Three Cheers for Joe Stiglitz

Joseph Stiglitz's new book, The Price of Inequality: How Today's Divided Society Endangers our Future. (W.W. Norton, New York, 2012) is a very important contribution to the debate about the harmful economic and other effects of extreme inequality. The book is broad and deep, and our quick review here will hardly even touch the surface. We would encourage people to read this well-written book in its entirety.

Stiglitz has no illusions about the way in which the market economy is working in the United States. He has lengthy discussions about rent seeking and market imperfections as sources of income of the 1%, and little confidence in the labor market as a mechanism for setting fair wages in the policy framework that has prevailed in the country in the last three or four decades.

Stiglitz's discussion (at pages 85 et seq.) of the harmful macroeconomic effects of inequality is worth quoting at length, because it decisively breaks rank with today's timid market economists:

It is perhaps no accident that this crisis, like the Great Depression, was preceded by large increases in equality: when money is concentrated at the top of society, the average American's spending is limited, or at least that would be the case in the absence of some artificial prop, which, in the years before the crisis, came in the form of a housing bubble fueled by Fed policies. The housing bubble created a consumption boom that gave the appearance that everything was fine. But as we soon learned, it was only a temporary palliative.

Moving money from the bottom to the top lowers consumption because higher-income individuals consume a smaller proportion of their income than do lower-income individuals (those at the top save 15 to 25 percent of their income, those at the bottom spend all of their income). The result: until and unless something else happens, such as an increase in investment or exports, total demand in the economy will be less than what the economy is capable of supplying – and that means there will be unemployment. In the 1990s that "something else" was the tech bubble; in the first decade of the 21^st century, it was the housing bubble. Now the only recourse is government spending.

Unemployment can be blamed on a deficiency in aggregate demand (the total demand for goods and services in the economy, from consumers, from firms, by government, and by exporters); in some sense, the entire shortfall in aggregate demand – and hence in the U.S. economy – today can be blamed on the extremes of inequality. As we've seen, the top 1 percent of the population earns some 20 percent of U.S. national income. If that top 1 percent saves some 20 percent of its income, a shift of just 5 percentage points to the poor or middle who do not save – so the top 1 percent would still get 15 percent of the nation's income – would increase aggregate demand directly by 1 percentage point. But as that money recirculates, output would actually increase by some 1 ½ to 2 percentage points. In an economic downturn such as the current one, that would imply a decrease in the unemployment rate of a comparable amount. With unemployment in early 2012 standing at 8.3 percent, this kind of shift in income could have brought the unemployment rate down close to 6.3 percent. A broader redistribution, say, from the top 20 percent to the rest, would have brought down the unemployment further, to a more normal 5 to 6 percent.

Stiglitz explains how the government's response to weak demand – low interest rates – led to bubbles in tech investments and housing – how deregulation made things worse, and how what we now call "austerity" has reduced government spending, the reverse of what was required.

One should note, however, that Stiglitz's argument on the effects of inequality is more descriptive and less analytical than that of Michael Kumhof and Romain Ranciere, which was reviewed on this blog on May 15: Inequality, Leverage and Crisis, IMF Working Paper WP/10/268, November 2010. Their paper really nailed the issue by developing a model that traced the causation from inequality to leverage (excessive mortgage borrowing) and crisis when the mortgage bubble burst.

A footnote on the OECD Economic Survey of the U.S.

The OECD's June 2012 Economic Survey of the United State contains a much weaker discussion than that of Stiglitz or Kumhof and Ranciere. It is agnostic regarding the macroeconomic damage caused by inequality, concluding that "there is no consensus in the economic literature that reducing inequality would be harmful to economic growth." Which falls short of a finding that reducing inequality – at least, reducing extreme inequality -- would actually be beneficial to economic growth, as clearly shown by Stiglitz, and Kumhof and Ranciere, and argued in the founding paper of this blog (see Home Page, click on "Read the Paper").

Needless to say, waiting for consensus on inequality among wobbly-kneed economists would be like waiting for consensus on climate change or the theory of evolution among Kentucky Republicans. The closest the OECD gets to the nub of the recent problems is the half-hearted statement that "Some have identified income inequality as one of the causes of the financial crisis since it may have encouraged subprime borrowing by households who tried to make up for their lack of income." It does not mention the complementary problem that the excessive savings of corporations and the wealthy provided the supply side of the subprime bubble, and the way in which the Fed enabled the growth of unsustainable subprime mortgages by its policy of easy money and lax regulation.