Economic ideology: Are the times a-changin?

It is pretty clear that if the U.S. economy is to be rebalanced so as to adequately fund health care, education, other social services and infrastructure, the direction of fiscal policy must be reversed. And the key element of the needed reversal is a reevaluation of taxes on the rich – certainly the 1 percent, maybe the 5 percent or 10 percent. There is no other source of additional funds to turn to, and increased starvation of public services would be harmful to the whole country.

But standing in the way of any rethink of taxation has been the view of economists that the disincentive effects of higher tax rates would outweigh the advantages. In the extreme case proposed by Arthur Laffer and depicted in his famous chart on a dinner napkin, increases in tax rates would reduce the tax base to such an extent that the amount of tax collected would actually drop. This kind of "analysis," which influenced President Reagan and his advisors, continues to influence economists to this day, and more importantly justifies the knee-jerk opposition of so many politicians (and voters) to tax increases. John Maynard Keynes remarked, in the concluding notes of his "General Theory," that "the ideas of economists and political philosophers, both when they are right and when they are wrong , are more powerful than is commonly understood…Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

While Keynes concluded, in the final sentence of his book, that "it is ideas, not vested interests, which are dangerous for good or evil," we don't need to argue about the relative dangerousness of these two influences in the tax arena. What we have suffered from in the decades since 1980 is a massive right-wing conspiracy of both the economic ideologues and the vested interests. The debate has gotten so distorted that it has become very difficult politically to argue for higher tax rates; the arguments in favor of increasing taxes generally run along the lines of further reducing tax rates, while closing tax loopholes.

But now perhaps the times they are a-changin. Exhibits A and B are articles by economics heavy hitters including Peter Diamond of M.I.T. and Emmanuel Saez of Berkeley. In a National Bureau of Economic Research working paper titled "Optimal Taxation of Top Labor Incomes : a Tale of Three Elasticities," Saez and two co-authors conclude that "socially optimal top tax rates might possibly be much higher than what is commonly assumed." And Diamond and Saez, in an article in the American Economic Association's Journal of Economic Perspectives (http://www.aeaweb.org/articles.php?doi=10.1257/jep.25.4.165), conclude that "very high earners should be subject to high and rising marginal tax rates on earnings."

An interesting feature of these findings is that they are quite extreme in the sense that they argue for the "optimality" of much higher effective tax rates than are currently in effect. This makes room for "directional" changes that move in the direction of "optimality" without necessarily going as far as the levels indicated by these studies. Generally, it is wise to apply pragmatic "reasonableness" tests to economic policies, including tax policies. It simply doesn't seem reasonable, even to somebody like Warren Buffett who is one of them, for multi-millionaires or billionaires to pay income taxes at an effective rate of below 15 percent. On the other hand, there is some upper level – 60%? 80%? --beyond which marginal tax rates would seem unreasonable. One can never please everybody, but there is a wide range of rates that might seem reasonable to a vast majority of Americans.

There are several factors that enter into the assessment of "reasonableness" when it comes to tax rates and fiscal policy as a whole. One is what alternatives to proposed tax increases are available. Another is the state of the country: How bad is the decline in education standards? How underfunded is road and railway infrastructure? The answers to questions of this kind will influence how much people are willing to push on the taxation front, how much they will regard as "reasonable."

Let's see how the debate develops. Hopefully, the times they are a-changin.

Don’t Forget the Small Local Producers

Currently, I am on assignment in the small seaport of Bogilasco ITALY where I see a few of the 99% in their 20’ fishing boats gathering barely enough fish daily to support their families. Because of past over-fishing plus commercial fishing by multinational fishing factory ships in “international waters” in the Mediterranean, these locals survive because they retain their placing by passing their fishing boat storage sites from generation to generation. No one new to the community can join or hope to compete because the price of entry is too high.

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The market conditions are tough. The large commercial boats set the price of seafood so low that these folks sell in town to a local market of people who want the catch of the day, as well as wanting to support the local community.

There are many small producers out there, surviving near the bottom of the income distribution, like family farmers, artisans and craftspeople, small builders and repair and maintenance people such as plumbers and electricians. They add to the richness and diversity of the economy, but how will they fare in the future? They will survive, I believe, if we as consumers recognize the value of what they provide, such as organic produce and local foodstuffs, and a large variety of other goods and services. By supporting them, we can enrich our communities and ourselves.

Inequality & Markets

There's a really interesting forum on inequality in the current issue of the Boston Review. (Well, a really interesting article, but I'll get to that in a moment...)

The lead article, written by David Grusky, puts forward a nicely reasoned argument that

Judging by current legislative proposals and Democratic Party rhetoric, there is an emerging case that our main response to inequality should be to increase tax rates for the well off.

but that

If we're serious about reducing inequality, we ought not to stop there.

I couldn't agree more.

He goes on to ask

[W]hy we reflexively assume that tax-based redistribution is the est way to take on inequality. This assumption only makes sense insofa as the institutions that generate wages and other income are treated as sacrosanct.

The set-up is pretty good, no? (And, coincidentally, quite similar to our own conclusions!)

The rich get richer…and demand languishes

In today's New York Times Steven Rattner reports on new data showing that 93 percent of the increase in U.S. personal income from 2009 to 2010 went to the top 1 percent of taxpayers, as the economy was just beginning to dig its way out of the financial crisis. This is not chicken feed; the increase in the economic pie that he is talking about is $288 billion. Just think what a stimulus it would have been to the economy if 93 percent of this income gain had gone instead to ordinary working families who would have spent most of the money on consumer goods and services, leading in turn to greater employment, further wage gains, and so on. And meanwhile the 1 percent, who were already having a hard time trying to figure out how to spend their money, wouldn't be pouring this windfall into already glutted investment markets, risking the inflating of new asset bubbles.

Meanwhile, Chairman Bernanke of the Federal Reserve is complaining about the sluggish growth of the economy. Unless economic growth picks up, he reminds us, it will be inadequate to reduce unemployment. Why is it so hard for economists to connect the dots? Why are our tax and wage policies so out of whack? How can the Fed be expected to provide so much stimulus through monetary policy, which in current circumstances must feel like pushing on a string?

Another trillion dollar burden

Student loans have topped a trillion dollars, says the NYT today. Just another trillion dollar mortgage against the future…and a deterrent against college education. No way to go.

Alan Krueger, welcome to the hood!

In today's New York Times columnist Eduardo Porter describes how the President's chief economist, Alan Krueger, sees the light, if only with one eye: he acknowledges that inequality can be "Too Much of a Good Thing". Up until recently, he preferred the term "income dispersion" to inequality! 

About

Why target inequality? And why now, in 2012? Because inequality – the gap between the 1 percent and the 99 percent, or more realistically the top 10 or 20 percent of the population and the other 80 or 90 percent who are struggling to make ends meet– has in recent years increased to a level not seen since the late 1920s. And – not coincidentally, we believe – economic instability has likewise become more prevalent and more painful. The Great Recession that began around 2008 and has given way to sluggish growth is reminiscent of the Great Depression that began in 1930 and finally ended only with the outbreak of World War II in 1939. Occupy Wall Street has taken up the call against inequality and brought the word to the center of economic debates. And 2012 is an election year, in which President Obama will be struggling for re-election against a Republican nominee whose proposed policies are more likely to increase inequality than to reduce it.
When the U.S. economy is not delivering full employment, and when financial instability can upend the best laid plans of working families to live in affordable housing or fund their retirement, something must be done. We are starting this blog in 2012 as one small effort to oppose the Republican call for austerity. We don't believe that belt-tightening is the way to solve the current crisis. On the contrary, our view is that increased spending by working families and state and local governments is what will pull the economy out of its slump.
This home page contains the first section of a paper we have written, "How to Unblock the Economy by Reducing Inequality," and the full paper is contained in the page titled "Read the Paper." Please read the paper and comment. We will try to respond as thoroughly as we can in future posts, and we encourage the interchange of ideas among our readers.

How to Unblock the Economy: Conclusions

            To sum up, if the grossly unequal distribution of income in the U.S. is not addressed through a set of measures such as those discussed above, the economy will be condemned to continue its recent pattern of financial instability and sluggish performance. While the measures proposed here are far-reaching, they are essentially conservative in the sense that they are designed to modify the current economic system in order to make it work better, not to replace it with a fundamentally new system. 

            Meanwhile, this analysis provides a framework for reviewing alternative policy proposals, a kind of litmus test. For example, if we look at some of the budget proposals being put forward in Congress and the states in 2011, we can see that they go in the wrong direction. In particular, they are having the effect of reducing government spending at all levels and further inhibiting the already-weak economic recovery.           

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Reconciling Short-Term and Long-Term Measures

            In the short term, as emphasized by Paul Krugman and others, the most important priority is to increase spending to create jobs, even if it means increasing the federal government deficit. But debts have to be paid back in the long run, and it is essential that the government should have a sound plan for restoring fiscal prudence to the country after the Bush years of tax breaks and profligate war spending.

            Higher effective corporate tax rates and higher effective taxation of the wealthy are clearly necessary in the near term if fiscal prudence is to be restored without jeopardizing the economic recovery. The overall effect would be to increase somewhat the share of taxes and government in the economy, although the increase should be well within the historical range.

            As the economy recovers, attention should shift to longer-run concerns like increasing basic wages. The reduction of health care costs and cutting the financial sector back to size would reduce the unacceptable economic burden of those sectors on consumers, lighten the burden of medical costs on government, and make it less likely that government would be called on once again to rescue ailing financial institutions.

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Searching for Policy Solutions in 6 Major Areas

In order to restore balance to the economy, we submit that there are six critical and related areas that have to be addressed, adding up to a necessary shift of income from wealthy individuals, banks and other corporations (who have more money than they are able to spend) to working people and to government (who have less money than they need).  We will discuss these areas after describing how this shift would unblock the circular flow of income in the economy by releasing funds to spending and thereby increasing final demand, especially consumer demand. This would stimulate employment and investment, which in turn would further increase demand.

            In the current situation of pervasive unemployment, and with this great imbalance in mind, policy proposals should be subjected to this litmus test: do they increase the flow of income in the near term? Second, however, are they compatible with a balanced federal budget in the long term? Increased effective taxation on corporations and high-end incomes to finance state and local government spending is an obvious example of a sound policy proposal.  Reduction of federal support of state and local government spending, by contrast, jeopardizes the economic recovery.  Increases in such support that are not coupled with increased taxation are justified in the near term but would contribute to the federal deficit in the longer term.

The case for a large reverse shift of earnings from wealthy individuals and corporations to ordinary working people – and to the government in the form of higher tax revenues – is obviously remote from the current budget debate in Congress. However, this is a good time to raise fundamental ideas because it is clear that something is fundamentally wrong with the economy. At a time like this, people are likely to be more receptive. Here are six areas that should be addressed.

            1. The problem of low basic wages.  At the heart of the economic imbalance is the problem of low wages. Paradoxically, the setting of wages at their current low levels is bad for business because it depresses demand. Of course, individual companies try to keep wage costs as low as they can, and the immediate impact of lower wages is to increase their profitability. But if you add together the effects of low wages in all the enterprises in the country, the result is that the sum total of wages is insufficient to buy the goods and services produced by those enterprises. When Henry Ford, in a similar epoch, was criticized for his high-wage policy, he said he wanted his workers to be able to buy the cars they produced. Mass production cannot exist without mass consumption.

Today, the circular flow of income is being unduly constricted by the tightness of the wage-setting process. It is remarkable that the average wage for non-supervisory personnel in the private sector has barely kept up with inflation since 1973, and is currently still under $20 an hour or $40,000 a year. And middle-class pay and benefits are under increasing pressure. The setting of wage rates, the most important set of prices in the economy, is not being reliably guided by Adam Smith’s omniscient “invisible hand,” which is supposed to optimize prices across the economy. In America in the early 2000s, just as in the 1920s, the invisible hand has been too tight-fisted to enable most Americans to sustain a middle-class lifestyle. Families have coped by taking on debt, most notoriously in the form of sub-prime mortgages, as depicted in the diagrams above. In 2008, the chickens came home to roost.

            We will not have a sustainable economic recovery – or sustainable economic growth in the longer term – unless and until basic pay levels are increased along with the general growth of the economy over time. There is no single solution to this problem of low wages, no magic bullet, but clearly the political economy of wage-setting needs to be changed. Elements of the solution probably include the spread and strengthening of labor unions, the toughening-up of labor laws such as enforcement of penalties for wage theft, labor bureaus to help workers find the best jobs, minimum wage laws set at living-wage levels, skill training, and the reduction of payroll taxes. 

            Let us deal head-on with the likely objection to higher wages, namely that they will make American companies unprofitable and uncompetitive, particularly in relation to cheap imports from other countries. (Part of income “leaks” out of the U.S circular flow of income and expenditure into cheaper imports, which is one reason why U.S. wages are not finding their way back into sufficient purchases of U.S. goods and services.) There are two broad ways to enhance the labor-competitiveness of U.S. manufacturers and other companies. One is to remove heavy cost burdens that are placed on employers and employees in the U.S. economic system. In particular, there are the burdens of payroll taxes and health care costs currently imposed on employers and employees as part of the labor cost package. (This is discussed below.)

            The other broad solution is to allow the U.S. dollar to decline in an orderly fashion against other currencies through the workings of the currency market, to the extent that wages in the U.S. are higher than those of competitive countries such as China.

            2. Excessively high upper-end incomes.  Secondly, in contrast to the low-wage policies for ordinary workers, the corporate sector in recent decades has increasingly been awarding astronomical salaries, bonuses, stock options and fees to top corporate officers and outside consultants such as financial advisers, advertising agents, and accountants.

            Professional salaries also evidence extreme inequality. While it would be hard to address this issue, perhaps a process for the selective review of price-setting may be in order in certain professions like medicine and law. To the extent that professions operate like “guilds” with restrictive membership, barriers to entry could be considered. In any event, it is hard to believe that salaries and fees running into the millions of dollars a year can be justified, while average wages languish.

            The other factor at work here is that profits as a share of national income are at a high level. Again, this is good for the individual firm, but to the extent that in aggregate those profits lie unused in the coffers of corporations and the wealthy, they are being blocked from performing a useful function.

            As is clear from the Congressional Budget Office study discussed above, almost all the growth in incomes in recent decades has accrued to the top few percent of income earners. Inequality is, in other words, a growing problem, which implies that the political economy underlying income-setting has changed at the upper level in the opposite direction to that in the basic wage-setting process for the mass of workers.  The present system at the upper level is a kind of crony capitalism in which corporate committees and consultants pat each other on the back by awarding each other ever higher salaries and fees.

            “But it’s our money,” the corporate insiders and advisers might object. “It’s ours to do with what we will.” Not so. If you look out across the whole country, across all Americans, it is clear that we are all stakeholders in the “private sector” and are all contributing to it – as consumers, ordinary workers, shareholders, taxpayers – and the rewards as between different stakeholder groups must be assessed, and modified if necessary, by all of us through the political process as well as the marketplace. The relatively unregulated marketplace of the 2000s has let us down.

            Various political and corporate measures could be introduced to reduce the excesses of insider earnings. For instance, greater transparency of salary- and fee-setting could be supplemented by greater rights for investors to challenge the way in which corporations are spending their money.

            A complementary and simpler way of getting the top end of the income distribution back into balance is by reversing some of the tax changes that have favored corporations and the rich. Higher effective high-end income taxes and corporate tax rates are undoubtedly justified

            The current implicit solution to the economic imbalance caused by the excess earnings of corporations and the rich is for the rich to increase their personal consumption, in the form of additional and larger dwellings, automobiles, yachts, airplanes, corporate perks, whatever. And it is no doubt true that in technical economic terms, if the rich were to succeed in consuming a larger share of their income, while investing less, a macro-economic balance between spending and investment could be reached, consistent with full employment, without addressing the distribution of income. To the wealthy and their pundits and politicians that might seem to be a satisfactory solution.

            However, the entrenchment of a small class of people literally and metaphorically in gated communities, with the rest of the population restricted to a low-wage environment providing goods and services to the wealthy directly or indirectly, is not consistent with democracy. Nor does it address the legitimate concerns of Occupy Wall Street.

            3. Burdens on employment costs.  There is no logic in treating social security and health care costs as part of the costs of employment. I repeat: there is no logic in treating social security and health care costs as part of the costs of employment. But for historical reasons both types of costs are currently recovered from employers and employees and at this point have become a crushing burden. It is no wonder that employers are reluctant to take on more workers, and it is not surprising that the wages left over after these costs have been paid are squeezed by employers. Consider the calculations made by automobile manufacturers about the costs per car of assembling cars in this country and the resulting competitive handicap.

            As hard as it is to imagine the American economy without the burdens of social security and health care costs on private sector employers, it seems necessary – if we are to achieve and sustain full-employment – to make this break and to recover these costs out of general tax revenues. At one stroke, manufacturing in this country – even with higher cash wages – would become more competitive than it currently is.

            4. Changes in Taxation.  The pair of changes discussed above – the elimination of payroll taxes and the removal of health costs from employers and employees – would significantly shift the burden of taxes. Additional or enhanced sources of tax revenues would be required to recover the additional costs. These would include the increases in income and corporate taxes mentioned above.

            What is necessary is not only to return nominal tax rates closer to levels that prevailed before the Reagan-Bush tax cuts, but to reduce tax breaks so that effective tax rates are returned to more reasonable levels. The point, again, is to unblock the flow of expenditure in the economy by, in effect, recycling additional income from the groups that can easily afford it to the government and consumers, who desperately need it.

            These sources might prove to be adequate, but if not, some additional form of taxation would be needed. (A general carbon tax would be a good candidate, because it would at the same time help address global climate change issues.)  Obviously, any major changes of this nature would be highly contentious and hotly debated, but the justification for them would be a huge reduction in the cost of employing labor.

            5. High health-care costs.  A solution must be found to the problem of high health care costs. While the focus of this paper is macroeconomic, one or two sectors are so large and so burdensome on the economy as a whole that it is worth singling them out for special mention.

            Health care is such a sector. Not only does it absorb approximately one out of every six dollars spent in the economy, it also is directly implicated in the budget problems of the federal government because of the large and rising costs of Medicare and Medicaid. Other things being equal, these costs will continue to rise as health care inflation continues and the population ages.  In the framework of a single-payer health care system or public option, however, there would be many opportunities to reduce the level of costs per capita, as is clear from comparison with all the other countries that have universal health care systems in place.

            6. The problem of the bloated financial sector.  Finally, the financial sector absorbs about 8 percent of the GDP, and although this is somewhat less than half the share of health care, the sector is directly implicated in the episodes of repeated bubbles and busts that have destabilized the economy.

            Adult supervision of the financial sector is required. Finance has doubled its share of GDP in recent decades, while the country’s economic performance has deteriorated. It is fair to label it as dysfunctional and to require fundamental financial reform if the country is to get back onto an even keel.

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Unblocking the Circular Flow of Income

            The blockage of the circular flow of income provides a unified explanation of the way in which extreme inequality has contributed to both the underlying economic weakness that is characterized by slow growth and stubbornly high unemployment on the one hand, and the financial crises of 2000 (the bursting of the dot-com bubble) and 2008 (the bursting of the housing bubble) on the other.

             There are, in other words, two sides to the coin of extreme inequality. On the one side, low wages (and high unemployment) are unable to support adequate consumer demand for the products of sound investments. The other side of the coin is high corporate profits and bloated high-end incomes that result in a build-up of unused cash, literally trillions of dollars that cannot be put to use, given the absence of demand for the products and services of further investments. In these circumstances, excess profits and high-end incomes feed speculative excesses such as the dot-com and housing bubbles, which sooner or later are bound to burst.

            To understand the concept of the circular flow of income that underlies this analysis, imagine the closed economy of a town in which everybody works for one company, which is owned by one local owner, and which provides full employment and produces all their consumption needs.

            The townspeople including the owner spend all their income on the goods and services sold to them by the company, which pays out all its revenue in wages and profits.

            Diagram 1 is a simplified depiction of the circular flow of money from households to companies (in the form of purchases of goods and services) and back to households (in the form of wages and profits). In other words, what goes around comes around – in a good sense – and the town economy can continue to function indefinitely with full employment.

            A simple economy of this type will not have unemployment or slack in the use of resources, assuming that other features of the town economy are also in balance. These features would include any spending on “imports” from other towns, which we assume would be equal to receipts from any “exports” to other towns.  Likewise, savings (which reduce demand) would be equal to investment (which increases demand).

            In the diagram we introduce some notional numbers. Assume the townspeople are paid $9 million a month in wages and salaries by the company, and the owner makes $1 million profit which he uses for his own consumption. In this example, the company will continue to have revenues of $10 million to disburse on wages and profits each month, which will enable it to continue to hire all the workers. 

 (click on chart for larger version)

             Now consider what happens if the owner – the “1%” – decides to cut costs by reducing wages to the townspeople – the “99%” – from $9 million to only $8 million a month, maintaining the level of prices and trying to double his profit to $2 million, although he does not or cannot spend more than $1 million on his own monthly consumption. This is the situation depicted in Diagram 2, which roughly reflects the “bubble” period leading up to 2008. 

 (click on chart for larger version)

            Note that demand for the goods and services produced by the company would be short $1 million a month, if it were not for the fact that we introduce a bank, in which the owner deposits his additional $1 million savings and which in turn lends that $1 million to the townspeople. Focusing on the center-left part of the diagram, we see that the 99% maintain their standard of living of $9 million by borrowing an additional $1 million each month from the bank in the form of cash-out refinancing of their homes, home equity lines of credit, etc.

            In this case the 99% not only maintain their spending at $9 million, the 1% can make a profit of $2 million, spend $1 billion from revenues and deposit $1 million in the bank, from which the bank can lend money to the other 99%. Together the 99% and the 1% can continue to buy 100 percent of the output of the company, which can continue to operate at full employment.  Welcome to the bubble economy!

            The bank, however, is accumulating additional deposits from the 1% and making additional loans to the 99% every month, with no prospect of the loans being paid off. So long as the 1% are willing to finance the debt from the bank, and the bank is willing to turn a blind eye to the financial situation of the 99%, this imbalance can continue indefinitely. But of course at some point the 1% and/or the bank will have second thoughts about the creditworthiness of the 99%, who are likely to be defaulting on their mortgages at an increasing rate. A “financial crisis” must ensue. Welcome to the “subprime” mortgage crisis of 2008!

            As the crisis unfolds, bad debts and unemployment emerge as huge problems and everybody looks to government to bail them out.  This is the situation depicted in Diagram 3, in which the government underwrites consumer spending by the 99%, directly or indirectly, to the tune of $1 million per month. 

 (click on chart for larger version)

             What the government is doing is replacing the bank as the lender of last resort.  It does so in this case, however, by borrowing from the 1% without increasing taxes to pay for the $1 million consumer spending each month. The situation is sustainable to the extent that the government deficit is sustainable. We believe that this deficit spending is necessary to avoid a double-dip recession, although it is not a permanent solution to the problem of inadequate demand, since it kicks the deficit can down the road for future governments to pick up.

            Of course, in reality we know that despite the boost to demand provided by government deficit spending, the situation deteriorated in 2008-2009 to the point where demand has remained far short of the level needed to create full employment. For the sake of simplicity, this is not shown in the chart. What has happened is that, as argued by critics such as Paul Krugman, the federal government simply is not spending enough, state and local governments are being constrained to tighten their belts, and other sources of demand such as investments are falling short.

            A broad solution is reflected in Diagram 4, in which the government increases the tax bill of the 1% by $1 million, and returns the economy to sustainability. Full employment is feasible in this situation, provided other sources of demand such as investments and exports (not shown in the diagram) contribute to the economic recovery, even if there is no stimulus from government deficit spending.

(click on chart for larger version)

            Is this a full account of the current economic “blockage” and a solution? Clearly not. For instance, the saving necessary to finance investment for the future would need to come from the 1% and hopefully a larger contribution from the now better-paid 99%. But the central fact remains that a tax regime that shifts a significant amount of the tax burden from working households to corporations and the wealthy is perhaps the largest single element of a solution. Other elements would include additional measures to favor investment and enterprise, which not only add to demand in the short term, but increase productivity over time.

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Why is there Insufficient Demand?

            Most economists agree that the immediate problem facing the economy is a lack of demand for goods and services, primarily consumer demand which accounts for over two thirds of the total. However, this is wrongly framed as merely a short-term problem, that there isn’t enough consumer demand to grow the economy out of the recent economic slump of 2008-2009. But why aren’t consumers stepping up to the plate? The Wall Street Journal’s lead headline of June 26, 2011 points out that “Debt Hamstrings Recovery.” Correct: indebted consumers (and indebted governments) are reluctant to spend money as freely as they otherwise might.  The Journal cites the work of Carmen Reinhart of the Peterson Institute for International Economics who, with Harvard economist Kenneth Rogoff, has thoroughly documented the depressing effect of heavy indebtedness on consumers and government following severe financial crises. But from a more fundamental standpoint, debt, like the weakness of demand, is more a symptom than a cause.

            Most of the proposed cures for our current malaise, such as most of those proposed by Paul Krugman in the New York Times, involve spending more government money to prop up the consumer. While this may be the most effective way to get consumers to spend more money, it does so, as noted above, by adding to the government deficit. A more fundamental solution must also entail paying off old debt so that consumers and government can spend more freely and grow the economy without starting a new cycle of indebtedness.

            In a provocative article in the New York Times of October 26, 2011, entitled “It’s Consumer Spending, Stupid,” Prof. James Livingston argues that “consumer debt and government spending” enhance economic growth, and he proposes “a redistribution of income away from profits toward wages, enabled by tax policy and enforced by government spending.”

            Prof. Livingston is clearly on the right track, although we believe he needs to address more fully the problem of debt. The simple broad solution to our current economic imbalance is to increase the take-home pay of working people.  As the economy emerges from recession, growth should be sustained by higher wages and tax revenues without resorting to continual increases in debt, and in fact, with a gradual reduction of both consumer and government debt over time. Meanwhile, Prof. Livingston correctly addresses the “bubble” side of the coin of inequality when he says that “corporate profits…are just restless sums of surplus capital, ready to flood speculative markets at home and abroad.”

            Nicholas Kristof (“America’s Primal Scream,” New York Times, October 15, 2011) draws the right conclusion:

“Economists used to believe that we had to hold our noses and put up with high inequality as the price of robust growth. But more recent research suggests the opposite: inequality not only stinks, but also damages economies.”

What is so powerful about Kristof’s article is that it is based on evidence that countries with more unequal economies grow more slowly, and are more prone to bankruptcies and financial panics. In other words, a highly unequal economy is less likely – not more likely – than a more equal economy to pass the performance tests proposed at the outset, including the fourth test, i.e., that it favors creativity, innovation and entrepreneurship, which would tend to be associated with financial stability and steady increases of demand.

            This blog will provide, in effect, a “why and how” narrative to accompany the evidence cited by Kristof. We can now develop a cogent account of why in the 2000s consumers were induced to take on too much debt – mortgages in particular – and then defaulted and nearly brought down the financial sector and the economy in the process. A moralistic account of the wickedness of lenders and the foolishness of householders is inadequate, although clearly many players in the financial markets leapt at the opportunity to participate in Wall Street’s bonanza of credit extension with little concern about the potential risks for either borrowers or investors.  

            The obvious fact, the elephant in the room, is that, on the one hand, ordinary consumers were (and are) getting too small a slice of the economic pie, period, and could not sustain a middle class lifestyle without taking on debt.  Similarly, the government sector has found itself with pressing needs for education, health care, infrastructure and so forth, but too little revenue; hence the resort to debt to cover massive deficits.   

            The unifying explanation proposed here – that under-consumption and over-indebtedness are the unavoidable results of the extremely unequal distribution of income – is not new in American economic theory, but it has fallen into disuse, perhaps because it did not fit economic conditions during the middle decades of the last century, when income was more evenly distributed. In the chart below we can see the long historical picture.

 

(click chart for larger version)

            As depicted in the chart, the share of the top 1 percent reached 23.5 percent in 2007, the highest that it had been since 1928, just before the Great Crash, when the 1 percent received 23.9 percent.  From 1929, it fell at first dramatically and then slowly until it reached a low of 8.9 percent in 1976. Then, especially in the Reagan and Bush years, owing in part to tax cuts and stagnant wages, it rose again to nearly its previous high level.

            The issue of an extremely unequal distribution of income has, clearly, become more and more relevant as the distribution of income has become more and more unequal since the 1980s, and by the 2000s the shoe fits well, better than it has at any time since 1929. Meanwhile most of the current generation of macro-economists seem to have forgotten about it.

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The State of Inequality

The facts regarding the increasingly unequal distribution of income have been widely publicized, but they have not lost their ability to shock. Or to bring out deniers. Fortunately, the bipartisan Congressional Budget Office (CBO), has issued a major study, “Trends in the Distribution of Household Income Between 1979 and 2007,” October 2011, which makes the raw data indisputable.

The data compiled by the Congressional Budget Office are striking. Between 1979 and 2007, the incomes of the top 1 percent increased by 275 percent, for the rest of the top 20 percent they increased by 65 percent, for the middle 60 percent the increase was 40 percent and for the bottom 20 percent only 18 percent. The result of these three “rich get (much) richer” decades is that the share of income received by the top 1 percent of the population more than doubled from 8 percent to 17 percent, while the share of income received by the bottom 20 percent actually declined from 7 to 5 percent. The incomes received by the top 1 percent in 2007 were more than three times the total incomes of the bottom fifth of the population. And the income of the top 20 percent exceeded that of the remaining 80 percent of the population.

The data can be presented in various ways. In Chart one, average household income is shown for the top 1 percent of the U.S. population, and for each fifth ranked from the highest income to the lowest, for the period 1979-2007. 

Chart 1.

 

(click on chart for larger version)

What is striking is that the lion’s share of the increases in income has been garnered by the top 1 percent. Taking the top 20 percent as a whole, the chart shows significant gains, but for the remaining 80 percent of the population the gains have been very small.

Chart Two shows how this growth of incomes at the top of the income distribution has changed the shares of each group in the total. The top 1 percent have dramatically increased their share of total income, and the top 20 percent as a whole have also succeeded in achieving a modest increase, but all the remaining fifths, constituting 80 percent of the population, have suffered diminishing shares.

 Chart 2.

 

(click on chart for larger version)

 

Judging by all the talk of hardship and the need to tighten belts, you would think that the cause of this decline in income shares of the vast majority of Americans must be related to the impoverishment of the country as a whole, but this is not the case. Chart Three shows that the value added per worker has continued to rise steadily in each decade, especially since 1980. What has lagged is not productivity but pay. Workers are producing more but not earning more. Since the mid-1970s, average pay per worker has basically gone nowhere, i.e., it has kept up with inflation but no more than that.

Chart 3.

(click on chart for larger version)

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The 1% Economy

The American economy is suffering from a fundamental imbalance. This imbalance, simply stated, results from the inadequacy of the current level of wages – and the current level of employment – to support economic activity and investment.

Like any market economy, the American economy depends on consumption to support economic activity directly, and to support it indirectly by buying the output of goods and services that makes investments profitable.

The economy is not paying ordinary working Americans enough for them to be able to support consumption, in other words to buy the goods and services they produce. A resort has been made to borrowing – by means of consumer borrowing through mortgages and other loans, and government deficits to sustain spending.

Meanwhile, wealthy individuals – the “1%”, as Occupy Wall Street calls them – and corporations are awash in cash, with not enough places to invest it. In a desperate attempt to maintain the profitability of their investments, investors and corporations are searching for – and in the process creating – one financial bubble after another. When the bubbles burst, recessions will result.

In this blog, we argue for the necessity of a large shift of earning from wealthy individuals and corporations to ordinary working people. The simplest way to achieve this is by reversing some of the tax changes that have favored corporations and the rich.

Would this redistribution be a Robin Hood kind of theft from the rich? Is it morally right? The simple answer is:

The economy should be answerable to the people, rather than the other way round – we must reject the myth that the economy “belongs” in any absolute sense to the rich.

If the economy is not the property of the rich, to be manipulated for their benefit, what is it good for?

The economy should provide a framework within which people have the opportunity to fulfill their potential.

With this objective in mind, what are people entitled to expect of the economy? Surely, at least, it should pass the following four tests:

(1)   Does the economy achieve reasonably full employment with wages at or above the living wage level for those people who are able to work?

(2)   Does it provide support for those people who are unable to work because they are too young, too old, too sick, or are in school?          

(3)   Does it create a framework of financial stability within which people are able to plan their working lives, housing, retirement, etc.?

(4)   Does it encourage individuals to be inventive, creative and entrepreneurial?

In 2012, as highlighted by the emergence of Occupy Wall Street, it is clear that the economy must be given a failing grade on at least the first three of these tests. Why has it been underperforming so badly, and what can be done to rectify matters?

The increasingly unequal distribution of income that has emerged in the United States in the past three decades constitutes an imbalance in the economy that has become pervasive and fundamental. This booklet makes the case that an extremely unequal distribution of income is incompatible with a stable full-employment economy.

While a degree of inequality may be conducive to the fourth test – providing scope for the entrepreneurial spirit – extreme inequality has the opposite effect of undermining economic growth and stability.

This blog has been established to explain and elaborate the whys and hows of 1% economy. 

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