revolution which took over the UK in the 18th and 19th centuries and which was rapidly copied by the other European nations.
As an interesting aside, much of the technology for the industrial revolution was contributed by my fellow Scots.13 The Scottish Education Act of 1496 made it compulsory for sons of barons and substantial freeholders to be educated in grammar schools. From 1560 education was encouraged as a result of the Scottish Reformation. For people to be enlightened they needed to be able to read so that they could read the Bible. In 1696 the Scottish Parliament passed the ‘Act for Setting Schools’, making it compulsory for each kirk (parish) to have a school. Thus education in Scotland was widespread throughout society at an early stage, creating a sufficient breadth of ideas and knowledge among people doing manual jobs. The mix of education and practical manual jobs provided the engineering knowledge that made the Scots of the era such great inventors.
In most other countries those who were educated did not actually do practical work and so were generally unable to apply their education to the artisan processes involved in the work of the educated but still artisan Scots. Thomas Telford, the great engineer, was a stone-mason originally but his mix of practical building knowledge and his education, which was not much more than most Scots of his era received, turned him into someone who could change the face of a nation.14 The experience of Scotland and indeed of émigré Scots in the US, Canada, Australia and New Zealand is powerful support for the theory that the most important means of securing equality is education.
One of the consequences of the Great Divergence was a massive increase in inequality, especially between countries. Even poor people in rich countries became typically much better off than the bulk of the population of poorer countries.
The industrial revolution – despite fears to the contrary which led to the Luddite rebellion of 1811-15 and the breaking of machines – in fact created more jobs than it destroyed (though real wages of manual workers fell in the UK in the early part of 19th century, both the two series commonly available show drops of around 25%).15 These declines in wages were however reversed during the second half of the 19th century.
Globalisation
I had got excited about globalisation while I was being brought up in Malaysia. It is hard for someone who was not in South East Asia through the third quarter of the 20th century to comprehend the scale of the change in living standards that took place in the country during that period. Between 1953 and 1976 when my family lived in Malaysia, per capita GDP in the country more than doubled from $1,440 to $2,910 despite rapid population growth.16
What this meant was that conditions in the country changed from the majority of people living below the breadline (or in their case the rice equivalent) to living with some minor creature comforts. Bicycles had become widespread during the 1950s and early 1960s. In the late 1960s and early 1970s small motorcycles started to flood the roads. By the 1980s the motorcycles had been replaced by cars, creating the epic traffic jams that are now so characteristic of the Far East.
In the early 1970s economic growth really started to take off with offshore manufacturing of electronic components.
Asia in the 1950s and 1960s was mainly thought of economically as a producer of commodities and very cheap basic goods. In 1968 that changed. The electronics company Fairchild made the first offshore electronics investment in Hong Kong. I have a personal view which has been rarely mentioned in the literature (the main study on this is in Korean, though it has now been translated) that the Vietnam War was catalytic in causing the first investments in East Asia.17 Young American soldiers were drafted into the war and sent to Asia. I’m sure that their unusual experience abroad in Asia (remember that at that time very few Americans of their generation ever left the US) may have influenced their attitude to investment in East Asia when they returned to civilian life and made business decisions.
The peak level of annual expenditure by the US on Vietnam was (coincidentally) also in 1968 when, according to the Congressional Research Service, $111 billion was spent on the war, which they have helpfully translated into $738 billion in 2011 (financial year) dollars and about $800 billion in today’s money.18 As Senator Everett Dirksen pointed out, ‘a billion here, a billion there, pretty soon you’re talking about real money’. $800 billion is real money and had already started to leach into the domestic Asian economies in the provision of basic supplies before Fairchild came in and started to make electronics products in Hong Kong.
We talk these days of wars creating ‘collateral damage’, which I feel is a nastily sanitised phase to describe the killing of innocent people which often occurs during a war. But there are occasionally also ‘collateral benefits’, such as the stimulus given to economic development in East Asia.
When I was studying for my Master’s at Oxford in 1972-74, the phenomenon of offshore electronics manufacturing in Asia already seemed developed enough for me to choose to perform a social cost–benefit analysis of the first two electronics plants in the Kuala Lumpur area for my thesis, which showed how massively these projects benefited all parties.19 The first plant took no more than a year to pay back its entire capital investment. The second took only ten months. Employees working in the plants typically tripled their living standards from their previous levels while, even though the plants were in tax-free zones (meaning no import or export duties and no profits taxes), government revenue was boosted strongly by income taxes, employment taxes and indirect taxes on the employees’ expenditure.
Incidentally, this is one reason why I am careful not to confuse companies who pay little or no corporate taxes with companies paying no tax at all. While I think companies should pay a reasonable amount of corporate tax on their profits, their main contribution to overall tax revenues is through sales and value-added taxes on their products, the various payroll taxes they pay and of course the taxes that their employees pay on their incomes and on their expenditure. Direct corporate tax payments on profits tend to be relatively unimportant in comparison, and if low rates of corporate taxes promote increased inward investment and hence economic growth, the government tax take is likely to gain much more than it loses from a reduction in corporate tax rates. This may change in the future though, if new technologies make businesses more capital intensive and reduce employee income shares.
This offshore manufacturing was clearly going to transform those medium-income developing countries that took it up, such as Hong Kong, Singapore, Taiwan, Thailand and Korea as well as Malaysia. It would transform the world economy as well as the economies of those countries in which manufacturing previously took place when countries such as China and India (who between them make up nearly two-fifths of the world’s population) emulated them.
What we saw starting to happen in Malaysia and Hong Kong, and also in Taiwan, Korea, Thailand and especially Singapore, was an important economic theme of the 1970s and 1980s, though because these economies were still relatively small as a share of the world economy, the impact on the global economy was muted.
These Asian countries plus Taiwan accounted for 3.2% of the world economy in 1870 and were about the same percentage, 3.3%, in 1970. Their share rose to a peak of 8.0% in 1997 before the Asian currency crisis.20 The rise was very rapid, but despite this the net impact on the scale of the world economy was limited.
Let me digress for a short time just to deal with Japan. Japan was the first East Asian economy to industrialise. This started after the Meiji restoration in 1868 and led to a process that finally saw Japan catch up with the Western economies. Japan’s standard of living doubled between 1870 and the First World War, doubled again by 1939, and after a major slump during the war – much more than in most of the other belligerent countries – had recovered its pre-war level by 1956 and caught up with Western Europe by 1973.
Japan is an outlier. It was the only Asian economy to industrialise so early. Although it had scale, with a population which reached 100 million in 1967, and its industrialisation was distinctly faster than in Western Europe, nevertheless its total impact on the world economy was still relatively minor because it represented just one country. Japan’s share of world GDP rose from 2.3% in 1870 to 8.7% at its peak in 1991, which is non-trivial but still not enough to mark a qualitative shift in things such as world demand for resources.
There are two other reasons (that is, other than the Second World War war) why Japan has been less disruptive: first, the speed of industrialisation – though rapid – has been about half that of East Asia and China. The second is that after the Second World War the US had the power to influence Japanese economic policy and the Japanese have been forced to allow the yen to appreciate to reflect its competitiveness. Thus the super-competitive conditions that we have seen elsewhere existed for only a short period before the appreciation of the yen changed the position.
But Japan has been important in the story. It proved conclusively to any racist who believed that only white people could industrialise that this was emphatically not the case. And of course, Japan’s actions in the Second World War, though ultimately self-defeating, spelt the end of the Western, especially British, empires in the East. My once fellow Gresham Professor, Sir Richard Evans,21 has written eloquently about this.22
The examples of the emerging economies in East Asia as well as that of Japan were bound to affect other Eastern economies. With Taiwan and Hong Kong on their doorstep, the Chinese in China would have had to be immensely obtuse or blinded by ideology not to realise that Chinese people everywhere other than mainland China seemed to be doing remarkably well while those in China were not. And once Chairman Mao had died, the new Chinese leadership was not obtuse or blinded by ideology. From the mid-1970s onwards they decided to copy what was being done in the economies on their doorstep.
In the 1960s President Johnson used to defend the actions of the US in Vietnam by talking about what he called the Domino Theory – that if one country fell to communism it would knock over its neighbour country. In the end, what happened was the Domino Theory in reverse. The economic success of East Asia changed China, which was one of the factors leading to President Gorbachev wanting to reform Russia and which over time was one of the factors that led to the fall of the Iron Curtain. I remember once explaining to Lee Kuan Yew, the eminent Singaporean leader, that he had caused the fall of the Iron Curtain – he was amused by the idea, though he seemed less amused when I explained that the previous time I had visited Singapore as a rebellious teenager in transit to Kuala Lumpur I had been kept in preventative detention at the airport because my hair was too long.
And of course we are not just talking about these economies alone. Latin America saw which way the wind was blowing and changed course. More importantly, other emerging economies, of which the most important was India, also began to change.
A coincidental factor that was hugely important in all this was the emergence of information and communications technology. The new electronic technologies created a mass demand for cheap mass-produced electronic components and products which have been the main driving technology for East Asian economic development. They have also reduced the tyranny of location and allowed businesses throughout the world to enter into the software industry. This has been especially important for India, since it allowed Indian software exports to escape the so-called Permit Raj that had – very much with the help of the professors of economic development – done so much to slow down India’s emergence from the economic doldrums.
The effects of globalisation have been to remove the Western world’s dominance of the production of economically sophisticated goods. This in turn has meant that ordinary workers in the Western world have lost their jobs or been forced to accept a squeeze in their living standards. Note that this does not mean that had the West put up protectionist barriers to this trade they could have avoided this squeeze. The squeeze has also resulted from changed terms of trade. Protection would not have helped the West improve its terms of trade by much and would have come at a cost in lost economic growth which would also have weakened the position of the worst off in the Western world.
It is argued elsewhere in this book that we may now be moving to a point where globalisation no longer increases inequality even in the Western economies. If this is so it will be because the Eastern economies compete with the more skilled jobs in the West just as aggressively as they previously competed with the less skilled jobs.
Type 3 Inequality
Type 3 Inequality is the growth in inequality that comes from changes in technology. Technically this results from what the experts call ‘skills-biased technical progress’, suggesting that technical progress is resulting in the substitution of machines and software for unskilled labour, while creating increased opportunities for skilled labour.
There is no a priori reason why technology should be labour substituting – it could easily go the other way, as Anthony Atkinson points out. But in recent years, since the 1960s, information technology has been the most pervasive source of economic advance and has been largely substituting for labour. One possible reason why technology has tended to be labour substituting is that in much of the world the main taxation base is labour incomes through payroll taxes, social contributions and income taxes.
The historic evidence on the extent of skills-biased technical progress is mixed23 but seems to suggest that technology on its own has not yet been the major driving force behind growth in inequality. However, Sir Anthony Atkinson, who specialised in the subject, believed that this was about to become much more important. From my background as chief economist for IBM UK, from being on the board of Marconi plc and from writing The Flat White Economy, I suspect he may be right.
The IMF economists Mai Dao, Mitali Das, Zsoka Koczan and Weicheng Lian, who have tried to explain what is happening, have suggested that it is not so much technology on its own but the interaction between technology and globalisation that has been particularly important.24 This seems plausible to me.
There are some examples of information technology reducing inequality. To give an example from my own field, it used to be possible for only major banks and other large institutions with access to huge and expensive mainframe computers to produce economic forecasts. Now a competent economist with access to a £300 desktop computer can do so. In the late 1980s the top economists in the City earned close to £1 million a year. Today there are many more economists employed but few earn as much as £250,000 (although of course other factors have been at work as well as technology).
In general, however, the technological divide has boosted inequality. First, communications technology has permitted the best to sell their services many times over rather than be limited to those whom they could easily reach physically. Second, the powerful tools permitted by technology can do much more to boost the incomes of those with the greatest skill in using them. For example, at some point the most sophisticated piece of capital equipment was a spade. No matter how good you were with a spade there was a physical limit to what you could do compared with an average wielder of a similar spade. But think of a modern IT system. A sophisticated user can find highly profitable arbitrage opportunities for derivatives trading yielding returns many million times more than those available to someone who can only use the system for word processing.
The impact of technology is about to face a further leap forward with advances in robotics and autonomous vehicles and a wide range of other technologies. A major study across 29 countries by the consultants Price Waterhouse Cooper has suggested that by the mid-2030s about 30% of current jobs are likely to be automated and 44% of unskilled jobs.25 Because of the pace at which this is likely to happen, it is probable that the labour markets in many countries will not adjust and that many may lose their jobs before others emerge. Obviously new jobs will emerge eventually unless prevented by social security benefit levels and minimum wage laws. But there may be an extremely painful period in between while the current jobs are being automated.
Type 4 Inequality
The rise in Type 4 Inequality emerges from an increasing influence from parenting and genetic inheritance, creating so-called ‘superbabies’ and their corollary in the lower socioeconomic classes. It is not patronising to point out that many mothers (often single) from lower socioeconomic groups achieve results that are close to miraculous in supporting their families and bringing up children at the same time. Yet these children are unlikely to have the advantages of those from more privileged backgrounds.
One cause of the increase in these so-called ‘superbabies’ is homogamy – the tendency for people to mate with similar people. It is not just that people like people who are like them, though there is evidence going back to 1943 that this seems to be the case.26 Rather it is the fact that this is combined with the tendency for people to mate with those whom they meet when they first leave home – in many cases when they go to the same university. This is discussed in much more detail in Chapter 8. But an unfortunate consequence is that the inequality that it perpetuates can become a real threat to social cohesion and can be difficult to counter. The data suggests not just that people tend to partner with others at the same university but even from the same course.
On top of this, and even more frightening in some ways, are the potential effects of genetic manipulation and modification on inequality. There is quite a good review article in Forbes magazine on this.27 Fortunately both taboos on human genetic manipulation and the difficulties of experimentation mean that this is still some way into the future.
But even without genetic manipulation the tendency for homogamy combined with the experience of co-education at university seems likely to be a disruptive social force that unless countered will entrench the position of the privileged.
What this chapter shows is that there are some quite different driving forces behind high and rising inequality and that different periods in history are likely to be associated with different factors pushing changes in the level of equality. The key is not to be blinded by ideology and to understand what is actually happening at any time. This is necessary to achieve the best mix of responses that can reduce inequality most without jeopardising the levels of economic activity necessary to provide prosperity.