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Paging Horatio Alger: Joseph Stiglitz on How Inequality Harms America

By Morgan Housel - Apr 24, 2013 at 10:22AM

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Joseph Stiglitz on wealth in America.

New York City is an odd place, home to financiers who earn more per month than ordinary folks will in a lifetime, but deep poverty as well. People gawk at the high cost of living in New York, but the city's median household income is actually below the national average. The gap between New York's rich and its average is off the charts.

It's against this backdrop that I visited economist Joseph Stiglitz at his office in Columbia Business School in early April to talk about his favorite subject: wealth inequality.

Stiglitz won the Nobel Prize in economics in 2001 for his work on information asymmetries. But it's his commentary on wealth inequality that has gained the most attention from admirers and critics. An article Stiglitz penned for Vanity Fair in May 2011 titled "Of the 1%, by the 1%, for the 1%" set off a wave of discussion about the nation's growing chasm of wealth, and helped spawn the Occupy Wall Street movement. TIME magazine named him one of the 100 most influential people in the world that year.

The article's success led Stiglitz to write a book on the subject. The Price of Inequality is a 500-page work outlining not only the extent inequality in America, but why it matters and how Stiglitz feels it harms the economy.

That's what I came to talk to him about.

A fair shake
Stiglitz's office in Columbia Business school is polished and spacious. There is some irony to this. I have interviewed economists to talk about the benefits of free markets in offices so austere there was no place to sit. Now I find myself with Stiglitz discussing the harms of concentrated wealth while in a glass-walled private library that is part of his office suite -- a suite larger than some apartments I've lived in.

But Stiglitz has earned his success. Lining the walls of the library are several dozen book titles. As I browse, I notice that each is authored by Stiglitz himself. "You wrote all of these?" I ask, awestruck. "Ha, well. These are a fraction of what I've written," he says. He is a giant in his field.

I ask Stiglitz why he became interested in wealth inequality. "I grew up in Gary, Indiana, which was a city marked by large inequalities. I wanted to understand that," he says. "But what has happened in the United States, particularly in the last 30 years, even more in the last ten years, is that inequality has grown out of bounds. The top 1% has doubled the percentage [of income] that it had just 30 years ago. The top 0.1%, three to four times what they got."

The overwhelming majority of those from across the ideological spectrum agree that those who work the hardest, or are the most creative, or the most gifted, should earn the most, and vice versa.

Stiglitz is among them. He is not anti-wealth. "I don't think anybody begrudges somebody who would have invented the laser, or discovered DNA, from becoming wealthy," he says. "They've made an enormous contribution to our society."

What troubles him are those whose fortunes come from advantages that have nothing to do with hard work, genius or discovery. Those who, as he puts it, are "taking advantage of corporate governance deficiencies to seize a larger fraction of the corporate pie to get them outsize benefits."

He often uses the term "rent-seeking" to describe those who don't create new wealth, but extract money out of existing wealth -- especially by nefarious means. Monopolies. Cronyism. Nepotism. Lobbying. Loopholes. Unfair regulations, regulations that stifle competition ... these are a few of the ways Stiglitz sees wealth -- huge amounts of wealth -- flowing to those who he thinks don't deserve it.

Take bankers. Many of those who ran their banks into the ground and stuck taxpayers with losses walked away with fortunes. After Bear Stearns imploded in 2008, former CEO Jimmy Cayne said, "When you lose a billion but you still have several hundred million left, then it's your heirs that get hurt, not you." Stiglitz explains:

That was one of the things that exposed this whole scandal of inequality when the CEOs, particularly the banks, got paid millions and millions of dollars in what they call "performance pay" for bringing the global economy to brink of ruin, and bringing their companies to the brink of ruin so they had to be saved by the U.S. Government. How could you call that performance? And yet they walked home with huge paychecks, and ordinary Americans were left unemployed and paying their bills.

This is prevalent beyond banks, of course. According to The Wall Street Journal, in 2010, "for every 1% decrease in shareholder return, the average CEO was paid 0.02% more."

I asked Stiglitz for more examples.

"Mitt Romney, when he was running for the president, openly said that he was paying only 14% of his reported income, and that he was keeping his income, his wealth, in the Cayman Islands," Stiglitz says. "Now it's very difficult for most of us to keep our income in the Cayman Islands, and he wasn't keeping the money in the Cayman Islands because the sunshine there was making the money grow faster. It was the lack of sunshine that allows for people to avoid taxes, not necessarily illegally, but to take advantage of the loopholes that they have succeeded in putting into the tax law."

Rolling on about taxes, he explains: "The most egregious example of this is the carried interest provision that allows those working Wall Street to treat their income, ordinary income, as if it were capital gains," he says. "So rather than paying 35% or now 39.6%, they get paid the capital gains, and take a tax rate of 15% to 20%."

Stiglitz cites laws that say credit default swaps are the first in line for payouts, but student loans can't be discharged in bankruptcy. He talks about the recent LIBOR interest rate scandal that allowed banks to manipulate interest rates "to take advantage of the rest of the society." He notes that credit default swaps are intentionally left opaque so the client on the other side of the trade has less information. "When markets get transparent, they get competitive. When they get competitive, profits get eroded, and so as an economist, let me say, I totally understand what they're trying to do. But from a public policy point of view, it's outrageous."

Hold on, I say. Those trading credit default swaps are not mom-and-pop novices. They're sophisticated investors who know how the game works. Stiglitz demurs. "I'm not sure that they understand the full consequences. You know, a company may be very sophisticated in making tractors or running their business, but that doesn't mean they're financially sophisticated in credit default swaps."

All of this is getting worse, Stiglitz reminds me. "And even more disturbing," he offers, "is that there has been a lack of equality of opportunity."

Paging Horatio Alger
At a conference last fall, Stiglitz was joined on stage by Harvard economist Martin Feldstein, a conservative voice meant to balance his views.

Feldstein didn't disagree with Stiglitz's fear of inequality. "But to me," Feldstein said, "the important part is poverty, low income, and low wealth." If economists want to talk about (or fiddle with) inequality, they should focus on creating opportunities for the poor, not sneering at the rich.

When I reminded Stiglitz of this conversation, he agreed with Feldstein's sentiment. The problem, Stiglitz said, is that opportunities for the poor are much lower than Americans think.

"Americans really believe the American Dream, that everybody can make it," he says. "The statistics don't show that. The statistics show that an American child's lifetime prospects is more dependent on the income and education of his parents than in almost any other of the other industrial countries."

"The notion of the 'American Dream' is a myth," he boldly states.

This sounds like an appalling claim, but dig into the numbers, and there's a shocking amount of truth to it. In 2010, the OECD calculated the extent to which a son's income is statistically correlated with his father's income, or "the persistence of earnings across generations." In the world of Horatio Alger, there would be little correlation. What your father earned would be irrelevant to the outcome of your career.

But in America, almost 50% "of the economic advantage that high-earnings fathers have over low-earnings fathers is transmitted to their sons," the OECD found. That was a higher correlation than in all other developed nations, save for Italy and Great Britain.

The most common explanation for this is education. Higher-income fathers can provide a good education for their children, which is highly predictive of future wages. Low-income fathers often can't.

Other studies confirm this. In 2001, economist Bhashkar Mazumder calculated that if a father earned $1 more than average, his children could expect to earn $0.50 to $0.60 more than average. Amazingly, Mazumder found that incomes among brothers are more correlated than height or weight. Literally, if you have a brother who is rich and tall, you are more likely to also be rich than you are tall.

Now, everyone knows someone (or is someone) who started from nothing and became something. The problem, as they say in journalism, is that the plural of "anecdote" is not "trend." Yes, some are born into poverty and work their way up into wealth. Many, even. But most don't. Just 4% of those born into the lowest income quintile eventually make it to the top income quintile, but 40% of those born into the highest income group will stay there as adults, according to the Pew Economic Mobility Project. Of those born into the lowest income quintile, more than 70% won't make it out of the bottom half of wage earners as adults. For those born into the richest quintile, more than 63% will remain in the top two income groups as adults.

These are the kind of statistics that rile Stiglitz up. "We have an education system that is very dependent on where you live," he says. "Where you live depends on what you can afford. We've become a more economically segregated society. That is to say, rich people live in their communities, poor people live in their communities much more than it used to be the case. So that means that this access to the kind of education that would allow you to compete in a 21st-century economy is not there for those who are in the bottom of our income distribution."

It wasn't always this way. Inequality has changed dramatically over the last century. "The period after World War II was a period in which we grew together," he says, highlighting the GI Bill. "Inequality came down, and it was a period in which the economy grew faster than in, say, the period after 1980, where we grew apart." 

"The important lesson of that is that you can grow faster with a more equal society. That actually is part of the price of inequality that we pay."

The solutions
Anyone can criticize. What distinguishes a pragmatist from a crank is the proposal of solutions. So I ask Stiglitz a simple question: You're king for a day. What three things would you do to help fix income inequality?

"I would begin with education," he says. "Because to me, opportunity is really important, and we are not giving opportunities. And when I say 'education', I mean preschool. I mean access to health care so that you can take advantage of education. If you don't have adequate health care, you're not going to be able to do well at school."

"Nutrition for children -- I'd put a lot of emphasis on children and opportunity."

"Second thing," he says, "is our tax law. I really do think our tax law distorts our economy and is unfair and has wider consequences. If Americans think that the tax system is unfair, they lose confidence in government. And I think government is very important providing certain basic services to our society."

"And thirdly, there's a whole set of regulations that distort our economy and lead to more inequality and more inefficiency. More effective enforcement of anti-monopoly laws, antitrust laws, more effective regulations so that the banks can't take advantage of the poor with predatory lending and abusive credit card practices and manipulation of markets."

These all sound admirable, I think to myself. But I can't help feeling that the Ivory Tower bias is kicking in. "Begin with education." What does that mean? Open more schools? Raise teacher salaries? Punish bad teachers? Punish bad students? Nearly every politician in the last three decades has expressed a desire to fix education. Many have tried valiantly. Far fewer have succeeded in making a difference. Diagnosing a problem is easier than fixing it.

Same with the tax code. Everyone knows the tax code needs simplification. But try taking away a deduction or a loophole, and someone squirms. "I can't tell you how many times I felt like Charlie Brown," said former White House budget director Peter Orszag last year. "I'd meet with a senator who said they wanted to lower tax rates and broaden the tax base. They'd start by telling me how much they wanted to cut tax rates. Then I'd ask them what deductions they wanted to cut. Mortgage deduction? 'Nope, can't touch that, son.' Health insurance, interest, retirement savings? No, no, no."

As my time ends, I ask Dr. Stiglitz what he would tell a student who comes to his office seeking advice on how to live a better life.

Stiglitz recalls what his parents told him as a youth.

"They said first, money's not going to make you happy," he says. "You need money to live, but what's really important is not money."

As I leave, I'm reminded that annual tuition at Columbia Business School, the building we're meeting in, is $58,000 per year, or 20% more than New York's median household annual income. It takes a tremendous amount of money to gain the opportunity to be taught how little money will do for you. Inequality is a more complicated issue than it seems, I tell myself.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics


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