Why the Wealth Gap Matters

Just to follow up on Hugh's post below - I'm approaching this from the standpoint not of any principals of right/wrong equality/fairness or what have you. Simply from the standpoint of practical function.

Capitalism is a constant interplay between consumption, labor and capital. Consumption demand tells capital where to invest. Capital deploys labor to meet consumption demand. Labor provides the wage foundation for consumption demand. These elements must be in balance to some degree.

When you have increasing wealth concentration over time, what are the consequences? Take it to the extreme, say you reach a point where one person has all the income and owns all the capital and everyone else is unemployed. With no broad-based labor income, any consumption would have to come from debt growth among consumers with no income. With vast demands put on social welfare programs, the government would also have to be funded mostly with debt. With insufficient consumption demand to tell capital where to deploy, and a surplus in capital driving down interest rates, investments would cease to yield satisfactory returns.

So we could expect consequences such as indebted consumers, soaring government debt, and lackluster performance in investment markets.

Of course the opposite extreme has consequences too: if you pay everyone exactly the same, regardless of occupation or quality of work. This eliminates motivation to produce quality work for the cost of labor invested. Consequences we would expect would be declining productivity and high inflation.

So clearly somewhere in between there are acceptable ranges of income and wealth gradations that result in healthy functioning economies. So that's the 'why'. Clearly, it matters. Where the optimum level is exactly I don't claim to know, but history gives us some guide as to what sort of concentrations don't work, where they begin to destabilize the system. The late 1920's for example, similar to today's situation.

Left to its own, capitalism will tend to concentrate wealth until the system destabilizes and there is a financial crash. This cycle of 'panics' was the norm in the 1800's, with some sort of financial collapse occuring once a decade or so. Like a flywheel winding up and spinning down, it was an unsettling time for labor and capital.

You can mitigate this tendency with counter-cyclical dampeners -- a progressive income tax, an escalating minimum wage, management of the money supply. All of these can be structured to build a foundation of stability. See the period from the 1940's to the 1970's, when top tax rates were 70-90%, labor unions were huge, the middle class was growing, and there were no financial panics.

Even left to its own, the balance between labor, capital and consumption will self-restore eventually (albeit in perhaps a sudden and wrenching fashion for capital). The system can correct via either: (1) growth in wages faster than capital , (2) a heavy contraction in capital relative to labor/consumption (i.e. financial panic, depression/deflation), or (3) inflation - growing wages and consumption nominally and to some degree in real terms but usually devaluing capital in real terms.

Fun historical footnote: in the 1800's there were political factions who called themselves 'inflationists', who were in favor of a more elastic money supply. This was decades before the Fed.