National Journal | September 27, 2012
AT A salon dinner in Washington recently, the subject was inequality. An economist took the floor. Economic inequality, he said, is not a problem. Poverty is a problem, certainly. Unemployment, yes. Slow growth, yes. But he had never yet seen a good reason to believe that inequality, as such—the widening gap between top and bottom, as distinct from poverty or stagnation—is harmful to the economy.
Perhaps he spoke too soon.
Once in a while, a new economic narrative gives renewed strength to an old political ideology. Two generations ago, supply-side economics transformed conservatism’s case against big government from a merely ideological claim to an economic one. After decades in which Keynesians had dismissed conservatism as an economic dead end (“Hooverism”), supply-siders turned the tables. The Right could argue that reducing spending and (especially) tax rates was a matter not merely of political preference but of economic urgency.
Something potentially analogous is stirring among the Left. An emerging view holds that inequality has reached levels that are damaging not only to liberals’ sense of justice but to the economy’s stability and growth. If this narrative catches on, it could give the egalitarian Left new purchase in the national economic debate.
“Widely unequal societies do not function efficiently, and their economies are neither stable nor sustainable in the long term,” Joseph E. Stiglitz, a Nobel Prize-winning economist, writes in his new book, The Price of Inequality. “Taken to its extreme—and this is where we are now—this trend distorts a country and its economy as much as the quick and easy revenues of the extractive industry distort oil- or mineral-rich countries.”
Stiglitz’s formulation is a good two-sentence summary of the emerging macroeconomic indictment of inequality, and the two key words in his second sentence, “extreme” and “distort,” make good handles for grasping the arguments. Let’s consider them in turn.
INEQUALITY’S BROKEN PROMISE
Equality and Efficiency: The Big Trade-off was a 1975 book written by the late Arthur Okun, a Harvard University economist and pillar of the economic establishment. Okun’s title encapsulated an economic consensus: Inequality is the price America pays for a dynamic, efficient economy; we may not like it, but the alternatives are worse. As long as the bottom and the middle are moving up, there is no reason to mind if the top is moving up faster, except perhaps for an ideological grudge against the rich—what conservatives call the politics of envy.
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.
“The debate for many years looked settled,” said Robert Shapiro, an economist with Sonecon, a Washington consulting firm. “Changes in the economy and changes in the data have reopened the debate.”
Economists know more today than they did in Okun’s day about the distribution of income. “There’s been enormous progress in measuring inequality—Nobel Prize-level progress,” said David Moss, an economist at Harvard Business School. As the data came in and the view got clearer, the picture that emerged was unsettling.
“In the 1990s,” Moss said, “it began to appear that income was being concentrated among the very highest earners and that stagnation was occurring not just at the low end but across most income levels.” It wasn’t just that the top was doing better than the rest, but that the very top was absorbing most of the economy’s growth. This was a more extreme and dynamic kind of inequality than the country was accustomed to.
According to a recent Congressional Budget Office report, those in the top 1 percent of households doubled their share of pretax income from 1979 to 2007; the bottom 80 percent saw their share fall. Worse, while the average income for the top 1 percent more than tripled (after inflation), the bottom 80 percent saw only feeble income growth, on the order of just 20 percent over nearly 30 years. The rising tide was raising a few boats hugely and most other boats not very much.
It thus began to seem that the old bargain, in which inequality bought rising incomes for all, had failed—much as the Keynesian bargain (bigger government, faster growth) had failed two generations earlier. “The majority of Americans have simply not been benefiting from the country’s growth,” Stiglitz wrote, overstating things—but not by a lot.
PATHWAYS TO PERIL
So much for “extreme.” Next came the financial-system meltdown of 2008 and the Great Recession, which bring us to “distort”—how an excess of inequality may have warped the economy.
As the data on inequality came in, economists noticed something else: The last time inequality rose to its current heights was in the late 1920s, just before a financial meltdown. Might there be a connection? In 2010, Moss plotted inequality and bank failures since 1864 on the same graph; he found an eerily close fit. That is, in both the 1920s and the first decade of this century, inequality and financial crisis went hand in glove. Others noticed the same conjunction. Although Moss recognized that a simple correlation based on only two examples proves nothing, he wasn’t alone in wondering if something might be going on. But what?Different economists suggest different pathways by which inequality at the microeconomic level might cause macroeconomic problems. What follows is a composite story based on common elements.
As with supply-side, the case starts with the two extreme ends of a curve. Supply-siders pointed out that two tax rates produce no revenue: zero percent and 100 percent. Inequality traces an analogous curve. At both extremes of inequality—either perfect inequality, where a single person receives all the income, or perfect equality, where rewards and incentives cannot exist—an economy won’t function. So, Moss said, “the question is: Where are the break points in between?”
Suppose various changes (globalization, technology, increased demand for skills, deregulation, financial innovation, the rising premium on superstar talent—take your pick) drove most of the economy’s income gains to the few people at the top. The rich save—that is, invest—15 to 25 percent of their income, 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.
So inequality might suppress growth. It might also cause instability. In a democracy, politicians and the public are unlikely to accept depressed spending power if they can help it. They can try to compensate by easing credit standards, effectively encouraging the non-rich to sustain purchasing power by borrowing. They might, for example, create policies allowing banks to write flimsy home mortgages and encouraging consumers to seek them. Call this the “let them eat credit” strategy.
“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.
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.
TOO MUCH OF A BAD THING
In the 1970s, supply-siders argued that tax rates had become high enough to choke off growth and destabilize the economy. Today’s rethink makes the same kind of case against inequality. “Some inequality is a good thing in terms of establishing incentives to pursue arduous career paths,” economist Brown conceded in an interview. “But it’s been taken to such an extreme that it has become a major economic problem and a huge social problem.”
With the arguable exception of Stiglitz, the new macro-egalitarians are modest in their claims. Most acknowledge that much work needs to be done to tease out cause and effect. Most also reject remedies that rely on aggressive redistribution. Instead, they emphasize measures, such as better education and training, that attempt to raise the bottom and middle rather than to bring down the top. In comparison with many of the supply-siders, these guys are recklessly responsible.
At a minimum, however, they have found smoke, and there has certainly been a fire. The era when Washington economists and politicians could dismiss inequality as a second- or third-tier issue may be ending. And progressives, potentially, have a case against inequality that might put accusations of “class warfare” and “politics of envy” behind them.