Let’s understand income inequality before we try and fix it

By James McCusker Herald Columnist

The political pundits, at least some of them, are telling us that income inequality is a hot issue. Maybe so, but the opinion polls indicate that it is more important to politicians than to voters.

The difference in the way politicians and voters see the issue is undoubtedly attributable to a single cause: voters have more sense. They certainly have enough sense to recognize that if income inequality is a problem, who will fix it? Will it be the ever-popular Congress, or the ever-campaigning President?

There are people who might see comedy in the idea of presidential mandates redistributing Americans’ incomes while the millionaires in Congress argue about whether it’s a good idea. And there are people who would find the idea truly frightening. In between, there is the vast majority, comprised of those who think the whole idea is proof of the damage a few loose screws can do.

The politicians could still get their way, though, and income inequality could become a campaign issue if it could be structured as a simple choice. Politics has a built-in preference for either-or choices, because they lend themselves to the fundamental political decision-making process: voting yes or no, them or us.

At its best, politics tends to simplify things by jettisoning extraneous stuff and bulldozing through complexities. At its worst, it over-simplifies things by using the same techniques.

That is the situation we face with income and wealth disparity as an “issue.” What we know about income and wealth disparity is so tiny compared with what we don’t know that the healthy American tradition of “doing something” could get us into trouble.

Most of what we know about income and wealth disparity comes from work done a century ago, which should tell us something. It began with the work of Italian economist, Wilfredo Pareto, whose research showed that 80 percent of Italy’s land was owned by 20 percent of the population. This gave birth to the “80-20 Rule” that we still use, and misuse, today, and it explained a lot about the interaction between economics and politics.

Subsequent efforts by economists were essentially efforts to wrangle with the statistics involved in measuring income. In 1905, an American graduate student in economics, Max Lorenz, devised a way to present and analyze income data. Now called the “Lorenz Curve,” it shows income as cumulative percentages; that is, the amount of income received by, say, the top 10 percent or the bottom 30 percent.

In 1912, another Italian economist, Corrado Gini, developed a way to measure income inequality. By establishing a 45-degree straight line as “perfect equality” — that is, everybody in the population has the same income — he could measure how different the actual income distribution was by calculating the area under the Lorenz curve and comparing it with the total area under the 45-degree line.

The difference between perfect equality of income and the actual distribution at any given time is called the GINI Coefficient. There are different ways to present the data, but in its basic form perfect equality (everybody’s income is the same) would have a coefficient of zero, and perfect inequality (one guy has all the bananas) would be 1.

The Gini Coefficient offers advantages such as being able to compare one country to another, or to compare changes over time. Not surprisingly, the United States has greater income inequality than developed nations with larger, tax-supported government sectors.

What is more interesting from an economic policy standpoint, though, is the historical pattern of income inequality in our country, which shows that income inequality began to grow in the 1970s and has continued to worsen ever since.

It is not surprising that the 1970s saw the origin of the problem. It was a decade that spawned a long list of problems besides bad grammar and bad haircuts. What is surprising, though, is how consistent the trend toward income inequality has been, seemingly unaffected by major changes in monetary policy, fiscal policy, tax policy, or shifts in political power.

The past few years have shown a marked increase in inequality, which probably is caused by the underlying nature of the recession and recovery. The economic policies we used to stabilize our economy after the financial crash were, naturally, focused on financial markets and financial assets. The recovery that resulted then, tended to favor those who made their incomes from financial assets. It may also have had the unintended consequence of slowing down the recovery in the “real” economy.

If we can understand that process better, it may help us to understand what has been happening to our economy since the 1970s and provide us with the wisdom to fix what needs fixing and leave the rest alone.