Why the Massive Wealth of the 1% Could Ruin the Economy

By Erik Brynjolfsson and Andrew McAfee

If the tech revolution continues to enrich the superstars and depress the bottom half, both parties might ultimately find themselves working less, leading to a smaller economy

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Technology changes the shares of income for the skilled vs. unskilled, for superstars vs. the rest, and for capital vs. labor. Is this simply a zero-sum game where the losses of some are exactly offset by gains to others? Not necessarily. On the positive side of the ledger, inequality can provide beneficial incentives for skill acquisition, efforts toward superstardom, or capital accumulation. However, there are also several ways it can hurt economic well-being.

First, one of the most basic regularities of economics is the declining marginal utility of income. A $1,000 windfall is likely to increase your happiness, or utility, less if you already have $10 million than if you only have $10,000. Second, equality of opportunity is important to the efficiency and fairness of a society, even if unequal outcomes are tolerated or even celebrated. Equality of opportunity, however, can be harder to achieve if children of poverty get inadequate health care, nutrition, or education, or people at the bottom are otherwise unable to compete on a level-playing field. Third, inequality inevitably affects politics, and this can be damaging and destabilizing. As economist Daron Acemoglu puts it:

Economic power tends to beget political power even in democratic and pluralistic societies. In the United States, this tends to work through campaign contributions and access to politicians that wealth and money tend to buy. This political channel implies another, potentially more powerful and distortionary link between inequality and a non-level playing field.

Finally, when technology leads to relatively sudden shifts in income between groups, it may also dampen overall economic growth and potentially precipitate the kind of collapse in aggregate demand reflected in the current slump.

Consider each of the three sets of winners and losers discussed earlier. When skill-based technical change, or SBTC, increases the incomes of high-skill workers and decreases the incomes and employment of low-skill workers, the net effect may be a fall in overall demand. High-skill workers, given extra income, may choose to increase their leisure and savings rather than work extra hours. Meanwhile, low-skill workers lose their jobs, go on disability, or otherwise drop out of the labor force. Both groups work less than before, so overall output falls.

One can tell a similar story for how super-wealthy superstars, given additional wealth, choose to save most of it while their less-than-stellar competitors have to cut back consumption. Again, overall output falls from such a shift. Former secretary of labor Robert Reich has argued that such a dynamic was in part responsible for the Great Depression, and Nobel Prize winner Joseph Stiglitz has written in detail about how the increasing concentration of wealth in a relatively small group can be corrosive to economic growth.

Finally, it's easy to see how a shift in income from labor to capital would lead to a similar reduction in overall demand. Capitalists tend to save more of each marginal dollar than laborers. In the short run, a transfer from laborers to capitalists reduces total consumption, and thus total GDP. This phenomenon is summarized in a classic though possibly apocryphal story: Ford CEO Henry Ford II and United Automobile Workers president Walter Reuther are jointly touring a modern auto plant. Ford jokingly jabs at Reuther: "Walter, how are you going to get these robots to pay UAW dues?" Not missing a beat, Reuther responds: "Henry, how are you going to get them to buy your cars?"

Over time, a well-functioning economy should be able to adjust to the new consumption path required by any or all of these types of reallocations of income. For instance, about 90% of Americans worked in agriculture in 1800; by 1900 it was 41%, and by 2000 it was just 2%. As workers left farms over the course of two centuries, there were more than enough new jobs created in other sectors, and whole new industries sprang up to employ them. However, when the changes happen faster than expectations and/or institutions can adjust, the transition can be cataclysmic. Accelerating technology in the past decade has disrupted not just one sector but virtually all of them. A common way to maintain consumption temporarily in the face of an adverse shock is to borrow more. While this is feasible in the short run, and is even rational if the shock is expected to be temporary, it is unsustainable if the trend continues or, worse, grows in magnitude.

Arguably, something like this has happened in the past decade. Wages for many Americans fell well short of historical growth rates and even fell in real terms for many groups as technology transformed their industries. Borrowing helped mask the problem until the Great Recession came along. The gradual demand collapse that might have been spread over decades was compressed into a much shorter period, making it harder for workers to change their skills, entrepreneurs to invent new business models, and managers to make the necessary adjustments equally quickly. The result has been a dysfunctional series of crises. Certainly, much of the recent unemployment is, as past business cycles, simply due to weak demand in the overall economy, reflecting an extremely severe downturn. However, this does not negate the important structural component to the falling levels of employment, and it is plausible that the Great Recession itself may, in part, reflect a delayed response to these deeper structural issues.


TEMPLATEReadMoreBookExcerpts.jpgThis is the second part of our three-part excerpt from Erik Brynjolfsson and Andrew McAfee's Race Against the Machines (Digital Frontier Press). Read Part 1 here.

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This article available online at:

http://www.theatlantic.com/business/archive/2011/10/why-the-massive-wealth-of-the-1-could-ruin-the-economy/247277/