[While Noah is on vacation, we present a series of classic posts from his American Scene days. This one first appeared 12/15/10 -- ed.]

Tyler Cowen has written a really excellent piece in the American Interest about inequality, how it matters, and how it doesn’t. I strongly recommend reading the whole thing, but if I can summarize his two key points:

- On the one hand, it’s not clear that gross inequality across the social spectrum is increasing, and if it is, it isn’t clear that it’s a problem. It may not be increasing because prices have been declining for inexpensive goods even as they have been increasing for luxury goods, so apparently stagnating wages in the bottom four quintiles may actually represent increases in purchasing power, while rising wages in the top quintile may be substantially eaten up by inflation in that quintile’s typical basket of goods. It’s not clear it matters because the overall level of wealth has gone up so much that even relatively poor people in modern America are relatively comfortable on an absolute scale. Moreover, people don’t really worry about the “deserved” wealth earned by Bill Gates or Tiger Woods or J. K. Rowling; they only get annoyed at “undeserved” wealth.

- On the other hand, it is clear that inequality is increasing massively at the very top – between the top 1% of earners and the rest of society, and within the top 1% of earners. Some of that increase in inequality is due to the increased market power of outstanding individuals in a winner-take-all market driven, in turn, by the greater reach of modern communications. This explains Tiger Woods, J. K. Rowling, and, arguably, Bill Gates. We don’t have to worry about that. Most of the increase in inequality at the top, however, is driven by changes in the nature of modern finance, and this we do need to worry about, not so much because of the effect (rising inequality) as the cause (rent-extraction and socialization of risk rather than productivity-increasing innovation). But it’s not clear that we know how to solve this problem.

I have three major comments:

1. My narrowest point, about the “deserving rich.” Cowen makes the point that most people appear to admire rather than despise extremely wealthy individuals like Bill Gates, Tiger Woods and J. K. Rowling who have “earned” their great wealth through great achievement. The far greater rewards that accrue to such extraordinary individuals today rather than thirty or sixty years ago is, he argues, not a matter of general social concern, being the result of changes in technology and impersonal market forces.

I would point out, however, that the state of the law does have some bearing on this question, specifically the state of patent and copyright law. The deserving “winners” that he cites – and, indeed, the ones we usually cite – are “winners” because they own intellectual property that has proven to be enormously valuable. But intellectual property, much more so than other forms, is a creation of the law. It is a form of legal monopoly, granted to innovators. J. K. Rowling, for example, would be far less wealthy if she did not own a robust passel of rights to the characters and stories she created, rights that, while nominally of limited lifespan, in practice appear to be trending toward permanence.

One can argue that such an arrangement is a good one – but it’s not simply the result of “market forces.” The law has changed on these matters since Dickens’ day, and those changes are not irrelevant to the existence of massive intellectual property fortunes. And we should not lose sight of the fact that the purpose of intellectual property law is not to reward innovators but to encourage innovation. And it is not at all clear that winner-take-all is the optimal strategy for encouraging most players.

2. My most technical point, about finance. Cowen correctly points out that much of modern finance involves bets against extreme outcomes. During normal times, these bets pay off, and everyone looks very bright. But when the extreme outcomes happen, the entire system is shocked, and so the risk is socialized. The banks (or, rather, their creditors and in many cases shareholders) get bailed out, and the losses are borne by the taxpayer. Cowen does a very good job of detailing how this happens. (Loose money advocates, pay particular attention to the section on the stealth bailout of banks via a steeply upward-sloping yield curve, paying interest on reserves, and other ways in which money is kept relatively tight.)

But the problem of asymmetric risk is more general than he says. Any public corporation has an agent/principal problem with respect to executive managers versus shareholders, and there’s always a structural asymmetry between shareholders and creditors, to say nothing of stakeholders in the larger society. All of this can drive behavior that socializes risk and privatizes reward. (Remember, GM got bailed out, too.)

What’s unique about finance, I would argue, is a crucial kind of information asymmetry – not merely that outside observers cannot know as much as insiders do (this is also generally true, not merely true of finance), but that in finance the asymmetry pertains to precisely the information needed to game the system. Put simply, financial executives will always know more about how to game the financial system than anybody else, because manipulating the financial system is their job.

Cowen points this out as well, and says this is one of the main reasons that solving the problem is so difficult. But solving the problem may appear difficult in part because we parameterize that problem as “how can we keep up with the smart finance types” and that may be the wrong way to think about the problem. As I’ve argued before, the existing regulatory architecture is designed to intelligently measure risk and then intelligently charge for it. This creates a perverse incentive to hide risk where it cannot be measured, because then a financial institution can leverage returns enormously. This was precisely what happened with all that triple-A-rated mortgage debt. Triple-A investments are virtually riskless (supposedly) and so require virtually no capital. (Oops.)

We need to learn how to fight intelligence with stupidity, a paradigm change that emphasizes the impossibility of perfectly measuring risk, and therefore overcharges in ham-handed ways for apparently riskless positions. This would create an incentive to simplify balance sheets and to take risks that can be measured, and therefore charged for intelligently.

I’ve harped on this a bunch in the past, particularly with respect to Finreg, and the maximum leverage ratio provision is one limited step in the direction i’m talking about. But I think it’s more broadly relevant. But I think it’s relevant not just to the stability of the financial system but to this point about inequality. I think the case that the financial sector is delivering itself outsized rewards relative to their contribution to economic growth is very powerful. Focusing on trying to reduce those rewards may be grasping the wrong end of the stick. It may make more sense to focus on those activities that generate large rewards but don’t contribute to the productivity of the economy (or even detract from it). My sense is that those activities are concentrated in areas that don’t use a lot of capital.

In the financial sector, we actually want to punish institutions for finding ways to make money apparently for free, because we have the conviction that it is impossible to do so at any kind of scale – if it looks like you’re making money for free, you’re really taking risk that isn’t being captured by the existing models. Tackling the activities that are most directly contributing to the instability of the financial sector will have the happy side effect of either reducing the earnings of financial executives or forcing them to earn their keep by facilitating the allocation of capital to genuinely productive activities.

3. My most philosophical argument. Cowen’s point about inequality possibly not increasing among the lowest four quintiles because of changes in the prices of goods is a valid and good one, as is his point about absolute improvement in material conditions. But the prices of some goods have not gone down – some of the most essential goods have, in some cases, gotten quite expensive indeed.

It is possible today to grow up in an American home with a 40-inch flat-screen television and a daily caloric intake so high that it actually becomes detrimental to health, but to lack access to basic medical and dental care, to run a material daily risk of rape or other profound physical violence, and to leave school functionally illiterate. Poverty today means something very different than it did in Dickens’ day, but it has not been abolished. And it seems to me that asking about the welfare of the lowest quintile is a much better way of approaching the problem of inequality in our society than looking at Gini coefficients.

On the other hand, I think his point about “threshold earning” is also very important, and raises a philosophical question about the meaning of wealth. I would argue that the right measure of wealth is not where one stands on a relative scale to other people but, simply, can you live off your assets. At whatever your chosen lifestyle level in your subculture is, do you need to work for a living, or can you live off the work of others (which is what living off your assets actually means). If you can, you’re rich, even if you continue to work, because your work is a choice, not a necessity. if you can’t, you aren’t. Perhaps you could be if you simply adjusted your perspective on what counts as an acceptable lifestyle – but we all know people who are “house poor” and the phrase has real meaning. (By which I do not intend to suggest it is truly analogous to actual poverty.)

We are living in a very interesting period in history, where the boundaries between work and play, and between productive and nonproductive activity, are becoming more and more fluid. Having the freedom to cross and recross that boundary is enormously valuable to an individual, and a society. But that freedom is not remotely evenly distributed. I hate to sound like some kind of socialist, but when we think about inequality, in my view we should be thinking primarily about two factors: first, whether absolute deprivation of essential goods is a real problem in our society (I would argue that it is, at least for some essential goods); second, whether some measure of wealth in the sense I am using it – as freedom, rather than as relative positioning – is reasonably broadly distributed across society, and is a plausible aspiration for most people at some point in their lives.