Throughout history, there's been a pattern where those with wealth tend to keep getting wealthier, while those with less struggle to catch up. This pattern, often called the Matthew effect after a sociologist named Matthew who talked about it in 1968, can be explained by something called preferential attachment. It's like a snowball effect - if you already have a lot, it's easier to get even more because you have resources to invest. But if you have less, it's harder to build up because you don't have as much to start with. However, just knowing this isn't enough to understand all the ways it affects society. So, in this article, we'll dig deeper into what this means and look at a thoroughly econometric analysis to investigate how the wealth gap has evolved over time.
Looking back at the 20th century, one might contend that, as per Kuznets' U curve, the wealth gap—or, if we dare to view it differently, the poverty gap—is intricately linked to a country's level of development. Initially, as a country embarks on growth and development, this inequality conspicuously rises. However, at a certain midway juncture, it tends to plateau, only to gradually diminish for the first time in the future, particularly within well-established states experiencing sustained development and growth. However, it's essential to acknowledge that while this theory held true in the 1970s, it no longer reflects contemporary realities, evident in the current situations in the US. The question arises: why?
Let's explore the nuances of Kuznets' approach and his theory. In the 1950s, economist Kuznets made a significant contribution by meticulously analysing the wealth distribution of nations. How did he accomplish this? Well, while we now commonly understand the concept of time series analysis in econometrics, it was relatively nascent at that time. Kuznets, however, pioneered the use of time series data from income tax records, employing statistical interpolation techniques informed by Pareto's laws.
Pareto's observations on population and wealth distribution were pivotal. He noted that roughly 80% of Italy's land was owned by just 20% of the population. Surprisingly, similar distributions were found in other countries upon his investigations. Essentially, Pareto proposed that in a prosperous economy, 80% of outcomes stem from 20% of the causes—a significant assumption that underpinned Kuznets' discoveries regarding the top percentage of income earners in the United States and Europe from 1913 to 2010.
One might argue that Kuznets theory is merely based on factual data, lacking logical arguments for his conclusions and their long-term invalidity. However, it must be acknowledged that in the past, data extraction methods were limited, particularly considering that time series analysis was still in its early stages. Surveys were often conducted over short periods, potentially resulting in the loss of crucial data and yielding erroneous conclusions. Moreover, long-term inequality was influenced by a multitude of factors beyond these data limitations, including country-specific institutions and historical circumstances, such as pivotal junctures, which led to divergent outcomes.
An intriguing perspective to begin with is the significant disparity in income inequality between Europe and the US in 1910, contrasting with today's scenario. It wasn't always the case that the wealthier segment of the population in the US earned a higher income percentage. In the past this figure stood at around 40% in the US and 45% in Europe. However, a century later, this dynamic reversed, with Europe's top percentile declining to 30% while the US's rose to nearly 50% of total income. The primary income under analysis in this article is currently at its peak in the US, even surpassing the pre-World War I era.
Turning to wealth inequality, measured by the share of net wealth held by the top 10% of the population, it has historically paralleled the trajectory of income inequality. Official data reflects similar patterns, yet the disparities are notably higher when discussing wealth inequality compared to income inequality in both the US and Europe. Notably, the bottom half of the population virtually possesses no wealth, amounting to less than 0.1% of the average wealth, while the upper bottom half earns approximately the average income. This highlights the extreme concentration of capital ownership, while income inequality, though significant, is relatively less pronounced, often tied more closely to merit-based circumstances.
Now, an interesting turn arises when examining the impact of World War I. Despite expectations, the two graphs did not intersect; instead, they continued to follow similar trajectories in the aftermath of the war. However, with the advent of World War II, the graphs crossed, signifying differing effects on Europe and the US. Although both regions suffered substantial capital losses post-World War II, from which they have yet to fully recover, a consequence of these events is that today, the middle class in Europe commands a larger share of wealth than in the US.
Yet, a dilemma emerges: while wealth inequality in the US is still less than that of Europe in 1913, why is income inequality higher in the US than in 1913 Europe? Logically, higher salaries should translate into greater savings capability. The reason is rather straightforward: in the past, the primary source of wealth was not derived solely from labour, but predominantly from the concentration of capital ownership (rent, interest, dividends). This meant a steady stream of income. However, in today's landscape, wealth stems equally from ownership and labour. Hence, this seemingly minor difference in approach translates into significant disparities in wealth gaps.
Now, let's introduce a third metric: the wealth to income ratio, which reveals another stark contrast between Europe and USA, indicating the overall significance of wealth as well as the capital intensity of production. Interestingly enough, in the past, wealth constituted around 6 to 7 years of national income in Europe, declining to about 2 to 3 years of national income in the 1950s, steadily rising since then, and currently back to around 5 to 6 years. The situation in the US is somewhat different, with the ratio remaining relatively stable; intriguingly, it's similar today to what it was in the 1900s.
Returning to Kuznets, we can observe the U-shaped pattern once more, evident in the wealth to income ratio in Europe and income inequality in the US. The US stands out as the realm of expansive top labour income globally, whereas Europe emerges as the hub of burgeoning wealth, albeit with a lower concentration than in the US.
In addressing the issue of wealth inequality over the long term, it's crucial to delve into historical lessons and project future trajectories. However, it's important to note that our analysis isn't conducted within a controlled experimental framework. While research endeavours strive to eliminate specific variables' effects and employ methodologies like the difference-in-differences approach, events like World War II, occurring as a stochastic phenomena in the 1940s, pose significant challenges. If we could go back in time to prevent certain events, like Hitler's actions, we might change history. But realistically, that's not possible. Despite these challenges, there's still hope for progress.
The aftermath of capital shocks during the 1914-1945 period in Europe elucidates factors contributing to the decline in wealth-to-income ratios. Post-war scenarios entailed physical capital destruction, diminished investment, and decreased asset values. Yet, the prolonged recovery period prompts scrutiny. Applying microeconomic theories like the Harrod-Domar-Solow formula suggests that wealth-to-income ratios eventually align with saving-to-growth rate ratios. This implies that capital resurgence parallels low growth rates. In a theoretical scenario of zero population and productivity growth, income remains fixed, and positive savings lead to infinite capital accumulation, resulting in an indefinite increase in wealth-to-income ratios.
Examining real-world scenarios, disparities emerge. Notably, the US experiences population and production growth rates of approximately 1% to 1.5%, totaling a 3% annual growth. Conversely, Japan and Europe exhibit near-zero population growth, resulting in productivity growth mirroring total growth rates of about 1% to 1.5%. Additionally, the US has lower savings rates compared to Europe, which is the reason why Europe's wealth-to-income ratio is higher than that of the US today.
Now, let's explore the dynamics of income inequality further. Kuznets argued that income inequality initially increases with economic development as higher-paying sectors emerge, but then decreases as more workers join these sectors. However, in the first half of the twentieth century, this wasn't the case. Inequality was driven by factors like wars, economic depressions, and regulatory policies, rather than a structural decline in labor income inequality.
So, what determines long-term labor income inequality? The prevailing economic model suggests it's a race between education and technology. The expansion of education increases the supply of skilled workers, while technological advancements raise the demand for skilled workers. Despite intense global competition for skills due to rapid technological progress, labor income inequality has remained relatively limited in Europe compared to the US. This is partly due to the soaring compensation of top executives in large US corporations, both financial and non-financial. Additionally, the US is known for its exorbitant university tuition fees, which contribute to significant income disparities later on. Studies have shown that graduates from prestigious universities like Harvard earn much more than those from community colleges, reflecting the differing costs of education.
In conclusion, income inequality isn't determined by a single process; rather, powerful forces alternately push for both rising and shrinking inequality. The ultimate outcome depends on the institutions and policies adopted by societies.
Bibliography
Rigney, D. (2010). The Matthew Effect: How Advantage Begets Further Advantage. [Unpublished manuscript]. Columbia University.
Piketty, T., & Saez, E. (2014). Inequality in the Long Run. The Science of Inequality, 344(6186), 838-843.