The idea that capitalism is necessarily associated with a high degree of inequality seems to have become part of conventional wisdom. Yet it is an argument that is as widely spread as it is wrong. A big deal of confusion seems to come from failing to differentiate between gaps of income that arise due to the process of “equalizing differences” and those that occur because of market inefficiencies (often even governmentally enforced). Capitalism having become synonymous with Gilded Age type policies often summarized under the label “neo-liberalism” does not help either. Countless think tanks supposedly interested in promoting a free market society have further built a reputation by distorting what the meaning of such an arrangement actually is. Freedom House’s measure of “economic freedom”, for instance, increases as “levels of government regulation over the economy” decreases. The Heritage Foundation’s Index of Economic Freedom does essentially the same thing in a slightly more elaborate fashion. Clearly, anyone who believes that less regulation (or government in general) automatically means more economic freedom has not thought the issue through. It is preposterous that these institutions are hailed as defenders of a free society when it is clearly their agenda, either on purpose or through almost criminal negligence, to destroy it.
The whole capitalistic ethic is based on each of the factors of production, including labor, getting its fair share of the output – the fair share being the amount that factor adds to the value of the produced good. The concept is fairly straight-forward, and its functioning absolutely vital to the functioning of the system as a whole. A free society based on voluntary cooperation between individuals can only function properly if each individual actually gets the total share of what he puts in. Even Marxist criticism implicitly acknowledges this. A main point of that criticism is that labor is exploited because it produces the entire surplus while only getting a small share of it. While that notion might be worthy of contemplation, it follows logically that “labor is exploited only if it is entitled to what it produces”, as Milton Friedman put it back in 1962. But let’s return to the issue of the seemingly obvious link between capitalism and inequality.
People are different. They are different in their gender, abilities, interests, preferences, you name it. A person deciding to take a lower-paying job that offers more spare time is, given the actual freedom to do so, making a conscious choice to forgo pecuniary rewards for non-pecuniary ones. A person choosing to work more hours in return for more money is doing the same, yet for whatever reason valuing the monetary aspects of his job more than the non-monetary ones. Some people might prefer a low-risk job and be willing to settle for an accordingly lower pay. Someone else might decide a high level of risk is justified as long as she is paid an adequate premium. Equal pay for all of them would not introduce equality, as is often argued, but rather create inequality. The same counts for people of different skill levels. It is interesting to think about how these differences in skill arise and what this means for the ideal concept of equality, but we’ll have to leave that for another day. Capitalism should further also be a boon for minorities often having suffered from oppression in the past. The market effectively makes both the production and consumption process fairly anonymous. There is generally no direct way of telling whether the goods I buy were produced by blacks, whites, Jews or Muslims. As long as there is a government that ensures markets operate the way they should, there is nothing inherently unequal in capitalism in any sense that matters.
In the 1980s, however, something interesting started to happen. We started to abandon a (considerably flawed but fairly workable) version of capitalism for a more extreme approach. As far as I can tell, the whole incident involved a massive misjudgment of what the actual problem was. An ugly combination of terrible macroeconomic policies and adverse supply shocks led to stagflation. Instead of saying “all right, we screwed up, let’s learn from this episode” politicians like Reagan and Thatcher somehow concluded that the state is incompetent to begin with, and decided to hand power over to the market. Deregulation sounds great on the surface, but has often had the effect not of increasing efficiency but rather of concentrating economic power. Wages started to lag behind productivity increases, mainly due to anti-union policies adopted in an attempt to eliminate these sources of “monopoly power”, but in fact exacerbating the difference in bargaining power between employees and employers.
In many countries around the world the main pillar of capitalism, namely “to each according to his contribution”, was effectively smashed by the iron fist of the state. The increasing levels of inequality in recent decades are not an economic failure but a political one. As another example, the increasing amount of deductions for income tax have greatly reduced the redistributive effectiveness of such a tax while at the same time rendering it highly arbitrary in nature. It is not capitalism per se that creates inequality. It is the way our political system distorts our economy so that it benefits only a few that does.