Sociology Essay Questions

182 THE PRICE OF INEQUALITY

aging globalization that are better for both our economy and

our democracy; but they do not entail unfettered globalization. We have learned the risks of unfettered markets for our econ-

omy and how to temper capitalism so that it serves the major-

ity of citizens, not a tiny, powerful fraction. So too, we can temper globalization; indeed, we must if we want to preserve

our democracy, prevent our rampant inequality from growing

worse, and maintain our influence around the world.

CHAPTER SIX

1984 IS UPON US

T H E BIG PUZZLE WE PRESENTED IN THE LASTchapter was how, in a democracy supposedly based on one person one vote, the 1 percent could have been so victori- ous in shaping policies in its interests. We described a process

of disempowerment, disillusionment, and disenfranchisement

that produces low voter turnout, a system in which electoral

success requires heavy investments, and in which those with

money have made political investments that have reaped large rewards-often greater than the returns they have reaped on their other investments.

There is another way for moneyed interests to get what they want out of government: convince the 99 percent that they have shared interests. This strategy requires an impressive sleight of

hand; in many respects the interests of the 1 percent and the 99 percent differ markedly.

The fact that the 1 percent has so successfully shaped public perception testifies to the malleability of beliefs. When others engage in it, we call it "brainwashing" and "propa- ganda."! We look askance at these attempts to shape public

views, because they are often seen as unbalanced and manip-

...

184 THE PRICE OF INEQUALITY

ulative, without realizing that there is something akin going

on in democracies, too. What is different today is that we

have far greater understanding of how to shape perceptions and beliefs-thanks to the advances in research in the social

sciences.

In contradistinction to the reality that perceptions and preferences can be shaped, mainstream economics assumes

that individuals have well-defined preferences and fully ratio-

nal expectations and perceptions. Individuals know what they want. But in this respect, traditional economics is wrong. If

it were true, there would be little scope for advertising.' Cor- porations use recent advances in psychology and economics

that extend our understanding of how preferences and beliefs

can be shaped to induce people to buy their products. In this

chapter we'll see how those in the 1 percent have shaped beliefs about what is fair and efficient, about the strengths

and weaknesses of government and the market, and even

about the extent of inequality in America today. It is clear that many, if not most, Americans possess a lim-

ited understanding of the nature of the inequality in our soci-

ety: They believe that there is less inequality than there is, they underestimate its adverse economic effects,' they under- estimate the ability of government to do anything about it,

and they overestimate the costs of taking action. They even fail to understand what the government is doing-many who

value highly government programs like Medicare don't realize that they are in the public sector,"

In a recent study respondents on average thought that the

top fifth of the population had just short of 60 percent of the

wealth, when in truth that group holds approximately 85 per-

cent of the wealth. (Interestingly, respondents described an

ideal wealth distribution as one in which the top 20 percent

1984 Is UPON US 185

hold just over 30 percent of the wealth. Americans recognize

that some inequality is inevitable, and perhaps even desirable if one is to provide incentives; but the level of inequality in American society is well beyond that Ievel.)"

Not only do Americans misperceive the level of inequality; they underestimate the changes that have been going on. Only

42 percent of Americans believe that inequality has increased in the past ten years, when in fact the increase has been tee-

tonic." Misperceptions are evident, too, in views about social

mobility. Several studies have confirmed that perceptions of social mobility are overly optimistic."

Americans are not alone in their mi~perceptions of the degree of inequality. Looking across countries, it appears that there is an inverse correlation between trends in inequality

and perceptions of inequality and fairness. One suggested explanation is that when inequality is as large as it is in the

United States, it becomes less noticeable-perhaps because people with different incomes and wealth don't evenmix."

These mistaken beliefs, whatever their origins, are having an important effect on politics and economic policy.

Perceptions have always shaped reality; and understanding

how beliefs evolve has been a central focus of intellectual his- . tory. Much as those in power might like to shape beliefs, and

much as they do shape beliefs, they do not have full control: ideas have a life of their own, and changes in the world-

in our economy and technology-impact ideas (just as ideas have an enormous effect in shaping our economy). What is different today is that the 1 percent now has more knowl-

edge about how to shape preferences and beliefs in ways that

enable the wealthy to better advance their cause, and more tools and more resources to do so.

In this chapter, I describe some of the research in econom-

.f.,:

186 THE.PRICE OF INEQUALITY

ics and psychology that extends our understanding of the links

between perceptions and reality. I show how the 1 percent

has .used these advances to alter perceptions and achieve its aims-to make our inequality seem less than it is and more

acceptable than it should be.

SOME BASICS OF MODERN

PSYCHOLOGY AND ECONOMICS

Understanding how people actually behave-rather than how they would behave if, for instance, they had access to perfect

information and made efficient use of it in their attempts to

reach their goals, which they themselves understood well-

is the subject of an important branch of modern economics called behavioral economics, This school holds that even if

behavior is not consistent with the standard tenets of rational-

ity, it still may be predictable. And if we can understand what

determines behavior, we can shape it." Work in modern psychology and behavioral economics has

observed that, in certain arenas, there are systematic misper-

ceptions. There are consistent biases in judgments. And the work has set out to explain what determines those biases and

misperceptions.

Framing and misperceptions

This research has emphasized .how much our perceptions are affected by "framing," for instance, the context in which the

analysis is posed. Police lineups are notorious: even if none of

the accused could have been at the scene of the crime, eye- witnesses will identify one of them as the culprit, with convic-

19 8 4 Is UPON US 187

tion. Much of the battle in politics today is over framing. The

frames that different parts of our society bring to bear affect their judgments. \

One can manipulate frames and thus perceptions and behav- ior. These frames and perceptions can be self-reinforcing. 10

One set of experiments shows how "fragile" and easily affected our beliefs can be. Individuals are asked to draw a

number out of a hat. They are then asked a question about

which they have relatively little information, such as the number of ships that passed through the Panama Canal last

year. The answer, it turns out, is systematically related to the random number they previously pulled oUt of the hat-those who pulled out a larger number systematically respond with a higher number. 11

Standard economic theory begins, as we have noted, with the presumption that individuals have well-defined prefer- ences and beliefs. They make decisions about how much to

save on the basis of a careful evaluation of the benefits of

consuming today versus consuming in the future. The real- ity is otherwise. When employers ask individuals how much

of their income they would like to put into their retirement accounts, the answer depends heavily on how the employer "frames" the question. If she says, for instance, that 10 per-

cent wil] be deducted from income and put into a retirement account unless the employee elects to save more (15 per-

cent) or less (5 percent), overwhelmingly the worker chooses 10 percent. But if the employer says that 15 percent will be ' deducted unless the employee chooses a smaller number (5

percent or 10 percent), the number 15 percent is chosen much 'more frequently. If she poses the question still differ-

ently, giving additional options of 20 percent or 25 percent,

these options-irrelevant for most individuals, because they

,f.:

188 THE PRICE OF INEQUALITY

wouldn't, in any case, be chosen-still affect the employee's

choice. 12 Such behavior should not come as a surprise (at least not

to someone who is not an economist). Individuals don't really

know what life will be like forty years from now and there-

fore have little basis for malting a judgment about how much to save now. The standard model in economics has individu-

als malting choices repeatedly-say, between red lettuce and green lettuce, experimenting and discovering what they truly like. But unless there is reincarnation, there is no way that an

individual can repeatedly go through the savings experiment over time: if he saves too little, he may live to regret it, but he

won't be able to live his life over again; the same applies if he saves too much. And today's world is so different from yes-

terday's that there is little that he can learn from his parents

about life cycle savings and little that his children can learn

from him.

Equilibrium fictions

There is a second important proposition from psychological research: individuals process information that is consistent with

their prior beliefs differently from how they process information that is inconsistent." Information that is consistent is remem-

bered, seen as relevant, and reinforces beliefs. Information that

is inconsistent is more likely to be ignored, discounted, or for-

gotten. This distortion is called "confirmatory bias."!" The "equilibrium fictions" that can result from this process

are beliefs that are maintained strongly because the evidence'

that people see-as they perceive and process it-is fully con-

sistent with those beliefs. IS

1984 Is UPON US 189

Behavioral economics and modern marketing

Shaping behavior is a central goal of marketing. Over the

years, firms have worked hard to understand what determines consumers' buying decisions; for if they understand that, they

can induce people to buy more of their products. Thus, the major objective of advertising is not to convey information,

but to shape perceptions. The best-known examples conjure a lifestyle-which may even be at odds with that of the real users of the product-that consumers aspire to. The Marl-

boro Man offers an egregious example of tHis strategy."

Perceptions affect behavior and market equilibrium

Beliefs and perceptions, whether they are grounded in reality or not, affect behavior. If people see the "Marlboro man" as

the type of person they aspire to be, they may choose that cig-

arette over others. If individuals overestimate some risk, they may take excessive precautions.

But important as perceptions and beliefs are in shaping individual behavior, they are even more important in shap- ing collective behavior, including political decisions affecting economics. Economists have long recognized the influence of ideas in shaping policies. As Keynes famously put it,

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more

powerful than is commonly·understood. Indeed the world is

ruled by little else. Practical men, who believe themselves to

1.90 THE P RIC E 0 FIN E QUA LIT Y

be quite exempt from any intellectual influence, are usually

.the slaves of some defunct economist. I?

Social sciences like economics differ from the hard sci-

ences in that beliefs affect reality: beliefs about how atoms

behave don't affect how atoms actually behave, but beliefs

about how the economic system functions affect how it actu-

ally functions. George Soros, the great financier, has referred

to this phenomenon as reflexivity," and his understanding

of it may have contributed to his success. Keynes, who was

famous not just as a great economist but also as a great inves-

tor, described markets as a beauty contest where the winner

is the one who assessed correctly what the other judges would

judge to be the most beautiful. Markets can sometimes create their own reality. If there is

widespread belief that markets are efficient and that govern-

ment regulations only interfere with efficiency, then it is more

likely that government will strip away regulations, and this

will affect how markets actually behave. In the most recent

crisis what followed from deregulation was far from efficient,

but even here a battle of interpretation rages. Members of

the Right tried to blame the seeming market failures on gov-

ernment; in their mind the government effort to push people

with low incomes into homeownership was the source of the

problem. Widespread as this belief has become in conserva-

tive circles, virtually all serious attempts to evaluate the evi-

dence have concluded that there is little merit in this view.

But the little merit that it had was enough to convince those

who believed that markets could do no evil and governments

could do no good that their views were valid; another example

of "confirmatory bias.""

1984 Is UPON US 191

Perceptions of inequalit-y and individuol. behavior

As we discussed in chapter 4, if individuals believe that they

are being treated unfairly by their employer, they are more

likely to shirk on the job. If individuals from some minority

are paid lower wages than other equally qualified individuals,

they will and should feel that they are being treated unfairly-

but the lower productivity that results can, and likely will,

lead employers to pay lower wages. There can be a "discrimi- natoryequilibrium."20.,

Even perceptions of race, caste, and gerlder identities can

have significant effects on productivity. In a brilliant set of

experiments in India, low- and high-caste children were asked

to solve puzzles, with monetary rewards for success. When

they were asked to do so anonymously, there was no caste

difference -in performance. But when the low caste and high

caste were in a mixed group where the low-caste individu-

als were hnown to be low caste (they knew it, and they knew

that others knew it), low-caste performance was much lower

than that of the high caste." The experiment highlighted the importance of social perceptions; low-caste individuals some-

how absorbed into their own reality the belief that lower-caste

individuals were inferior-but only so in the presence of those

who held that belief.

Perceptions of fairness and the politics of inequalw»

I explained earlier how our perceptions are affected by "fram-

- ing," and thus it's not surprising that much of the battle today

192 THE PRICE OF INEQUALITY

is over the [Taming of inequality. Fairness, like beauty, is at

least partly in the eyes of the beholder, and those at the top want to be sure that the inequality in the United States today

is framed in ways that make it seem fair, or at least accept-

able. If it is perceived to be unfair, not only may that hurt pro-

ductivity in the workplace but it might lead to legislation that

would attempt to temper it. In the battle over public policy, whatever the realpolitik of

special interests, public discourse focuses on efficiency and fairness. In my years in government, I never heard an industry

supplicant looking for a subsidy ask for it simply because it would enrich his coffers. Instead, the supplicants expressed

their requests in the language of fairness-and the bene-

fits that would be conferred on others (more jobs, high tax

payments). The same goes for the policies that have shaped the grow-

ing inequality In the United States-both those that have contributed to the inequality in market incomes and those

that have weakened the role of government in bringing down the level of inequality. The battle about "framing" first centers

on how we see the level of inequality-how large is it, what

are its causes, how can it be justified? Corporate CEOs, especially those in the financial sector,

have thus tried to persuade others (and themselves) that high pay can be justified as a result of an individual's larger con-

tribution to society, and that it is necessary to motivate him to continue making those contributions. That is why it is

called incentive pay. But the crisis showed to everyone what economic research had long revealed-the argument was a

sham. As we noted in chapter 4, what was called incentive

pay was anything but that: pay was high when performance

was high, but pay was still high when performance was low.

1984 Is UPON US 193

Only the name changed. When performance was low, the name changed to "retention pay."

If the problems of those at the bottom are mainly of their own making and if those collecting welfare checks were really living high on the rest of society (as the "welfare deadbeats"

and "welfare queen" campaign in the 1980s and 1990s sug- gested), then there is little compunction in not providing

assistance to them. If those at the top receive high incomes

because they have contributed so much to our society-in

fact, their pay is but a fraction of their social contribution-

then their pay seems justified, especially if. their contributions were the result of hard work rather than jJh luck. Other ideas

(the importance of incentives and incentive pay) suggest that there would be a high price to reducing inequality. Still others

(trickle-down economics) suggest that high inequality is not

really that bad, since all are better off than they would be in a

world without such a high level of inequality. On the other side of this battle are countering beliefs: fun-

damental beliefs in the value of equality, and analyses such

as those presented in earlier chapters that find that the high level of inequality in the United States today increases insta-

bility, reduces productivity, and undermines democracy, and that much of it arises in ways that are unrelated to social

contributions, that it comes, rather, from the ability to exer-

cise market power-the ability to exploit consumers through monopoly power or to exploit poor and uneducated borrowers

. through practices that, if not illegal, ought to be. The intellectual battle is often fought over particular poli-

cies, such as whether taxes should be raised on capital gains.

But behind these disputes lies this bigger battle over per-

ceptions and over big ideas-like the role of the market, the

state, and civil society. This is not just a philosophical debate

.J.

,f.;

How ideas evolve

human rights, human nature, and the meaning of democ-

racy and equality. Debates and perspectives on these issues

have taken a different course in the United States 'in recent

years than in much of the rest of the world, especially in other

advanced industrial countries. Two controversies-the death

penalty (which is anathema in Europe) and the right to access

to medicine (which in most countries is taken as a basic

human rightj-s-are emblematic of these differences. It may be difficult to ascertain the role the greater economic and social

divides in our society has played in creating these differences

in beliefs; but what is clear is that if AmeI'~can values and per-

ceptions are seen to be out of line with those in the rest of

the world, our global influence will be diminished, as we sug-

gested in the last chapter.

1984 Is UPON US 195

Changing ideas about these fundamentals are both cause and

consequence of a changing society and economy-e-including

changes in societal inequality.

The history of ideas describes how ideas. evolve. No one

controls the evolution." Change is more organic. Ideas

emerge from a variety of sources-often in response to the

events of the moment, sometimes as part of a natural evolu-

tionary process." Ideas get thrown out (one can think of them

as intellectual mutations), and some find fertile ground: they

help people understand the world, especially as it is in their

self-interest to understand it.

In the past, beliefs sometimes changed in ways that

enhanced the well-being of the elites, as when ideas that justi-

fied slavery or inequality became prevalent. Sometimes beliefs

changed in ways that worked against their interests. Surely

194 THE P RIC E 0 FIN E QUA LIT Y

but a battle over shaping perceptions about the competencies

of these different institutions. Those who don't want the state

to stop the rent seeking from which they benefit so much,

and don't want it to engage in redistribution or to increase eco-

nomic opportunity and mobility, emphasize the state's failings.

(Remarkably, this is true even when they are in office and could

and should do something to correct any problem of which they

are aware.) They emphasize that the state interferes with the

workings of the markets. At the same time that they exagger-

ate the failures of government, they ,exaggerate the strengths

of markets. Most importantly for our purposes, they strive to

make sure that these perceptions become part of the common

perspective, that money spent by private individuals (presum-

ably, even on gambling) is better spent than money entrusted

to the government, and that any government attempts to cor-

rect market failures-e-such as the proclivity of firms to pollute

excessively-cause more harm than good.22

, This big battle is crucial for understanding the evolution

of inequality in America. The success of the Right in this

battle during the past thirty years has shaped our govern- ment. We haven't achieved the minimalist state that libertar-

ians advocate. What we've achieved is a state too constrained

to provide the public goods-investments in infrastructure,

technology, and education-that would make for a vibrant

economy and too weak to engage in the redistribution that

is needed to create a fair society. But we have a state that is

still large enough and distorted enough that it can provide a

bounty of gifts to the wealthy. The advocates of a small state

in the financial sector were happy that the government had

the money to rescue them in 2008-and bailouts have in fact

been part of capitalism for centuries." These political battles, in turn, rest on broader ideas about

196 THE PRICE OF INEQUALITY

elites in the UK would have preferred that Enlightenment

ideas had not crossed the Atlantic. Slave owners in the South would have liked to keep the expression "all men are created

equal" more narrowly defined. That there were at least some

instances in which beliefs evolved in ways that were counter

to the interests of the elites suggests that, at least in the past, the elites didn't in fact dictate how they evolved.

Globalization has, for instance, brought new ideas to many

countries, including ideas about democracy, human rights, and equality. A change in technology or market structure-the

move from agriculture to manufacturing, or from manufactur- ing to a service sector economy-inevitably is accompanied

by societal changes of enormous magnitude, including ideas

about how society and the economy should be organized. The development of manufacturing required a more educated

labor force, and it was difficult to make an argument not to

extend voting rights to the well educated, even if they were

not members of earlier elites. Successes and failures of governments and markets have

played an important role in the evolution of ideas about the role of each in the past century. With the Great Depression,

when one out of four workers was out of a job, it was hard for anyone but a devoted ideologue to see markets as always effi- cient. It was not surprising that under those circumstances, the idea that government should playa more important role

in macromanagement gained strength. Before 1960, in most

developing countries around the world, markets (at least as

shaped by colonial powers) by themselves were not deliver-

ing growth. It was natural that many in these societies came to the conclusion that government should playa more impor-

tant role in development. With the failures of communism,

though, it was similarly hard for any but a devoted ideologue

1984 Is UPON US 197

to believe that government should take a dominant role in the

economy. Out of these experiences, out of observations that

markets often fail, but so do governments, the idea advocated here-'that there needs to be a balanced role between mar-

kets, the state, and civil society-naturally evolved. What that

balance would be could differ across countries and over time.

In East Asia there arose the idea of the developmental state,

one that orchestrated development, but used market mecha-

nisms. There were some enormous successes, the fastest sus-

tained growth ever, with huge reductions in poverty, and large

gains for the vast majority of citizens.,

But ideas and interpretations of historit~l events are always

contested. Some look at these experiences and, somehow, come up with alternative interpretations. Some (like the

Nobel laureate and University of Chicago economist Milton

Friedman) constructed an interpretation of the Great Depres-

sion that focused on government failure, just as the Right

looks at the Great Recession and seeks to put blame on gov- ernment efforts to promote housing for the poor. Some looked

at the enormous successes of the United States in the years after World War II-its relative stability, its rapid growth, a

. growth from which all shared-and said that growth could

be even faster, if only we deregulated and lowered taxes. (Of course, as earlier chapters pointed out, that didn't happen: growth in the era of deregulation and lower taxes was slower, and the country grew apart.)

As our discussion of equilibrium fictions emphasized, evi- dence doesn't always resolve these disputes: the advocates of

different perspectives see evidence in different ways. Even if growth in the era of deregulation and low taxes was slower

and most Americans didn't do well, something else can be

blamed-there were still too many regulations and too much

.i:

198 THE PRICE OF INEQUALITY

uncertainty caused by those advocating more regulations.

Analyses showing that Fannie Mae and Freddie Mac were not

at the center of the Great Recession are simply dismissed." Some ideas are transformative, but for the most part soci-

etal change and change in beliefs occurs slowly. Sometimes,

there is a disparity between the pace of change of ideas and of society; sometimes the disparity between beliefs and reality

is so startling it forces a rethinking of ideas-or a change in

society. Change often occurs less rapidly than it seems that it

should, and the slow evolution of ideas is one of the reasons

that societies sometimes change slowly. The Declaration of Independence may have enunciated clearly in '177 6 the prin-

ciple that all men were created equal, but it would be almost

two centuries before the United States adopted civil rights

legislation that would embrace this principle, and full equality

has yet to be achieved. One of the reasons that ideas change slowly is that ideas

and perceptions are social constructs. My willingness to hold a belief is related to others' holding similar beliefs. As I travel

around the country and the world, I am often struck how in

some places one set of ideas is part of conventional wisdom- such as that government is necessarily inefficient or that government caused the recession or that global warming is a fiction-and in others just the opposite is taken to' be the

"truth." Most individuals don't themselves examine the evi-

dence. Few have the capabilities of assessing the evidence on

global warming even if they had the time. But the fact that

others that they talk to and trust hold certain beliefs rein-

forces their conviction in their correctness. Some of these socially constructed ideas and perceptions

provide the lens through which we see the world. Categories,

1984 Is UPON US 199

like race and caste, are relevant in some societies, but not in others. But as we have noted, these "ideas" have real conse- quences, which can persist.

Societies can get "stuck" in a particular set of beliefs, with

each individual's beliefs changing only.if enough others' change;

but those beliefs won't change, if those of the rest don't. The notion that ideas and perceptions are social constructs

also helps explain how societal beliefs sometimes can change

rather rapidly. If, somehow, enough people find the idea attractive, there may be a tipping point: it becomes part of

a new "social construction of reality,". the new conventional wisdom. The notion' of racial differences"moves then from a

concept to be proven to a concept to be disproved. Or there is

a switch in beliefs from the notion that inequality is necessary

for the functioning of a market economy to the belief that the level of inequality in America today impairs the functioning

of our economy and our society. The new ideas become part

of the conventional wisdom-until some other intellectual or

real current arrives to disturb the intellectual equilibrium.

The social context of beliefs is critical. If different groups interact little, they can develop differing perceptions of real-

ity. So it is with the debate about the legitimacy and even the

magnitude of inequality. In some groups (including both rich and poor), the rich are believed to have obtained their wealth

largely through their own hard work, with contributions from others and luck playing merely a minor role; among others,

the belief is just the opposite." Not surprisingly, these groups have different views about tax policy. If an individual believes

what he has is a result just of his own efforts, he is less willing

-to share that wealth with others who he thinks chose to exert less effort. If an individual sees his success as a result largely

of good luck, he is more willing to share that good fortune.

200 THE P RIC E 0 FIN E QUA LIT Y

Shaping perceptions about policies

Today those who wish to preserve societies'inequalities actively

seek to shape perceptions and beliefs to make such inequali-

ties more acceptable. They have, the knowledge, the tools, the

resources, and the incentives to do so. Even if, in the past,

there were many attempts, to shape societal perceptions, today

there is increased sophistication in doing so. Those who seek to

do so know, for instance, more about how to manipulate ideas

and preferences. They don't have to just hope and pray that the

evolution of ideas works out in their favor."

The fact that those at the top can shape perceptions rep-

resents an important caveat to the idea that no one controls

the evolution of ideas. Control can happen in several ways,

which we will explore in greater depth in this section. One

is through access to education and the media. If one group is

greatly disadvantaged in opportunities for education or access

to public office and to the media, then it will not participate

on equal terms in the deliberative space in which the "con-

ventional wisdom" emerges. Some ideas will therefore not

emerge; other ideas can be effectively suppressed.

A second way is through the creation of social distance. If one group's economic opportunities leave it much poorer than

other groups, then the interactions of the first group with

people from other groups will be limited, and it is likely to

develop a different culture. Then ideas about intrinsic differ-

ences of the poor group are more likely to take root and to

persist. As I noted in earlier work on cognitive frames," part

of the power of socially constructed categories depends upon

their not seeming to be socially constructed. People put in

different categories come to act differently and thus to appear

intrinsically different.

1984 Is UPON US 201

Most importantly, if goods can be marketed, so can ideas

and especially the ideas that underpin policies. Modern

marketing has taught the art and science of shaping percep-

tions-and for those with enough resources (disproportion-

ately the wealthy) there are tools to do so.

In promoting products, many firms have felt few qualms

about providing distorted information-or even lying. Thus

the cigarette companies succeeded in casting doubt on the

scientific evidence of the health hazards of smoking, even

though they had in their own possession evidence to the con-

trary. Similarly, Exxon exhibited no compunction in supporting

so-called think tanks casting doubt on th~: scientific evidence on the risks of global warming-even though there was over-

whelming evidence to the contrary. Truth-in-advertising laws

try to circumscribe firm behavior, but in promoting ideas and

policies, there is no such thing. 30 We've already seen several

examples-such as the claim that while America may not

be as equal as others, it offers more equality of opportunity,

or that it was government efforts to promote housing for the

poor that were at the root of the Great Recession-and we'll

take a closer look at others.

Education, of course, also shapes beliefs and perceptions,

and perhaps with no group is that more the case than with

economists. There is now considerable evidence that econ-

omists' perceptions, say, about fairness, are markedly differ-

ent from those of the rest of society. The Chicago economist

Richard Thaler reports that while 82 percent of respondents

in the general population believed it was unfair to increase the

price of snow shovels after a storm, among his MBA students,

only 24 percent held that view." It could be partly because

economics attracts those who, among the population, put less

weight on notions of fairness. But there is evidence as well

202 THE P RIC E 0 FIN E QUA LIT Y

that training in economics shapes perceptions-and given the

role that economists have increasingly had in public policy,

their perceptions of what is fair and their views of trade-offs between equity and efficiency may have had disproportionate

consequences. The Right has recognized the importance of education in

shaping perceptions, which is why it has been active in trying to influence the design of curricula in schools and embarked

on an "education" program to make judges more "economic

literate," that is, to see the world through the narrow lens of conservative economics. 32

One of the most effective ways of influencing public

opinion is to capture politicians. After all, politicians, are merchants of ideas. (Persuading politicians to adopt one's

perspectives and perceptions has a double advantage: not only do they sell the ideas to the public; they translate the

ideas into legislation and regulation.) For the most part, poli-

ticians don't originate ideas; rather, they take those emanat-

ing from academia and from public intellectuals, and from within governments and from nongovernmental organiza-

tions (NGOs). They put together a pastiche of these ideas

that accord with their worldview, or at least that they think their constituents will favor. In America's moneyed politics,

not all constituents are created equal. Politicians have an incentive to espouse ideas that serve the moneyed interests.

In some other countries, politicians can be directly

bought. But American politicians are, for the most part, not

so crass. They don't accept stuffed brown envelopes. Money

goes to their election campaigns' and into the coffers of their party. This has come to be called "corruption Ameri-

can style." Some will reap monetary rewards after they leave

office, part of the process of revolving doors that is endemic

1984 Is UPON US 203

in the United States; for others, the pleasures of power today

suffice. Backing up these ideas are armies of "experts" willing to

provide testimony, arguments, and stories to show the right-

ness of these views. This battle of ideas occurs, of course,

in many playing fields. The politicians have their surrogates, their minions who are not running for office but who advance

variants of these ideas, and challenge those of rivals. Evidence

and argumentation on both sides are assembled. This "battle of ideas" has two objectives (like advertis-

ing more generally)-to mobilize those who are already true

believers and to persuade those who hav~ not yet made up their minds. The former entails rallying the troops and rein-

vigorating commitment. In an expensive electoral democ- racy like the United States, arousing the "base" is important

because the outcome of elections often hinges on raising

campaign funds and getting out the vote. Labeling a rival as a "liberal" or a "neoconservative" can help motivate voting, even

when one's own candidate is lackluster. Much of the battle of persuasion is for "independent voters."

To win them over simple, distorted stories, often repeated,' can be more effective than longer and more subtle ones. Messaging

that appeals to feelings is often more effective than appeals to reason. Advertisers are good at distilling a message down to a

sixty-second ad that strikes just the right notes-an emotional

response seemingly reinforced by "reason.I"

THE WEAPONS OF WAR

There is a real battlefield of ideas. But it does not, for the

most part, involve a battle of ideas as academics would under-

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204 THE P RIC E 0 FIN E QUA LIT Y

stand it, where evidence and theory on both sides are care-

fully weighed. It is a battlefield of "persuasions," of "framing,"

of attempts not necessarily to get to the truth of the matter

but to understand better how ordinary citizens" perceptions

are formed and to influence those perceptions.

In this battle of ideas, certain weapons playa central role.

In the last chapter, we discussed one of these weapons-the

media. It should be obvious that imbalances in the media can

lead to a battlefield in the war of ideas that is far from level.

However ideas get disseminated, much of the battle is,

as I have suggested, over framing; and in that. battle, words

are pivotal. The words we use can convey notions of fairness,

legitimacy, positive feelings; or they can convey notions of

divisiveness and selfishness and illegitimacy. Words also frame

issues in other ways. In American parlance, "socialism" is akin

to communism, and communism is the ideology we battled for

sixty years, triumphing only in 1989 with the fall of the Berlin

Wall. Hence, labeling anything as "socialism" is the kiss of

death. America's health care system for the aged, Medicare, is

a single-payer system-the government pays the bill, but the

individual gets to choose the provider. Most of the elderly love

Medicare. But many are also so convinced that government

can't provide services efficiently that they believe that Medi- care must be private. In the tumultuous discussion of health

care reform during President Obarna's first year in office, one

man was heard to say, "Keep your government hands off my

Medicare.'?" The Right attacks extending the Medicare pro-

gram to the rest of the population as "socialism." That ends

the debate. One doesn't have to discuss whether it's efficient

or inefficient, whether the quality of care is good or bad, or

whether there is choice or not.

Americans have come to believe in markets, and inc en-

1984 Is UPON US 205

tives make markets work. Hence labeling pay as "incentive

pay" puts a halo over it; it provides justification regardless of

the amount. The issue of outsize pay has come tip episodi-

cally. In 1993, at the beginning of the Clinton administration,

the intensity of criticism was so high that the administration

decided to impose a surtax on salaries in excess of a million

dollars. But th.en an exception was made for pay related to

J performance." That, of course, provided an incentive to label

all high payments incentive pay. But as we saw earlier, it also

provided a whole set of distorted incentives that had impacts

beyond mere compensation.,

To take another example, credit card companies impose

rules on merchants that accept their cards. One such rule is

known as' the "no surcharge rule." It forbids merchants from

passing on the cost of credit card transaction fees to their cus-

tomers; But the price system works only if individuals see the

costs associated with the choices they make. When individu-

als make a purchase, they make a choice of a payment mecha-

nism. No one would say it is a "surcharge" to charge more for

an expensive product than a cheap one. But by labeling any

charge as a surcharge, credit card 'companies are attempting to "frame" the charge, to make it seem unreasonable. They

want customers to believe that such a charge is so unreason-

able as to warrant switching away from merchants who do

impose such charges" and thus to induce merchants not to

"charge." The absence of an explicit (sur)charge means that

the credit card companies can raise the fees they charge mer-

chants to high levels-near to the "breaking point," where the

merchant would rather lose the customer than pay the fee.

A final example concerns the price discovery function of markets. In well-functioning markets, demand is equated to

supply; and the resulting equilibrium price "reveals" the mar-

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206 THE P RIC E 0 FIN E QUA LIT Y

ginal value of the good to the buyer and the marginal cost to

the seller. This information is of value in making decisions.

Many economists argued, by analogy, that in a stock market,

. the prices that emerge reflect the true value of the asset. This

is called the "price discovery" role of markets. The words are

emotive: discovering the true value of an asset is presumably

valuable, and markets are to be commended for perform-

ing this important social function. Indeed, market advocates

claimed that markets were fully efficient-prices revealed all the information available to market participants. This was a

matter of religious belief, an article of faith. The use of lan-

guage was important: because "efficiency" was good, it was

obvious that fully efficient markets were good. But this notion

was based on deeply flawed logic. Indeed, if markets fully

revealed all the information to all market participants, no one

would have any incentive to gather information about pub-

licly traded assets, since those who did not spend the money

would have equal access to the information. If the efficient-

markets hypothesis were true, it would ironically mean that

stock markets would necessarily be very inefficient, since no

one would gather any information."

In the aftermath of the Great Recession, the efficient-

markets model has taken a beating." In the meanwhile, though, some market advocates continue to use the "price

discovery" argument for defending changes in markets that

were actually making it more volatile and less efficient.

A major change occurred in markets around the turn of this

century: most trading (some 61 percent in 2009, 53 percent

in 2010) on the stock exchange was done by computers trad-

ing with other computers, using certain algorithms. Offers to

buy and sell were based not on market research, on informed

views about the prospects of, say, steel or the efficiency of a

1984 Is UPON US 207

particular steel company, but rather on extracting information

from the pattern of prices and trades, and on whatever other

information a computer could absorb and process on the fly.

Offers to buy and sell were held open for a nanosecond. The

response to the suggestion that any firm making an offer to,

say, buy a stock at a particular price hold open that offer for

one second was: "Do you want to go back to the Middle Ages."

Of course, the prices that were determined in those nanosec-

onds were of no relevance to any real decision making. No steel firm would base its decision on whether to expand or

contract on these rriicroadjustments of stock prices. The algo-

rithmic traders claimed that they were-making markets more

liquid ("deeper"), but itwas a liquidity that disappeared when

it was needed, when a real disturbance occurred to which the market needed to adjust. The result was that the market

began to exhibit unprecedented volatility. On one day alone,

May 6, 2010, stock market prices plummeted so much that

the Dow Jones temporarily lost about 10 percent of its value,

including a nearly 600-point drop in a five-minute period."

Before the end of the day, the market regained much of its

value nearly as fast as it had been lost. No one could claim

that the real value of the country's assets had diminished in

that short period of time. Yet, constant reference to "price dis-

covery" and "efficient markets" provided the halo that made

this kind of flash trading seem not only acceptable but even

desirable. In fact, there are reasons to believe that flash trading actu-

ally makes markets not just more volatile but also less "infor-

mative." Computers attempt to-use complex mathematical

algorithms to extract whatever information is in the market,

in a modern and more sophisticated version of front running,

the old-style illegal activities by which brokers try to use

..,

208 THE P RIC E 0 FIN E QUA LIT Y

information they glean from those placing orders to enhance

their own profits. Of course, market participants know this. If some market researcher discovered that some company

was going to do well (had just made a valuable discovery),

he might rush, placing a large order. But the computer trad-

ers would immediately sense this and tty to use his informa- tion for their own purpose. Today, of course, the first trader

knows the game he's playing, so he would never place a large

order, but would place a myriad of small orders. There's been an arms race, where those doing the hard work of research

tty to keep their information away from the algorithmic trad-

ers, and the algorithmic traders try to break their code. One might say it's just a waste of resources-a fight over the rents

associated with early information. But it's worse than that.

To the extent that the algorithmic traders succeed in outwit-

ting those who do the real research, the returns to research fall; there will be less investment in information, and mar-

kets actually will convey less of the information that we care about.

THE BATTLE OVER POLICIES AS

A BATTLE OVER PERCEPTIONS

The extent to which the battle over policies is' a battle over

perceptions is particularly striking. The following paragraphs consider three big battles that occurred in recent years-

over the repeal of the estate tax, the bank bailout, and mort-

gage restructuring. The latter two were, of course, front

and center in discussions over the response to the 2007-08 financialcrisis. All are critical to our understanding of how

America has come to be so unequal. Without an estate tax,

1984 Is UPON US 209

we create a new plutocracy, marked by dynasties that are

self-perpetuating. The bailout provided money to the finan- cial sector-one of the important sources ofmohey at the

top. And the failure to do enough about mortgage restructur-

ing has contributed to economic stress at the bottom and in the middle. .

Estate taxes'?

As we've seen, the Right has been able to persuade many

Americans to support policies that are not in their self-interest. The estate tax, which is imposed on tHose who have large

estates passed on to heirs, provides the quintessential exam- ple. Critics of the estate tax call it a death duty and suggest

that it is unfair to tax death. Under current law, the tax is

levied only on the amount passed on that is in excess of $5 million (usually $10 million for a married couple), 40 so that

it is unlikely that most Americans would ever be touched

by the tax, even with their overoptimistic view of mobil- ity in American society." Yet, because of the concentration

of wealth in our society, the tax can raise large amounts of money. Moreover, in theory a "fair" society would put every-

one on a level playing field at the start. We know that that's impossible; but the tax is designed to limit the extent of "inherited" inequality-to create a slightly more level play-

ing field. It should be obvious that the tax is in the interests of most Americans, and yet the Right has persuaded large numbers to oppose it42-against their own interests. For a

brief moment, in 2010, it was totally repealed as a result of tax cuts passed in 2001 under the George W. Bush admin-

istration. The Right talks about how much the tax affects

small businesses, yet the vast majority of small businesses

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210 THE P RIC E 0 FIN E QUA LIT Y

are too small to be touched; and provisions within the estate

tax allow for spreading the payment over fourteen years, pre- cisely so that it will not be disruptive."

Bank. recapitalization

As the financial crisis unfolded, we saw how the banks man- aged perceptions. We were told that we had to save the

banks to save the economy-to protect O'LLf jobs no matter

how unsavory the bailouts felt at the time; that if we put conditions on the banks it would roil the markets, and we

would all be the worse for it; and that we needed to save not only the banks but also the bankers, the bank's shareholders,

and the banks' bondholders. There were, of course, coun-

tries like Sweden that had done otherwise, that had played

by the rules of "capitalism" and put banks whose capital was

inadequate into conservatorship, a process akin (for banks)

to bankruptcy, focused on protecting depositors and "con- serving" the banks assets; but those were "socialist" coun-

tries. To follow Sweden was not the "American way." Obama

not only bought into this line; by repeating it, he lent it an aura of authenticity. 44 But this line had no factual basis and

was designed to make the world's most massive transfer of wealth acceptable: never in the history of the planet had so

many given so much to so few who were so rich without asking anything in return.

The question could have been framed very differently. It

could have been argued that the real American way is the rule

of law. The law was clear: if a bank can't pay what it owes

and what depositors demand back, then it is restructured;

shareholders lose everything. Bondholders are made the new

shareholders. If there is still not enough money, the govern-

1984 Is UPON US 211

ment steps in. Bondholders a~d unsecured creditors then lose everything, but insured depositors get back what they have

been promised. The bank is saved, but the government, as

the new owner of the bank, will eventually decide to wind

it down, reprivatize it, or merge it with a healthier bank. Its objective in part is to recover as much for the taxpayer

as possible. We don't wait, of course, until the bank has no

money to take these drastic actions. When you go to the bank and put in your ATM card, if the light flashes, "insufficient

funds," we want it to be because your account, rather than the bank itself, had insufficient funds. This is the way banking

is supposed to work; but it wasn't the Way things worked in the United States during the Bush and Obama administra-

tions. They saved not only the banks-there was a rationale for doing that-but also the shareholders, bondholders, and

other unsecured creditors. This was a victory in the battle of

perceptions. There was an alternative way to frame the policy question.

This narrative would have begun not with the suggestion that what Sweden did was not in our "tradition" but with an anal-

ysis of what economic theory and. history had shown. That

analysis would have demonstrated that we could have saved the banking sector, protected depositors, and maintained a flow of credit, all at less cost to the government, by follow-

ing the ordinary rules of capitalism. This was, in fact, what

Sweden and the United States had done in other situations when banks got into trouble.

Put simply, the economy's interest could have been better

protected and a sense of fairness in our system better pre- served, if Obama and Bush had played by the rules of ordi-

nary capitalism, rather than malting up the rules as they went

along-if they had, in a sense, abided by the rule of law.

212 THE PRICE OF INEQUALITY

Instead, the bankers got their money without conditions. The

money was supposed to recapitalize the banles, and recapitaliz- ing the ban7es was supposed to lead to more lending. But money given to the banks that went to pay bonuses couldn't simul-

taneously be used to recapitalize the banks. The bankers and

their backers won the momentary battle-they got the money into the coffers of the banks and the bankers. But they lost the

long-run battle of perceptions: virtually everyone sees what

was done as unfair-and unjustified even by the unusual eco- nomic circumstances. It is this, as much as anything else, that has provided the impetus to the current backlash."

Restructuring mortgages

When the housing bubble burst, many homeowners found themselves "underwater": they owed more on their home

than the home was worth. The bank bailout and the case for mortgage restructuring provide a clear contrast in the battle

of perceptions: in one case, the perception that shaped gov- ernment action was that a large bailout is desirable, while in the other, the perception that shaped government action was that a large restructuring is undesirable. Today the bailouts of the banks are widely seen as far from desirable. And ironi- cally, there is increasing recognition that without doing more

for the housing/mortgage market, our economy won't recover. What has happened in the mortgage market has been far

from efficient. When foreclosure forces families out of their home's, everyone loses. The cost to the family-the disrup-

tion to their lives, the loss of their life savings-is obvious.

Worse still, an empty home, uncared for, decreases the value of neighboring homes. More of them will go underwater.

1984 Is UPON US 213

Communities with large numbers of foreclosures inevitably suffer. The bank loses too: the most important determinant offoreclosures is the extent to which the home is underwater,

Foreclosures beget foreclosures: by making more houses go underwater, the banks increase foreclosures and their result-

ing losses; they lose still more from the substantial legal fees that accompany each foreclosure.

There are better ways of dealing with this unfortunate spiral: a write-down of the principal (what the homeowner

owes), perhaps with a debt-to-equity conversion that gives the lender a share in the capital gain when the house is sold.

Homeowners still have an incentive to ~aintain their homes; houses aren't thrown onto the market, depressing housing

prices; the costly foreclosure process is averted. Communi- ties are protected. It's to everyone's advantage to give home-

owners a fresh start. The lender gets as much or more than

she would have otherwise. Executing this strategy would have

required modifications to existing law, but the bankers-and the Obama administration-rejected this approach out of

hand, at least until the 2012 election approached."

The banks saw that restructuring mortgages would make them recognize their losses, an outcome they had successfully kept at bay with deceptive but legal accounting maneuvers that treated impaired mortgages-those in which the borrower

was not keeping up with his payments-as if they eventually would be repaid. The true market value of these nonperform-

ing mortgages was often a fraction of the face value. But rec-

ognizing the losses would have required the banks to come

up with more capital, and they were struggling to get enough

capital under the current regulations, let alone the new regu- lations (called Basel III) adopted in fall 2010.

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214 THE P RIC E 0 FIN E QUA LIT Y

Of course, the Obama administration and the bankers

didn't present their case this way." Two main arguments were advanced for not doing much for homeowners. It would be

"unfair" to help those who were struggling with their mort-

gages when there were so many good and responsible citizens who had worked hard and paid off their mortgage, or were

able to make their current payments. Furthermore, offering relief to homeowners would exacerbate the problem of moral

hazard: if individuals were left off the hook, it would under- mine incentives to repay."

What was curious about these arguments was that they could have applied just as easily, and with greater force, to

the banks. The banks had repeatedly been bailed out: The

Mexican bailout of 1995, the Indonesian, Thai, and Korean bailouts of 1997-98, the Russian bailout of 1998, the Argen-

tinean bailout of 2000, these and others were all really bank bailouts, though they carried the name of the country where banks had lent excessively. Then, in 2008-09, the U.S. gov- ernment was engaged in yet another bailout, this one the

most massive ever. The banks had proven the relevance of moral hazard-bank bailouts had repeatedly and predict- ably led to excessive risk taking by banks-and yet both

the Bush and the Obama administrations ignored it and refused to discourage future bad behavior by, for instance, firing executives (as the UK did]"? or malting shareholders and bondholders take a hit. 50 Unlike the banks, most of the

people losing their homes were not repeat offenders. Yet

they were asked to lose all of the equity that they had put into their home, while bank shareholders and bondhold-

ers were given a massive gift. 5 I Moreover, few homeown-

ers would have been Willing to put themselves through the

anguish that they have experienced-worries about losing

1984 Is UPON US 215

their life savings as well as their home-had they known

what was in store for them; their mistake was to trust the

bankers, who seemed to understand markets and risk, and

who had assured them that the risks they were undertaking

were easily manageable.

The bankers and their allies unleashed tirades against the homeowners who were losing their homes. They were labeled

as having been reckless. A small percentage had bought mul-

tiple houses, and, in an attempt to tarnish all of those losing

their homes, they were labeled "speculators." Of course, what

else might one call the gambling of so pany of the banks?

Their reckless speculation lay at the heartibf the crisis.

But the greatest irony was the claim that helping some poor homeowners and not helping others would be "unfair."

Yet these inequities pale in comparison with those that arose from the hundreds of billions of dollars thrown at the finan-

cial 'sector. Inequities related to the bank bailouts were never

mentioned, and if a critic raised them, they were dismissed as

the unfortun~te but necessary price to resuscitate the econ-

omy. There was no mention of the idea that stopping the flood

of foreclosures might be a good thing for resuscitating the economy-and helping ordinary citizens.

There were ways of helping homeowners that would not have cost taxpayers a dime and that would have left home-

owners who had managed their debts prudently far better-off than those who hadn't; but the bankers resisted any and all

such proposals." We saw in chapter 1 part of the consequence of the com-

bination of the bank bailout without constraints and the

absence of help for homeowners: the increase in the inequal- ity of wealth, including the dramatic reduction in the wealth of those in the bottom half of the population. 53

.u

216 THE PRICE OF INEQUALITY

THE BATTLE OVER THE BIG IDEAS:

GOVERNMENT VERSUS MARKET

FAILURE

I have illustrated the fight over perceptions in the context of

quite specific battles, but the battles rage most intensely in the

field of big ideas. One such battle involves on one side those who believe that markets mostly work well on their own and that most market failures are in fact government failures. On

the other side are those who are less sanguine about markets and who argue for an important role- for government. These

two camps define the major ideological battle of our time. It is

an ideological battle, because economic science-both theory and history-provides a quite nuanced set of answers.

This battle plays out in every realm of public policy. It

affects the role that government takes in ensuing macrosta-

bility, in regulating markets, in investing in public goods, in

protecting consumers, investors, and the environment, and in providing social protection. Our focus here, though, is more

narrow: this is the big battle the outcome of which will have much to say about the evolution of inequality in the United

States, whether it continues to increase, as it has been, or starts to diminish.

A central thesis of chapters 2 and 3 is that market fail-

ures-and the failure of government to circumscribe them-

playa key role in explaining inequality in America. At the' top

there are rents (such as monopoly rents); at the bottom there

is underinvestment in human capital. Hidden subsidies that

distort the market and rules of the game that give an upper

hand to those at the top have compounded the problems.

As we noted in chapter 3, economic theory has shown that

1984 Is UI'ON US 217

markets don't exist in the abstract. At the very least, there is a

need for government to enforce contracts and to provide the basic legal structure. But how governments do this makes a

difference, both for efficiency and for distribution. The Right

wants the "right" rules of the game-those that advantage the wealthy at the expense of the rest. They've tried to shape the

debate, to suggest that there is a single set of rules that would be best for all. But, throughout the book, we've seen how

that's just not true. Economic theory has shown that markets work well when

private and social returns are well aligned, and don't when

they are not. Market failures are penJ~sive. Externalities, for instance, are not limited to the environment. Our banks

polluted the global economy with toxic mortgages, and their failures brought, the global economy to the brink of ruin,

imposing huge costs on workers and citizens throughout the

world. Some of these market failures are easy, in principle, to

correct: a firm that is polluting can be charged for the pollu-

tion it creates. But the distortions caused by imperfect and asymmetric information are present everywhere, and are not

so easily corrected. Managers do not always act in the inter- ests of "stakeholders" (including shareholders), and there's

little that they can do about it. As we saw in chapter 4, incen- tive pay that was supposed to align their interests didn't do so;

the managers benefited, at the expense of everyone else." But if you listened only to arguments from the Right, you

would have thought that markets always worked and govern- ment always failed. They worked hard to create this percep-

tion within the public, most simply by ignoring private market failures and government successes. And they've tried to

ignore-and to get others to ignore-the distributive conse-

quences of these market failures, who gains and who loses

.U:

218 THE PRICE OF INEQUALITY

when private rewards and social returns are not well aligned.

The crisis provided an instance where it was easy to see the

winners and losers; but in almost every case, whether it's envi-

ronmental pollution or predatory lending or abuses of corpo-

rate governance, it is those at the top who are the winners,

and the rest who are the losers.

Of course, not every government effort is successful, or as

successful as its advocates would have liked. Indeed, when

the government undertakes research (or supports new private-

sector ventures), there should be some failures. A lack of fail- ures means you are not taking enough risks. Success occurs

when the returns from those projects that succeed are more

than enough to offset the losses on those that fail. And the

evidence in the case of government research ventures is

unambiguously and overwhelmingly that the returns from

government investments in technology on average have been

very, very high-just think about the Internet, the Human

Genome Project, jet airplanes, the browser, the telegraph,

the increases in productivity in agriculture in the nineteenth

century, that provided the basis for the United States' moving

from' farming to manufacturing. When I was chairman of the

Council of Economic Advisers, we assessed the average social

returns on government R&D, and it turned out to be well in

excess of 50 percent, far higher in other areas of investment (including private sector R&D).55

Governments are human institutions, and all people, and

the institutions they create, are fallible. There are govern-

ment failures just as there are market failures. Recent eco-

nomic theory has explained when each of these is more likely

to fail, and how governments and markets (and other civil

institutions, including those that serve as watchdogs on both

corporations and government) .can complement each other

1984 Is UPON US 219

and provide a system of checks and balances. We have seen

myriad instances of this kind of complementarity: a govern-

ment initiative created the Internet, but private-sector firms

like Google built many of products and applications that have

placed it at the center of people's lives and our economy. Gov-

ernment may have created the first web browser, but the pri-

vate sector and open-source movement have refined it.

That there are successes and failures in both the public

and the private sector is clear. And yet many on the right seem

to think only the government can fail. Part of the reason for

these disparate perceptions about markets and governments

has to do with the theory of equilibriumsfictions described

earlier. Those who believe in markets discount information

about market failure while assigning high saliency to exam-

ples of government failure. They can easily recall examples

of failed government programs, but the massive failures of

our financial system in the run-up to the Great Recession are

quickly forgotten, described as an anomaly, or blamed on the

government. The fact of the matter is that there has been no success-

ful large economy in which the government has not played

an important role, and in the countries with the most rapid

growth (such as China) and in those with the highest stan-

dards of living (such as those in Scandinavia)," the govern-

ment plays a very important role. Yet the prevailing ideology

on the right is so strong that there continues to be a push for

a small government; for contracting out government services

and privatization and even a resistance to regulation.

This Right fails to note not only the successes of govern-

ment but the failures of markets. In the aftermath of the

crisis of 2008, however, it is hard to ignore the repeated finan-

cial crises that have marked capitalism since its origins."

220 THE P RIC E 0 FIN E QUA LIT Y

Repeated bank bailouts have imposed high costs on taxpayers.

If we add up the losses from the financial sector's misalloca-

tion of capital before the crisis and the shortfall between the

economy's potential output and actual output after the bubble

burst, we get a number in the trillions of dollars.

After the Great Depression, government succeeded in reg-

ulating the financial sector, producing almost four decades of

financial stability and rapid growth, with banks focusing on

lending, providing the money needed for the rapid expansion

of our enterprises. Government helped make markets act the

way markets are supposed to function, by reducing the scope for fraud and consumer deception and enhancing competi-

tion. But beginning with President Reagan and continuing

through President Clinton, government stepped back. The

deregulation led to instability; with less oversight, there was

more fraud and less competition. Nor is this the only example. Private health insurance com-

panies are much less efficient than the government-run Medi-

care program. 58 Private life insurance companies are much

less efficient than the government's Social Security prograrn.P

To take another example: a recent study showed that, on

average, contractors "charged, the federal government more

than twice the amount it pays federal workers" for perform- ing' comparable services.r? As much as one out of four dol-

lars spent on contracting in Iraq and Afghanistan was wasted

or misspent, according to the Commission on Wartime Con-

tracting in Iraq and Afghanistan." In an earlier study, Linda

Bilmes and I showed how the government could have saved

billions by having the armed forces provide these services.f

But this-and other experiences-suggests that it was not

just ideology that drove the contracting/privatization agenda:

it was rent seeking.

1984 Is UPON US 221

Liberalization and privatization.

The irony is that advocates of privatization (turning over previ-

ously publicly run enterprises to the private sector) and liber-

alization (stripping away regulations) have long claimed that

these policies are necessalY to restrain rent seeking. They note

corruption in the public sector but seldom acknowledge that

on the other side of evelY public-sector employee who takes a

bribe is a briber, and that briber is typically a private party. The

private sector is fully involved in the corruption. Worse still,

in a fundamental sense, the agenda of privatization and liber-

alization has itself been corrupt: it has gard~red high rents for those who used their political influence to push it. 63

Around the world, the examples of failed privatizations are legion-from roads in Mexico to railroads in the UK.

The major privatization in the United States of recent

years-,of the company that makes enriched uranium, used

for nuclear power plants and making atomic bombs (USEC,

the U.S. Enrichment Corporation)-has been plagued with

criticisms of dishonest dealing. While the former government

officials who engineered the privatization and the investment

bank that facilitated it made millions, the company was never

able to turn a profit. For more than a decade and a half after

privatization, government subsidies were at the center of their

business model. The results have been so troubling that there have been proposals to renationalize USEC.64

But had President George W. Bush had his way, there would

have been a much, much bigger privatization-the (partial)

privatization of Social Security, at the center of his State of the

Union address of 2005. Americans are, of course, now thank-

ful that his efforts failed. For if they had succeeded, America's

elderly would have been in an even worse position than they

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222 THE P RIC E 0 FIN E QUA LIT Y

are today: those who had put their money in the stock market

would have seen much of their retirement wealth gone; those

who put their money in safe T-bills would be struggling to sur-

vive, as the Fed pushes interest rates down to near-zero levels.

But even before the crisis, it should have been obvious that

privatization was a bad deal for most Americans. We noted

before that Social Security is more efficient than private pro-

viders of annuities. Private insurance companies have much

higher transactions costs. In fact, that was the whole point of

privatization: for the elderly, transactions costs are a bad thing;

but for the financial sector, they are a good thing. That's their

income. That's what they live off of. Their hope was to get a

slice of the hundreds of billions of dollars'" that people put

every year into their Social Security accounts."

Liberalization/deregulation initiatives have had as mixed

a record as those of privatization-with the most notorious

being financial sector· deregulation and capital market lib-

eralization. For those devoted to the ideology of the Right,

these failures are a mystery. To those more apprised of the

limitations of the market, they are predictable-and often

predicted. This also applies to other liberalization initia-

tives, including the disastrous liberalization of electric power

in California. Enron, one of the big advocates of the liber-

alization and an outspoken advocate of the wonders of the

market (before it went down in 200 I, the largest corporate

bankruptcy ever recorded up to that point), manipulated the

C~lifornia electricity market to make millions and millions for

itself, a transfer of money from ordinary citizens of that state

to Ken Lay, its CEO, and the others who ran the company.

Bush officials blamed the shortages that Enron had managed

to create on excessive environmental regulation that discour-

aged new construction. The reality was otherwise: as soon as

1984 Is UPON US 223

Enron's market manipulations to inflate prices were exposed

and regulations were restored, the shortages disappeared.

Innovation and the resistance to regulation

Opponents of regulation always complain that it's bad for

business. Regulations that prevent pollution, of course, are

bad for businesses that would have otherwise polluted. Reg-

ulations that prevent child labor are bad for businesses that

would have exploited children. Regulations that prevent

American companies from engaging in bribery or abuses of

human rights may be bad for businesses)that engage in brib-

ery or human rights abuses. As we've seen, private rewards

and social returns often differ; and when they do, markets

don't work well. The task of government is to align the two.

If it were true, as some have claimed, that new banking

regulations will stifle innovation, we still would have to weigh

the benefits of the regulation against the costs. If regulations

can prevent another near-collapse of the banking system, the

benefits would be enormous, possibly in the trillions of dol-

lars. And well-designed regulations did succeed in ensuring

the stability of our financial system for decades, so regulations

can work. Moreover, this period of tight financial regulation

was also one of rapid economic growth, a period in which the

fruits of that growth were more widely shared than they are

today. By contrast, in the period of "liberalization" the growth

of a typical citizen's income was far lower than in the period

of regulation.

There is a simple reason for the failure of liberalization:

when social returns and private rewards are misaligned, all

economic activity gets distorted, including innovation. The

innovation of the financial sector was directed not to improv-

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224 THE P RIC E 0 FIN E QUA LIT Y

ing the well-being of Americans but to improving the well-

being of bankers. At least for a time, it succeeded in doing

that; but it failed miserably in improving the plight of the

.ordinary American or even spurring growth in the American

economy as a whole. .

SUCCESSES IN THE BATTLE OF IDEAS

I have described the war of ideas-including those ideas that

are central to the policies that determine societal inequality-

and while the wealthy (and corporations) have been enor-

mously successful in shaping perceptions in ways that benefit

them, they have lost, or are losing, at least some of the battles.

The marketplace of ideas, while far from perfect, is still com-

petitive. This is a reason for hope. In the following paragraphs I describe three such battles in

which the tide has been turning: that over corporate welfare;

that over the IMF, its governance, and some of the policies

that it used to pursue; and that over the ultimate objectives of

public policy.

Class warfare and corporate welfare

When President Clinton entered office, there was both high

unemployment and a large deficit, though the unemployment

and debt levels pale in comparison with those of today. It was

natural forus to look for budget cuts that would increase effi-

ciency without endangering the core agenda of "putting people

first" and perhaps, by redirecting spending, even stimulate the

economy. Obvious candidates for cutting were large expendi-

tures on what Robert Reich (then secretary of labor) and I

1984 Is UPON US 225

called corporate welfare, subsidies to American corporations. The Council of Economic Advisers was tasked with drawing

up a list of cuts-not as easy as it might seem, because much

of the corporate welfare is hidden within the tax code. Even

then, toward' the top of the list were subsidies to the banks

(for instance, via IMF bailouts), to agriculture, arid to the coal

and other natural resource companies.

I thought that there would be broad consensus within the

administration on the principle, but considerable reservation

on the politics. I expected the departments that doled out the

subsidies to try to defend their turf. What surprised me was

the strong reaction from the head of the National Economic

Council (later, secretary of Treasury) Bob Rubin: he suggested

that we were trying to wage class warfare. It was, of course, nothing of the kind. For a Democratic administration trying to

focus its attention on economic recovery and helping people,

expensive subsidies that distorted the economy and increased

inequality made no sense. Besides, to pretend that.there were

not large inequalities, large divisions, in our society was put-

ting one's head in the sand. Warren Buffett put it correctly

when he said, "There's been class warfare going on for the last

20 years and my class has won."67 But the accusation of class

warfare suggested that those who were trying to reduce corpo-

rate welfare were being divisive.

.In the Clinton administration, we made only a little prog-

ress in cutting out corporate welfare. The big subsidies for

agriculture and energy remained. So did the smaller, but

highly symbolic, subsidies for corporate jets.

But during the 2008 crisis, corporate welfare reached new

heights. In the great bailout of the Great Recession, one cor-

poration alone, AIG, got more than $180 billion-more than

was spent on welfare to the poor from 1990 to 2006. 68

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226 THE P RIC E 0 FIN E QUA LIT Y

As deficits have become larger, there has been increas-

ing scrutiny of the budget, and cutbacks of corporate wel- fare-whether by that name or not-have been on the table.

Some cutbacks have already occurred-as we noted earlier,

at the end of 2011 the $6 billion ethanol subsidy, in place for

three decades, ended. But I suspect that the more powerful

industries and firms will be able to retain much of what they

receive. There is a role for government in providing a safety net, in

"social protection," but it should be protecting individuals and families against the risks that they face, especially those against which they cannot insure; it should not be protecting corpora- tions from facing the consequences of bad business judgments

or providing subsidies to enrich their coffers. Markets can't

work if there isn't some discipline-if companies get only the

upside of the risks, with taxpayers bearing the losses.

The IMF: the emperor has no clothes

In Globalization and Its Discontents.Y. described the intense battles between the IMP and some of those in developing countries and emerging markets in a variety of arenas-in

developmental policy, in the policies of transition from com- munism to a market economy, and in the management of the

East Asia crisis. I explained how the IMP had imposed con- tractionary policies on countries facing economic downturns, and I explained how its "structural adjustment" policies-

forcing privatization and liberalization-had often led not to

growth but instead to hardship, especially among the poor. At the time I wrote the book, the IMP was viewed as the

authority on these matters, especially in the West. Many in the developing world were skeptical: they saw that the poli-

1984 Is UPON US 227

cies pushed by the IMP often failed. They perceived the IMP as advancing the interests of the global financial sector and

corporate interests in the advanced industrial countries. But

they typically felt they had no choice except to follow the

IMP's strictures. They needed its money. I set out to show

that the emperor had no clothes: that the favored IMP policies were not based on the best economic science; to the contrary,

many of the doctrines that they had pushed had been thor- oughly discredited by research in economics over the preced- ing quarter century.

I also sought to expose both some of the intellectual incon- sistencies and the failures in governance. Over this period, the'

IMP increasingly had focused on "governance," yet its own governance left much to be desired. The financial sector had

too much influence, the developing countries had too little.

The excessive influence of the financial sector helped explain

the IMP's devotion to contractionary policies-its first priority was to get Western creditors repaid, and that meant countries

had to cut back their spending, so that more money would be left to repay debts. It also helped explain its advocacy of

capital market liberalization, the stripping away of regulations that affected the flows of money (especially short-term hot

money) into and out of a country. While there was little evi- dence that capital market liberalization led to faster growth,

there was ample evidence that it led to more instability. But from the perspective of the advanced industrial countries, it was still desirable, because it gave more scope for Western

financial firms to come into developing countries-and make more profits there. Evidently, the IMP had been captured by

a self-reinforcing combination of ideology and interests. Not surprisingly, the IMP did not take kindly to these per-

spectives-and the response was personal and vituperative.

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228 THE P RIC E 0 FIN E QUA LIT Y

The suggestion that under certain circumstances capital con- trols might be desirable was greeted with suggestions that I was trying to sell snake oil.

Ten years later, the battlefield looks different. There has been a major change in perceptions, to which my book may have contributed, and there is a broad consensus on the need for governance reform-with some already under way, and more scheduled for the future.

The IMF has admitted that capital controls may be desir- able under certain circumstances." In some of its programs, such as that for Iceland, it has accepted capital controls and has pushed for much less austerity than was its wont. Behind the scenes, in some of the European countries in crisis, it pushed for debt restructurings-making creditors bear more of the costs, taxpayers less. But there have been powerful forces on the other side, including the European Central Bank. While in Greece the notion that a deep debt restruc- turing was finally accepted, in Ireland even unsecured bond- holders were protected-they got the high return, supposedly for bearing risk, but in the end, they were protected, at great expense to Irish taxpayers.

In pursuit of the wrong goals

America has been hot in pursuit of the wrong goals. We've lost our way. We thought that simply by increasing GOP all would benefit, but that has not been the case.' Even if the American economy produces more goods and services, if, year after year, most Americans have lower and lower incomes, our economy is not performing well.

It is obvious now that the standard way of measuring eco- nomic performance, the level of real per capita GOP (the sum

1984 Is UPON US 229

of all of the goods and services produced inside the country, divided .by the number of people in the country, adjusted for inflation) and the rate at which it is growing, is not a good measure of success. America has been doing fairly well in terms of real per capita GOP, and those numbers lulled it into

.thinking that all was going well. (Even then, the United States

was not the top performer-Luxembourg Norway, Switzer- land, Denmark, and "socialist" Sweden" had a higher GOP per capita in 2010.)71

To take one example of how GOP can give a false impres- sion of a country's success, GOP petcapita mismeasures the value of goods and services produ2bd in several sec- tors, including health and the public sector-two sectors whose importance today is much greater than when GOP first started to be measured a half century ago. America, for instance, gets worse health outcomes, in terms of longevity or virtually any other measure of health performance, but spends more money. If we were measuring performance, the lower efficiency of America's sector would count against the United States, and France's health care sector output would be higher. As it is, it's just the reverse: the inefficiency helps inflate America's GOP number.

Our standard measure of performance, GOP, doesn't take into account sustainability-both individuals and countries can live beyond their means, but only for a time. That, of course, was the case for the United States. Not only were most individuals borrowing to sustain their living standards; so was the country as a whole. A housing bubble kept the economy going for much of the first decade of this century-a kind of artificial life-support system that gave rise to unsus- tainable consumption.

Most importantly for the purposes of this book, our con-

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230 THE P RIC E 0 FIN E QUA LIT Y

ventional measures of income don't adequately reflect a

broader sense of what's happening to most citizens. As we saw in chapter 1, GOP per capita could be going up; and yet most

citizens in the country could be stagnating or even becoming

worse-off, year after year: precisely what has been happening

in the United States. And just as there are large inequalities in income, there are

large .disparities in almost all of the other dimensions that con-

tribute to our general welfare, and none of these are reflected in GOP as a measure of economic performance. Take, for

instance, health, education, or the environment. The environ-

mental justice movement has called attention to the adverse environmental conditions under which many of the poor live-

the only housing they can afford is near polluting factories or

noisy airports and trains. 72 How we measure performance is an aspect of the battle

over perceptions and makes a difference, especially in our

performance-oriented society. Our systems of measurement affect our perception of how well we are doing-and of the

relative performance of different economic systems. If we measure the wrong thing, we will be tempted to do the wrong

thing, and to make the wrong inferences about what is a good

economic system. If we measure our success by GOP, that's what we'll push

for, and we'll pay insufficient attention to what's happening to 11'LOst Americans. To take another example: critics of, say,

environmental regulations suggest that they are costly, that

they reduce growth. But how we see that trade-off depends

on how we measure output. If in our measurements of GOP,

we take into account the cost of environmental degradation,

then better environmental regulation may actually improve

GOP correctly measured.

1984 Is UPON US 231

For years the standard measure of economic performance

was GNP, gross national product, roughly equal to the gross

income of the citizens of a country. But then, around 1990, there was a switch to GOP, gross domestic product, the

value of the goods and services produced within a country.

For a country in isolation, not trading with other countries or receiving inward investments, the two numbers are equiva- lent. But the switch occurred just as the pace of globaliza-

tion was increasing. This had some profound effects: if the

income associated with goods produced in the country went

elsewhere, GOP could go up while GNPgecreased. And this was not just a theoretical nicety. Papua N~w Guinea's (PNG)

gold mines were developed by foreign .companies, from Aus-

tralia, Canada, and elsewhere. Most of the value of what was

produced accrued to the foreign companies. PNG got a pit- tance-not enough even to compensate it for the destruction

of its environment, or other adverse effects on its economy or

the health of its people." A focus on GOP encouraged coun- tries to undertake such projects-the measure of their suc-

cess was improved. But had the old measure, GNP, been the

focus, such projects might have been· rejected. When I was chairman of the Council of Economic Advis-

ers, I tried to encourage the United States to address some of these problems, for instance, by constructing "Green GOP"

accounts, which would take into consideration the depletion of natural resources and the degradation of the environment.

I knew that I had hit on something important when the coal industry responded with vehemence, and when congressio-

nal representatives of the coal states even threatened to cut

off funding for work on this area. The coal industry realized that perceptions mattered: if it became widely recognized

that, correctly measured, the coal industry might have been

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232 THE P RIC E 0 FIN E QUA LIT Y

making a negative contribution to the nation's output, that

would have had significant policy implications. Today there is almost universal recognition that we have to

change our metrics. President Sarkozy of France set up the

International Commission on the Measurement of Economic

Performance and Social Progress, which I chaired." Experts were drawn from statistics, economics, political science, and

psychology, and the group included three Nobel Prize win-

ners. We unanimously agreed not only that GOP was a bad, and potentially badly misleading, measure but that it could

be improved upon." I cannot say, at this point, that we have

fully won this battle, but the tide has turned. Even the United States has begun work in broadening its measures. The G-20

endorsed work to find better metrics. The GECD, the organi-

zation of the advanced industrial countries, has undertaken a

large project following up on our work. And countries around the world-Australia, New Zealand, Scotland, the UK, Ger-

many, France, Korea, Italy, and many others-have begun ini-

tiatives along these lines. ' In democratic societies, even given the power of the wealthy

to control the media and shape perceptions, it is impossible

to completely suppress ideas. And when these ideas resonate with so'many citizens, they can take on a life of their own.

CONCLUDING COMMENTS

In politics, perceptions are crucial. Devoted ideologues on

each side will cherry-pick examples and draw from them

broad generalizations. As we've tried to argue, many individu-

als will perceive or remember only the evidence that is consis-

tent with their initial beliefs. This is so perhaps especially in

1984 Is UPON US 233

ideologically charged issues, such as the role of government,

particularly in dealing with inequality. That itself may be a reflection of the high inequality in the United States.

1 A great

deal of money is at stake for the 1 percent in winning this

debate. Given that, it becomes harder, not easier, to weigh all

considerations in a balanced way. In this chapter, I've tried to present a case for a nuanced

and balanced approach to the proper role of the market and

the government. We don't decide whether a given medical

intervention is good or bad by considering only the successes

or only the horror stories. Instead, we try",to understand the conditions under which a medical interJ~ntion is likely to work or not. What are the risks of doing nothing? What are

the limitations of intervening? The same care should be taken with both the "big" ideas we nave been discussing and the

more specific policy interventions. The powerful try to frame the discussion in a way that ben-

efits their interests, realizing that, in a democracy, they cannot

simply impose their rule on others. In one way or another, they

have to "co-opt" the rest of society to advance their agenda. Here again the wealthy have an ·advantage. Perceptions

and beliefs are malleable. This chapter has shown that the wealthy have the instruments, resources, and incentives to shape beliefs in ways that serve their interests. They don't

always win-but it's far from an even battle. We've seen how the powerful manipulate public perception

by appeals to fairness and efficiency, while the real outcomes

benefit only them. In the next chapter, we'll see how they achieve this not only in the court of public opinion but also in

America's courts.

.c: