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The European Union is undergoing multiple crises. The UK may vote in favour of leaving the Union in June. European Union member states are in deep disagreement on various crucial issues, not only on how to handle the stream of refugees from the Near East, but also on how to combat terrorism, and how to deal with Russia. And, in each election, Eurosceptic parties garner an increasing share of the vote. Given the urgency of these issues, the Eurozone crisis has been relegated to the background of public debates.
In many scholarly and activist circles, the International Monetary Fund (IMF, or ‘the Fund’) has a reputation as a global bully. The phrase ‘Washington consensus’ has come to invoke a rigid orthodoxy of austerity and liberalization which the Fund, along with its cousins the World Bank and the US Treasury, imposes on developing countries. As an organization, the IMF is seemingly monolithic, drawing comparison to the Vatican even amongst its own staff.
There’s a puzzle around economics. On the one hand, economists have the most policy influence of any group of social scientists. In the United States, for example, economics is the only social science that controls a major branch of government policy (through the Federal Reserve), or has an office in the White House (the Council of Economic Advisers). And though they don’t rank up there with lawyers, economists make a fairly strong showing among prime ministers and presidents, as well.
But as any economist will tell you, that doesn’t mean that policymakers commonly take their advice. There are lots of areas where economists broadly agree, but policymakers don’t seem to care. Economists have wide consensus on the need for carbon taxes, but that doesn’t make them an easier political sell. And on topics where there’s a wider range of economic opinions, like over minimum wages, it seems that every politician can find an economist to tell her exactly what she wants to hear.
So if policymakers don’t take economists’ advice, do they actually matter in public policy? Here, it’s useful to distinguish between two different types of influence: direct and indirect.
Direct influence is what we usually think of when we consider how experts might affect policy. A political leader turns to a prominent academic to help him craft new legislation. A president asks economic advisers which of two policy options is preferable. Or, in the case where the expert is herself the decisionmaker, she draws on her own deep knowledge to inform political choices.
This happens, but to a limited extent. Though politicians may listen to economists’ recommendations, their decisions are dominated by political concerns. They pay particular attention to advice that agrees with what they already want to do, and the rise of think tanks has made it even easier to find experts who support a preexisting position.
Research on experts suggests that direct advisory effects are more likely to occur under two conditions. The first is when a policy decision has already been defined as more technical than political—that experts are the appropriate group to be deciding. So we leave it to specialists to determine what inventions can be patented, or which drugs are safe for consumers, or (with occasional exceptions) how best to count the population. In countries with independent central banks, economists often control monetary policy in this way.
Experts can also have direct effects when possible solutions to a problem have not yet been defined. This can happen in crisis situations: think of policymakers desperately casting about for answers during the peak of the financial crisis. Or it can take place early in the policy process: consider economists being brought in at the beginning of an administration to inject new ideas into health care reform.
But though economists have some direct influence, their greatest policy effects may take place through less direct routes—by helping policymakers to think about the world in new ways.
For example, economists help create new forms of measurement and decision-making tools that change public debate. GDP is perhaps the most obvious of these. A hundred years ago, while politicians talked about economic issues, they did not talk about “the economy.” “The economy,” that focal point of so much of today’s chatter, only emerged when national income and product accounts were created in the mid-20th century. GDP changes have political, as well as economic, effects. There were military implications when China’s GDP overtook Japan’s; no doubt the political environment will change more when it surpasses the United States.
Less visible economic tools also shape political debate. When policymakers require cost-benefit analysis of new regulation, conversations change because the costs of regulation become much more visible, while unquantifiable effects may get lost in the debate. Indicators like GDP and methods like cost-benefit analysis are not solely the product of economists, but economists have been central in developing them and encouraging their use.
The spread of technical devices, though, is not the only way economics changes how we think about policy. The spread of an economic style of reasoning has been equally important.
Philosopher Ian Hacking has argued that the emergence of a statistical style of reasoning first made it possible to say that the population of New York on 1 January 1820 was 100,000. Similarly, an economic style of reasoning—a sort of Econ 101-thinking organized around basic concepts like incentives, efficiency, and opportunity costs—has changed the way policymakers think.
While economists might wish economic reasoning were more visible in government, over the past fifty years it has in fact become much more widespread. Organizations like the US Congressional Budget Office (and its equivalents elsewhere) are now formally responsible for quantifying policy tradeoffs. Less formally, other disciplines that train policymakers now include some element of economics. This includes master’s programs in public policy, organized loosely around microeconomics, and law, in which law and economics is an important subfield. These curricular developments have exposed more policymakers to basic economic reasoning.
The policy effects of an economic style of reasoning are harder to pinpoint than, for example, whether policymakers adopted an economist’s tax policy recommendation. But in the last few decades, new policy areas have been reconceptualized in economic terms. As a result, we now see education as an investment in human capital, science as a source of productivity-increasing technological innovations, and the environment as a collection of ecosystem services. This subtle shift in orientation has implications for what policies we consider, as well as our perception of their ultimate goals.
In the end, then, there is no puzzle. Economists do matter in public policy, even though policymakers, in fact, often ignore their advice. If we are interested in understanding how, though, we should pay attention to more than whether politicians take economists’ recommendations—we must also consider how their intellectual tools shape the very ways that policymakers, and all of us, think.
The business press and general media often lament that firm executives are exhibiting “short-termism”, succumbing to the pressure by stock market investors to maximize quarterly earnings while sacrificing long-term investments and innovation. In our new article in the Socio-Economic Review, we suggest that this complaint is partly accurate, but partly not.
What seems accurate is that the maximization of short-term earnings by firms and their executives has become somewhat more prevalent in recent years, and that some of the roots of this phenomenon lead to stock market investors. What is inaccurate, though, is the assumption that investors – even if they were “short-term traders” – would inherently attend to short-term quarterly earnings when making trading decisions. Namely, even “short-term trading” (i.e. buying stocks with the aim to sell them after few minutes, days, or months) does not equal or necessitate “short-term earnings focus”, i.e., making trading decisions based on short-term earnings (let alone based on short-term earnings only). This means that in case the media observes – or executives perceive – that firms are pressured by stock market investors to focus on short-term earnings, such a pressure is illusionary, in part.
The illusion, in turn, is based on the phenomenon of “vociferous minority”: a minority of stock investors may be focusing on short-term earnings, causing some weak correlation between short-term earnings and stock price jumps / drops. But the illusion is born when this gets interpreted as if most or all investors (i.e., the majority) would be focusing on short-term earnings only. Alas, such an interpretation may, in the dynamic markets, lead to a self-fulfilling prophecy – whereby an increasing number of investors join the vociferous minority and focus increasingly on short-term earnings (even if still not the majority of investors would focus on short-term earnings only). And more importantly – or more unfortunately – firm executives may start to increasingly maximize short-term earnings, too, due to the (inaccurate) illusion that the majority of investors would prefer that.
Rolls Royce, by Christophe Verdier. CC-BY-2.0 vis Flickr.
A final paradox is the role of the media. Of course, the media have good intentions in lamenting about short-termism in the markets, trying to draw attention to an unsatisfactory state of affairs. However, such lamenting stories may actually contribute to the emergence of the self-fulfilling prophecy. Namely, despite the lamenting tone of the media articles, they are in any case emphasizing that the market participants are focusing just on short-term earnings. This contributes to the illusion that all investors are focusing on short-term earnings only – which in turn may lead a bigger majority of investors and firms to actually join the minority’s bandwagon, in the illusion that everyone else is doing that too.
Should the media do something different, then? Well, we suggest that in this case, the media should report more on “positive stories”, or cases whereby firms have managed to create great innovations with a patient, longer-term focus. The media could also report on an increasing number of investors looking at alternative, long-term measures (such as patents or innovation rates) instead of short-term earnings.
So, more stories like this one about Rolls-Royce – however, without claiming or lamenting that most investors are just wanting “quick results” (i.e., without portraying cases like Rolls-Royce just as rare exceptions). Such positive stories could, in the best scenario, contribute to a reverse, self-fulfilling prophecy – whereby more and more investors, and thereafter firm executives, would replace some of the excessive focus on short-term earnings that they might currently have.
Quite abruptly income inequality has returned to the political agenda as a prominent societal issue. At least part of this can be attributed to Piketty’s provoking premise of rising concentration at the top end of the income and wealth distribution in Capital in the Twenty-First Century (2014), providing some academic ground for the ‘We are the 99 percent’ Occupy movement slogan. Yet, this revitalisation of inequality is based on broader concerns than the concentration at the very top alone. There is growing evidence that earnings in the bottom and the middle of the distribution have hardly risen, if at all, during the last 20 years or so. Incomes are becoming more dispersed not only at the top, but also more generally within developed countries.
We should distinguish between increasing concentration at the top and the rise of inequality across the entire population. Even though both developments might take place simultaneously, the causes, consequences, and possible policy responses differ.
The most widely accepted explanation for rising inequality across the entire population is so-called skill-biased technological change. Current technological developments are particularly suited for replacing routine jobs, which disproportionally lie in the middle of the income distribution. In addition, low- and middle-skilled manufacturing jobs are gradually being outsourced to low-wage countries (see for instance Autor et al., 2013). Decreasing influence of trade unions and more decentralised levels of wage coordination are also likely to play a role in creating more dispersed earnings patterns.
Increased globalisation or technological change are not likely to be main drivers of rising top income shares, though the larger size of markets allows for higher rewards at the top. Since the rise of top income shares was especially an Anglo-Saxon phenomenon, and as the majority of the top 1 per cent in these countries comes from the financial sector, executive compensation practices play a role. Marginal top tax cuts implemented in these countries and inherited wealth are potentially important as well.
So should we care about these larger income differences? At the end of the day this remains a normative question. Yet, whether higher levels of inequality have negative effects on the size of our total wealth is a more technical issue, albeit not a less contested one in political economy. Again, we should differentiate between effects of increasing concentration at the top and the broader higher levels of inequality. To start with the latter, higher dispersion could incite people to put forth additional effort, as the rewards will be higher as well. Yet, when inequality of income disequalises opportunities, there will be an economic cost as Krugman also argues. Investment in human capital for instance will be lower as Standard & Poor’s notes for the US.
High top income shares do not lead to suboptimal human capital investment, but will disrupt growth if the rich use their wealth for rent-seeking activities. Stiglitz and Hacker and Pierson in Winner-Take All Politics (2010) argue that this indeed takes place in the US. On the other hand, a concentration of wealth could facilitate large and risky investments with positive externalities.
If large income differences indeed come at the price of lower total economic output, then the solution seems simple: redistribute income from the rich to the poor. Yet, both means-tested transfers and progressive taxes based on economic outcomes such as income will negatively affect economic growth as they lower the incentives to gain additional wealth. It might thus be that ‘the cure is worse than the disease’, as the IMF phrases this dilemma. Nevertheless, there can be benefits of redistribution in addition to lessening any negative effects of inequality on growth. The provision of public insurance could have stimulating effects by allowing individuals to take risks to generate income.
How to leave from here? First of all, examining whether inequality or redistribution affects growth requires data that makes a clean distinction between inequality before and after redistribution across countries over time. There are interesting academic endeavours trying to decompose inequality into a part resulting from differences in effort and a part due to fixed circumstances, such as gender, race, or educational level of parents. This can help our understanding which ‘types’ of inequality negatively affect growth and which might boost it. Moreover, redistribution itself can be achieved through multiple means, some of which, such as higher heritage taxes, are likely to be more pro-growth than others, such as higher income tax rates.
All things considered, whether inequality or redistribution hampers growth is too broad of a question. Inequality at which part of the distribution, due to what economic factors, and how the state intervenes all matter a great deal for total growth.
Inequality has been on the rise in all the advanced democracies in the past three or four decades; in some cases dramatically. Economists already know a great deal about the proximate causes. In the influential work by Goldin and Katz on “The Race between Education and Technology”, for example, the authors demonstrate that the rate of “skill-biased technological change” — which is economist speak for changes that disproportionately increase the demand for skilled labor — has far outpaced the supply of skilled workers in the US since the 1980s. This rising gap, however, is not due to an acceleration of technological change, but rather to a slowdown in the supply of skilled workers. Most importantly, a cross-national comparison reveals that other countries have continued to expand the supply of skills, i.e. the trend towards rising inequality is less pronounced in these cases.
The narrow focus of economists on the proximate causes is not sufficient, however, to fully understand the dynamic of rising inequality and its political and institutional foundations. In particular, skill formation regimes and cross-country differences in collective wage bargaining influence the quantity and quality of skills and hence also differences in inequality. Generally speaking, countries with coordinated wage-setting and highly developed vocational education and training (VET) systems respond more effectively to technology-induced changes in demand than systems without such training systems.
Yet, there is a great deal of variance in the extent to which this is true, and one needs to be attentive to the broader organization of political institutions and social relations to explain this variance. One of the recurrent themes is the growing socioeconomic differentiation of educational opportunity. Countries with a significant private financing of education, for example, induce high-income groups to opt out of the public system and into high-quality but exclusive private education. As they do, some public institutions try to compete by raising tuition and fees, and with middle- and upper-middle classes footing more of the bill for their own children’s education, support for tax-financed public education declines.
This does not happen everywhere. In countries that inherited an overwhelmingly publicly-financed system only the very rich can opt out, and the return on private education is lower because of a flatter wage structure. In this setting the middle and upper-middle classes, deeply concerned with the quality of education, tend to throw their support behind improving the public system. Yet, they will do so in ways that may reproduce class-based differentiation within the public system. Based on an analysis of the British system, one striking finding is that a great deal of differentiation happens because high-educated, high-income parents, who are most concerned with the quality of the education of their children, move into good school districts and bid up housing prices in the process. As property prices increase, those from lower socio-economic strata are increasingly shut out from the best schools.
Even in countries with less spatial inequality, in part because of a more centralized provision of public goods, socioeconomic inequality may be reproduced through early tracking of students into vocational and academic lines. This is because the choice of track is known to be heavily dependent on the social class of parents. This is reinforced by the decisions of firms to offer additional training to their best workers, which disadvantages those who start at the bottom. There is also evidence that such training decisions discriminate against women because firm-based training require long tenures and women are less likely to have uninterrupted careers. So strong VET systems, although they tend to produce less wage inequality, can undermine intergenerational class mobility and gender equality.
The rise of economic inequality also has consequence for politics. While democratic politics is usually seen as compensating for market inequality, economic and political inequality in fact tend to reinforce each other. Economic and educational inequality destroy social networks and undermines political participation in the lower half of the distribution of incomes and skills, and this undercuts the incentives of politicians to be attentive to their needs. Highly segmented labor markets with low mobility also undermine support for redistribution because pivotal “insiders” are not at risk. Labor market “dualism” therefore delimits welfare state responsiveness to unemployment and rising inequality. In a related finding, the winners of globalization often oppose redistribution, in part because they are more concerned with competitiveness and how bloated welfare states may undermine it.
Economic, educational, and political inequalities thus also tend to reinforce each other. But the extent and form of such inequality vary a great deal across countries. This special issue helps explain why and suggests the need for an interdisciplinary approach that is attentive to national institutional and political context oppose redistribution.
Marius R. Busemeyer is Professor of Political Science at the University of Konstanz, Germany. Torben Iversen is Harold Hitchings Burbank Professor of Political Economy at Harvard University. They are Guest Editors of the Socio-Economic Review April 2014 special issue on The Political Economy of Skills and Inequality which is freely available online until the end of May 2014.
Socio-Economic Review aims to encourage work on the relationship between society, economy, institutions and markets, moral commitments and the rational pursuit of self-interest. The journal seeks articles that focus on economic action in its social and historical context. In broad disciplinary terms, papers are drawn from sociology, political science, economics and management, and policy sciences.
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