The Frontal Cortex

David Leonhardt has an excellent column on the squeezed middle class. He notes that while inequality is increasing, the other common complaint - that the income of middle class workers is now more volatile - is not supported by government statistics. There has been no great risk shift, at least when you look at income. As Leonhardt notes, accurately diagnosing the problem is a necessary part of coming up with a solution:

There is now a big push in both Washington and state capitals to come up with policies that can alleviate middle-class anxiety. That's all for the good. In fact, it is overdue. If it's going to succeed, however, it will have to focus on the actual causes of the squeeze.

I think some classic experiments from behavioral economics and neuroeconomics can help us better understand why the middle class feels so unsettled. I think the big issue is the perception of fairness. As I noted yesterday, the top 25 hedge fund managers last year earned $14 billion, which is enough to pay New York City's 80,000 public school teachers for nearly three years. Whether or not these managers are worth that amount of money is almost irrelevant. From the perspective of the middle class, such an unimaginable income just seems unfair.

Look, for example, at the ultimatum game, that simple economic task where one person (the proposer) is given ten dollars and told to share it with another person (the responder). The proposer can divide the money however they like, but if the responder rejects the offer then both players end up with nothing.

Classical economic theory makes two predictions about the outcome of the ultimatum game: the offers will always be unfair, and the unfair offers will always be accepted. Since both players are rational, they understand that a small amount of money is still better than no money at all. Reason and greed should trump ethical notions of fairness.

But that isn't what happens. Experiment after experiment has demonstrated that most proposers offer about $5, which is completely fair and utterly irrational. Their selfishness is systematically suppressed. Why do proposers engage in such generosity? Because they are able to imagine how the responder will feel if they make an unfair offer. Proposers know that a lowball proposal will make the responder angry, which will lead them to reject the offer, which will leave everybody with nothing. So the proposers suppress their greed, and equitably split the ten dollars. They understand that maintaining the appearance of fairness is better for everybody.

When fairness breaks down, bad things start to happen. All primates expect to be treated fairly, and if these expectations are violated, they respond by going on strike. One of the more powerful examples of this behavior comes from Franz Waals and Sarah Brosnan, who trained brown capuchin monkeys to give them pebbles in exchange for cucumbers. Almost overnight, a capuchin economy developed, with hungry monkeys harvesting small stones. But the marketplace was disrupted when the scientists got mischievous: instead of giving every monkey a cucumber in exchange for pebbles, they started giving some monkeys a tasty grape instead. (Monkeys prefer grapes to cucumbers.) After witnessing this injustice, the monkeys earning cucumbers went on strike. Some started throwing their cucumbers at the scientists; the vast majority just stopped collecting pebbles. The capuchin economy ground to a halt. The monkeys were willing to forfeit cheap food simply to register their anger at the arbitrary pay scale.

This labor unrest among monkeys illuminates our innate sense of fairness. It's not that the primates demanded equality - some capuchins collected many more pebbles than others, and that never created a problem - it's that they couldn't stand when the inequality was a result of injustice. Humans act the same way. When proposers do something to deserve their riches, nobody complains. But when they get rewarded for no reason and then refuse to fairly distribute their reward, people get furious. They begin doubting the integrity of the system, and become more sensitive to perceived inequalities. They reject the very premise of the game.

If I were a policymaker in Washington, I'd focus on preserving the perception of fairness. (And if I were a presidential candidate, I'd make that a key part of my platform.) The great increase in inequality suggests that our society is becoming more unfair. This is troubling. People have a deep need to believe that you get what you deserve, that there aren't different rules for the rich and the middle-class. That simple and instinctual belief is a foundation of our economic system.