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The Income Inequality Hoax

Mises Daily: Friday, March 10, 2000 by

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A pestilence stalks the land. It threatens to undo the current economic expansion. It may undo any social good that has been accomplished this past decade and may even result in blood in the streets.

What is this unspeakable horror, this evil genie that, if fully unleashed, could mean the downfall of us all? What is this scourge that causes increases in heart disease, cancer, depression, and even asthma, according to the "experts?" According to some economists, this unfolding tragedy is...income equality.

Since income equality has never existed at any time in any society, on the surface one seems hard-pressed to come up with an economically sound reason for someone to use such apocalyptic language. As usual in this business, there must be some other reason as to why so many journalists and economists are beating the equality drums again.

Before going farther, we must define income inequality. Statisticians like to divide people in this country into five categories, or quintiles, according to income. They take the average and median incomes from each quintile and then compare them with each other.

For example, the average income of the people in the bottom fifth might be $12,000, and the average income of those in the next quintile $20,000. The $8,000 is the income gap. Demographers claim that during the last 10 years, the average incomes of those in the top quintile have grown more than the incomes of those in the lowest group. So even though absolute incomes have grown in both groups, the fact that the income spread between them has become greater becomes the cause for alarm.

The issue behind this differential is explained in this simple example. Jones makes $10,000 a year, while Smith earns $20,000. Assuming no inflation, a year later Jones is earning $15,000 and Smith makes $30,000.

It is clear that both Jones and Smith are better off than they had been before, although in absolute terms Smith has earned a greater increase in income than has Jones. According to the "inequality" economists, only Smith is better off. In fact, according to their logic, Jones is actually worse off after he has increased his income because the income spread between Smith and him has grown. No matter that both men are better off. Economists have declared, instead, that inequality has become greater.

This may seem impressive to statisticians and welfare-minded politicians, but, in truth, economists do not own the analytical tools that allow them to declare the change in the "inequality gap" has made Jones relatively worse off. To do so would involve what economists call interpersonal utility comparisons. Economic analysis simply does not permit one to perform such analysis, as Murray Rothbard pointed out in Man, Economy, and State. Therefore, even in its inception, this fetish regarding income differences is bogus.

Nevertheless, we next need to explain how the arguments about inequality are being presented. According to a recent U.S. News article, the news of the alleged growing income gap is "deeply troubling." "The country's social and political fabric could be damaged, some economists and others fear, if the new wealthy are perceived as being more isolated, if resentment builds, and if the have-nots increasingly shun the political system."

The writer, James Lardner, then goes to the heart of the matter, declaring, "And there are more-pragmatic concerns: if too few Americans are taking part in the boom, who is going to keep buying all that stuff at Wal-Mart or Amazon.com? After all, consumer spending represents roughly two thirds of the nation's economy." In other words, it all comes down to aggregate demand. If "too much" income goes to the rich, they won't spend it quickly enough or, worse, they may actually save their money (read that, stuff it in their mattresses), and the fall in spending will ultimately lead to recession.

But wait, there's more. Lardner declares that "a spirit of egalitarianism was part of what set this nation apart in its early years." He appeals to Alexis de Tocqueville's 1831 description of America as a place with a "general equality of position among the people."

This last statement is important, as Lardner unwittingly confuses the abolition of the rigid Old World class structure with a non-existent abolishment of income differentials between Americans. The former has been a staple of this country since its beginnings, while the latter has never existed.

The "inequality" economists make their second mistake by appealing to aggregate demand, demonstrating that a certain segment of this unfortunate profession still has not progressed beyond Mandeville's Fable of the Bees. Fable was a 17th Century poem in which the author insisted that what seemed to be private virtues (saving and investing) were really harmful public vices. Three hundred years after Fable, John Maynard Keynes took the same ideas out of poetry and tried to convert them to a crude form of mathematics and logic. Mandeville, wrong as he was, actually made more sense.

Without going into a lengthy explanation of Say's Law, suffice it to say that one of the central themes of aggregate demand "theory" (we hesitate to apply such an august word to this proposition) is that production and consumption are two distinct and unrelated entities. There is a grain of truth to this idea, as the mere production of something does not guarantee its sale in the marketplace. However, as J.B. Say pointed out in 1803, the ability to consume is directly derived from what one produces, as one's income is dependent upon the productive services he or she provides the rest of society.

The only way for such a condition to change even marginally is for government to violently intervene into economic affairs, and even those actions do not change the underlying truth of Say's Law. As Rothbard has pointed out, consumption and production cannot be separated in an economic system.

Throughout modern history, governments have attempted to spur "aggregate demand" by creating and distributing new money in hopes that people will quickly spend it. As Ludwig von Mises and Rothbard successfully noted, artificial credit expansion by government is always inflationary and distorts the economy's structure of production, ultimately leading to the booms and busts of the business cycle.

Another government intervention scheme to promote income "equality" is the progressive income tax. While in reality this is nothing more than a naked attempt by the parasitical political classes to seize the wealth of productive citizens, some economists promote progressive taxation as an "automatic stabilizer." According to these economists, the government will wisely spend the money that the taxpayer would have foolishly saved (stuffed in his ever-present mattress).

In reality, the idea of calling the confiscation of someone's paycheck to spend on political schemes something that "stabilizes" the economy is terminology only politicians and Keynesian economists could love.

Part of the damage Keynesians have inflicted upon economic thinking is promotion of the mistaken belief that production simply occurs automatically. There is no human element to an economy that is measured by aggregates. Thus, if production cannot be linked to the actions of each individual, then productivity has no relation to individual income. The result, according to modern macro theorists, is that income is just randomly distributed.

In fact, according to the Keynesians, capitalist economies not only distributes income unfairly, but also over time the mechanics of capitalism skew income toward the rich and away from others. In other words, to paraphrase Lardner, the rich get richer and the poor get poorer. The only thing that can keep such a tragedy from occurring is the wisdom of the state.

When one examines economics from a praxeological or human action viewpoint, however, a different picture emerges, as has been demonstrated by the Austrian School of Economics for more than a century. Income is not something that just randomly flows into an economy. It is the result of individuals providing productive services that are purchased in a marketplace.

The truth of this statement is self-evident. In the absence of coercion--the hallmark of a free market economy--income is either earned or given to someone in form of charity or a gift. (The source of that charity or gift is someone else's productivity.) An individual who earns income has received it from someone else in exchange for a product or service that the first person has provided.

Of course, even "inequality" economists recognize the relationship between income and occupation. Thus, they insist that patterns established by capitalism will push more and more people into menial, low-productivity jobs while creating a class of highly productive and highly paid citizens.

It is the old Keynesian argument with a different twist. Economists Robert Frank and Philip Cook even have a published theory that blames the personal computer for what they believe to be growing income inequality. According to Frank and Cook, as firms can expand their operations beyond their respective region because of the internet and other forms of telecommunications, they increase competition. The new emphasis upon technology, they say, "brings dramatically increased economic power to an elite of managers, professionals, and deal makers." This action, they say, increases market share for some and pushes others into poverty.

Some clear interpretation of their theory is in order here. What they are saying is that advances in computer technology allow for information to pass more quickly between sources and that some individuals are able to sell their products and services to a wider market than before these technologies came on line. Thus, by creating more competition, they actually create monopoly. The less-competitive, more rigid structure is replaced by a more competitive--and even more rigid--structure. These last two thoughts do not fit together, but that is what these economists are asking us to believe.

Again, we see the "fallacy of the bees." In reality, this new and more productive economy has permitted low-skilled workers opportunities they never had before. News reports of lawyers quitting their jobs to become window washers or cocktail waitresses do not occur in a vacuum. As productivity increases, demand for once-mundane jobs is growing.

Take the current wave of immigration into the United States. While there are obvious problems that accompany such large migrations of people,few will argue that the vast majority of these relatively unskilled workers have found jobs and a decent standard of living in this country. If Frank and Cook, along with the Keynesians, were correct, unskilled workers would have no incentives to come here for jobs, as what jobs would be available would be so low-paying as not to be attractive.

Finally, as Thomas Sowell has pointed out on many occasions, these so-called income categories are not rigid. We do not have a fixed caste system in this country, and a free market economy allows people to move up and down the income ladder. According to Sowell, numerous studies have pointed out that few people stay in one income category very long, including poor people. In other words, the infamous "cycle of poverty" is another myth propagated upon us by the political classes.

If there are dark economic clouds on the horizon, they have been placed there by the state. Violent government intervention into peaceful exchange and production can never result in production of more wealth. Instead, government creates winners and losers and changes the system of incentives. Where once people had to be inventive and creative in order to create products that others wished to purchase, now they must pay off their respective politician who will then attempt to change the structure of property rights in order to transfer wealth from productive to non-productive people. Read the Microsoft antitrust files for the latest example of this outrage.

Then there is the Federal Reserve System, which inflates the currency and creates its own set of winners and losers. Of course, as the Austrian Economists have demonstrated, an economic boom fed by currency expansion cannot sustain itself for long, and when the inevitable bust occurs, many economic opportunities are lost.

As Ludwig von Mises and Murray Rothbard, along with other Austrian Economists, have pointed out, methodology matters. The praxeological method recognizes the importance of individual productivity and the role of peaceful exchange. Modern neoclassical economics, on the other hand, has embraced something that is unworkable and makes no sense when examined carefully. Thus, when neoclassicals declare that capitalism is causing inequality and sowing the seeds of its own destruction, remember that such talk truly belongs in the marxian dustbin of history.

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William Anderson, an adjunct scholar of the Mises Institute, teaches economics at North Greenville College. Send him mail