Is the Public Wrong to be Anti-Globalization and Income Inequality?

Apologies to be somewhat late to this item and more terse (and spare on links for some of the arguments) than I’d normally be (I’m at sea and the satellite connection is pricey).

Monday, the Financial Times reported that a poll it commissioned jointly with Harris found widespread international opposition to globalization, as well as rising income inequality (I haven’t done my usual checking around the logical suspects in the US media, but I have a sneaking suspicion this item went underreported in the US):
A popular backlash against globalisation and the leaders of the world’s largest companies is sweeping all rich countries, an

FT/Harris poll today shows.

The British have the least admiration of any national group for the leaders of their country’s largest companies, and a large majority believes the government should impose a pay cap on the heads of companies to limit their rewards.

Large majorities of people in the US and across Europe want higher taxation for the rich to counter a widespread belief that rewards are unjustified.

Believing that globalisation is an overwhelmingly negative force, citizens of rich countries are looking to government to cushion the blows they perceive have come from the liberalisation of their economies to trade with emerging countries.

Those polled in the UK, France, the US and Spain were about three times more likely to say globalisation was having a negative rather than a positive effect on their countries. The majority against globalisation was smaller in Germany, with its large export base.

Corporate leaders fared little better with only 5 per cent or fewer people in the US and all large European economies, except Italy, saying they had a great deal of admiration for those who run large companies.

In the UK, nearly 80 per cent of those polled thought corporate executives earned too much,60 per cent said they should be taxed more and the same proportion thought the government should limit their pay directly.

In response to fears of globalisation and rising inequality, the public in all six rich countries surveyed wanted their governments to increase taxation on those with the highest incomes.

Europeans overwhelmingly support the principle of free competition within the EU, contrary to Nicolas Sarkozy’s wishes at the recent European summit, but in France, Germany and Spain the populations want their political leaders to play a larger role in managing their economies.

The depth of anti-globalisation feeling in the FT/Harris online poll, which surveyed more than 1,000 people in each of the six countries, will dismay policymakers and corporate executives. Their view that opening economies to freer trade is beneficial to poor and rich countries alike is not shared by the citizens of rich countries.

Now one can quibble with the methodology of the survey. Online surveys probably have a bigger element of self-selection, since there isn’t a live human being to arm-twist the hesitant into participating. However, the fact that the survey may have gotten a higher proportion of cranks than in the population at large was probably partially, if not entirely offset by the fact that Internet users (at least in the US) are more educated and affluent than the population at large and therefore one would assume they’d look more favorably upon free trade and income inequality (they would be presumed to come out ahead on both counts).

Now doubtless many pundits will bemoan how dumb the public is, how they are taking positions that are contrary to their economic interests (we will leave aside for the moment that people are not merely economic automatons and might have other priorities in life than simply maximizing lifetime income and consumption). As an aside, I’m often amused that the same people who see free markets as virtuous because they provide a mechanism for netting out various views as to price and quantity will take exception to polls when they produce results they don’t like. If the public is smart enough to express its economic views intelligently in one forum, why are they not trusted in another?

In fact, in a bit of synchroncity, David Brooks, in an op-ed column, “A Reality Based Economy,” in the New York Times, attempted to dispute many popular beliefs about the current state of play. I would very much like to address this largely wrongheaded piece point by point, but let’s limit ourselves to the most germane bit:

The fourth complicating fact is that recent rises in inequality have less to do with the grinding unfairness of globalization than with the reality that the market increasingly rewards education and hard work.

A few years ago, the rewards for people earning college degrees seemed to flatten out. But more recent data from the Bureau of Labor Statistics suggests that the education premium is again on the rise.

Fifth, companies are getting more efficient at singling out and rewarding productive workers. A study by the economists Thomas Lemieux, Daniel Parent and W. Bentley MacLeod suggests that as much as 24 percent of the increase in male wage inequality is due to performance pay.

On Brooks’ point four, Paul Krugman has discussed ad naseum that most of the glaring increase in inequality is at the very top, the top 1% and even more dramatic in the top .1%. It is this group of super rich that is contributing heavily to the skew in incomes, and the specter of a group of people at the top having not only exorbitant incomes, but likely exorbitant influence, that creates a gnawing sense of unease. And the performance of this group cannot be explained by education.

On point 5, the belief that pay and promotion is meritocratic is a necessary fiction of corporate life. Our colleague Susan Webber addressed this point at length in her Conference Board Review article, “Fit vs Fitness”, which cited research not available on line on the inherent defects of performance appraisal systems.

In fairness, Brooks does acknowledge that, “Inequality is obviously increasing. There’s evidence that global trade is producing more losers.”

In addition to Brooks’ argument, the classic response is that more open trade produces gains for all participating countries, and that what these countries need to do is to implement more progressive taxation and stronger education and retraining programs to assure that the gains of globalization are shared. (Elsewhere, Dani Rodrik has pointed out that commonly cited level of income gains attributed to trade are methodologically bogus, and the benefits are much more modest. Rodrik has also provided a list of conditions that have to hold for free trade to produce its expected benefits. They differ in very significant regards from the real world. Yet most advocates keep invoking theory rather than trying to examining the facts on the ground to see what benefits “more open” trade produces.

Now the mysterious knzn has pointed to an interesting paper in progress by Karl Smith (no relation), a professor of economics and government at Chapel Hill. knzn gives this intro:

Karl Smith has an interesting idea about trade, explained here discursively and with a link to his paper in progress here. The traditional Ricardian theory of gains from trade applies in the case of certainty: those who benefit from liberalized trade will have sufficient benefits that they could (theoretically) compensate the losers and still end up better off, so trade is Kaldor-Hicks efficient ex post. But in a world with uncertainty (and with incomplete insurance markets), liberalization of trade can be Pareto inefficient ex ante. That is, the increased risk to everyone could be such a disadvantage that it outweighs the average expected gains and makes the contemplated liberalization a net disadvantage to everyone involved.

Karl Smith has posted a preview on his blog:

Kaldor-Hicks tends to overestimate the net benefits of a policy whose distribution is uncertain.

That is, when we think about whether a policy is a good idea we do a cost-benefit analysis. We add up all the costs to whomever they occur and all of the benefits to whomever they accrue. If the benefits are greater than the costs we declare the policy to be efficient.

Perhaps, the policy is not equitable but it is efficient. The winners could compensate the losers and be better off.

Now the problem is that the winners don’t compensate the losers. And, that’s not just a problem for the reason you think it is. We all admit that the distribution of the gains may be such that the winners don’t personally value their gains as much as the losers personally value their losses. However, without the ability to do interpersonal comparisons we are stuck.

Yet, there is another problem. If the distribution of the gains is not certain then the individual agents will value them at less than their face value. Likewise if the distribution of the losses is not certain than the individual agents will value them at more than there face value.

This means that even if the total benefits outweigh the total losses with certainty, uncertain distribution can lead to individual agents preferring not to make the trade.

To drive the point home I create the following example:

There is a policy were the gains to the winners outweigh the losses to the losers with certainty but NO AGENT wants to see the policy enacted. That is, there is a policy which passes cost-benefit analysis but is uniformly rejected by each person affected by it.

The simplest example is easy. Suppose that the benevolent government is offered the following deal. One million of your residents will be selected and given $100,000. Another one million of your residents will be selected and charged $99,999.

To make matters simple only residents who have at least $99,999 will participate in this program. However, whether the resident is a winner or loser is chosen at random.

This program seems like an economic free lunch. The gains are guaranteed to outweigh the losses by $1 million. The selection process is completely random, so there are no economic distortions. In fact, there is no a priori reason to expect that the winners will have lower marginal utilities of income than the losers.

Yet, we could expect that every single agent will reject this program. Why? They reject it because the program exposes them to risk. The cost of that risk outweighs the expected benefit of program.

Perhaps, the agents could insure against the risk. Since the expected gains are positive they should be able to write a contract that splits the expected gains with an insurer so that everyone winds with more than what they started with.

However, what if I said that I am not going to announce the winners and the losers? I am simply going to subtract the losses from the losers net worth and add the gains to the winners net worth with no record of the transaction. How could one insure that?

If this seems a little far fetched and unrelated to real world issues, allow me to change the offer again. Rather than simply adding $100,000 or subtracting $99,999 I am going to do this.

The winners will receive an increase in the demand for their services and a pay raise. The losers will see their jobs outsourced to Asia. The winners won’t know for sure why they lost they received a raise. The losers won’t know for sure why they lost their job.

To add another layer of realism lets change the terms a little. I won’t change any of the expected values but this time instead of selecting 1 million winners and giving them each raises worth $100,000, I will select 100 million winners and give them each raises worth $1000.

The expected gains from this deal are still $1 million. Does anyone want to go for it?

There are two insights that I draw from this thought experiment.

1) That distributional risk is a real concern in policy. If the winners don’t know they will be winners and the losers don’t know if they will be losers the policy will seem better than it really is.

This was the idea that I started with. Workers I talked to disliked outsourcing not just because some people did loose there jobs but because they felt like any of them could loose their jobs. The difference is subtle but important. The first is just about direct costs; the second includes a notion of risk.

2) The second insight I take away is that just as Von Neumann / Morgenstern risk comparisons allow us to define cardinal rather than simply ordinal utility. Who-will-gain risk comparisons allow us to define a sort of interpersonal utility comparison. If you had an equal shot of being on any end of this policy would you still support it? Its not exactly interpersonal comparisons but it carries much of the intuition we want to gain from it.

Smith will need to tighten his argument a bit( (his discussion about uncertainty are mixing the notion of lack of information with the not surprising observation from behavioral finance that people are very risk averse if exposed to the possibility of non-trivial losses) but this is a useful advance in the debate.