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Arrow to the Heart of Inequality

December 1, 2011 at 10:56 AM

Our series of posts this week describing trends in income inequality has prompted a natural question: what has caused the sharp rise in inequality over the past three decades or so?

The causes are complex and not fully understood, but via Mark Thoma, a good place to start is a new essay by Nobel Prize-winning economist Kenneth Arrow.

Arrow acknowledges the standard economic explanations, based on the impact of technological advances and globalization:

Skilled industrial jobs have disappeared, while growing information services require a different set of skills. This shift has undoubtedly been augmented by globalization, which has resulted in considerable imports of manufactured goods. The weakening of unions is in good measure attributable to the relative decline in manufacturing, where unionization is easier.

He also points to the "steady attack on the use of the tax system as a means of equalizing income," citing the steep drop in the top marginal income tax rate in recent decades and the weakening of the estate tax.

In addition, Arrow notes that "Contemporaneous with the decline of manufacturing has been the increase of two service industries, finance and health. Profits from the finance sector, which historically have been about 10 percent of all profits, have risen to an extraordinary 40 percent." And while Gordon Gekko's "greed is good" mantra may well apply to the normal competitive process, which tends to raise standards of living more broadly, it does not apply to today's finance industry:

After all, the search for improvement in technology, and consequently in the general standards of living, is motivated by greed. When the market system works properly, greed is tempered by competition. Hence, most of the gains from innovation and good service cannot be retained by the providers....

But the products of the finance and health industries are individualized and complex. The consumer cannot seriously evaluate them -- a situation that economists call "asymmetric information." ... In these circumstances, greed becomes more relevant. There arises an obligation to present the relevant information as fully as possible, an obligation that has been violated in the financial industry.

The piece as a whole is well worth reading.