Inequality and the FaceBook IPO

A major event in the financial markets last month was the initial public offering of FaceBook (ticker symbol FB).  Despite the subsequent decline in price, the financial press reported that this IPO “instantly” created many new millionaires and billionaires.  By doing so, the IPO has worsened economic inequality in the U.S.  This is because inequality is measured either as the share of total income or wealth owned by the top 1% (or .1%) or by the ratio of the income or wealth share of the top part of the distribution over that of the bottom part of the distribution.  Is society as a whole worse off for an increase in the number of rich people? 

If you haven’t seen them, the TED talks are worth looking into.  There are now 1100 free talks available on diverse topics, with great speakers and terrific graphics.  Recently my son recommended a TED talk on by famed academic Richard Wilkinson on the topic “How economic inequalityharms societies”

http://www.ted.com/talks/richard_wilkinson.html

Professor Wilkinson has collected data across countries and across states in the U.S. on average income per capita, income inequality (measured as the ratio of the share of aggregate income earned by the top ten percent of income earners to the share of income earned by the bottom ten percent of income earners), and a variety of indicators of social welfare including life expectancy, infant mortality, obesity, drug addiction, alcoholism, depression, suicide rate, etc.  Many of these indicators are captured in one index of well-being called the Quality of Life Indicator (or QLI). 

The professor then uses this data to show two types of comparisons.  First, he shows the relationship between average income and QLI.  Up to a point, as average income rises QLI rises as well.  However, once a society reaches a certain level of affluence (roughly equal to Uruguay, and well below the current level of affluence in the U.S.), there is no further improvement in QLI as a country gets richer.  The second comparison shown is the relationship between income inequality and QLI.  Here the professor focuses on the 30 richest countries and finds a very strong negative relationship:  the higher the inequality, the lower the quality of life.  Since the relationship appears so strong, and holds for most of the quality of life indicators individually as well as in the aggregate, it naturally raises the question of what factors are driving inequality and QLI.

Professor Wilkinson concludes that the reason for the strong relationship is simply that income inequality causes social problems (and lower QLI).  His story is that peoples’ satisfaction levels are driven primarily by their relative status.  So, in a highly unequal society, there are many people who suffer from extreme dis-satisfaction because people at the top of the income distribution have so much more than they do.  This causes stress which leads to poor health and causes people to turn to drugs or alcohol or crime.  Many people go deeply into debt in order to attempt to maintain high consumption levels.  Naturally, this causes more stress.

Of course, this is not the only possible story. If two variables X and Y are highly correlated (in this case income inequality and QLI), it could be that X causes Y, or it could be that Y causes X, or there could be one or more third variables Z that cause both X and Y.  My take on the professor’s data is that there must be some commonality among the various factors that cause income inequality and QLI.  One possibility that leaps out is that the proportion of children that are born out of wedlock could be one of these Z factors that causes both income inequality and low QLI.  Then the next question would be what causes out of wedlock births.

Professor Wilkinson does not believe you need to introduce third variables; to him the data tell a dramatic story of inequality causing social problems.  And given that explanation, he concludes that any policy that succeeded in reducing income inequality would necessarily improve the quality of life.  Broadly, there are two ways to reduce reported inequality.  First, you can attempt to raise the level of income or wealth at the bottom of the distribution.  Second, you can attempt to limit or reduce the income or wealth at the top of the distribution.  It appears that Professor Wilkinson would support both approaches.

I would prefer to focus on ways to raise income or wealth at the bottom of the distribution.  Here there are some policy levers that could both reduce inequality and increase social welfare.  A good example is improved pre-kindergarten and K-12 educational environments for underprivileged children.  Professor Wilkinson would probably agree with this example, but would go much farther and support any proposal aimed at reducing measured income inequality, such as confiscatory taxes on the wealthy.  A major problem that I see with such a proposal is that it is possible, even likely, that very high rates of taxation would reduce economic growth and job opportunities for everyone.  Professor Wilkinson does not appear to be worried about this.  After all, his data suggest that quality of life does not rise with wealth, so continued economic growth for the rich countries is not all that important.  Further, given concerns over the potentially adverse effects of manmade global warming, the professor seems to believe that slowdown or even elimination of economic growth (in the rich countries) is desirable. 

By contrast, I think that economic growth is the answer, not the problem.  Not only does growth provide greater opportunity for the poor, it also builds capabilities for dealing with various problems including adverse effects of global warming, should they appear.  We should be pleased about the financial success of the founders and investors in FB, even if measured inequality goes up.

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