Monday, December 16, 2013

Income Inequality and the Question of What Creates Value

For all that they talk about free markets you'd think that the right wing would have a good grasp of how they work and their implications. However, almost everything I read from the right wing seems to imagine an agrarian economy in the early phases of marketization.

Today's example comes from Kevin Williamson at the National Review. He asserts that:

Incomes are going up at the top and stagnating or declining at the middle and lower end of the spectrum, but — and this is critical to understanding our challenge — the high incomes at the top do not cause the lower incomes at the bottom, nor vice versa. There is no such thing as “national income” or “income distribution.” There is no bucket labeled income the contents of which are ladled out by the government or by the statistical aggregation we call “the economy.” If people at the top made less money, that would not free up money for everybody else.
This is fair enough as an assertion, I'm not convinced but it's plausible. However, he contradicts this view just a paragraph down. Contrast:

The integration of global markets means that returns to successful entrepreneurship, managerial excellence (real or perceived), sought-after skills, etc., are very high and growing. Imagine the case of the CEO of a business worth $1 million: If through administrative skill or innovation* he adds 50 percent to the value to the business, he has created $500,000 in new wealth. Now consider the case of the CEO of a business worth $400 billion, as ExxonMobil is. If a CEO through administrative skill or innovation adds a mere 0.5 percent to the value of the enterprise, he has created $2 billion in new wealth. Scale matters: To be the third-largest car dealer in Muleshoe, Texas, is one thing; to be the third-largest car dealer in Houston is another; to be the third-largest car dealer in Texas or the United States still another, and to be the third-largest one in the world quite another thing. 

Nutella creates jobs in high-wage and low-wage countries alike, and it even manufactures in high-wage countries such as Canada and Germany, in part to be close to its final customers. But if you work in the back office of a bank, it does not much matter where you are — your product doesn’t spoil, doesn’t require shipping, and doesn’t have to be physically in hand to be consumed. If you work in a job like that, you are now in much more direct competition with a very large market full of relatively low-wage overseas competitors than were Americans during the short-lived golden age that persisted from the end of World War II to the turn of the century.
Did you notice how he shifted from value creation and scale for high wage workers to competition for low skill workers? Why are the two groups being treated differently? Why does scale justify high incomes for the wealthy but not for the not wealthy? Wouldn't it be just as possible for a firm to award all of its employees based on the value they create, adjust for the organization's scale, and not just those at the top?

He does attempt to assert that high income Americans are also high skill Americans but this doesn't really solve the problem. It should be fairly obvious that what is creating the wealth in the scenario he is describing is the system and not the individual.

This is something most of us have encountered in our careers. The same salesperson will rack up tens of thousands of dollars in one business, hundreds of thousands in another, and millions in a third. These wild discrepancies in payouts are the result of the system the salesperson is working in, it is implausible that someone's skills would have increased by orders of magnitude over a career.

If Williamson really did understand free markets he'd realize that the majority of wealth is created by the market system itself, and to a lesser degree, the firm. Markets drive businesses to make certain decisions, in reality, CEOs (at least the data driven ones) tend to be fairly constrained in their actions. Replace one with another and very similar results will usually emerge.

But the idea of marginal product is for the little people whose wages are pushed down by international competition and not the high skill individuals who receive their income based upon "new wealth" rather than the marginal value of replacing said CEO.

So, ultimately, Williamson's assertion that there is no such thing as a "national income" or an "income distribution" is false. The majority of income is being generated by the market economy itself, we are not an agrarian economy producing turnips that can be stacked up and measured. Our economy is so effective because it sharply constrains the choices that can be made by someone in the CEO slot. Furthermore, income distribution happens at the level of the firm. Since the institutions that make up the firm are the primary driver of value the people making up a corporation face a decision of how to distribute the income generated by those institutions. It is unsurprising that many firms make a choice to reward their upper offices based on value added* while awarding lower tiers based on replacement cost.

It's even less surprising that people are willing to pay other people to not only not get this but to defend this. It is depressing that our values have changed so radically that a political party can openly endorse the idea that the wealthy create value and that those not so privileged are simply commodities to be exploited for the enrichment of their betters. Incidentally, it also contradicts management best practices which emphasize the system and value creation throughout the organization rather than just at the top.

[An aside, I also take exception at Williamson's assertion that inequality has been rising throughout the world. While true, this is heavily distorted. Wealth and income inequality have risen particularly rapidly in the US, and to a lesser extent in economies that are structured similarly to ours. In other countries, while there has been a small increase, it is much smaller. So international competition can only explain a small fraction of what has been observed here. Other factors are more dominant. Most convenient source I could find: Piketty and Saez The Evolution of Top Incomes. ]

*Admittedly if we believe that it really was skill or innovation of the individual calling the shots that created the wealth this remains somewhat plausible. But this isn't how modern organizations make decisions. Those that do make decisions like characters out of an Ayn Rand novel are almost definitely lucky and not skillful since this contradicts pretty much everything management studies says about management.

**Productivity has been increasing steadily and has decoupled from wage growth. If lower tier employees were compensated according to value added, and not treated like commodities compensated at their replacement cost, income inequality would not be increasing.

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