Inequality: Economics, Ethics, and Policy

Adam Smith's invisible hand metaphor and the related concept of economic efficiency have dominated policy debates. We discuss why and how ethical and moral issues must also come into play.

Photo credit: hyejin kang, on iStock.com

Welcome Back to Win-Win Democracy

In this issue, we continue our previous discussion of economic inequality, where we reached three important conclusions:

1. Inequality in the United States has increased dramatically since the late 1970s and there is considerable evidence that rising inequality slows growth.

2. The common wisdom that people are paid what they are worth¹ is wrong because, in real life, markets for labor are not truly competitive: Rent-seeking and poor corporate governance help high-income people get more than they are worth; practices that weaken workers’ bargaining power cause them to get less than they are worth.

3. The trickle-down economics of the Reagan revolution have failed all but the wealthiest among us. Lower- and middle-income people are struggling as they get an ever-smaller share of an economy that is growing evermore slowly.

Our 40-year experiment in fostering inequality — expecting that giving more money to Mitt Romney’s “makers class” would grow the economy — has slowed our economic growth and slammed working-class people.

We must change. But to what? Should we try to be “fair”? If so, by whose definition of fairness? One person’s fairness is another person’s tyranny. Are there ethical principles that could guide us?

And, if we try to be fair — whatever that means — how will doing so affect the economy? Certainly, we know, for example, that redistribution to ensure full equality, where everyone has equal income and wealth, would be disastrous for the economy.

Although early economists grappled with the interplay between economics and ethics, through the 19th century and into the second half of the 20th century, the field’s mainstream focus was on developing a science of economics, with no room for the “fluffiness” of ethics. Fortunately, that’s changed and there’s now substantial thinking on the role of ethics in economics, especially as applied to public policy.

I’ve been guided in this pursuit by Professor Jonathan B. Wight’s book Ethics in Economics: An Introduction to Moral Frameworks, published in 2015 as part of the Stanford Economics and Finance imprint of Stanford University Press. Intended for undergraduates, the book is readable by those of us who are interested in but not necessarily expert in economics. I will refer to this book by the author’s initials, JBW.

In the Beginning

You likely know of Adam Smith’s invisible hand metaphor (from The Theory of Moral Sentiments (1759, as quoted in Wikipedia):

“The rich ... consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand [emphasis added] to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.”

The idea is that even if the “selfish and rapacious rich” act purely in their own interests, the invisible hand of what we now call the free market ensures that the needs of society are nevertheless met.

Smith also described what motivates ordinary economic behavior among common people (from The Wealth of Nations (1776, as quoted in JBW, p. 6):

“. . . man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. . . . It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantage.”

Modern day libertarians and free-market enthusiasts have latched on to Smith’s invisible hand metaphor to justify policies that benefit the wealthy with the expectation that those policies help the rest of us too.

Smith himself, however, understood that, as JBW put it (p. 155) “rules of cooperation are grounded in the natural instincts humans have to socialize and bond with others and are governed by emotional reactions.” It is not all just about self-interest. We also need to cooperate with each other as part of a society.

Efficiency and the Invisible Hand

If we wanted to know how well we’re doing as a society, what would we measure? Is our goal “having a chicken in every pot” (Herbert Hoover’s campaign slogan), or the most millionaires, or the fewest people in poverty, or the fewest people unemployed, or the highest average life expectancy, or what? A goal like this is called a welfare measure. (Importantly, the word “welfare” used in this context has nothing to do with government welfare programs; it simply means well-being.)

Standard economics texts study a particular welfare measure called preference satisfaction. Does an economy satisfy the preferences of the households that comprise it? Knowing what households prefer is, in general, difficult. But we could assume that preferences are expressed by the way people spend their money — if I prefer a hot dog and you prefer a salad, I use my money to buy a hot dog and you, instead, use your money to buy a salad, each of us thus expressing our preferences.

Efficiency, which we’ll see has been an influential concept in economics, considers whether, at any given time, an economy satisfies the most preferences possible given the resources available. The Pareto test asks whether there are any additional voluntary exchanges that could be made that would satisfy at least one more preference without harming anyone else’s preferences. If not, the economy is considered Pareto optimal or efficient.

Here’s an example (from JBW, Chapter 5): Sam, a college student with more time than money, arrives at the airport and takes his seat on a plane. At the same time, Sue, a high-powered attorney, discovers that she doesn’t have a seat and will miss an important meeting. If they both had that information and could communicate, Sue might offer Sam $500 for his seat and he might be happy to accept. Such a voluntary trade increases preference satisfaction for both and increases efficiency.

Indeed, the first fundamental welfare theorem says that under ideal assumptions competitive markets will always lead to an efficient (Pareto optimal) outcome.

This is, in essence, Adam Smith’s invisible hand.

Why is Efficiency Important?

Were efficiency only a theoretical concept, I wouldn’t have dragged you through it. But it has had an enormous impact in both economics and in public policy.

As the field of economics sought to establish itself as a science, governed by mathematics like other sciences, efficiency, and the many concepts that follow from it, became a cornerstone of economic theory. It was taught to all economists, many of whom advised political leaders. As JBW put it (p. 165):

“The virtue of greed was widely promulgated by some economists in the twentieth century.”

Novelist Ayn Rand, in her popular and influential books The Fountainhead and Atlas Shrugged, celebrated the idea that looking out for number one is best for society. Economic and political leaders like Fed chair Alan Greenspan and Congressman Paul Ryan shared this view.

Oliver Stone’s film, Wall Street, captures the ethos of the 1980’s with character Gordon Gekko’s mantra:

“… greed, for lack of a better word, is good. Greed is right. Greed works.”

Indeed, the term “efficiency” has great popular appeal. Who wouldn’t want our economy to be efficient? But when politicians get hold of an idea like this — an idea that has some inherent truth — they tend to ignore the details that matter in real life.

What Does Efficiency Miss?

Ideal Assumptions

The provisos inherent in the phrase “under ideal assumptions” in the statement of the first fundamental welfare theorem matter. Here are a few:

• Perfect competition (no monopolies or restraint of trade)

• Perfect information (everyone knows everything)

• No externalities (a trade doesn’t cause costs elsewhere, e.g., harmful pollution)

• No moral hazards (no party to a transaction shifts the risks of the transaction to someone else)²

Such ideal assumptions are never true in real life.

Value of Money

We also need to recognize that in this scheme preferences are expressed by economic behavior — if you have little or no money your preferences are irrelevant. So are the preferences of the yet unborn, who might, for example, want a world not beset by massive climate disruptions.

Moreover, a given amount of money impacts different people differently. A thousand dollars in the hands of a minimum-wage earner is tremendously impactful, but irrelevant to a billionaire.

Finland recognizes this in their system of fines. For some traffic infractions and certain crimes, fines are based on depriving someone of half of their daily earnings for a number of days that depends on the severity of the infraction. High earners can receive large fines in an absolute sense, which have the same impact on that individual as much smaller fines on lower earners. In 2002, for example, a Nokia executive was fined $103,000 (equivalent) for going 45 in a 30 zone.

Moral Limits to Markets

Furthermore, there are moral limits to markets. Certain transactions are repugnant in any given culture: In today’s US culture, for example, we reject the sale of human beings, votes, body parts, sex, grades, national security secrets, military hardware to enemies, and more. We reject transactions based on racial, religious, gender, and ethnic discrimination.

What’s considered moral and legal changes over time. At other times we’ve accepted some of the transactions now rejected, and rejected other transactions (e.g., the sale of alcohol) now permitted. Debate about what is acceptable is ongoing — should we permit the sale, for example, of recreational drugs or sex?

On the other hand, both our culture and human nature encourages certain transactions that are inefficient. Many of us donate to food banks, medical research, educational institutions, religious institutions, etc., in the hope of improving society or helping others less fortunate.

Bottom Line

To be clear, I’m not arguing that preference satisfaction and efficiency — or the invisible hand — are useless or irrelevant concepts, just that we need to be aware of the whole story when they are used to justify policy choices.

Economic Justice and Fairness

To appreciate how challenging it is to even define economic justice in a broad sense, take a look at the Wikipedia page on that topic. I’m not going to step into that quicksand.

Instead, following JBW, let’s talk about two notions of fairness:

• Fair process (also called procedural justice): the rules of the economic game are unbiased, favoring neither rich nor poor, well-connected or not. The government’s role is to maintain the unbiased rules, preventing, for example, practices that allow the rich to exploit the poor through monopolistic practices.

• Fair outcome (also called distributive justice): the outcome of the economic game is adjusted by redistribution to ensure desired outcomes. A society might, for example, want to ensure that all children are well-fed and educated, that health care is available to everyone, and that everyone can live in a safe place.

Most societies employ a mix of fair process and fair outcome. In the US, for example, both liberals and conservatives claim that they support evenhanded rules as essential to a strong economy and most agree that some redistribution is necessary to support the common defense and education of all children. (Unfortunately, actions often don’t follow words.)

Proponents of active government argue for a combination of fair process and fair outcome to provide both a level playing field and to ensure opportunities for people who are not, on their own, favored by good outcomes from the economic game. Unfortunately, politicians and government bureaucrats may make decisions that reduce the economy’s efficiency or have other unintended consequences.

Proponents of limited government argue for fair process and count on the invisible hand to manage distribution. Unfortunately, wanting to limit government often means wanting to limit the very laws and regulations needed to ensure fair process.

Indeed, the neoclassical economics of the twentieth century, to which many political leaders of both parties subscribed, emphasized that efficient outcomes are also fair outcomes and that workers would be paid what they’re worth. But as we’ve already seen, even if this were theoretically possible, our economic system is not a level playing field, with the rules controlled by people with both economic and political power for their own benefit.

Capabilities and Freedom

Nobel laureate in economics Amartya Sen and philosopher Martha Nussbaum introduced a new way of thinking about the economics and morality of welfare (again, in the economics sense of the word, not government programs), which is described in JBW Chapter 11.

Functioning refers to what persons actually do and experience; a capability is the ability to achieve a certain level of functioning. For example, the ability to read is a capability, but a person may or may not choose to actually read. But having the capability to read is an economic necessity in most societies.

Policies related to distribution should focus on capabilities not functioning. What a person chooses to do with a capability is a personal choice and each person should have the freedom to function as they choose within the capabilities they have.

Nussbaum has applied this approach to analyzing gender inequality around the world: in many societies women are denied the ability to acquire capabilities ranging from physical attributes related to nourishment, to education, freedom from violence and sexual abuse, etc.

The capabilities approach has formed the basis of the United Nations’ human development index, which is now used instead of GDP per capita as a measure of economic progress. Some countries have a high GDP per capita but a low human development index, indicating that resources are not distributed to provide a high level of capabilities to the broad population.

Freedom comes not solely from lack of government intervention in one’s life choices, but also from being given the equal opportunity afforded by the capabilities that are central to being able to function well in the economy in which one lives. Without nourishment, shelter, health, safety, and education, one doesn’t have the capabilities needed to compete for economic gain.

The classical economic notion of efficiency is not sufficient. People must be given the opportunities to achieve the necessary capabilities.

Economic Pluralism

We’ve talked about several approaches to understanding the interplay among economics, ethics, and public policy:

1. Preferences, efficiency and Adam Smith’s invisible hand metaphor

2. Values and beliefs affect the way that people behave in economic systems. Greed is good doesn’t comport with the ethics many of us have been taught.

3. Assumptions, both explicit and hidden, that imply that the results of efficiency theory don’t fully apply to real life economic systems

4. Fair process vs. fair outcome approaches to economic justice

5. Sen and Nussbaum’s capabilities and functions approach to understanding economic freedom

For many decades, the invisible hand metaphor, as expressed in the preferences and efficiency theories of classical economics has driven the policy discussion. We’ve seen why this is not appropriate. So, what do we do?

We recognize that no single economic theory completely and accurately describes how people, as economic actors, behave, nor predicts the outcomes of such behaviors. Instead of using efficiency theory as the indicator of welfare, we use it as an indicator. Instead of saying that the path to freedom is to let the invisible hand do its work, we recognize that societies and individuals benefit from considering fairness (both approaches) and assuring that people can acquire the capabilities that give them the freedom to participate fully in a competitive economy. This is pluralism in economics, recognizing that multiple approaches need to be brought into policy discussions.

What Next?

In the next newsletter issue, I will begin discussing win-win approaches to addressing inequality, using the discussion in this issue as context.

1. This is called the marginal revenue productivity theory of wages in economics.

2. Moral hazard was a major cause of the 2008 recession, as lenders who gave mortgages to unqualified borrows shifted the risk of those loans to other parties.