A critique of the transatlantic consensus on rising income inequality

ECONOMISTS are sometimes accused of being slow to react to changing events - that they are always seeking to explain the last generation's economic problems. In my view, economists are in fact quick to react to changing issues; indeed they could rather be faulted for being too fashion conscious. In the field of income inequality, there has been a swift response. There has become established a 'Transatlantic Consensus' that increased income inequality in the United States and high unemployment in Continental Europe are due to a shift of demand away from unskilled workers towards skilled workers. I refer to it as a 'Transatlantic Consensus' because it provides a unified explanation as to how a single cause has a differential impact on the United States and on Continental Europe. It also captures the fact that this view has been widely influential in the policy-making of international institutions on both sides of the Atlantic, such as the IMF and the OECD. This consensus is however open to question. Section 2 of the paper elaborates the underlying theory of distribution, treating in particular the international trade aspects, and argues that the Consensus view has so far fallen short of providing a complete explanation. Is there an alternative? Section 3 seeks to describe a different approach to explaining rising earnings inequality. One ingredient is a move from a simple skilled/unskilled dichotomy of the labour force to the more realistic assumption of a continuum of earnings capacity. This allows us to focus on the fact that it is not just the unskilled who have lost relative to the median but that the median worker has lost relative to high earners. There has in fact been a 'tilt' in the earnings/skill nexus. The second ingredient in the alternative approach proposed here is the explicit recognition of the role of social conventions or social codes in pay determination. Social conventions may allow the resolution of problems of incomplete contracting, where supply and demand considerations only place limits on the possible wage differentials. Changes in wage differentials may reflect shifts in such social conventions.