(This essay was published in Hong Kong Economic Journal on 4 June  2014)

 

“We are the 99%!” was the rallying call of the short-lived Occupy Wall Street movement. Their war cry reflected concern with the finding that the income shares of the top 1% have increased since the 1970s, and with an image of society divided between the very rich and the increasingly poor (at least in a relative sense) and the wide, impassable gulf separating the two.

 

I showed in last week’s essay why this static view is a deeply flawed picture of the competitive capitalist economy today. The puzzle of the rise in incomes of the top 1% can be explained to a large extent by the rise of superstars capable of earning vast sums in today’s globalized, digitized, networked, and financially integrated economy. That was not possible in the past. In addition, those in the English-speaking world seem to be better positioned than others to take advantage of this new environment.

 

An interesting feature of this new world is that those who make it to the top often do not stay there for very long either. Turnover among this top income group is high.

 

But the skewed income growth at the top is not the only reason why income inequality has increased since the 1970s. Another factor is that the top 20% are doing better and the bottom 80% are doing worse (at least relatively). The two ends of the income distribution are moving further apart and appear to be “polarizing”. So there is a second puzzle. Why has the income of the bottom 80% fallen behind, and why are the top 20% doing better? Many in the bottom 80% have experienced slow income growth and sometimes even negative real growth.

 

Household Income Inequality and Family Structure

 

Rising income inequality and slow income growth in the bottom 80% are the result of two separate (perhaps partly related) processes: one affecting individual income and the other household income. The former is primarily an economic process and the latter is a mixture of social and economic processes.

 

Empirically, we observe that households have grown smaller over time. This leads to two important results. First, individual income inequality has increased over time, but less so than household income inequality. Second, household income growth is slower compared to individual income growth. Median household incomes have grown slowly, sometimes even negatively so, because the rising number of small households in the population artificially lowers the median. For the same reason, household income inequality increases when the proportion of low-income households increases, as more households become smaller.

 

The development of smaller households is often economically a good thing. For example, more children now leave home as they grow up and very often even before they become married and have children. To a large degree this is a product of prosperity. They can afford to do so. So some rise in observed household income inequality is a positive economic sign.

 

On the other hand, households are becoming smaller because of rising divorce rates. Divorce is more prevalent among poorer households and this has worsened household income inequality. Divorce also has longer-term, negative effects on the upward mobility of children, directly through the disruption of family life and indirectly through community effects. Individuals growing up in communities where divorce rates are high seem to do worse than those who grow up in neighborhoods with a lower rate. The rise of household income inequality and poverty is complex and connected to many interrelated social and economic processes.

 

Education and Rising Individual Income Inequality

 

Why has individual income inequality also increased? The economics behind this process has been very well studied. As early as 1992, Professors Lawrence Katz of Harvard and Kevin Murphy of Chicago identified it as the result of skill-biased technological progress that increased the demand for skilled labor, resulting in a wider relative income gap between skilled and unskilled workers. Katz and Murphy defined the relatively unskilled as high school graduates and the relatively skilled as university graduates.

 

Katz and Murphy’s research is critical for understanding rising individual income inequality. Murphy received the John Bates Clark medal for his research contribution in this area. The late Professor Gary Becker (Nobel Laureate 1992) has called Murphy his brightest student. Goldin and Katz (2008), both of Harvard, followed Murphy’s lead to undertake a comprehensive historical analysis of individual income inequality in America.

 

Goldin and Katz’s research showed how the U.S. wage structure had evolved across the last century: narrowing from 1910 to 1950, fairly stable in the 1950s and 1960s, widening rapidly during the 1980s, and “polarizing” since the late 1980s. The increase in wage inequality since 1980 can be accounted for by rising educational wage differentials, just as a substantial part of the decrease in wage inequality in the earlier era can be accounted for by declining educational wage differentials.

 

They found that although skill-biased technological change had generated rapid growth in the demand for highly skilled workers throughout the past century, increases in the supply of skills had been uneven. Between 1910 and 1950, the expansion of tertiary education more than kept pace with the demand for skilled labor.

 

But since the 1980s, the supply of skilled workers has failed to increase sufficiently to meet the rising demand because tertiary education has failed to expand. A slowdown in the rise of educational attainment of successive U.S.-born cohorts has been behind the surge in educational wage differentials. The shortage of highly skilled workers in the U.S. led to rising returns from tertiary education, and individual income inequality began to worsen. Polarization developed in the labor market as employment shifted into high- and low-wage jobs at the expense of the middle.

 

What Goldin, Katz and Murphy found in the U.S. has also happened in other countries. After studying 144 countries from 1950 to 2010, Castelló-Climent and Doménech (2014) found that although most countries have experienced a very significant reduction in schooling inequality, it has not been accompanied by a similar reduction in income inequality. They showed that this third puzzle can be accounted for by two effects.

 

First, the return on schooling increases with the level of education. The return on tertiary education is higher than the returns on secondary and primary schooling. Second, globalization and skill-biased technological progress have widened wage differentials between better-educated and less-educated workers. For many developing countries, globalization is a more important factor than it is for the U.S. and the developed economies. The impact of globalization on labor markets in the developing economies is similar to the effects of skill-biased technological progress in the developed nations.

 

As wages at the top have increased, they have dominated the effects of improvements in schooling and the wages of the population at the bottom end of the income distribution. These findings are consistent with a low-quality educational system at the lower levels of schooling, which may lead to higher literacy rates and less schooling inequality, but does not necessarily contribute to significant skill accumulation. This effect has been seen in many countries. It does not mean educational policies have not reduced poverty and improved wages and the standards of living. But they have not reduced income inequality because they have not been able to offset the income effects of skill-biased technological progress and globalization.

 

Mistaken Views of Education and the Economy

 

Many government policy makers around the world still hold an old belief that one should not train too many university graduates because they will become sources of social and political unrest should they become unemployed or be unable to find good paying jobs. This is a mindset inherited from the 1960s and 1970s. At that time governments in most developing economies were practicing import substitution policies and an industrial policy of picking winners.

 

The economy was heavily regulated with many barriers to entry. Market forces were suppressed in favor of government action. Employment opportunities for university graduates were few and concentrated in a narrow range of capital-intensive and infrastructure industries favored by government. Under such conditions, policy makers had some justification for thinking there was little need to train too many graduates lest there be unemployment of the skilled.

 

But in the 1980s, the situation changed when globalization appeared everywhere and markets opened up to cross-border economic activities. Many previously closed economies welcomed international trade and foreign investments. Suddenly there was a huge demand for skilled labor everywhere, severe shortages appeared and their wages surged. Outsourcing production from developed to developing countries worsened the mismatch of skilled and unskilled labor at home. Individual income inequality rose everywhere, in both rich and poor countries. Past fears of over-education had resulted in the curse of insufficient educational investment.

 

Those who oppose and criticize globalization for causing inequality have failed to appreciate that this need not have been an outcome. Globalization and skill-biased technological progress would not have led to rising income inequality if there had been adequate investment in education. The failure of education policy to rise to the challenge is the critical missing link. How to promote education, raise its productivity, so that it can effectively reach the poor and help the less privileged to get ahead is a major challenge for our era.

 

No Good Jobs or No Suitable Skills?

 

What happens when the economy has a growing demand for skilled workers that cannot be met? Employers seeking skilled workers complain they are unable to attract workers unless they pay very high wages and this cuts into their profitability. Companies and industries are driven out unless they have sufficiently high value-added and can afford to pay high wages for skilled workers. This thins out jobs that are important for supporting a middle class.

 

Low value-added employers, however, are able to survive by employing unskilled workers. The abundance of unskilled workers and the intense competition among them keeps their wages low. Evidence indicates that there has been an increase in lower-paying jobs with less stability, often part-time, and providing few benefits. Moreover, median full-time income has hardly increased for years and in some instance decades. No wonder unskilled workers complain that they cannot find good jobs. But without a sufficiently skilled labor force, companies and industries would have to take on too much risk to start businesses that employ highly-skilled workers.

 

Take Hong Kong as an example. One of the fastest-growing sectors is retail business, but it hardly employs highly-skilled workers. The most innovative businesses have been restaurants. Not only have there been many Michelin star awards for great cuisine and service, but even at the low end there have been breakthrough successes as witnessed by the number of restaurant chains that are listed on the stock exchange. I personally have been particularly impressed by the success of hot-pot restaurants that have been able to run a business quite profitably by replacing waiters with bussers and creating job opportunities for those without any skills (the almost unemployables).

 

The landscape of opportunity has become more tilted over time, increasing the level of polarization in the labor market as the mismatch between the demand and supply for skilled workers continues. Jobs in the middle ground are being hollowed out as the gap between skilled and unskilled workers widens.

 

At the same time, some sectors of the economy have added well-paying jobs demanding high skills and education. Many of these jobs can be found in the financial and technology sectors, as well as in several of the professional fields. These jobs pay exceptionally well because skilled workers are in shortage and have too few competitors.

 

Fortunately, the new labor market is not static. The same individual over his entire working life may experience poverty, affluence, or neither condition. Rank and Hirschl (2001) showed that between the ages of 25 to 75 years old, about 51% of the population in the U.S. would fall below the poverty line at some point in their lives (see Table 1), while another 51% would experience affluence. Affluence was defined as 10 times the poverty line income level. Mobility in and out of poverty and affluence characterizes the new labor market landscape. This type of turnover may produce economic insecurity for not a few. But it is not a picture of a fixed class structure that many of us are misled to believe by looking at static income distribution figures (for example, Piketty and Saez 2003).

 

Table 1: Cumulative Percentage of U.S. Adult Population Experiencing Poverty and Affluence from Age 25

 

At Age Experienced Poverty Experienced Affluence Experienced neither Condition
25 5.9% 1.9% 92.2%
35 19.7% 14.2% 67.2%
45 28.2% 26.9% 50.0%
55 35.4% 40.2% 35.8%
65 42.8% 48.9% 25.9%
75 51.1% 51.0% 20.1%

 

Table 1 gives the cumulative percentage of the adult population in the U.S. who experienced poverty, affluence or neither condition at different ages starting from the age of 25. So at age 25, around 6% of people have experienced poverty (presumably in that very year). And then from there, the number grows and grows. It cannot decline obviously because you cannot un-experience poverty. By the time people reach age 75, 51% of them have experienced at least one year of poverty. By the same token 51% would have experienced at least one year of affluence. And only 20% have experienced neither condition. To be clear, this figure pertains to the percentage of people facing these situations at least once in their lifetimes, not those who are facing these situations right now.

 

Some critics blame markets for inequality, for example, for not “creating” enough good jobs in the economy that pay well. Others blame the government for failing to provide an effective social safety net for those who fall into poverty. They believe income inequality is the product of a capitalist market system that ensures there will always be economic losers. But they miss the point that capitalist markets respond to economic opportunities.

 

If the quality of the labor force is insufficiently skilled, then businesses will only create low-end jobs to make the best of what is available. The real failure is that of public policy and insufficient investment in education to address the shortage of skilled workers over the past 30 to 40 years. With slavery banned, education suffers from capital market imperfections that require public intervention. The government has failed in the area where its presence is most needed.

 

There is another failure of public policy and that is the supply of land and property to facilitate development. This is an issue I shall discuss in the future when I review Professor Thomas Piketty’s Capitalism in the 21st Century and reflect on the situation in Hong Kong.

 

References

 

Amparo Castelló-Climent and Rafael Doménech, “Human Capital and Income Inequality: Some Facts and Some Puzzles,” BBVA Research Working Paper, 12/ 28, 2014

 

Claudia Goldin and Lawrence F Katz. The Race Between Education and Technology, Harvard University Press, 2008

 

Lawrence F Katz and Kevin M Murphy, “Changes in Relative Wages, 1963-1987: Supply and Demand Factors,” Quarterly Journal of Economics, February 1992.

 

Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States, 1913-1998,” Quarterly Journal of Economics, February 2003.

 

Mark A Rank and Thomas A Hirschl, “Rags or Riches? Estimating the Probabilities of Poverty and Affluence across the Adult American Life Span,” Social Science Quarterly, December 2001.

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