Ever since I came across the Piketty and Saez publications on the dramatic rise of the top 1% of incomes in the US, I’ve been trying to follow the growing literature on what explains this massive rise in the incomes of the very top. When I began working for Greta Krippner, who has been studying financialization for close to a decade now, I started to understand some of the connections between the rise of finance and income inequality. Hacker and Pierson take up the point forcefully in their new book, placing the blame squarely on the failures of the political system (though they focus on CEO pay as much as finance – and it’s not clear that’s where we should be focused).

All this legwork leads up to a fantastic new essay by Tyler Cowen in The American Interest. Cowen aptly describes the above trends and adds his own, very nuanced, but readily understandable take on the situation. Cowen focuses on how very smart finance professionals have managed to make a lot of money by betting very heavily against unlikely outcomes – like home prices going down – and simply walking away when the improbable disaster eventually comes. But he also mentions some key, and often ignored trends, that explain some of the increases in income inequality below the top 1% in not so malevolent ways (like changing demographics, which leads to more apparent inequality). It’s worth a full read, but here are a few choice excerpts:

The broader change in income distribution, the one occurring beneath the very top earners, can be deconstructed in a manner that makes nearly all of it look harmless. For instance, there is usually greater inequality of income among both older people and the more highly educated, if only because there is more time and more room for fortunes to vary. Since America is becoming both older and more highly educated, our measured income inequality will increase pretty much by demographic fiat. Economist Thomas Lemieux at the University of British Columbia estimates that these demographic effects explain three-quarters of the observed rise in income inequality for men, and even more for women.
…
[F]or 2004, nonfinancial executives of publicly traded companies accounted for less than 6 percent of the top 0.01 percent income bracket. In that same year, the top 25 hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning more than $100 million a year was nine times higher than the public company executives earning that amount.
…
The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

While the pieces of this analysis are mostly not new, Cowen does an excellent job putting it all together. He also paints a compelling if dismal picture of the inability of regulators to do much about it, at least in the short term. Cowen concludes on this pessimistic note:

Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.

Owch. But looking at the anemic financial reform bill passed by this Congress, and the impossibility of anything stronger happening anytime soon, coupled with Wall Street having another banner year for profits, I don’t see much to disagree with here. I don’t always agree with Cowen’s politics, but I’m not sure how much more I could add to an essay like this*. A set of painful truths, well worth the read. Though I might have ended with a call for action, Cowen’s pessimistic take will almost surely be the better prediction.

For a slight critique of Cowen (basically for ignoring regulatory capture), see this excellent Economist post.

Update: Rortybomb has some more detailed comments/critiques/extensions of Cowen here. Highly recommended as well.

* Except perhaps to note that Cowen pays no attention to growing racial disparities, for example, which are an important part of the story. While he signals in the beginning that he will discuss the problems of rising persistent unemployment in greater detail, the essay treats the issue pretty perfunctorily.