Inequality: reframing the debate, reforming institutions and rooting out rent-seeking

Marilyne Tolle.

Inequality sits near the top of Western politicians’ agendas and exercises the minds of academic economists and policymakers alike. While attention to the living standards of the poorest is warranted, I argue that the current focus on inequality is misplaced for two reasons: first, because inequality of outcome is of second-order economic importance compared to improving absolute living standards; and second, because it shifts attention away from tackling the inefficiencies caused by rent-seeking. Addressing these via institutional reforms would foster growth, raise the living standards of the poorest, and, as a by-product, reduce inequality.

Relative vs absolute poverty

Economic inequality is simply ‘relative poverty’, a cross-section concept that measures the distribution of wealth or income at a given point in time. It’s not obvious why this aspect of poverty should take precedence over ‘absolute poverty’, a time-series concept that tracks poverty through time and captures the evolution of living standards.

At the heart of rising living standards is growth, in particular technological innovation, which allows novel and more efficient combinations of factor inputs to increase the productive capacity of an economy. In the short run, technological progress tends to be associated with ‘technological unemployment’, by favouring skilled over unskilled labour. “But this is only a temporary phase of maladjustment. All this means in the long run is that mankind is solving its economic problem”, as Keynes notes in Economic Possibilities for Our Grandchildren (1930). Few people today would lament the demise of blacksmiths in the early 20th century.

Reflecting on ‘absolute poverty’ helps to put ‘relative poverty’ into perspective. We in the West forget how much wealthier we are compared to our (great-)grandparents. Where in the UK today does one see entire city blocks with a single loo as could be the case in the 1920s? Who anymore digs coal from the ground by hand by candlelight? George Orwell’s The Road to Wigan Pier (1937) is a sobering read.

Reframing the debate

The debate on inequality has essentially focused on pitting factors of production against each other: capital against labour (Piketty, 2013); skilled workers against unskilled workers, reflecting skill-biased technological change (e.g. IMF Staff Discussion Note, 2015).

A hidden premise is that the creation of ‘winners’ (capital owners, skilled labour) and ‘losers’ (unskilled labour) is part and parcel of economic progress and capitalism, and the market forces that underpin them. A call for more government redistribution from the ‘winners’ to the ‘losers’ is a direct corollary to this.

While such a framing of the inequality debate is intellectually sound, it strikes me that by appealing to secular economic forces (capital accumulation, globalisation, demographic and technological change), it largely eschews the role of institutions – the ‘rules of the game’ or what Douglass North calls “humanly devised constraints that structure political, economic and social interaction” (Institutions (1991)). In particular, discussion of the role played by the institutions (both formal and informal) that give rise to and support rent-seeking – the appropriation of wealth by certain groups (the rent-seekers) via non-competitive mechanisms – has been peripheral in the inequality debate.

The role of institutions and the incentives they create

Rent-seeking occurs when institutions warp incentives and distort the market, curtailing competition’s role as a disciplining device and allowing the (legal) appropriation of wealth via non-market forces. By distorting the allocation of resources to the benefit of some, rent-seeking not only fosters inequality, it also stifles growth.

As Joseph Stiglitz notes in his book The Price of Inequality (2012), “[r]ent seeking takes many forms: hidden and open transfers and subsidies from the government, laws that make the marketplace less competitive, [and] lax enforcement of existing competition laws (…)”.

A telling example is provided by two-tier European labour markets, where the rent-seekers or ‘insiders’ (typically lifelong employees) enjoy strong job protection with advantageous benefits, while the ‘outsiders’ (the unemployed, the young) tend to get precarious, low-paid interim contracts. It’s hard to think of a more unequal system. Yet that inequality is not the root cause, it’s a by-product of uncompetitive labour-market legislation (formal institution) that makes hiring excessively costly and prevents companies from adjusting to changing conditions.

In the financial services industry, perhaps the single most important institution that shaped the rent-seeking behaviour of systemically important bankers and financiers was the implicit taxpayer guarantee provided by the government. As explained in a recent Financial Stability Paper (2012), by creating ex-ante expectations of taxpayer bailouts, this implicit guarantee created two distortions. First, by lowering banks’ funding costs, it granted them an unwarranted competitive advantage in the form of an implicit funding subsidy, allowing them to appropriate more resources than commensurate with their risk profiles. Second, the implicit guarantee encouraged moral hazard, increasing banks’ incentives to take risk for ever greater financial gain. But the large profits didn’t amount to wealth creation. Rather, the excessive risk-taking, combined with risk-offloading (securitisation) and risk-underestimation by the credit-rating agencies, sowed the seeds of the financial crisis and the attendant destruction of wealth. When big banks failed and governments stepped in, spending taxpayer money to avert a systemic collapse, the toxic combination of privatised gains and socialised losses at the heart of this model became evident. As Matthew Klein noted in a recent post, the greater risk-taking was simply a wealth transfer from taxpayers to the financial industry.

Institutional reforms are needed to create the right incentives

To discourage rent-seeking, improving codes of conduct and standards of behaviour is important – rent-seeking can permeate a country’s social norms (informal institutions) and become culturally embedded. Recent endeavours to align compensation and reward with risk-taking behaviour go in the right direction. But introducing formal rules that elicit the right incentives is even more important – one way or another, rent-seeking stems from institutional arrangements born in law and/or regulation.

This is increasingly recognised by regulators in the financial sector. The setting up of resolution regimes to manage the failure of Global Systemically Important Banks – ensuring that creditors bear the losses – is part of a necessary withdrawal of the taxpayer safety net. The exposure to loss should give a wider set of creditors the incentive to monitor banks’ risk-taking, improving market discipline. Separately, progress has been made in addressing the oligopolistic structure of the UK banking sector, with steps taken to increase competition, including by lowering barriers to entry.

Sustaining the resolve for reform, including outside the financial sector, is essential if governments are serious about tackling both ‘relative’ and ‘absolute’ poverty. Rooting out institutionalised rent-seeking in Western democracies – whatever forms it takes depending on the country – wouldn’t just reduce inequality, it would also, crucially, ensure a more efficient allocation of resources, lifting growth and living standards in its wake.

A modest proposal

In practice, a sweeping push for reform is bound to meet resistance. Rent-seeking is a feature of a myriad professions (energy providers, transport workers e.g. taxi drivers), where individuals secure oligopoly power over the supply of a good or service to reap a financial benefit. The insiders, who enlist the help of politicians by using the stick (strikes, protests) and/or the carrot (financial donations, high tax contributions), have a vested interest in preserving the status quo – why relinquish their privileges when they can buy out the outsiders with a generous welfare system, propped up by redistribution? Yet ever-increasing levels of redistribution are a mere sticking plaster because they fail to address the root problem.

So, presuming political appetite and courage, what can be done about it?

In liberal democracies, two solutions have been tried historically: confrontation à la Thatcher, which consists in breaking the insiders, and negotiation based on mutual consent, à la Shroeder (German labour market reforms). The Thatcher method proved effective but inefficient – breaking the unions was economically and socially costly. Negotiation is more efficient but might not be as effective depending on how much bargaining power the insiders wield. One notable pitfall is that the insiders might water down the reforms substantially.

There might be another solution, proposed by Jacques Delpla and Charles Wyplosz in their book The End of Privileges, Paying for Reforms (2007). It’s based on Pareto’s observation that when reforms are implemented, groups of people inevitably stand to lose out and will therefore oppose change. Their solution is to neutralise resistance by literally buying off the insiders with lump-sum compensatory transfers (e.g. down-payments to remove barriers to entry in certain services and retail trade; compensation of employees for the end of lifetime employment). That approach amounts to monetising the cost of dealing with the insiders and front-loading the expense. With a clean slate, far-reaching institutional reforms can begin.

Such a solution seems far-fetched but is not without precedent. According to Delpla and Wyplosz, ‘paying for reforms’ was successfully implemented in late 19th century Japan, when Emperor Meiji borrowed from international markets to compensate the samurais for giving up their medieval rights. Many samurais invested in industrial ventures, helping to launch Japan’s industrial revolution, which would eventually turn Japan into a world power.

Marilyne Tolle works in the Bank’s External MPC Unit

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