Illustration by Ana Benaroya
Illustration by Ana Benaroya

Americans are egalitarian. This trait has long frustrated plutocrats who, more than a century ago, invented Social Darwinism to teach that the rich prospered because they were smart and productive. Few people believed this, not then and not now.

A new Census Bureau report released last week showed that since 2009 economic gains have accrued only to the top 5 percent of households; the rest have gained almost nothing; poverty remains high and inequality has worsened. Yet libertarians still ask: Does inequality matter? Is our fondness for equality good economics or does it stand in the way of creativity, hard work and just rewards?

Economists have argued about this for more than 200 years. Adam Smith, that apostle of markets, saw the political danger of inequality, and expressed it most compactly: “Wealth is power, as Mr. Hobbes says.” John Maynard Keynes wrote of the Victorian era: “It was precisely the inequality of the distribution of wealth which made possible those vast accumulations of fixed wealth and of capital improvements which distinguished that age from all others.” On the other hand, the Austrian economist Joseph Schumpeter argued that inequality is the force behind technical advance. According to Schumpeter, progress is a lottery. And if the prizes are really big, more people will try to win them. There will be many failures -- but much invention.

Rising Inequality

Inequality waned during most of the 20th century, to Schumpeter’s dismay. By 1958, even John Kenneth Galbraith could write, “few things are more evident in modern social history than the decline of interest in inequality as an economic issue.” In the 1980s and 1990s, though, inequality shot up and interest revived. These days the battle rages on.

Of course, market outcomes are unequal. And to liberals’ chagrin, inequality is exacerbated in good times. In the late 1990s, under President Bill Clinton, the U.S. had four years of full employment, and income inequality hit levels not seen since 1929. The reason is simple: Inequality is driven mainly by capital gains, stock options and the proceeds of venture capital and initial public offerings, all of which exploded during the information-technology boom.

But do more unequal countries, generally, work better? In Europe, “labor market flexibility” has been the mantra of conservative reformers for years. According to them, skilled workers were paid too little and unskilled workers too much. The supposed remedy was to weaken unions, cut pensions and reduce state benefits for working people. Recently Greece, Portugal, Ireland, Italy and Spain carried out such “reforms.” Competitiveness didn’t return and unemployment rose.

Here are two facts: First, rich countries are usually more equal than poor ones. For a nation to be rich and developed, it must -- by definition -- have a large middle class. Second, inequality and unemployment rise and fall together. If pay gaps are large, people will quit low-paying jobs (on farms, for example) and move to factory towns (or technology centers) where the jobs are better -- but scarce. Those who can’t get the good jobs stay unemployed. It’s pretty simple. Also, if wage rules forbid low pay, then businesses innovate more rapidly and productivity increases. Decades ago the Scandinavians grasped this dynamic, and since then, those countries have become some of the richest on earth.

In short, as economics, inequality is like blood pressure. There’s a healthy range. Within that range, lower is better but too low can be dangerous and zero puts you in the morgue. When inequality rises, the symptoms aren’t necessarily immediate. It may even feel pretty good; credit booms do. But rising inequality is a sign of crisis to come. We saw that in 1930, in 2000 and again in 2008. You can’t eliminate inequality, and we don’t want to. But it should be kept under control.

Minimum Wage

So, on one side, we want the lure of large prizes to help drive innovation. On the other, we want a stable and secure middle class. Can we have both? Would raising the minimum hourly wage -- let’s say to $12 or even $15 -- threaten innovation? Of course not. Nor would a more generous Social Security system, easier terms on student loans or a robust public jobs program. Nor for that matter would raising the top income tax rates or rates on capital gains. The lure of big prizes isn’t diminished much by having to pay a little more in taxes.

What is key, though, is that innovation’s big prizes not fund dynasties. The second and third generations never replicate the genius (or luck or graft) of the first. Instead, the descendants go into politics, or become speculators or tax evaders. An effective estate-and-gift tax works to prevent this. With a high rate and a generous exemption or even a full deduction for qualified philanthropy, those who have won great fortunes will give most of them away. They will endow universities, hospitals, museums, libraries, parks, theaters and churches. Within a generation, the money goes out of family hands and the proceeds go back to the community, funding good works and creating jobs.

We can tolerate inequality, in other words, as long as we meet two conditions. First, there must be a strong, stable foundation for middle-class life with protection from poverty. Second, great fortunes can pile up but they must then be dispersed. In a democracy, no one should rule by inherited wealth -- or it’s no democracy to speak of.

(James K. Galbraith is the author of “Inequality and Instability: A Study of the World Economy Just Before the Great Crisis.” His next book is “The End of Normal,” due in 2014. He teaches at the LBJ School of Public Affairs at the University of Texas at Austin.)

To contact the writer of this article: James K. Galbraith galbraith@mail.utexas.edu.

To contact the editor responsible for this article: Alex Bruns at abruns@bloomberg.net.