March 25, 2012 8:32PM

Don’t Look to Government If You Want Equality

In a not so subtle brief for taxing the rich, Washington Post business and economics columnist Steven Pearlstein looks critically today at Rep. Paul Ryan’s latest House Republican budget proposal. Addressing what he sees as “the false choice between equality and efficiency,” he starts out well enough, with the “bedrock principle of economics: Incentives matter.” In fact, he rightly quotes Ryan’s budget rationale – that “Republicans ‘don’t want to turn the social safety net into a hammock that lulls able-bodied people to live lives of dependence and complacency, that drains them of their will and incentive to make the most of their lives.’” Echoing the oft-noted aperçu that “those systems that have put liberty ahead of equality have done better by equality than those that have put equality above liberty,” Pearlstein concludes that:

In a society where incomes are made to be too equal, there is little reason to work harder or to defer current consumption in order to save and invest. There is no incentive to take the risk of launching a new enterprise or to spend hours in the lab or the garage dreaming up the next breakthrough technology. Without the prospect of earning more or getting ahead, there would be less reason for getting much beyond the most basic education and training. And it is precisely these factors – work effort, investment in human and physical capital, development of technology – that are key to determining how fast an economy grows.

So far so good. But then Pearlstein goes astray, charging that Ryan Republicans, ignoring that “society wants both fairness and economic growth,” have “not only elevated growth as the sole objective of economic policy” – thus himself ignoring Ryan’s “social safety net” – “but declared that fairness is everywhere and always a deterrent to growth.” All of which brings Pearlstein to ask “if we’ve reached the point where any additional increase in inequality results in less growth, not more?”

A fair question, in answer to which Pearlstein cites two IMF economists who’ve argued recently “that countries that experienced longer periods of strong economic growth were significantly more likely to be characterized by more equality than less.” But they also speculated that inequality

might amplify the risk of financial crises, which are often followed by long periods of slow or negative growth. It might bring about political instability, which can discourage investment. Inequality might make it harder for ordinary citizens to invest in entrepreneurial activity, or even invest in their own training and education.

And why might inequality produce those untoward results? Citing the rise in inequality over the past 20 years, accompanied by “repeated and severe financial crises,” Pearlstein offers up a mix of “explanations,” so called: households taking on too much debt as they struggled in light of nearly three decades of stagnant wages; the wealthy “misallocating” their wealth by bidding up the prices of “houses in the Hamptons” and private schools; “a dramatic slowdown in college graduation rates,” and “a decline in business startups and other measures of entrepreneurial activity.” And then he adds an “explanation” that gets closer to the heart of the matter, even as he misreads it:

Can anyone doubt the connection between rising inequality and the increasingly partisan and divisive nature of American politics, which has made it difficult, if not impossible, for government to respond quickly and intelligently to the major economic challenges facing the nation? Surely that can’t be good for growth.

Yet from that, Pearlstein draws exactly the wrong conclusion. Finding it “strange that Republicans assign such overriding importance to economic incentives for investors, executives and hedge-fund managers while remaining totally clueless about the economic incentives faced by everyone else,” he notes that “over the past 30 years, the entire increase in the nation’s income has been captured by the 10 percent of households at the top of the income scale.” We then get the clincher: “Do you think that maybe, just maybe, the lack of a pay raise for the other 90 percent might have had any impact on their productivity, their work effort, their creativity or their willingness to take risk?”

Couple that with Pearlstein’s finding that it is difficult, if not impossible, for government to respond to the economic challenges facing the nation, and it’s clear that the unstated assumption, echoing the “Occupy” refrain, is that something ought to be done about “the lack of a pay raise for the other 90 percent” – and it ought to be done by government.

But isn’t that just what brought about the financial crises of the past many years? After all, it was in the name of government seeking to reduce inequality that the Fed, Fannie, and Freddie, along with the Community Reinvestment Act, encouraged households to take on too much debt, to take just one of Pearlstein’s examples. More far-reaching still, however, like all who call on government to take measures to reduce inequality in the countless ways they do, Pearlstein seems oblivious to the fact that we’ve had a surfeit of such measures in recent years, yet they’ve only increased inequality, and for reasons economists have long understood: rich people more than poor, large corporations more than small, are all far more able to adjust to those intrusions into the workings of the market.

And so we’re back to the basic insight: If you want to reduce economic inequality, don’t shoot for it through government redistributive programs; get out of the way and let the market bring about whatever measure of equality is optimal. Few have put that point better, more than two and a half centuries ago, well before the rise of public choice economics, than the Scottish enlightenment philosopher David Hume:

Render possessions [or income] ever so equal, men's different degrees of art, care, and industry will immediately break that equality. Or if you check these virtues, you reduce society to the most extreme indigence; and instead of preventing want and beggary in a few, render it unavoidable to the whole community. The most rigorous inquisition too is requisite to watch every inequality on its first appearance; and the most severe jurisdiction, to punish and redress it. But besides, that so much authority must soon degenerate into tyranny, and be exerted with great partialities; who can possibly be possessed of it, in such a situation as is here supposed? Perfect equality of possessions, destroying all subordination, weakens extremely the authority of magistracy, and must reduce all power nearly to a level, as well as property.