When is inequality harmful? When it's caused by cronyism

Reuters

Microsoft founder Bill Gates (R) answers a question next to billionaire financier and Berkshire Hathaway Chief Executive Warren Buffett at a joint news conference in Beijing September 30, 2010.

Article Highlights

  • President Obama wants to put inequality at the center of America's political discourse. Fine.

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  • Inequality can be messy to talk about: it is entangled in many different concepts that need to be considered separately.

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  • Every American has an obligation to feed the hungry and house the homeless.

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  • If a person can’t reasonably expect to do better than his parents, that saps incentives for hard work.

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  • Is it a bad thing for a country to have some really rich people? Again, it depends on how they got rich.

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President Obama wants to put inequality at the center of America's political discourse. Fine. Here’s the opening question: “Does inequality matter?”

The answer: “It depends.” It depends on how governments react to inequality, it depends on how developed the country is, it depends on whether it's wealth inequality or income inequality.

It also depends on how the wealthy got wealthy, according to a recent academic study. In short: Inequality doesn’t hurt a country, unless the inequality results from government favors.

Inequality can be messy to talk about, because it is entangled in many different concepts that need to be considered separately.

For starters, poverty is bad. Every American has an obligation to feed the hungry and house the homeless, not just because it's the right thing to do but also because poverty drags down productivity and economic growth.

Also, immobility is bad. If a person can’t reasonably expect to do better than his or her parents, that saps incentives for innovation and hard work and undercuts the moral basis of capitalism. Obama spoke a bit about this last week in his inequality talk.

Putting aside poverty and immobility, what’s left in the concept of inequality? One simplified way to put it might be: How rich are the rich?

In other words, is it a bad thing for a country to have some really rich people? Again, it depends on how they got rich.

Sutirtha Bagchi of the University of Michigan’s business school and Jan Svejnar of Columbia’s School of International and Public Affairs studied how inequality correlates with economic growth. In general, more inequality meant slower growth, and less inequality meant faster growth.

But in many countries, over various time periods, growing inequality had no effect on economic growth. The new study suggests that an increase in inequality hurt the economy when the rich were getting rich through political connections.

That is, inequality hurts the economy when “a large share of the national wealth is held by a small number of politically connected families,” as the authors put it.

It’s a subjective distinction, but Bagchi and Svenjar took pains to classify political billionaires as narrowly as possible. Just being politically connected wasn’t enough to earn that label. Simply profiting from government policy didn’t trigger the designation. The political billionaires were only people who “would not have become a billionaire in the absence of political connections that resulted in favoritism and/or explicit government support.”

For instance, Indonesian businessman Prajogo Pangestu is a political billionaire because the government-owned bank extends him loans on absurdly generous terms and the state erected tariffs to protect his business from competition.

Or here’s a Wall Street Journal account of Russian Mikhail Fridman: “[Fridman was] among a handful of businessmen who helped to finance Boris Yeltsin’s re-election campaign in 1996. The Kremlin rewarded these men by selling them state-owned oil and metals companies at bargain-basement prices.”

Contrast these men to America’s richest people. Bill Gates and Warren Buffett haven’t abstained from politics (Buffett is an Obama fundraiser), but they overwhelmingly made their money by inventing well and investing well.

When a country’s wealthiest people got their wealth as Pangestu and Fridman did, inequality places a drag on the economy. When a country’s wealthiest got wealthy through market means, the resulting inequality has no negative effect on economic growth.

This jibes with what we know about free markets. If people can get rich by providing valuable things at good prices, then society will get more valuable things at good prices—and people across the income spectrum benefit. But if people get rich by pocketing subsidies and using the state to crush competitors, then they gained their wealth at the expense of everyone else.

Bill Gates became a billionaire by making and selling something that makes regular people more productive and more connected. Buffett got rich largely by providing capital to underfunded but well-run businesses.

If Bagchi’s and Svejnar’s findings are correct, then the bottom line is this: Inequality itself doesn’t hurt the economy. Cronyism hurts the economy.

Timothy P. Carney, The Washington Examiner's senior political columnist, can be contacted at [email protected] His column appears Sunday and Wednesday on washingtonexaminer.com.

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