Inequality in America is not inevitable

Capitalism is the best economic system yet discovered for giving people the goods and services they desire at the lowest possible price, and for producing innovative economic growth. But there is a cost associated with these benefits, the boom and bust cycles inherent in capitalist systems, and those costs hit working class households — who have done nothing to deserve such a fate — very hard. Protecting innocent households from the costs of recessions is an important basis for our social insurance programs.

It is becoming more and more evident that there is another cost of capitalist systems, the inevitable rising inequality documented by Thomas Piketty in Capital in the Twenty-First Century, that our social insurance system will need to confront.

Why is rising inequality a matter that our social insurance system should address? The idea behind insurance is to spread the costs of harmful events we cannot control across a large number of people. With fire insurance, for example, participants pool their money into a large sum, and the unlucky few that experience fires draw from the pool of money to cover their losses. In the end there is a redistribution of income from the winners who escape a fire to the unfortunate who don't, but it would be wrong to view this as a net cost to the winners. The insurance premiums buy protection from fire — a benefit — and presumably the benefit exceeds the cost of the insurance.

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Many social insurance programs work in the same way. With unemployment compensation, for example, workers pool their money through monthly premiums, and those who are unlucky and become unemployed through no fault of their own are able to draw from the pot of money and partially offset their losses. Hopefully, it's enough to allow them to survive while they get back on their feet once again.

Protection against the rising inequality that comes with capitalists systems can be justified similarly. There are winners who succeed largely on luck — the wealth of their parents for example — and the unfortunate who, try as they might, are not able to achieve the same success. As former UC Berkeley economist and current chief economist at Google, Hal Varian, says, "If luck plays a substantial role in the determination of income, it makes sense to have a progressive income tax, creating a form of social insurance in which the lucky subsidize the unlucky."

There is another way to justify using social insurance to offset rising inequality. Some social insurance programs, ObamaCare, Medicare, and Social Security for example, overcome market failures that prevent the private sector from providing the insurance in sufficient quantities, or at all. In the case of Social Security for example, people know that society won't let them starve in old age, or end up in the streets with no shelter. So why bother to save for old age, especially if your income is low and those savings won't amount to much more than society will provide in any case?

The solution to this "moral hazard" problem is to force people to save for their own retirement through the Social Security system. There will still be some degree of income redistribution from the lucky to the unlucky — from richer to poorer households through the insurance part of the system — but for the most part the system exists to solve a market failure. It forces people to pay for their own retirement instead of relying upon the rest of society.

While there is most certainly a large degree of luck involved in which side of the inequality coin a particular household finds itself, there are also market failures that make the problem even worse. Monopoly, monopsony, and political power, for example, tilt the economic playing field toward the lucky and distort the flow of income in their favor. Since there is no reason to expect the private sector to solve these market failures on its own — if anything the problems would get worse if the private sector is given a free hand — there is a role for government to claw back and redirect these economic rents to less fortunate households, and to use tools such as anti-trust legislation to reduce the degree of economic power that the fortunate enjoy.

Some degree of inequality is needed to provide the incentives that make a capitalist system work, but inequality has risen far past what is needed to induce the effort that makes the system function. Would those at the very top of the income distribution — where inequality is increasing the most — really work less if they only received $250 million instead of $350 million per year for their efforts?

At some point, one I believe we've passed already, the benefits of inequality in terms of incentives are surpassed by the costs. As Joseph Stiglitz argues, "Inequality leads to lower growth and less efficiency. Lack of opportunity means that its most valuable asset — its people — is not being fully used. Many at the bottom, or even in the middle, are not living up to their potential, because the rich, needing few public services and worried that a strong government might redistribute income, use their political influence to cut taxes and curtail government spending. This leads to underinvestment in infrastructure, education, and technology, impeding the engines of growth."

Capitalism is a wonderful economic system, but it is not perfect. Government intervention is needed to soften the impact of recessions, to overcome market failures, and to offset the rising inequality that threatens capitalism's ability to serve the vast majority of households to the fullest possible extent.

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