Let’s Amend, Not End, Capitalism

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The United States prides itself as being the “land of opportunity”.  With the U.S. being a favored destination for immigrants across the world, that distinction still has merit.  However, there are disturbing trends where many are questioning the value of capitalism due to its contribution to income inequality.  Even so, we must acknowledge the role that capitalism played in lifting not only Americans out of poverty and into prosperity, but in Canada, Europe, and all parts of the world.  Having said that, we must recognize that our current economic system needs to be amended to level the playing field.

Many Americans are divided on the moral implications of income redistribution.  On one hand, there are those that believe that extravagant wealth is immoral and that there should be a limit on executive pay.  In fact, Japan has embraced this culture and have stifled executive pay.  Their executives must publicly disclose their pay if it exceeds $1.1 million and only 7.5% of them exceeded this baseline.  That is dwarfed by American executives, whose top 10 earn between $43 to $131 million in annual salaries.

Then there are others, who believe too much income redistribution is immoral because it unfairly penalizes hard work and achievement.  When an individual makes sacrifices in their education and career, why should they be forced to give up a portion of their earned pay to subsidize an irresponsible individual, who squandered opportunities by not valuing their education early in life?  If taxes are increased substantially as your income rises, then the payoff of extra work and risk is lowered.  Why go through the rigors of medical school, engineering, and law school, when one can make a similar amount in a less demanding field?

In deciding between two competing narratives, the difference comes down to economic mobility.  Is our present economic system more conducive to promoting competition between social classes?  Unless one believes that effort and ability is only consigned to the affluent, one would think that the U.S. economy and its promotion of economic liberty would result in healthy movement between the poor, middle class, and upper class.  However when compared to our peers, we are laggards Markus Jantti’s study comparing the U.S. with the United Kingdom, Denmark, Norway, Sweden shows that Americans are less likely to rise from poverty across generations than any of those four countries.

Certainly, it is fair that a successful professional, who has excelled at their craft, should be able to pass their hard-earned dollars to their children to help them compete.  One of the motivations to taking on additional responsibilities on a project or working 60-70 hours a week is to provide a better life for our children.  That means living in a better neighborhood and access to superior schools.  However, should there be limits imposed on those advantages in the form of higher taxes?

Specifically, there’s a growing body of research that income inequality imposes significant costs on the economy.  In order to counter these costs, there are policy initiatives that would boost equality and shift the economic gains would shift from the affluent to the low and middle class.    When there is too much income inequality, it can actually inhibit economic growth and cause more instability.  Raghuram Rajan elaborates on this view in Project Syndicate.  Specifically, he blames deregulaton and legislative acts promoting home ownership as the root causes of the financial crisis as low- and middle-income households took on too much debt to maintain their standard of living in the face of declining income growth.

With rising inequality, the occurrence of rent-seeking is more prevalent.  This is where individuals use their financial resources and influence to affect policies that benefit their interests over society.  The prevalence of special interest groups and less restrictive campaign financing laws provide the potential to seek loopholes and other avenues to enrich themselves at the expense of others.  Columbia University economist Stiglitz pointed to lack of effective oversight of the financial industry where irresponsible mortgage products caused our steep recession.  Then there are exploitations of the tax code where societal benefits are minimal when these advantages boost corporate balance sheets, rather than worker payrolls.  Lastly, it stunts the progress of competitors who are not able to buy influence.

It is imperative that we achieve legislative reform that minimizes the influence of special interests and replace it with investments toward minimizing the skills divide.  A two-pronged attack is necessary.  First, we need a quick fix in updating adult skill sets that are struggling to meet the requirements of a technology-based economy.  As for schools, they must find ways to increase academic performance within low-income and middle-income households despite challenges within family structures and less than ideal neighborhoods.  This must start with better parental training and access to early child education resources.  Both will require more funding and resources.

Capitalism remains the ideal economic system in the world, but ignoring the negative effects of income inequality can lead to its demise.

How To Achieve Growth and Prosperity

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For my Principles of Macroeconomic students, they are currently learning how living standards vary across the globe in the Production and Growth chapter of Mankiw’s Principles of Economics.  While the U.S. and Canada enjoy “rich” country status with GDP Purchasing Power Parity (PPP) per capita figures of 48,387 and 40,541, respectively, there are other countries, such as Ukraine and Indonesia, whose GDP (PPP) per capita figures are fractions of that at 7,233 and 4,666.

That might lead to this question:  What is GDP (PPP) per capita?  This measures living standards and is a proxy on how much each individual contributes to their economy.  Global comparisons are difficult to make because currency valuations differ.  For instance, a Zimbabwean could make 1 million Zimbabwe dollars, while a German makes twenty thousand Euros.  One would assume that the Zimbabwean is better off, but that is far from the case because Zimbabwe has a very weak currency relative to the Euro.  In fact, 1 million Zimbawean dollars would only be approximately 2,122 Euros.

Therefore, purchasing power parity is used to take out the bias of currency exchange rates and allows for more accurate global comparisons.  Referring back to the U.S. and Ukraine, we can make a rough estimate that the typical American contributes $48,387 to economic output, which is must higher than the typical Ukrainian, who only produces $7,233 to their economy.

What accounts for these vast differences?  One can point to these four factors to explain the wealth differences across the globe:  physical capital per worker, human capital per worker, natural resources per worker, and technological knowledge.  Typically, countries, who score high in economic freedom, also rate high in most if not all of those four factors.

In particular, a country’s score in the following four areas from the Index of Economic Freedom are drivers to high U.S. productivity and prosperity:  Rule of Law, Limited Government, Regulatory Efficiency, and Open Markets.

When comparing and contrasting countries across the world, there is a distinct relationship between economically free countries than those that are repressed.  That is because economically free countries respect private property rights, which encourages individuals to take more risk and build wealth.  In repressed economies, most decisions on producing goods and services are determined by state government officials, who lack the dynamism and expertise to adjust sufficiently to rapidly changing market forces.  Also, state-run economies have less competition and result in more corruption that erode wealth accumulation.

Though it should be pointed out that the U.S. ranking in economic freedom has declined over time as rising budget deficits and an expanding role for government to deal with the financial market crisis and rising health costs have taken its toll.  We still rank in the top 10 and are only behind Canada among advanced economies.   When looking at advanced economies, which include the U.S., Canada, Germany, Italy, United Kingdom, France, and Japan, most have economic freedom scores that rank as mostly free with the two exceptions being France and Italy, which are still considered moderately free.  It may not be a coincidence that France and Italy also has experienced more economic turmoil in Europe than Germany or the United Kingdom.

While some would dismiss these rankings and point to historical colonialism of Europe and the U.S. over much of Central America, South America, and Africa, that does not explain how developing countries in those three parts of the world who embrace economic freedom mostly enjoy greater living standards than those with lower scores.

It is noteworthy to point out that pursuit of growth often comes at the expense of equality.  That speaks to the tradeoff between equality and efficiency.  However, Canada has been able to achieve a high economic freedom score and still provide a substantive safety net, including universal health care.  Though, it is difficult to achieve both.