reddytoread

Chrystia Freeland, who fairly recently parachuted into Canadian politics from a career in journalism abroad, in which she was among other roles a senior functionary of the Financial Times, has just been appointed the Minister of International Trade in the new Liberal Party Cabinet.   When her book on Plutocrats came out in 2012, I was a discussant at an event centred on the book at the Institute for Public Knowledge at NYU.  I delivered a comment on that occasion, before the Piketty deluge, for what it’s worth, which was entitled ‘Where do Plutocrats Come From?’ [1].  It was not included in the symposium that was published online followed the panel, including Robert Frank and Shamus Khan, as I was not able to make the changes requested by the editor. I have to admit that I was not overwhelmed by the book, but it was good that someone was talking about the plutocracy, if in a defanged way.  Here is my comment:

Chrystia Freeland has told us a great deal about the lives and attitudes of the super rich, and that is a great service.   It has long been  understood that “studying up” can tell us more about the world than “studying down” but there are too few instances of it.

Not very long ago in the world’s leading academic and policy institutions the ruling doctrine was that globalization was in no way responsible for the emerging inequalities that were being observed in the labor market. The further recognition that inequalities went beyond the labor market to encompass very sizable inequalities in income and in wealth in the society as a whole had not yet emerged. U.S. (and more generally western) labor economists, at the supposed pinnacle of the profession, were obsessed with a very small question at that time, which generated detailed methodological debates — how to understand the sources of the widening gap between the wages of skilled and unskilled workers in the American economy and elsewhere. We know that there has been a widening gap between the wages of, let’s say, middle-tier managers and those who work in the front line in fast food restaurants but such differences only begin to capture the scale of the problem and the relevant questions.

The dominant interpretation of what was taking place was that something called “skill biased technological change” accounted for the rising inequalities which were being observed between wages of workers of different kinds. Skill biased technological change basically meant that computers and IT-enabled services of various kinds were entering into firms, and these required skilled people who could read, write and manipulate numbers, as well as engage in a degree of conceptual abstraction. There was a widening gap in wages between high school dropouts or high school graduates and college graduates because their marginal contributions to output had diverged for technological reasons: a deus ex machina!

Other explanations, such as that globalization, policy changes that affected the relationship between labor and capital or the two together may have played a role, were rejected as explanations; the thought that trade, investment flows and so on might matter in determining the bargaining power of less educated workers as well as in determining what was happening at the very top end of the distribution, which largely went unnoticed, was not only —for the most part—not recognized as an explanation, but when it was at all entertained, it was as a bugbear to be dismissed.

I would like to argue that, in fact, globalization is at the very heart of the phenomena which we are observing around the world, or have been observing in the last 20 years—the emergence of a yawning gap between the vast majority of the population and a tiny sliver; whether the relevant tiny sliver is 5% or 1% or 0.1% of the population can be debated and varies across countries. Professor Frank’s suggestion is reasonable that there seems often to be a fractal or self-similar character to the distributional pattern which has emerged in the developed countries in the recent three decades, so that an increasing gap has opened between the top tenth of one percent of the population and the remainder of the top one percent just as a gap has opened between the top one percent and the remainder of the top ten percent or the top ten percent and the rest. These changes have moreover happened after a period in the mid-twentieth century of considerable stability for income distributions within developed countries, in which it had been thought a ‘stylized fact’ that income distributions change slowly if at all.

One way to think about the problem is in terms of the powerfully simple insight of Arthur Lewis, the great Nobel Prize winning economist from the Caribbean, contained in a very famous paper which he published in 1954 called “Economic Development with Unlimited Supplies of Labor”.   The observation appears toward the beginning of the paper that when one first arrives in a developing country, one is met by “young men who rush forward asking to carry your bag as you appear”.   Lewis built upon such examples to create a deep and unifying perspective. His argument had at its hear the recognition that in poor countries around the world, there is a “surplus” of labor—a gigantic reservoir that is available to be tapped, and that there is no need to raise wages substantially in order to draw people into particular occupations.

Workers can be pulled from the traditional occupations in which they are engaged into the so-called modern sector as it grows and develops for quite some time, without it becoming necessary to notably raise wages. It is only at the point when that labor reservoir is exhausted that wage increases are required, and thus come to be observed. Arguably, this is what has been observed in China, where wages have been rising quite rapidly (indeed increasingly rapidly) only in recent years.[2]

In China, and elsewhere, there’s considerable discussion as to what this means, but the dominant explanation is that the “kink” in the Lewisian labor supply curve has been reached in China—the labor reserve has been exhausted. As a result even Chinese companies are today going to countries such as Vietnam to find workers who are available to them at lower wages.

Globalization is the phenomenon by which this global labor reserve has been made available — effectively available and not just theoretically available — for production. As a result, production processes have become geographically dispersed, involving enormous movement of goods from country to country in the course of production. This reflects in part the advantages which arise from making use of cheap (or at any rate, cheaper) labor through its incorporation into global production processes. Of course, labor costs are not the only factor in production. For a very long time, China had a decisive advantage in the production of certain kinds of commodities—for example, in garments—over countries with lower wages, such as, say, Bangladesh. An overall unit cost advantage arose from the fact that in China, to a rough approximation, the ports worked, the roads were not clogged, the power supply was uninterrupted, and there were effectively, until very recently, few if any strikes. None of this was comparably the case in Bangladesh. All of these elements came together to generate lower unit costs in China and to make it an attractive site for production. (Of course, we are speaking of the private costs which are encountered by firms and not of any environmental and social costs generated by their activities).

Arthur Lewis observed the following about the historical process by which labor is absorbed from this labor reservoir into the modern sector, as he called it, in the course of development: not only would wages not rise during this historical process, but as a counterpart, profits would rise. As more and more capital was accumulated in the modern sector, more capital would be employed per worker, the average productivity of workers in the modern sector would rise, national income per capita would rise, and since wages would be little changed, the profit share would rise.

What underlies the global boom in profits which took place between roughly 1980 and 2008? The answer has very much to do with the Lewisian observation just mentioned. An important factor in enabling an unprecedented increase in profits was that an enormous number of workers became more effectively available on a world scale to be tapped in production processes of various kinds without wages having to rise much in the course of employing them.

There are, of course, many other factors which have also been involved in generating the boom in profits in the long last quarter of the twentieth century. Scale is another factor. Globalization makes it possible to sell goods to consumers who are more widely dispersed and who are larger in number. It also means that those scarce resources which were previously largely demanded by a national market now face a much expanded level of demand, global in scope. Chrystia Freeland profiles billionaires around the world. A few of them whom she mentions, such as Azim Premji in India, were associated with new and dynamic sectors of the economy such as information technology enabled services.   However, a great many others, in India, in Russia and elsewhere, are engaged in what Marx called “primitive accumulation”: through a combination of happenstance, connivance and outright crime, they have appropriated a disproportionate share of the common heritage of humanity. What the classical political economists called “land” (by which they meant natural resources of all kinds) have been appropriated and thus given rise to great wealth.   A number of wars that are impoverishing people – and not just causing inequalities – such as those in the Great Lakes region of sub-Saharan Africa, for example, are connected with the struggle to establish control of natural resources.

Globalization is also connected, equally fundamentally although perhaps less obviously, to the creation of scale and network effects which have underpinned the fortunes created in the ‘new economy’ by software barons and others. The global scale of social networks adds to their profitability and the establishment of proprietary global standards that are not easily be challenged by new entrants adds to their profitability.

In the developed countries one of the dimensions of globalization has been that it has significantly changed the bargaining power of workers through what are called “threat effects.” This is a phenomenon that the mainstream economics profession either did not acknowledge or dismissed throughout the heyday of globalization in the 1980s and 1990s. It is only now beginning to recognize them. According to the standard model of international trade, the only way that wages change as a result of international trade is that international trade enables the importation of goods and services which implicitly contain certain factors of production, which in turn compete with the factors of production which are present within a country. From that point of view, even in the standard theory, it would not be a surprise if the wages of unskilled workers in developed countries were to fall as a result of opening to international trade (as might be predicted by the Stolper-Samuelson theorem, a famous result in international trade theory).   Nevertheless, many eminent international trade economists such as Jagdish Bhagwati, engaged in intellectual somersaults to argue that although international trade was bringing about gains from trade, by enabling the importation of labor-intensive commodities from elsewhere—thus becoming an engine of development in poor countries—at the very same time, it was not harming the living standards of developed country (and in particular, American) workers. They argued, in particular, that the quantity of the labor that was implicitly imported in traded goods could not account for the observed wage stagnation of American workers.

The standard theory of international trade leaves out the possibility that globalization, both international trade and the possibility of exporting capital abroad, underpinned by improvements in transportation and communication and alignment of cultural norms, could influence the bargaining power of workers and thereby the share of the surplus of firms that they can command, whether they work in the United States or other developed countries. Labor unions in the heyday of unionization aimed to do that, and often did so quite effectively. Of course, the unionization rate has fallen precipitously in the United States and other countries, in part endogenously, because isolated labor unions are less effective in globalized conditions, and because of policy changes which have made it more difficult for them to exist. Even in the absence of formal unions, however, the effective bargaining power of workers has diminished.

One consequence has been the stagnation of the median wage which has been observed over a long period in the United States, and related phenomena in other developed countries. In some countries, the consequence has been a failure of employment to grow. In the former industrial heartlands of the United States and of other developed countries, this is well understood. The narrative about deindustrialization is not obscure, but rather is intuitively graspable because it is possible to see its effects.

The idea that the new billionaires are self-made men (not so much women, as Freeland points out) whose numeracy and sophistication in the application of quantitative methods is what enabled them meritocratically to enter their ranks is mostly hogwash. We know from observation of recent history (most recently from the illuminating information that has come out in court cases occurring in London between Russian billionaires) that the sharpening of long knives has played a not inconsiderable role in establishing some of the largest fortunes of the recent period, alongside the application of managerial or accounting principles to increase efficiencies, or fundamental innovation.  In the former communist countries, a transfer of state property from public hands to very specific private hands was at the core of the new wealth.

There are three other themes that it may be fruitful to introduce in commenting on the issues raised by the book.

The first theme concerns the connection between the inequalities that have emerged in various countries and the macroeconomic instabilities in those countries and in the world economy as a whole. It is not a very difficult case to make[3] that some of the accumulation of debt which households undertook in the period leading up to the crash of 2008 was the other side of the median wage stagnation which has taken place, and that this led to a highly leveraged real estate market and resulting financial instability.

Similarly, it is now common wisdom that China ought to shift from an economy that is centered on exports to one in which domestic demand plays a larger role. Such a shift is necessary in part because the world cannot sustain the level of Chinese exports which are necessary in order to continue to enable China to develop without further widening of existing imbalances. In particular, the US may not be able to sustain its role as a major importer of Chinese goods. How can such an adjustment be brought about? The most obvious route would be through an increase in wages for Chinese workers and of governmental social expenditures on their behalf.  China’s billionaires and millionaires are not going to be able to buy enough luxury goods to ensure the required adjustment, and so there is no way around a general increase in wages. One can tell a different story for India which carries much the same lesson. In India, the narrow islands of prosperity which have emerged are poorly integrated with the larger economy and society surrounding them. This has resulted in an import-intensive pattern of demand which has led to balance of trade deficits which can only be met by continued inflows of foreign funds and make the Indian economy highly dependent on foreign investor confidence. Only by creating a basis for more sustained and widespread production and consumption outside of the privileged islands can the Indian economy shift its orientation and escape this dependence. The cross-cutting idea linking these cases is that there is a relation between the sources of macro-economic instability and societal inequalities.

The second theme is that, much as the marginal productivity theory of wage determination is dazzling, it is far from obvious that the story that Professor Frank tells about the need to pay someone with a special expertise ‘his’ marginal contribution to revenue in order to elicit effort from that person fully accounts for the gigantic earnings often observed. There are many instances around the world of substantial effort being elicited through other means. Japan provides an obvious example in which, famously, the gap between CEO’s pay and ordinary line workers’ pay has historically been roughly ten to one. Whether or not one thinks that Japan is a continued economic success, it is difficult to deny that Japan has had a very different model.

The third theme concerns the views of some of the billionaires whom Freeland interviewed that they were the exploited, by heavy taxation and other exactions, and that, contrarily, the resources that they have earned ought to be their own to dispose of as they wish, because they have “earned” them. There is a very interesting discussion which has happened among philosophers in regard to this question. Robert Nozick, of course, famously made the libertarian argument in his Anarchy, State, and Utopia, in the early 1970’s, that people should not be taxed except to the bare minimum, in order to provide for essential public goods such as national defense. There have been powerful counterarguments. In particular, I would like to point to one line of argument, represented by the response of Thomas Pogge to the ideas of Nozick[4]. Pogge points to the arbitrariness of the baseline with reference to which one makes the determination of what one has “earned” oneself. There is the point, famously made by Paul Samuelson, that the marginal productivity theory of wage determination has no normative significance, because to think otherwise is to fetishize partial derivatives. More fundamentally, however, whether a contract which two agents are willing to enter into with one another has any particular significance depends on background understandings concerning social rules (e.g. concerning what is the agent’s to dispose of or not, and what conditions attend such disposal). Such background understandings may determine what is understood as being one’s “own” earnings, as well as what is legitimate for the society to expect by way of taxes. Thomas Nagel and Liam Murphy of NYU have also written a book-length argument developing related points concerning taxation[5]. Whether or not one agrees with these arguments, it is clear that they must be confronted. Happily for the billionaires described by Freeland, they appear entirely able to protect themselves from such uncomfortable ideas.

[1] Dept. of Economics, The New School for Social Research; reddys1@newschool.edu

[2] See e.g. Figure 1 and Figure 2 in Yang, D.T., Chen, V. and Monarch, R. (2010), “Rising Wages: Has China Lost its Global Labor Advantage?” Institute for the Study of Labor (IZA) Discussion Paper No. 5008, available on papers.ssrn.com/sol3/Delivery.cfm?abstractid=1631143 .

[3] It has indeed been made by prominent economists. See for example, Stiglitz, J., Freefall, 2010, W.W.Norton and Co.

[4] See Realizing Rawls, Cornell University Press, 1989.

[5] See The Myth of Ownership: Taxation and Justice, Oxford University Press, 2004.