Fractal Inequality & The Great Divergence

Share of capital income earned by top 1% and bottom 80%, 1979-2003

William Easterly notes the fractal nature of inequality in his blog, and Paul Krugman responds with his own take on the matter. Easterly challenges Krugman to “come up with a nice theory of why inequality behaves fractally.” Having addressed such distributional patterns in a paper and a blog post, I have a few thoughts on the matter. This post will focus on the US path to extreme inequality; a later installment will look at some global trends.

Within the US, many factors may explain the “great divergence” in incomes, including trade, immigration, technology, government policy, and education. It’s difficult to tease out the relative impact of these factors. There are confounding variables, and a factor that may be extremely important in one sector could be unimportant in others. But it’s worth focusing on at least two developments: the vast growth of the global labor force over the past two decades (as formerly command economies opened up for global investment), and the steady increase in CEO and Wall Street income over the past forty years. Both have caused (and are still causing) a hollowing out of many developed countries’ middle classes. A 2008 HBS study indicated that up to 42 percent (57.2 million) US jobs are offshorable, including “high-skill jobs such as financial analyst and microbiologist.”

This global pool of labor gives many of those at the top of business organizations strong bargaining power vis a vis their immediate subordinates, who, in turn, enjoy strong bargaining power vis a vis their own immediate subordinates. If CEO has VP’s A, B, and C, and each VP has employees 1 through 10, etc., each VP is going to be competing to reduce costs. Oftentimes the easiest way to do so is to reduce the pay of subordinates, or lay them off. (Indeed, a recent study finds tremendous returns to CEO’s for engaging in layoffs.) Note that this kind of cost-cutting isn’t exactly rocket science, as Sam Pizzigatti suggests in his skewering of ex-H-P CEO Mark Hurd:

[W]hat “rare” talent did Hurd actually demonstrate? Does slashing R&D demand [expertise]? Are CEOs who can wheel and deal their way to one job-killing merger after another few and far between? . . . Hurd demonstrated no special talent. His basic merge-and-purge business plan at HP made sense only as a personal enrichment strategy.

Or as an effort to enrich shareholders, a group whose gains are notoriously skewed to the wealthiest. Wall Street has taken an ample cut of the financial gains of investors, and financial firms have enjoyed a generally rising share of all corporate sector profits. There, again, desert is disputed: “in July, Kenneth R. Feinberg . . . said that nearly 80 percent of the $2 billion in 2008 bonus pay was unmerited.” Simon Johnson and James Kwak explore financiers’ power in great detail in 13 Bankers; suffice it to say for now that much pre-bust compensation resulted from decisions to “pay themselves more than their firms [were] worth and then default on their debt obligations.”

I think a key takeaway here is recognizing the extraordinary role that power plays in determining distributions of income. Buoyed by a great global pool of labor, CEOs of the 2000s were much less constrained than CEOs of the 1950s, and that’s one key reason why they made between 300 to 400 times their average worker’s pay in the later period.* Finance firms saw their campaign contributions richly rewarded. Yes, one can make better and worse staffing decisions at the top of a company, or investment decisions at a Wall Street firm. But the decisive factor permitting runaway incomes at the top is relative power. If that power further infiltrates politics, expect the “great divergence” to accelerate.

*An American CEO in 1960 could only expect to make about 50 times his average worker’s pay, and Japanese CEOs presently make far less than their US counterparts. Current US CEO pay appears to be an anomaly both temporally and cross-nationally.

Hat Tip: Andrew Sullivan.

Image Credit: From G. William Domhoff.

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