Why the Rest of the World Gains from U.S. Inequalities


Innovation is deemed crucial to sustained economic growth and welfare improvement. One may subsequently pose, as I do, that innovations require some sort of inequality before they can blossom. This does not mean that some people need to be kept poor so that others can innovate; it means that those individuals who have the potential to significantly improve things for society should be enabled (or left free) to act on that potential.

One of my favourite writers (and speakers), Milton Friedmanexplains that experimentation, which is closely related to innovation, can bring tomorrow’s laggards above today’s mean. I’ve drawn the picture below to illustrate what he means (or at least how I understood he meant it):

Bringing tomorrow's laggards above today's mean

Bringing tomorrow’s laggards above today’s mean

Thus, if we accept that today some inequities exist, which means that some are poorer than others, tomorrow the poorest (the “laggards”, on the left end of the graph) may be better off than the average today. The crucial insight is that inequalities are relative. Even though some may be better off relatively, everyone is better off absolutely.

Milton Friedman frequently argued that it is the brilliance of a few individuals, instead of the efforts of an organised collective (i.e. the federal government), that meant that welfare could increase as massively as it did in past centuries. Examples include plumbing, electricity, cars, medicine, antibiotics and immunisations – all innovations that sprouted from the minds of individuals.

I don’t have any exact numbers (they might not even exist, because concepts like innovations and welfare are extremely difficult to comprehensively quantify), but I am sure that the lion’s share of the innovations of the past century that changed the world for the better were developed in the United States (e.g. look at the innovations mentioned in the previous paragraph, but also think about the innovations of American companies like Apple and Google).

This is not a coincidence. The U.S. provides the perfect breeding ground for (especially radical and breakthrough) innovations. Good schools exist to nurture ideas. People are not risk-averse – they are prepared to take risks in order to develop an innovation. Personnel can be hired quickly to act upon a sudden technological development, but can be laid off relatively easily when the development proves to be less promising than expected. Entrepreneurs can swiftly obtain sizable profits by going to the well-developed stock market – but even if don’t, they are quickly able to try again, without a social stigma of failure.

Some tension therefore exists between the wish to be supportive of innovations on the one hand, and the desire to pursue ideals of the welfare state on the other. So, which one is more important? Some may argue that there need not necessarily be a tension. A frequently heard argument is, “look at the Scandinavians; they have both higher welfare and higher equality.” Such an argument would correspond with the picture below.

IMAG7735

The logical mistake here is that these are not two separate cases – they are connected. The argument would only hold if innovations would not travel across national boundaries. If there is one thing at which American entrepreneurs excel, it is quickly marketing their products internationally. To stick to one example, consider Apple’s MacBooks and iPods. Although the initial innovations behind Apple occurred entirely in the U.S., its operations now stretch far beyond the American border. Distribution centres, local salesforce, and production facilities have generated employment well oustide the U.S., to the point that now only a small minority of the people paid by Apple actually works in the U.S.

Apple products are just one example, but I pose that it is more the case that products based on U.S. inventions are sold abroad than that products of non-U.S. origin are sold in the U.S. Moreover, I am sure that in the past century American innovations have raised living standards in the rest of the world more so than the other way around.

Of course, a price is paid. iPods are not handed out for free outside the U.S. Only, that price does not include the costs to the American society that are associated with being a fertile ground for innovations (e.g. the inequities), nor does it compensate for the societal benefits experienced by the rest of the world, such as extra jobs and increased living standards. This is caused by that the benefits of innovations to society are not entirely or easily appropriable; it may be difficult to make those who benefit from innovations pay for them. This is the case because innovations cannot be contained. The U.S. cannot decide that “Scandinavia can no longer benefit from American innovations, because we provide more innovations than they do.”

The rest of the world therefore derives more value from American innovations than vice versa. What happens is that other countries – let’s stick to Scandinavia – can focus on reducing inequalities, because they can rely on the U.S. for innovations. As soon as innovations occur, the knowledge diffuses, and can be intregrated into the Scandinavian economy. There is no need for Scandinavia to have the necessary inequities, since innovations come from the U.S. anyway.

To relate this to what Friedman said, one may argue that American innovations not only raise their own laggards above yesterday’s mean, but also the Scandinavian ones. As a matter of fact, since Scandinavia need not bother too much about creating innovations, it can more intensively focus on the distribution of wealth and a more short-term focus on welfare creation – since the Americans will stimulate long-term welfare creation through their innovations.

It is therefore that the rest of the world should be thankful for American inequalities. I end this post by illustrating this graphically:

IMAG7739

Scenario 1 is the current, actual one. The U.S. has greater inequalities (the upward-sloping curve), and the rest of the world (i.e. countries 1, 2, and 3) benefit from the innovations. Scenario 2 is the one where the U.S. would listen to European criticism. Yes, making firing personnel more difficult, instituting universal healthcare benefits, increasing social security benefits, raising tax levels, and executing other measures that would make the U.S. more of a welfare state would definitely reduce inequalities. In the end it would, however, also reduce living standards – especially in Europe.

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