Inequality update

It's been a while since this blog has reviewed the latest literature on inequality percolating around the internet, and it's probably time for an update. Leading off is this National Journal piece by Jonathan Rauch that has attracted considerable attention, having been highlighted by Ryan Avent, Andrew Sullivan and RealClearPolicy. Early in the piece Rauch notes that leftists who raise the income inequality issue have struggled to justify it as an economic threat:

For years, the idea that inequality, per se, is economically neutral has been the mainstream view not just among conservatives but among most Americans outside the further reaches of the political Left. There might be ideological or ethical reasons to object to a growing gap between the rich and the rest. But economic reasons? No.

He adds, however, that that may be beginning to change. Here's the meat of his argument:

The rich save—that is, invest—15 to 25 percent of their income, [Joseph] Stiglitz writes, whereas those on the lower rungs consume most or all of their income and save little or nothing. As the country’s earnings migrate toward the highest reaches of the income distribution, therefore, you would expect to see the economy’s mix of activity tip away from spending (demand) and toward investment. 

That is fine up to a point, but beyond that, imbalances may arise. As Christopher Brown, an economist at Arkansas State University, put it in a pioneering 2004 paper, “Income inequality can exert a significant drag on effective demand.” Looking back on the two decades before 1986, Brown found that if the gap between rich and poor hadn’t grown wider, consumption spending would have been almost 12 percent higher than it actually was. That was a big enough number to have produced a noticeable macroeconomic impact. Stiglitz, in his book, argues that an inequality-driven shift away from consumption accounts for “the entire shortfall in aggregate demand—and hence in the U.S. economy—today.” 

True, saving and spending should eventually re-equilibrate. But “eventually” can be a long time. Meanwhile, extreme and growing inequality might depress demand enough to deepen and prolong a downturn, perhaps even turning it into a lost decade—or two.

The theory presented here appears premised on the idea that macroeconomic health is a function of aggregate demand -- a proposition which is far from obvious. If gains to the top depressed consumer spending, thus undermining the economy, then how does one explain the economic boom that last from roughly 1982-2008 that saw inequality consistently grow? Furthermore, recall that money not used for consumption spending is available to be used as investments in things like new factories, companies and R&D, which drives economic progress. Indeed, this is why many economists consider investment preferable to consumption, as explained here by Matt Yglesias.

Rauch then presents another potential hazard stemming from income inequality -- too much credit:

...“Cynical as it may seem,” Raghuram Rajan, a finance professor at the University of Chicago’s Booth School of Business, wrote in his 2010 book, Fault Lines: How Hidden Fractures Still Threaten the World Economy,“easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly.” That certainly seems to have happened in the years leading to the mortgage crisis. Marianne Bertrand and Adair Morse, also of Chicago’s business school, have found that legislators who represent constituencies with higher inequality are more likely to support the easing of credit. Several papers by International Monetary Fund economists comparing countries likewise find support for the “let them eat credit” approach. And credit splurges, they find, bring on instability and current-account deficits. 

You can see where the logic leads. The economy, propped up on shaky credit, becomes more vulnerable to shocks. When a recession comes, the economy takes a double hit as banks fail and credit-fueled consumer spending collapses. That is not a bad description of what happened in the 1920s and again during these past few years. “When—as appears to have happened in the long run-up to both crises—the rich lend a large part of their added income to the poor and middle class, and when income inequality grows for several decades,” the IMF’s Michael Kumhof and Romain Rancière wrote, “debt-to-income ratios increase sufficiently to raise the risk of a major crisis.” 

But wait. Which is it? Does inequality depress demand? Or does it inflate credit bubbles that maintain demand? Unfortunately, the answer can be both. If inequality is severe enough, there could be enough of it to cause the country to inflate a dangerous credit bubble and still not offset the reduction in demand.

Here is an alternative explanation for the first paragraph: legislators from areas with high inequality are also likely to be from areas with high housing costs; think NYC, Connecticut, San Francisco, etc. To help ameliorate the impact of high housing costs, these legislators are more likely to push for an easing of credit (indeed, a loosening of mortgage rules was one of the factors examined by the Bertrand and Morse study). If this alternate theory is correct, the real culprit is not income inequality, but factors that drive up housing costs (government regulation to a large extent). Even if incorrect, the point still stands that the authors have only established correlation, and that other potential causal explanations exist.

Furthermore, it is not apparent that government efforts to juice the economy through an easing of credit are driven by income inequality and concerns over relative welfare. Rather, voter complaints over the economy that prompt such efforts usually are made from an absolute perspective -- typically items such as joblessness or stagnant incomes. Rare is the voter who has both a job and steadily rising income, but nonetheless cites the economy as a concern because their income isn't rising as quickly as the top 1 percent.

The last paragraph, meanwhile, is rather convenient -- inequality both prompts an ease of credit while depressing demand? C'mon...

And, no, we’re not finished. Inequality may also be destabilizing in another way. “Of every dollar of real income growth that was generated between 1976 and 2007,” Rajan wrote, “58 cents went to the top 1 percent of households.” In other words, for decades, more than half of the increase in the country’s GDP poured into the bank accounts of the richest Americans, who needed liquid investments in which to put their additional wealth. Their appetite for new investment vehicles fueled a surge in what Arkansas State’s Brown calls “financial engineering”—the concoction of exotic financial instruments, which acted on the financial sector like steroids. 

Those changes, the French economists Jean-Paul Fitoussi and Francesco Saraceno wrote in a 2010 paper, “help explain why the expansion of the financial sector was so out of touch with the economy. And why, for example, in the U.S., the financial sector represented about 40 percent of the total profit of the economy.” Alas, when the recession struck, the financial sector’s gigantism and complexity helped turn what might have been a brush fire into a meltdown.

The problem with this theory however, is that -- even if true -- the culprit here is not income inequality, but simply people having a lot of money.  If every non-rich American were given a million dollars, thus reducing inequality, it would not change the fact that many billions of dollars were sloshing around in search of a productive use. Indeed, making millionaires out of more Americans could well exacerbate the problem.

Ultimately, all of the various theories presented in the article suffer from being more rooted in conjecture than hard evidence, which is why Rauch says in his conclusion that with the "arguable exception of [Joseph] Stiglitz, the new macro-egalitarians are modest in their claims" and that most of them "acknowledge that much work needs to be done to tease out cause and effect."

Speaking of Joe Stiglitz, this recent Der Spiegel interview with him contains an interesting nugget:

SPIEGEL: Don't the rich also give something in return? In Germany, the upper one percent contributes almost a quarter to the tax revenue, and the top ten percent more than half of the taxes. Isn't that an appropriate share? 

Stiglitz: I don't know about the German numbers. What I can say is that the top one percent in the United States has an average tax rate of less than 30 percent of their reported income, and the large proportion who take much of their income as capital gains pay far less. And we know that they are not reporting all of their income.

Notice that while the interviewer cites the percentage of taxes paid by the rich, Stiglitz responds by noting the tax rates. But tax rates are merely a means to an end -- revenue. And here's what the revenue picture looks like:

In other words, while in Germany (where income taxes are higher) the top 1 percent pay 25 percent of the taxes and the top 10 percent pay over 50 percent, in the US the corresponding numbers are 37 percent and 70 percent. Stiglitz is too smart of an economist to not know this, so one can only conclude that he tries to change the subject because such facts do not fit his preferred narrative.

Next up is this Nick Kristof column on inequality, the obvious highlight of which is his pronouncement that "I buy into the Chinese mantra of the reform era: 'To get rich is glorious.'" However, it also contains this bit:

On [the inequality issue] issue, Americans seem by intuition to be flaming lefties. A study published last year by scholars from Harvard Business School and Duke University asked Americans which country they would rather live in — one with America’s wealth distribution or one with Sweden’s. But they weren’t labeled Sweden and America. It turned out that more than 90 percent of Americans preferred to live in a country with the Swedish distribution.

Perhaps nothing gets done because, in polls, Americans hugely underestimate the level of inequality here. Not only do we aspire to live in Sweden, but we think we already do.

That Americans prefer to live in Sweden is not at all obvious. Rather than looking at what Americans say, let's look at what they actually do in terms of where they prefer to live. If Americans really want to live in places with more equal income distributions, then why aren't they flocking to Wyoming and Alaska (two of the top three states for lowest inequality), and are instead heading to Texas and Florida (both in the bottom ten)? This is also difficult to square with the fact that Washington DC has witnessed a population boom even though it would rank dead last in income inequality if it were a state.

While the observations of Americans' behavior is completely at odds with their pronouncements about preferring to live in Sweden, it nicely comports with the theory that they assess their welfare from an absolute perspective rather than a relative one.