The emerging digital economy also creates unique opportunities for income concentration. Consider the recent purchase of WhatsApp by Facebook. Just 55 employees at WhatsApp created an astonishing $19 billion of value in a few years. Photo: Bloomberg
The emerging digital economy also creates unique opportunities for income concentration. Consider the recent purchase of WhatsApp by Facebook. Just 55 employees at WhatsApp created an astonishing $19 billion of value in a few years. Photo: Bloomberg

Robots, offshoring, WhatsApp—and the inequality question

The deterioration in the distribution of incomes is a growing worry. The economic thinking on this issue is more nuanced than the political rhetoric

Economics intersects with science fiction in the Foundation novels by Isaac Asimov. His psychohistorians use their knowledge of history, sociology and mathematics to save the galactic civilization they live in. Nobel laureate Paul Krugman has said that he chose to study economics after he read as a young boy how a social science such as the fictitious psychohistory could help a society.

However, it is not the psychohistorians but the protagonists of the three laws of robotics thought up by Asimov in his wonderful stories that are more salient to one of the most important issues that contemporary economists are grappling with: inequality. The growing use of robots in production has sparked off a spirited debate among economists about the impact of technological change on income distribution.

There are two ways to approach the inequality issue. The first is to examine how national income is distributed between households. The second is to study what economists call the functional distribution of income between workers and owners of capital. In fact, the publication of French economist Thomas Piketty’s magnum opus—Capital in the Twenty-First Century—has fanned a firestorm of interest in the functional inequality question.

The crux of his argument is that capitalism has a natural tendency towards growing inequality because the rate of return on capital exceeds the rate of economic growth. Piketty has empirically challenged two hoary truths in economics that took root more than five decades ago.

The first was the observation of the US economist Simon Kuznets that income inequality increases in the initial stages of development but then eventually falls as countries complete their structural transformation from agriculture to modern industry. The second was one of the six stylized facts about economic growth proposed by British economist Nicholas Kaldor: the share of national incomes going to capital and labour in any country is roughly equal over long periods of time.

Piketty has shown in his data, which he has helpfully made available online, how inequality has been increasing once again in recent decades while the share of income going to capital is also trending up.

There are three grand narratives in economics about growing inequality.

The first narrative deals with the impact of technological change on labour incomes. Piketty is not the first economist to show that the share of capital income has been going up. For example, Loukas Karabarbounis and Brent Neiman show in a paper published in June 2013 that the share of labour income has been dropping across the world over the previous 35 years. They argue that about half of this fall in the labour share of global income can be explained by the fall in the relative price of machines thanks to the introduction of new production technology. I will deal with this complicated issue in greater detail in a while.

The second narrative looks at the impact of globalization on the functional distribution of income. The entry of over one billion Chinese and Indian workers into the global economy over the past 25 years basically drove down the relative price of labour, and hence the share of workers in national income. These extra workers from the two most populous countries in the world have had the same effect on global wages that Karl Marx expected from what he called the reserve army of labour.

A recent paper by Michael Elsby, Bart Hobijn and Aysegül Sahin shows that the decline in the labour share of US income can be explained by offshoring to low-income countries. But the research done by Karabarbounis and Nieman shows that the share of labour income has been declining even in China; so globalization can perhaps explain what is happening in one country but may not be able to tell us why the same trend can be seen in countries across the world.

The third narrative about inequality deals with the tendency of the new global economy to give disproportionate rewards to a handful of winners. The classic paper was published in 1981 by Sherwin Rosen on the economics of superstars. He showed that new technologies allow the best to capture most of the returns in an industry. The obvious examples are in creative pursuits such as film, music or sports. The superstars dominate.

The emerging digital economy also creates unique opportunities for income concentration. Consider the recent purchase of WhatsApp by Facebook Inc. Just 55 employees at WhatsApp created an astonishing $19 billion (around 1.1 trillion) of value in a few years. The network externalities that can be harvested in the digital world ensure that there is a natural tendency to dominance—the winners take all.

The globalization and network externalities arguments are powerful but many economists have now been focusing their attention on the impact of new production technologies—especially robots—on the changing shares of labour and capital incomes. Some of the analysis is glum. In a paper published in December 2012, Jeffrey Sachs and Laurence Kotlikoff try to show that robots are the enemies of the next generation.

Their basic model is as follows. Smart machines such as robots complement the skills of older workers but displace younger unskilled workers. The latter see their wages decline. They are then unable to invest in skills as well as physical capital. This creates an economy with increasingly less human and physical capital. The process means there is a risk that each generation is worse off than its predecessor. Smart machines lead to long-term misery.

Does new technology always drive down wages? A lot depends on the nature of technical change. One of the finest expositions of this reasoning takes off from the classic 1932 paper by John Hicks, The Theory of Wages. Much depends on the extent to which technical change is “capital-biased".

Krugman has used the insightful framework developed by Hicks to explain in a lucid blog post: “It’s wrong to assume, as many people on the Right seem to, that gains from technology always trickle down to workers; not necessarily. It’s also wrong to assume, as some (but not all) on the Left sometimes seem to…that rapid productivity growth is necessarily jobs- or wage-destroying. It all depends. What’s happening right now is that we are seeing a significant shift of income away from labour at the same time that we’re seeing new technologies that look, on a cursory overview, as if they’re capital-biased."

What could be the larger economic impact of the growing use of robots in production? Martin Wolf of the Financial Times recounted a delicious story in one of his recent columns. The manager of a large automobile factory in the US was showing the union official around the new assembly line dominated by robots. “They will not be going on strike," said the manager. The union official quickly retorted: “Yes, but they will not be buying your cars either."

There is a serious economic issue highlighted here. The increasing use of robots could indirectly damage effective demand because the standard assumption in Keynesian economics is that those with lower incomes have a higher marginal propensity to consume. So a lower share of wages in national income will tend to depress demand.

But the more insightful analysis comes from the brilliant heterodox Polish economist, Michal Kalecki. He put the division of national income between labour and capital at the heart of his analysis of economic fluctuations. Kalecki argued that a higher share of labour income is expansionary because workers have a higher propensity to consume.

The Kalecki model has microeconomic foundations. Not only does income distribution play a key role in his theory of effective demand but he also argued that the relative share of profits in national income is determined by the degree of monopoly in an economy. His analysis has faded into the background but this link between monopoly and profit share could be useful in the emerging fourth narrative about inequality—its link with what is loosely called crony capitalism. An economy that does not have competitive markets could push up the share of national income going to owners of capital.

The converse of what Kalecki said is that a more unequal distribution of income will lead to a higher share of capital income that will be reinvested. Richard Godwin argued in a 1967 paper that a higher wage share will reduce investment and hence economic growth. The two views—Kalecki and Godwin—were analyzed well by Engelbert Stockhammer and Robert Stehrer in a June 2009 paper .

Is inequality growing?

The answer is more complicated than many assume. Inequality within countries is definitely growing. But inequality in the world as a whole is perhaps reducing because of the rapid income growth in the two most populous countries in the world: China and India. Hundreds of millions of people in these two countries have moved closer to the global average. However, the growing inequality within nations attracts more attention because politics is national. Growing inequality within nations will likely be a growing area of concern in the coming years even as global inequality declines.

“Disparities are increasing—between the rich and poor in individual countries, and until recently, between countries. The global financial crisis is keeping real incomes stagnant in advanced economies but it probably narrowed global inequality between citizens of the world, because most developing countries continued with strong growth," wrote World Bank economist Branko Milanovic, one of the greatest scholars on inequality. Even the International Monetary Fund has said in a staff paper released in January that it will be sensitive to the impact of the policies it recommends on inequality in member nations.

In a celebrated essay titled The Economic Possibilities of our Grandchildren, John Maynard Keynes had predicted the “euthanasia of the rentier" because of low interest rates: “The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital."

The current era of low interest rates has in fact seen inflated asset bubbles that have multiplied wealth at the top of the income pyramid. It is never clear whether a rich man is a rentier or a risk-taker—a lot depends on the ideological bias of the writer. But there can be no doubt that the complicated debate about inequality has nuances that deserve more attention in the midst of all the loud political rhetoric.

Economics Express features interesting reads from the world of economics and finance. It appears online every Thursday.

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