Why Economists Avoid Discussing Inequality

(Bloomberg Opinion) -- Why would economists rather talk about efficiency than inequality? Having lived among them for a while, I don’t think the reason is what many people think. The common narrative on the political left is that economists are shilling for the rich, focusing on growth in order to draw attention away from how a few are gaining enormous wealth.

But a more likely explanation is that economists are trying to avoid getting entangled in politics. In economics parlance, a Pareto improvement — named for Italian economist Vilfredo Pareto — happens when the economy changes in a way that makes life better for some people without leaving anyone worse off than before. Economists typically concentrate on looking for these win-win situations, because Pareto improvements would theoretically be able to please everyone at once — theoretically avoiding the need for them to take one side or the other in political battles. Contrary to the old adage about free lunches, economists are always on the lookout for them.

But Pareto improvements are hard to find. In particular, one thing that makes win-win situations very rare is the existence of social preferences — i.e., when people care about not just what they have, but what their neighbors have.

Here’s an example. Suppose two neighbors, Pete and Charlie, each only care about the size of their own TV. In that case, giving Pete a bigger TV, but leaving Charlie’s the same, is a Pareto improvement — it makes Pete better off without hurting Charlie. But now suppose that Pete and Charlie each would resent it if the other had a bigger TV. Now, giving Pete a bigger one will arouse Charlie’s resentment, meaning that someone has been hurt — thanks to social preferences, it’s harder to find a Pareto improvement. In the extreme worst-case scenario, where Pete and Charlie each only care about the relative size of their TVs, no Pareto improvement is ever possible, because one person’s gain is always equal to someone else’s loss.

In reality, people probably aren’t that purely motivated by competitiveness and envy — people really do want bigger TVs not just to make their neighbors jealous, but because bigger screens are nice. But social preferences are almost certainly real, and they complicate economists’ efforts to find win-win situations for society.

A recent paper by economists Sumit Agarwal, Vyacheslav Mikhed and Barry Scholnick shows just how pervasive these competitive instincts are. They looked at what happened to Canadian households’ financial outcomes when their neighbors won the lottery. Obviously, neighborhoods with lots of households that play the lottery in the first place are different from other neighborhoods, so Agarwal et al. compare households that won big prizes with households that won small prizes. They then looked at neighboring households, to ascertain whether envy of the winners’ newfound riches motivated them to spend beyond their means.

The authors find that when someone wins a bigger prize, their neighbors start to borrow more, and tend to declare bankruptcy more, compared to people whose neighbors won the smaller prizes. That’s strong evidence that when people’s neighbors start to spend more money, people are motivated to try and spend more to keep up with them, even if doing so comes at the cost of unsustainable borrowing. When they see their lottery-winning neighbors flaunting new cars, home improvements or other conspicuous consumption, the feelings of competitiveness and envy are so strong that they can even overwhelm financial good sense.

Agarwal et al.’s research tends to agree with earlier findings. A 2011 paper by economists Peter Kuhn, Peter Kooreman, Adriaan Soetevent and Arie Kapteyn, for example, found that the neighbors of Dutch lottery winners buy more cars.

This obviously has implications for financial bubbles and the theory of business cycles. If housing bubbles like the one the U.S. had in the mid-2000s act like lotteries — if people who manage to flip their house for a huge gain are like lottery winners, and their neighbors borrow to keep up appearances — then this might be another link between bubbles and debt crises.

It’s also another reason to worry about inequality. In the U.S. and many other nations, inequality has risen in recent decades. Here’s the income Gini coefficient, a common measure of income inequality, with higher numbers representing greater disparity:

Why Economists Avoid Discussing Inequality

This inequality could be motivating Americans to spend more and save less, which increases the risk of debt crises, and also reduces investment and therefore makes future generations poorer.

But social preferences also complicate efforts to reduce inequality. The same competitive instinct that applies to lottery winnings may also apply to government transfers. A 2008 paper by economists Manuela Angelucci and Giacomo De Giorgi found that government cash transfers in Mexico increased borrowing and reduced saving among households that didn’t receive the transfers.

So the existence of social preferences means that governments should try to design welfare programs that either flow to everyone equally — like universal basic income — or seem fair in some way, such as disability or age-based programs. Otherwise, well-intended redistribution may end up arousing envy among those who don’t receive the checks.

In a world of social preferences, everything becomes more complicated. But that appears to be the world we live in, and we must deal with it accordingly.

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