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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