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This guest commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics

Two Tales of Income Inequality - White House economist cartoon 10.14.2016

There were two presentations on economic inequality by two Nobel Prize winning economists at the 2017 National Association of Business Economists Economic Policy Conference. The two tales couldn’t have been more different.

Joseph Stiglitz, Professor of Economics at Columbia University, noted that the idea of “free trade” paid too little attention to the redistributive effects of trade. He suggested that was perhaps because economists were following the dictum of another Nobel Prize winning economist, Robert Lucas, that “nothing is as ‘poisonous’ to the sound of economics as focusing on income inequality.”

Confusing politics with economics, Stiglitz went on to note (correctly) that there are no “free trade” agreements. Trade agreements are hammered out by governments with the aid of considerable lobbying by special interests. Consequently, there are always winners and losers. But who wins and who loses is often determined more by politics than economics—economics doesn’t create barriers to competition, politics does.

The other tale of inequality was made by Sir Angus Deaton, Senior Fellow at the Woodrow Wilson School, Princeton University. Deaton had no problem with inequality due to someone being more productive, more talented, or developing a product that was in high demand. However, he was concerned about inequality due to rent seekers—individuals or firms who get special favors from the government to increase their income and wealth. He gave two noteworthy examples: “bankers during the financial crisis and much of the health care industry today.”

Two Tales of Income Inequality - thornton callout image

I would add the U.S. tax code, much of which is written to favor special interests. Deaton pointed out that rent-seeking slows economic growth and reduces output because resources are used for rent seeking rather than production. Deaton’s speech, here, is well worth the 30 minutes it takes to watch it.

inequality is due to Politics, not Economics

Both economists get to the right answer—inequality of the sort that society should be concerned about is due to politics, that is, rent seeking. However, Stiglitz confuses rent-seeking—a political activity—with economics. Deaton does not. Deaton recognizes, as does Robert Lucas, that economics has nothing to say about income or wealth inequality beyond the fact that as long as there are differences in talent, intellect, motivation, skill, physical ability, so on and so forth, income and wealth inequality will exist.

Stiglitz made another statement that is difficult to square with economics. Challenging the economic theory of David Ricardo on the benefits from trade, he said that some time ago he reasoned that “if exports create jobs, imports must destroy jobs.”

Ricardo’s theory of comparative advantage shows that if people or countries that specialize in things that they do best (the things they are the most productive at doing) and trade with each other, total output goes up. Everyone wins. There is more and better employment. Ricardo’s economic reasoning is impeccable. But, of course, he was thinking about trade governed by economics, not by politics. So again, Stiglitz confuses politics with economics.

Such thinking is dangerous because it leads people to favor the wrong solution, more political interference, more laws and more regulations created in an effort to offset the negative effects of previously enacted laws and regulations. Societies need laws and regulations that are driven by economics and a level playing field, not laws that are made to benefit special interests, many of whom are rich and/or well-connected politically.

I venture to add that most of the income and wealth inequality we see in the United States and elsewhere in the world is due to politics, not economics. Politics increases the income and wealth, not to mention power, of many beyond what economics would dictate. Hence, it increases the disparity between the “rich” and the “poor” beyond what would be otherwise.

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.