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July 13, 2006

Principles of Inequality
by Hans F. Sennholz

Many Americans are unhappy about the growing inequality in individual income and wealth. Corporate profits are rising, executive salaries are soaring, but the wages of most workers are barely moving. Even employees with technical skills are feeling squeezed and college graduates are finding it difficult to make a fitting beginning. It is not surprising that politicians, in search of a popular issue, are adding their interpretations and recommendations. On the left, they are criticizing corporations for unpatriotic behavior, exporting American jobs in search for ever higher profits. On the right, they are condemning corporations for hiring illegal aliens who come to the United States and labor in the underground economy. Both sides are waving the American flag and filling the air with political malice and strife.

Men are made by nature unequal. Surely, to assure social peace, all men must be equal before the law and have an equal right to the protection of the law. But they do not have equal ability and productivity and, therefore, do not have equal incomes. A political order that endeavors to create economic equality by force is unnatural; it is destined to self-destruct in destitution, discord, and strife.

Individual incomes always depend on a person's productivity in rendering services to others. Most individuals merely earn compensation for services rendered, commonly called wages, salaries, fees, or honoraria. Thrifty individuals may enjoy also interest income on their savings. And enterprising individuals may even reap pure profits which flow from correct anticipation of future needs and supplies, future costs and prices, in short, future states of the market. In a welfare state many people also enjoy transfer benefits forcibly taken from taxpayers. More than fifty million Americans presently draw such payments from their fellow countrymen.

In a free market economy individual differences in income may be very visible although rather limited in numbers. There are few corporate executives, artists, and authors with million-dollar salaries and honoraria every year. There are not many investors enjoying million-dollar interest payments on their holdings. But there always are some young entrepreneurs who manage to foresee important market changes and therefore reap million-dollar profits. But all such differences pale in significance when compared with those caused by man's choice of social and economic organization. Depending on his perception of the nature of man and on his understanding of social and economic cooperation, he may choose to live in a great variety of economic orders. Some are highly productive yielding high standards of living for all; others are barren and poor condemning members to short and wretched lives. According to The Economist's World in Figures, 2006 edition, the people in Luxembourg, for instance, are enjoying an annual gross domestic product (GDP) of $55,500 per year, in Norway they are producing $37,910, and in the United States $37,750. In contrast, the people of Somalia subsist on $440 a year, in Sierra Leone on $530, and in Malawi on $590. The life expectance in the latter is about one-half of that in the former.

Such country differences began to develop some 300 years ago when in Western Europe a new social and economic philosophy began to remove institutional barriers to economic development. The laissez-faire philosophy of Adam Smith, David Ricardo, and many other authors in England, France, Germany, and the United States replaced old doctrines that branded economic freedom and acquisitiveness as immoral and advocated legal barriers to economic inequality. The new philosophy set the people free to remove these barriers and pursue their economic interests. Economic production immediately accelerated and standards of living increased visibly. Unfortunately, occasional relapses to old thoughts and policies interrupted the economic progress, and many countries that have never been exposed to the light of economic freedom continue to linger in dismal poverty.

At the present, the light is spreading slowly throughout many parts of the world, even where the political structures continue to be authoritarian. China, Vietnam, and India seem to be leading the way. But economic stagnation is holding many other countries in its grip as new production barriers are being erected to reinforce the old. Business taxes may be raised and business capital may be consumed not only by the poor and needy but also an ever-hungry bureaucracy. There is economic stagnation in France, Germany, Italy, Japan, and Switzerland. In many countries some economic pursuits do prosper while others stagnate or even decline.

Economic progress builds on the formation and investment of business capital which raises output and income. It may do so with new methods of production and new inventions or without altering the mode of production. Market pressures then divide the new income between the entrepreneurs who lead the way and the suppliers of the factors of production. In the short run, the entrepreneurs may be the beneficiaries but, in the long run, production adjustments always eliminate the entrepreneurial profits and make workers the primary recipients. In the United States and all other capitalistic countries they have been the main beneficiaries ever since obstacles were first removed and new investments were made.

Short-run syndromes of change now are permeating the American economy. Some executive incomes are counted in the millions of dollars, but the wages of many workers are barely keeping up with the rate of inflation. And once again, old explanations are making their appearance, finding grievous fault with such profits and the profit motive. These critics favor a more progressive tax system that would reduce the gap between the rich and the poor. They would reform and expand social welfare, in particular the health care system and the public pension system. And above all, they would restructure the education system in which only three percent of students at top colleges come from the poorest quarter of the population. Unfortunately, such reforms not only would boost the powers of the political reformers but also raise the costs of labor and weaken the labor market. They may even increase the rate of unemployment, especially of unskilled workers. There would be more beneficiaries of Social Security, Medicare, Medicaid, and generous scholarships, but social mobility would suffer another blow. In a heavily taxed and regulated economy it is much more difficult for a poor worker to advance in income, wealth, and position than for a wealthy person to remain wealthy.

Globalization is outsourcing some white-collar jobs, which is more grist for the mill of the reformers. Their eyes are glued on executive incomes; they are blind to policies that have undesirable consequences, policies that may even give rise to the very effects which they deplore. There cannot be any doubt that the monetary policies of the Federal Reserve System greatly affect not only the purchasing power of the U.S. dollar but also individual income and wealth. When economic activity slowed down in 2002 the Fed immediately slashed its discount rate to 1¼% and then 1%, the lowest in 45 years. Resting on the Fed rate, all other interest rates promptly plummeted to levels far below true market rates, which induced some investors to search for higher rates and higher incomes abroad. With the discount rate at 1% and all other rates not much higher, and with foreign rates at double and triple levels, it is only natural that many investors seek higher returns abroad. They may even have to leave the country in order to meet the competition that is now abroad. Surely, the driving force is the investor's profit motive, but it is the Federal Reserve policy that creates the foreign opportunities.

In a free and unhampered economy the short run is a period of readjustment to a changing market condition. Entrepreneurs and investors react quickly in order to maximize their profits. When legislators and regulators, for any reason, erect their barriers, they obviously delay the readjustment; labor productivity and wage rates may stagnate or even decline. Legislation and regulation may turn a free market economy into a command economy with rigid income and class structures. Massive deficit spending may pave the way. At the present, the federal government is suffering budget deficits amounting to hundreds of billions of dollars, which are readily financed by the Federal Reserve System. Surely, the Fed does not directly purchase new Treasury I.O.U.s; it merely enables American and foreign financial institutions to buy them.

Extraordinary expansion of money and credit gave rise to phenomenal trade deficits, $618 billion in 2004, some $700 billion in 2005, and probably higher yet in 2006. Suffered by any other country, such deficits would soon cause the national currency to flounder and thus call an early halt to the deficits. But the U.S. dollar is the primary reserve currency of the world, which persuades many foreign creditors to cling to their dollars or invest them in dollar claims. According to some estimates, foreign banks and investors are holding some $9 trillion of U.S. paper assets. They are owning some 43% of U.S. Treasuries, 25% of U.S. corporate bonds, and 12 % of U.S. corporate equities. Dollar cash holdings as well as U.S. Treasury obligations obviously are no investments in business facilities, such as corporate stocks, bills, notes, or bonds, which would raise labor productivity and wage rates.

Many Americans undoubtedly are unhappy about the growing inequality in individual income and wealth. They are guided by simple motives and beliefs in the equality of man, which theologians, philosophers, and statesmen have featured since the beginning of time. Thomas Jefferson affirmed it in the Declaration of Independence: "We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of happiness." No matter how we may read this declaration, it does not dwell on any equality of income and wealth. On the contrary, it speaks of "unalienable rights" in "the pursuit of happiness," which undoubtedly comprises also the right to pursue income and wealth.

When Thomas Jefferson wrote the Declaration Continental Congress had little money and poor means of obtaining more. The financial situation was rather precarious. Congress then authorized many issues of paper dollars and the states followed suit, issuing their own. By the end of the war, they were "not worth a Continental." Surely, the current situation differs significantly from that of the American Revolution, but it also resembles it in several important aspects. Then and now the political authorities eagerly issued paper dollars that lost some of their value every day. The economic maladjustments which the issues brought about created countless opportunities for knowledgeable entrepreneurs to make the needed readjustments. While labor productivity and income stagnated or even declined, business opportunities and profits actually soared.

The old order always changes, yielding to the new; but many economic changes merely reflect variations in monetary policy and their inescapable consequences.

Hans F. Sennholz
www.sennholz.com

Copyright © 2002-2007 Hans F. Sennholz

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