Friday, October 24, 2014

Is Inequality Inhibiting Growth?

CHICAGO – To understand how to achieve a sustained recovery from the Great Recession, we need to understand its causes. And identifying causes means starting with the evidence.

Two facts stand out. First, overall demand for goods and services is much weaker, both in Europe and the United States, than it was in the go-go years before the recession. Second, most of the economic gains in the US in recent years have gone to the rich, while the middle class has fallen behind in relative terms. In Europe, concerns about domestic income inequality, though more muted, are compounded by angst about inequality between countries, as Germany roars ahead while the southern periphery stalls.

Persuasive explanations of the crisis point to linkages between today’s tepid demand and rising income inequality. Progressive economists argue that the weakening of unions in the US, together with tax policies favoring the rich, slowed middle-class income growth, while traditional transfer programs were cut back. With incomes stagnant, households were encouraged to borrow, especially against home equity, to maintain consumption.

Rising house prices gave people the illusion that increasing wealth backed their borrowing. But, now that house prices have collapsed and credit is unavailable to underwater households, demand has plummeted. The key to recovery, then, is to tax the rich, increase transfers, and restore worker incomes by enhancing union bargaining power and raising minimum wages.

This emphasis on anti-worker, pro-rich policies as the recession’s primary cause fits less well with events in Europe. Countries like Germany that reformed labor laws to create more flexibility for employers, and did not raise wages rapidly, seem to be in better economic shape than countries like France and Spain, where labor was better protected.

So consider an alternative explanation: Starting in the early 1970’s, advanced economies found it increasingly difficult to grow. Countries like the US and the United Kingdom eventually responded by deregulating their economies.

Greater competition and the adoption of new technologies increased the demand for, and incomes of, highly skilled, talented, and educated workers doing non-routine jobs like consulting. More routine, once well-paying, jobs done by the unskilled or the moderately educated were automated or outsourced. So income inequality emerged, not primarily because of policies favoring the rich, but because the liberalized economy favored those equipped to take advantage of it.

The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans. Thus, while differing on the root causes of inequality (at least in the US), the progressive and alternative narratives agree about its consequences.

The alternative narrative has more to say. Continental Europe did not deregulate as much, and preferred to seek growth in greater economic integration. But the price for protecting workers and firms was slower growth and higher unemployment. And, while inequality did not increase as much as in the US, job prospects were terrible for the young and unemployed, who were left out of the protected system.

The advent of the euro was a seeming boon, because it reduced borrowing costs and allowed countries to create jobs through debt-financed spending. The crisis ended that spending, whether by national governments (Greece), local governments (Spain), the construction sector (Ireland and Spain), or the financial sector (Ireland). Unfortunately, past spending pushed up wages, without a commensurate increase in productivity, leaving the heavy spenders indebted and uncompetitive.

The important exception to this pattern is Germany, which was accustomed to low borrowing costs even before it entered the eurozone. Germany had to contend with historically high unemployment, stemming from reunification with a sick East Germany. In the euro’s initial years, Germany had no option but to reduce worker protections, limit wage increases, and reduce pensions as it tried to increase employment. Germany’s labor costs fell relative to the rest of the eurozone, and its exports and GDP growth exploded.

The alternative view suggests different remedies. The US should focus on helping to tailor the education and skills of the people being left behind to the available jobs. This will not be easy or quick, but it beats having corrosively high levels of inequality of opportunity, as well as a large segment of the population dependent on transfers. Rather than paying for any necessary spending by raising tax rates on the rich sky high, which would hurt entrepreneurship, more thoughtful across-the-board tax reform is needed.

For the uncompetitive parts of the eurozone, structural reforms can no longer be postponed. But, given the large adjustment needs, it is not politically feasible to do everything, including painful fiscal tightening, immediately. Less austerity, while not a sustainable growth strategy, may ease the pain of adjustment. That, in a nutshell, is the fundamental eurozone dilemma: the periphery needs financing as it adjusts, while Germany, pointing to the post-euro experience, says that it cannot trust countries to reform once they get the money.

The Germans have been insisting on institutional change – more centralized eurozone control over periphery banks and government budgets in exchange for expanded access to financing for the periphery. Yet institutional change, despite the euphoria that greeted the latest EU summit, will take time, for it requires careful structuring and broader public support.

Europe may be better off with stop-gap measures. If confidence in Italy or Spain deteriorates again, the eurozone may have to resort to the traditional bridge between weak credibility and low-cost financing: a temporary International Monetary Fund-style monitored reform program.

Such programs cannot dispense with the need for government resolve, as Greece’s travails demonstrate. And governments hate the implied loss of sovereignty and face. But determined governments, like those of Brazil and India, have negotiated programs in the past that set them on the path to sustained growth.

As a reformed Europe starts growing, parts of it may experience US-style inequality. But growth can provide the resources to address that. Far worse for Europe would be to avoid serious reform and lapse into egalitarian and genteel decline. Japan, not the US, is the example to avoid.

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  1. CommentedFrank O'Callaghan

    Of course inequality is inhibiting growth. The great years of growth have been when the majority of the population could feed demand. Once by having wage increases and latterly by debt. Debt is not a long term solution. Redistribution is urgently needed.

  2. CommentedFrank O'Callaghan

    Of course inequality is inhibiting growth. The great years of growth have been when the majority of the population could feed demand. Once by having wage increases and latterly by debt. Debt is not a long term solution. Dedistribution is urgently needed.

  3. CommentedMark Simmelkjaer

    Raghuram Rajan highlights a number of different factors contributing to income inequality among them technological improvements and increased competition. For the US to combat inequality in the long term, Mr. Rajan, educational improvements must be a focal point. Unfortunately, many of those in Washington are more bet on short term policies that have no major long term impacts (ie. Tax Cuts, Deficit Spending). I can see why Mr. Rajan remains my favorite economist. Definitely check his book "Fault Lines" -Mark Simmelkjaer

  4. CommentedMatthew Lee

    It seems that this explanation of diverging income inequality fits very well for the question of a lagging middle class, but not so well for the sky-rocketing wealth of the top 1%, 5%, etc. The question then is: what has caused the income of the top 1% to increase so quickly?

    Take a look at this graph from The Economist, for example:

    Even Rajan mentions, as one of his two facts, "most of the economic gains in the US in recent years have gone to the rich, while the middle class has fallen behind in relative terms."

    I believe the culprit behind the diverging income inequality actually lies in the financial industry. We see nowadays that the 1% are composed of financial workers or executives of public corporations that are big on the stock markets. And the recent events of 2008 clearly show the massive scale of wealth and effect that trading securities and little "slips" of paper can have.

    As some economists are beginning to suggest and Moritz touched on below, the rich work mostly in the financial sector, which has become profitable in itself. They can use it to spin things to a very large scale, and come out with copious profits. It is this new "economy" that has allowed the rich to get richer than ever before.

    That is not to say Rajan's outsourcing suggestion is incorrect--in fact it is very insightful. But the explanation for a lagging middle class must be coupled with that for the sky-rocketing 1%.

    If interested, there is a more detailed explanation here:

  5. Portrait of Francesco Saraceno

    CommentedFrancesco Saraceno

    Raghuram Rajan argues that income inequality, which has been on the rise since the 1970’s, can be explained in two ways. Progressive economists blame pro-rich policies. The “alternative” explanation (or, more accurately, the conservative view) focuses on skill-biased technological progress.

    According to Rajan, while both explanations maintain that inequality led to excessive debt, causing the global economic crisis, only the “alternative” explanation accounts for European countries that maintained more egalitarian policies, despite low productivity. According to this view, Germany’s economic strength stems from the structural reforms – entailing fewer worker protections, limited wage increases, and reduced pensions – that were implemented to contend with historically high unemployment following reunification.

    Now Southern Europe should implement similar reforms, Rajan argues, and accept the resulting increase in inequality, in order to avoid sliding into an “egalitarian decline” like Japan.

    But Rajan’s analysis is problematic for three reasons. First, he establishes a largely artificial contrast between the two explanations of inequality’s causes. In fact, a progressive economist would be unlikely to deny that globalization and technological progress have increased income inequality – albeit to a lesser extent than Rajan believes. Likewise, a conservative economist would probably concede that pro-rich policies have fueled inequality (including in Europe, where the marginal income- and corporate-tax rates dropped dramatically almost everywhere).

    Indeed, both phenomena probably contributed to the widening income gap. Skill-biased technological progress and competition from emerging economies undermined low-skilled workers’ value and, in turn, their political influence, resulting in unfavorable policies that exacerbated inequality.

    The second problem is that Rajan’s analysis rests on the claim that inequality directly caused the crisis via debt accumulation. But this explanation fails to account for the disparities between the United States, where inequality’s link to the debt crisis is obvious, and the European Union, where it is more difficult to establish (except in Spain and Ireland).

    In both the US and the EU, growing inequality depressed aggregate demand while motivating the wealthy to save more. Then, institutional differences and policy choices caused the US, where consumption was sustained by rising debt, to diverge from most European countries, where declining consumption led to low growth. Finally, the additional savings at the top financed asset bubbles (first in the stock market, and then in the housing market) and rising public debt in countries like the US, Spain, and Ireland, triggering the crisis.

    Inequality thus contributed indirectly to the crisis by intensifying global imbalances, which imposed balance-of-payment constraints on growth in many advanced countries that continue to encumber recovery; but inequality did not directly cause the crisis. This interpretation, which accounts for the performance gap between Europe and the US, undermines Rajan’s basis for supporting the conservative explanation.

    Finally, and most problematic, Rajan’s analysis assumes that increasing inequality is a necessary condition for sustained growth. Only by accepting structural reforms that reduce worker protections, he claims, can Europe recapture growth.

    In his book Fault Lines: How Hidden Fractures Still Threaten the World Economy, Rajan complements this notion with a sort of “trickle-down” argument (wealth benefits all of society, regardless of whom, or how many, have it). But statistics show that median wages in most countries have stagnated, suggesting that wealth does not automatically trickle down.

    Furthermore, the idea of a tradeoff between inequality and economic efficiency relies on a textbook dichotomy between the long run, in which only supply-side factors matter, and the short run, in which demand might also affect economic performance. Only in this idealized environment is the economy’s long-run efficiency, and hence its growth capacity, disconnected from income distribution. When the long and short runs are connected, the tradeoff becomes controversial, and may even vanish.

    This argument represents the real divide between the conservative and progressive views. Many progressive economists, including Joseph Stiglitz and James Galbraith, deny the tradeoff’s existence. They contend that increased inequality hampers the economy’s capacity to produce wealth, and that a more egalitarian society would not only be ethically desirable, but would also stimulate growth, by, for example, attracting more productive firms (as in Scandinavia).

    Moreover, Rajan’s claim that reducing labor-market protections would have only positive effects neglects the short-run advantages of such protections, which give workers the capacity to invest in their own human capital or to consume – and thus provide revenues for businesses. Just as austerity can be self-defeating to the extent that its short-run recessionary effects weaken long-run performance, reducing social protection might hamper an economy’s long-term growth capacity.

    Rather than champion structural reforms based exclusively on their short-run effects, economists should abandon their reliance on mainstream supply-side theory. We must understand how the linkages between the short and long run render untenable the traditional dichotomy between an economy’s supply and demand sides – a dichotomy on which the argument in favor of structural reforms is based. Only then can we determine whether inequality is inhibiting growth. If it is, we need pro-growth policies that reduce it, not exacerbate it.

  6. CommentedGabriel Atega

    The prevailing economic analysis based on national economic conditions is now misleading as economic activity becomes more and more global. When people pay an extra dollar for a gallon of fuel, where does this extra expenditure go? When global consumption of fuel translates to millions of barrels per day, a dollar a day from every consumer worldwide is a tsunami of an impact the repercussions of which go beyond the national shores.

    Economic analysis as presently practiced is becoming obsolete. Global data and global analysis become more relevant.

    Unemployment for one must no longer be seen in the context of national employment. Rather we should begin to see how many millions of people are added to the workforce on a worldwide basis. Globally speaking, the question I would ask is whether on a worldwide basis the number of workers have been decreasing or increasing over the last decade. Unemployment seen in one country may be growth in another.

    Perhaps it is now time to begin to see ourselves as citizens of Earth instead of Europe, Asia or America. As such, employment barriers at national levels must begin to be abolished. Allowing labor to freely flow in and out of countries may be the proper remedy over the long term. Realistically though this is difficult as people continue to think they are citizens of their countries instead of the Earth.

  7. CommentedMoritz G€d1g

    Of cause this is true, but it does not explain the high exponent of the income distribution.
    Engineers and high skill technicians do not earn much more. It is the top-manager, corporate lawyer and salesmen in the financial "Service" sector that got wage increases. The highest incomes went to the already rich, who got dividends and rent.
    The author looks at the unspectacular middle of the distribution, that is least problematic.
    To compare Europe to the USA and Japan and suggest that the USA are a good example for Europe shows misunderstanding on multiple levels. Europe is not a State and the "trickle down" "solution" of the USA is nothing to aspire to. Without sufficient growth there is nothing to trickle down.

  8. CommentedDavid Elvira

    When income grows, who gains?:

    Capital owners!!

  9. CommentedAmit Sadhukhan

    Just one question: Suppose rest of the European countries follow the economic policies what Germany did, is it possible (or sustainable) for rest of the European countries to experience growth like Germany?

      CommentedMoritz G€d1g

      MBAs fall for the competition fallacy\paradox all the time. It is just too much for their little brains.

  10. CommentedRicardo Santos

    I really have to challenge the author here. That deregulation brought increased competition as the author implies is but one truism that seriously lacks the evidence the author states to be needed in his first paragraph: "And identifying causes means starting with the evidence.".
    The evidence in all markets but particularly in the financial markets was of mergers, acquisitions, consolidation... the reinforcement of oligopolistic structures. These can be clearly documented and, in fact, is even part of the current rhetoric of the Conservative Party in the UK, the need to split big banks.
    Truisms like the one that fills this paragraph build some sort of a legend that fails the test of reality: for instance, how come it wasn't neither the US or the UK that saw their technological prowess to rise during the deregulation years? Currently, after deregulation, most of the British motor industry is foreign controlled, as is some of the most significant US brands, and the newest technologies were born outside, for instance in Finland (Nokia), South Korea (Samsung, among others)..., that, although liberalizing, never adopted the full fledged Anglo-Saxon model.
    A full paragraph of cornerstone assumptions that seems, to me, lacking the test... of evidence.

  11. CommentedAli Muhammad Usmani

    we can say it as artificial or augmented (Technological use, major portion has been misused like most of the people suppose to have mobile phone for fun or music, where as its new use like email, news update etc has not been explore by the majority of public, according to me it is premature demands) demand along with availability of credit money being the main source of stagnant growth.

  12. CommentedAli Muhammad Usmani

    few more factor being the cause of recession in US and Europe are, Risk Management or Recovery Management was not empower the provider to took any comprehensive action, in case of default, which in turn collapse the Financial Institution and being a threat for clients or general public, and ultimately gave birth to uncertainty over future returns.

  13. CommentedYoshimichi Moriyama

    Viswanathan, I agree.

    Darvish is a Japanese baseball pitcher. He is playing as a Texas Ranger. He is playing in accordance to the international, namely American, rules of 'three strikes and the batter is out, and four balls and the batter goes to the first base.' He is doing quite a nice job.
    What if we changed the rules to 'ten strikes and the batter is out and one ball to the first base?' He would be miserable.

    A lot of people are earning millions or billions of dollars in an instant. It is undoubtedly due to their genes...genes for avarice. They owe their earnings, fundamentaly, more to the financial rules of money games

  14. CommentedViswanathan Suresh

    I dis-agree with your comment "...raising taxes on the rich sky high which would hurt entrepreneurship..." This somehow rests on the preposterous assumptions:
    - Trickle down effect: The rich use their wealth to consume and that will generate jobs
    - The rich have perhaps become rich by dint of their entrepreneurial skills and taxing them will somehow dilute these skills
    - Non-rich sections of society lack these skills

    Fact is that many of the rich you see today such as bankers, stockholders of private equity firms and so on made their wealth from dubious financial engineering methods rather than by exercising entrepreneurial acumen. Bain Capital & Barclays Bank are more representative of this tribe than say a Hewlett-Packard or IBM.

      CommentedMoritz G€d1g

      The assumption is also that people who start businesses do so on the assumption/chance to get into the top income braked.
      Most of cause will not, and for few this chance will be the deciding factor.
      I doubt the potential 70% tax on the top section of the income will be a deciding factor for not starting a business.

  15. CommentedYoshimichi Moriyama

    The only part to which I can unconditionally agree is about Japan. Joseph Grew was U.S. ambassador to Japan for about ten years until the outbreak of armed hostilities in 1941. He kept a journal, in which he noted that the Japanese turn around instead of facing up when they come to a difficult problem. This is a cultural pattern of cognizance and the Japanese do not understand that they are shying away.

    The Japanese economic bubble, its bust and prolonged stagnation were of course the result of economic policies of the government. Some of these mistaken policies were, however, partly due to the fact that the government took the advice of the United States too seriously and carried it out without considering a different economic climate of Japan.

    The rest of this article is a too simplistic explanation of growth by simply correlating inequality with growth or ungrowth.

  16. CommentedA. T.


    I don't see how revenues and expenditures can be separated for the government (indeed, the fact that they currently appear on paper to be less linked than they are causes unnecessary problems). The government is not an economic unit the way a business is – it is simply a logistical structure to organise communal consumption. Think ordering pizza with your roommates or something – the consumption and expenditure is split among all the people involved, even if it is only one guy who actually makes the call and pays the collected money to the delivery driver (so as to make logistics simpler). Said person's collecting of the money to pay during delivery is not really 'revenue'. Revenue comes from the jobs everyone has that allow them to order the pizza in the first place. The government does not spend money or make money; it is simply an intermediary that helps organise some of the ways in which WE spend money.

    This is why I cannot figure out how government borrowing in the form you describe is any different from taxation – a loan that will never be repaid is simply the taking of money. The value of a bond is not the number written on a piece of paper, but the likelihood of getting the loaned assets back. A bond with zero likelihood of getting the loaned assets back will be worth $0. A government taking $10M out of the community in return for a bond worth $0 will make the community $10M poorer (indeed, if no one is compelled to buy such bonds, no one will ever buy them voluntarily). Of course, the idea is that in return for that expenditure the community gets some good of greater value. Same way buying a pizza makes you $10 poorer, but a pizza's-worth less hungry.

      CommentedGary Marshall

      Hello AT,

      And the erstwhile R and D department has become a financial mess in public finance.

      In a private corporation there are many controls with which to measure performance. And if the department does not produce according to those measures, then its funds are cut back.

      There are no such controls upon government. It grows and takes with little control. And the shareholders or citizens can do little to stop this wasteful and unaccountable leviathan.

      So implement borrowing and the public will once again exert rigid control over this one department. Expenditures will fall drastically, and deterrence for worthy economic activity will disappear.

      The R and D department or rather the government will incur large debts to the greater corporation. The nation transfers money to the government and in return receives government IOUs.

      Has the financial position of the entire corporation changed? Not at all. We have a big minus with government's finances and an equivalent plus with its IOUs.

      Now the government the money in all sorts of worthy and profitable public projects that provide great new ideas and resources for the larger corporation to manipulate, exploit, and sell. Revenues soar beyond all costs. The public projects generate immense returns for the greater nation. It is far wealthier with the government than without it, far wealthier with controls on government finances than without it.

      Because the public expenditures or investments paid off in a big way, the wealth of the corporation increases leaving room for the government to borrow and invest anew.

      For an example. Before borrowing, government expenditure is $200 billion in a $1 trillion dollar economy. After implementing borrowing, government expenditure drops to $100 billion. Deterrence costs a nation's economy say $100 billion in lost activity, either not done or done elsewhere.

      Debt $100 billion at 5% interest

      Asset $300 billion (with $100 billion earning 5%, $100 billion freed up from wasteful government expenditures and $100 billion in additional productive activity, plus government investments of $100 billion earning 7% average returns.)

      The corporation is now $200 billion wealthier and getting wealthier with the yields on public projects.

      Before, the government just took $200 billion and offered some services worth maybe a fraction of worth. Now the government is taking far less and offering accounted returns on those public investment. In doing so, the nation is wealthier with less government, with returns on public expenditures, and without the deterrent upon worthy economic activity.


      Gary Marshall

      CommentedA. T.


      You write:

      "Its sort of like the R and D department. All it does is advance the knowledge upon which the corporations products are based. It generates no revenue of its own. However, the money it receives and expends gives the company the basis of far better, desired, and more profitable products, which return far greater financial benefits than all costs combined. So like the R and D department, the government is a perpetual financial loser. Everything is cost and no revenue. But for every other department, their valued efforts will form the essence of future returns."

      I agree with this 100%! But an R&D department never borrows money from the corporation that houses it. The corporation just gives it a budget to work with. The corporation gives the R&D department money (without expectation of having that money paid back), and the R&D department provides the corporation with services that allow the corporation to make more money.

      To me this is identical to "you pay taxes and we provide you with the defence and courts necessary for economic growth". An entity that provides benefits for others but not itself has no scope to borrow – it returns to those who finance it not the loan, but some useful services.

      CommentedGary Marshall

      Hello AT,

      A balance sheet balances. There are assets, liabilities, and shareholder's equity if you wish. The shareholder's equity in the corporation of the US would be assets less liabilities, or in other words -- wealth spread amongst the people.

      You say that you cannot loan yourself money to buy a car. That is incorrect. If I have 2 bank accounts and I have $30,000 in one and nothing in the other. I can easily transfer money from the one to the other with some sort of repayment scheme, if I should choose to do so.

      Let us say that I wish to run a courier business. Without a car, I have nothing. A purchased vehicle will supply revenues above expenses, hopefully. I can then repay the loan to my first bank account, a personal bank account, with the sums building in my business account.

      So with a $30,000 investment, I shall earn returns on the fixed equipment purchased to justify this investment.

      Government is simply one department within the greater corporation. Its job is to borrow and invest. Its sort of like the R and D department. All it does is advance the knowledge upon which the corporations products are based. It generates no revenue of its own. However, the money it receives and expends gives the company the basis of far better, desired, and more profitable products, which return far greater financial benefits than all costs combined. So like the R and D department, the government is a perpetual financial loser. Everything is cost and no revenue. But for every other department, their valued efforts will form the essence of future returns.

      Does this better explain the existence and purpose of government in my system?

      An employee does not serve the interests of the customer. He serves the interest of the corporation. Certainly, he must take care of his customer, but only as long as it serves the interests of the corporation.

      Yes, the government is there to serve its masters, the citizens of the jurisdiction. Citizens do buy stuff in a collective sense, but its more complicated. They give the government the means to provide specified and needed goods and services that individually cannot be obtained or only with great difficulty. Everything that government does is an investment, an investment by the people through the agency of government for the benefit of the people. Education, clean water, good roads, etc.

      If some project qualifies as an investment and generates returns, then the money can be taxed or borrowed and the investment generate returns beyond all costs. If those investments generate returns beyond all costs, then why tax when the money can be borrowed?

      Government is the child of the community. The community is not the child of government. The 2 are not synonymous. The Government serves the community. The community does not serve the government, though with forced confiscation this is exactly what the relationship has become.


      CommentedA. T.


      Assets and liabilities must be balanced and not identical. It does not matter if they are decreasing or increasing as long as this is the case. You can make infinite promises for future payments if you have infinite sources of future cash INFLOWS from which to make them. Put otherwise, you cannot loan yourself $30k to buy a car. If you do not have the money in the first place, you will still not have the money after the attempted loan. If you do have the money and buy the car, you will have a car but be $30k poorer – a situation identical to just buying a car outright.

      I think our disagreement stems from how we conceptualise the government. You seem to see it as a separate economic entity from the community (just as a business is), while I see it as an administrative organ thereof. The main reason for my perspective is this – a business's employees serve the interests of at least two opposed groups – the stockholders and bondholders, and the customers. The latter would like the products to be sold as cheaply as possible, while the former want the profits to be maximally high. Thus, the former invest in the hopes of obtaining some value from the latter. Or, in a bank, you have the people providing the capital (depositors, shareholders, bondholders, etc.) and the people/companies taking out loans from that bank.

      Government employees, however, serve only one interest group – the citizens. Citizens just want to buy stuff together, so they select some individuals among themselves to sort out the logistics of all of it. Any loan from the community to the government is thus a loan from the community to the community, and we go back to the car buying problem outlined above. Taxes aren't there to pay the government for its own needs, they are there to buy the stuff we, the people want to jointly buy. Would your proposed financial arrangement make sense if you replaced every instance of the word "government" with the word "community"? Because the way I see it, the two are synonymous when it comes to finances. A bank that has only depositors/shareholders does not make any loans and has neither need nor ability to borrow money itself.

      CommentedGary Marshall

      Hello AT,

      Well, who does the bank borrow from if not from its depositors, or its bondholders?

      Only money in demand deposits is redeemable on demand.

      And how does the bank pay back its bondholders? Do its assets and liabilities decrease over time? Or do they increase?

      If they increase, then the bank is paying no one back. In fact, it is increasing its pool of lenders.

      You appear to admit this when you say that a bank can pay its depositors back if it should so wish because its assets are superior in value to its liabilities. Quite correct.

      Now you then say something that makes me smile. You say, "A government is not an economic entity, it is a logistical/administrative one – a government is to the entire country is like what the purchasing department is to a company. The purchasing department does not borrow money from the company to buy next year's printer paper supplies, for instance, it just acts on behalf of the company."

      Exactly correct though I may not have worded it this way. And who is making the purchases then in your description of government?

      Is it the government? Of course not. Their revenue is only what the corporation supplies.

      So who is it? Well, its all the taxpaying citizens and corporations of the land. These people and firms, which are owned by people, are supplying the funds for government to contract for services and goods, and to underwrite its debts. It is their combined wealth that stands behind the government's finances.


      So if the taxpaying citizens and firms, owned by citizens, are enriched, then government finances stand on a better footing. If not, then government finances are shaken. It is not the other way around.

      So if a government contracts for services and goods that enrich the nation beyond all costs, the nation is wealthier because of it.

      Now you ask me how a government can repay its lenders. It will do it in the same way a bank does. All a bank does is satisfy its lenders of the security of their loans to the bank. When a lender decides to obtain a better return elsewhere, the bank substitutes a lender for the one departing. With a nation, the liabilities will grow indefinitely with the abolition of Taxation. However, the assets sired by those liabilities will grow that much faster, enriching the nation, not impoverishing it.

      If a nation has issued $20 billion in debts, know that the nation through its various people and firms has acquired assets of $40 billion to underwrite those debts from profitable public expenditures.

      If $20 trillion in debts, then $40 trillion in assets. Meaning $20 trillion in wealth sired by the public expenditures elicited chiefly from the abolition of Taxation.

      Do that make it clearer?


      CommentedA. T.


      I'm not sure I would say the bank borrows from its depositors. It takes money from them, but that money is redeemable on demand. As for bondholders – it does pay them back. Moreover – and this is the critical difference, in my opinion – it CAN pay them back because it has different sources of income. A bank (or a corporation) uses money to generate returns, a government uses money for communal consumption. A government is not an economic entity, it is a logistical/administrative one – a government is to the entire country is like what the purchasing department is to a company. The purchasing department does not borrow money from the company to buy next year's printer paper supplies, for instance, it just acts on behalf of the company. It is a cost centre. Cost centres can't borrow.

      CommentedGary Marshall

      Hello AT,

      A bank operates in much the same way. It borrows from its depositors and bondholders. Once money is borrowed, it is never repaid in the aggregate. So why does this constitute a success for a bank?

      Corporations always borrow ever greater sums with their liabilities rising generally. So in effect, once a firm borrows money, it is forever borrowed. This is a sign of a corporation investing for future returns.

      Is this not correct?


  17. CommentedMATTHEW M

    Although I agree with the basic premise of technology and automation increasing income for creative, highly skilled workers and depressing wages for lower skilled workers, what are we to do when "automation" takes over (already eroding) engineering, medical and more high skilled work?

    So question to the author who is opposed to a more egalitarian economy: How is wealth to be distributed when the End of Work, the End of Money arrives on our doorstep?

  18. CommentedKaren Williams

    "This emphasis on anti-worker, pro-rich policies as the recession’s primary cause fits less well with events in Europe. Countries like Germany that reformed labor laws to create more flexibility for employers, and did not raise wages rapidly, seem to be in better economic shape than countries like France and Spain, where labor was better protected."

    This paragraph ignores the global nature of the modern economy. A large share of Germany’s robust economic activity goes to satisfying foreign demand.

    A second problem with this paragraph is its carelessness about timing. During the boom, which is when French and Spanish wages were rising rapidly, the French and Spanish economies were going like gangbusters. It’s only now, after the crash, when widespread unemployment has greatly lowered effective wages in France and Spain, that those countries’ economies are weak.

  19. CommentedBen Leet

    According to the President of the Center on Budget and Policy Priorities, Robert Greenstein, March 9, 2011: " Between 1976 and 2007, the U.S. gross domestic product (GDP) grew 66 percent per person, adjusted for inflation. But the average income for the top 1 percent of Americans increased by 280 percent, in inflation-adjusted terms, while the average income of the bottom 90 percent of Americans stagnated, growing just 8 percent over this 30-year period." Lawrence Mishel at the Economic Policy Institute states, May 3, 2012, "From 1978–2011, CEO compensation grew more than 725 percent, substantially more than the stock market and remarkably more than the annual compensation of a typical private-sector worker, which grew a meager 5.7 percent." An article "Rising Inequality as a Root Cause of the Present Crisis" by Engelbert Stockhammer appears at, April 2012. Inequality chokes off aggregate demand and creates an uglier society. The CBO report Trends in the Historic Distribution of Income Between 1979 and 2008 (I always have a problem with that title) shows that the top 1% increased its post-tax and post-transfer income by 9% over the 30 years, from 8% to 17%, and all its gains in share came at the cost of lost share to the lower-earning 80% of households, who are relatively poorer. If the same distribution as 1979 held today, all those households, 94.4 million, in the lower 80% would each have over $10,000 more income. The question: Would that improve growth? my blog,

  20. CommentedDavid Elvira

    There is an important point for explaining Euro crisis that is missing here. The macroeconomic indicators of Europe like inflation target, government deficit, exchange rate, etc. have been since the beginning of the Euro, very close as what is best to suit the biggest economy in Europe: Germany. These indicators have contributed to control inflation and wages in Germany but in the same time, increased inflation and wages in peripheral countries. Now peripheral governments are trying to fix the gap in competitiveness created by the macroeconomics, only by a mix of rising taxes and cutting government expending. But the macroeconomic indicators of the eurozone are still favoring German growth and stability and forcing other countries to address the competitiveness gap the hard way (deflation, wages cuts, debt control etc). As these measures are generating recession, investors consider there is more risk on lending to these countries forcing the interest rates to rise. This in turn, generates more deficits.
    I don't think this austerity method will last without killing the euro. As conditions are today, it is better for peripheral countries to go back to their local currencies. Then, with some devaluation, they will become competitive again. If Germans do not devaluate in parallel, the competitiveness issue will be transferred to them. Buying a BMW will be too expensive for a Greek or a Spaniard. They will need to find someone else.

      CommentedGary Marshall

      Hello David,

      Here are some comments I made to another. The point of a government is to increase wealth, not increase GDP.


      The government will obtain its funds if the returns justify the expenditures. If not, the project does not go ahead. So government expenditures will decline accordingly, from those in a system in which the government can take your money and do as it please to those in which the government must justify every expenditure and return. As government will need far less money to operate than it currently does, the nation will be enriched. There will also be no deterrent effect, meaning another large source of increased wealth. With all that extra money laying about, one can certainly expect large increases in worthy economic activity and far less of the other kind. There will also be a lot more money to fund worthy and profitable public enterprises.

      So the government can make a one time investment of $1 million in some project, say the closure of an unused or little used public facility, for a reduction in costs of $10 million annually leaving a net profit of $9 million in the community. The government borrows the money from its citizen lenders at 5%. After one year, the cost of the project becomes with interest $1.05 million. As the interest was borrowed from resident lenders, the assets created by the public venture will become $10 million plus government interest of $50,000 plus the added returns on the $9 million freed from public expenditures, say at 4% annually, of $360,000.

      The nation’s finances will then look like this.

      Debt after year 1: Liability $1,050,000
      Asset $10,410,000
      Wealth $9,360,000
      Debt after year 2: Liability $1,102,500
      (interest on $1,050,00 of 5% = $52,500)
      Asset $21,226,900
      ($10,410,00 + $10 million + $52,500 +4% on $9.36 million+ 4% on $9million.
      Wealth of $20,124,400

      Every year subsequent will show assets outpacing liabilities. Even if there were no returns, the liability of $1,050,000 would be matched with a created asset of $1,050,000 leaving no change in wealth. But there will be a return because the public will demand it.

      The community is far wealthier. Its bank accounts are now much larger thanks to the fact that it no longer has to fund a decrepit public facility and its idle employees. There is now much more money in the community to fund all sorts of worthy economic activities, some of them new public expenditures. There is no need to force others through Taxation to come up with $1 million. The investment pays for itself.

      Now in a system of confiscation or Taxation, the facility will continue to operate and its employees will continue to be paid to sit idle performing work of no value. Or the money will be taken and wasted elsewhere. The cost borne by the community will be $10 million per year and doubtless rising.


      Any reckless government can increase GDP with some stupid government program like digging holes in the morning and filling them in the afternoon. But the point of any public expenditure should be to increase the wealth of the land, enriching its people and improving their comforts.


      CommentedDavid Elvira

      I would like to come back to a few comments before. You said that the solution was less government expending and tax cuts. To me less government expending means less growth for the economy, less demand. Tax cuts means less income for government. So, together this leads to recession deficit and more public sector debt.
      On the opposite side, the private sector working for the government will need to find someone else to work with or close. People will benefit of tax cuts that will increase their income. But in exchange they will need to pay more for basic services like education, health, etc. Also it is very hard for private sector to invest on big infrastructure projects. The lack or the decadence of infrastructure will limit economy potential.
      So, to conclude, I think that what is needed is more investment from public sector on infrastructure and research. To get the money for investments, you can mix some new debt with tax increases on high income people.

      CommentedGary Marshall

      Hello AT,

      I forgot to mention that you have noted something very important.

      When government takes such gargantuan sums from the nation in Taxation, no one seems interested in how it spends that money. There is no cost and benefit analysis of any of the public expenditures.

      Yet, when government I argue that government should be forced to borrow instead of tax and pay interest on the borrowed money, you demand some proof of financial benefit.

      Isn't that something. That is what I call progress in public finance.

      Without a police department, one can basically expect lawlessness. Either you hire private protection in the form of insurance or a private security force, or you face the losses in property by yourself.

      The costs to society of such private protection would be unaffordable for most. By calling into existence a police force that can handle most threats to life and property, insurance rates will drop demonstrably.

      If the cost of this police force were $10 million before the abolition of Taxation, and $6 million after, the community is wealthier by $4 million, which they may now use to further retire debt, invest in retirement, consume or save.

      What a great difference, don't you agree?


      CommentedGary Marshall

      Hello AT,

      The idea and proof is a revenue question, not an expenditure question. The government can borrow or tax to obtain the funds to pay for police. If they borrow in place of tax, the cost to the community will be nil.

      At some point in the future, the government may collect the taxes owed to pay its bondholders. It will take principal plus interest from the taxpayers in the community and hand principal plus interest to the bondholders in the community. The debt will disappear and the community's aggregate finances will not have changed. Money taken in taxes from the community is just money handed back to the community to retire debts. Its a wash.

      The transfer is theoretical. It will never take place.

      However, on the expenditure side I shall make some predictions. When government must face its perpetual banker everyday, its habits had better change, and quickly.

      With Taxation abolished, government expenditures will decline drastically. No more favoritism. No more squander. No more corruption. No more vote buying subsidies. No heavy, harmful, and unneeded regulation. Government expenditure will come with a capital charge. And if a project generates returns greater than the charge, fine. If not, then the project is shelved.

      Secondly, there is no deterrent on the accumulation of wealth or on productivity. All that worthy activity currently impeded by high taxation and unneeded regulation will disappear, sending growth surging.

      These 2 primary factors will come into play and create massive increases in the nation's assets. I conservatively estimate the creation of $2 in the nation's assets, held by its citizens, for every $1 invested by the nation's agent, the Government.

      The nation will be far wealthier with the abolition of all Taxation.

      In the case of the police, their attitude and conduct will change for the better in a big way. Useless laws will be nullified. Useless or idle cops will disappear as will top heavy administration and costly police political programs.

      Instead of costing the community x dollars, the police department would cost the community a fraction of it, say 60%, an excellent return.

      In short, bereft of Taxation, government expenditures will pay for themselves.


      CommentedA. T.


      I don't get it. Sounds like perpetual motion to me...

      Say my community agrees that we like law and order and figure out that we need $10M to run our police department for next year. We all put some money into the proverbial hat (taxes) and use that money to pay the officers, the electricity bills, fuel the cars, etc. That money is obviously not coming back – it is for services rendered... for extra efforts expended by specific others on the community's behalf. So, next year we have to go through the same process.

      Suppose instead it is a loan. After putting the money in the hat, a person we have empowered writes us a piece of paper saying that we will get our money back. The money is used the same way. At the end of the year the police department has no money – either to pay us back or to function for another year (which we want it to do). Now what? Issue 2x more debt – half to pay back the old debt and half for next year's operations? But the first half is the equivalent of simply tearing up the IOU paper we got, which makes the second part (and the past year's financing) equivalent to a tax.

      Money, after all, is just an accounting unit. If you want to consume some actual value, you have to create it first. No financing trick can make said value magically appear for free.

      CommentedGary Marshall

      Hello David,

      How does the following sound:

      The individual European countries have the means to remedy their current problems with ease. There is not need of some collective fiscal measure or coordinated prescription.

      The means to that end is contained in the little proof below for the abolition of Taxation, which novelty may be absurd on its face, but not so when examined.

      If you or anyone can find the flaw in this proof, I shall be more than happy to give the reward of $50,000. None have yet been successful. Perhaps because so few have tried.

      Its not the end of Europe or the world, but a new beginning.



      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

      CommentedA. T.

      GM, total US tax revenues (federal and local) as % GDP have hovered around 25% since at least the early 1970s, throughout which time they have been among the lowest in the OECD (with those of Japan and Switzerland sometime falling lower). How low (as in a specific number) would you want this metric to be, and why? Keep in mind that taxes are not some sort of feudal tribute – within a democracy (where our government is comprised of our elected representatives), taxes are either accounting for externalities (where economic value inappropriately captured by one party is transferred to it appropriate place) or are funding undertakings that are most efficiently pursued on a communal basis (e.g. armed forces or basic research).

      CommentedGary Marshall

      Hello David,

      What about the road less or never travelled? How about tax cuts?

      The problem is not the deficits. The problem is excessive government expenditure. Reduce government expenditure and offer large tax cuts, and the economy shall thrive.


      CommentedGary Marshall

      Hello David,

      What about the road less or never travelled? How about tax cuts?

      The problem is not the deficits. The problem is excessive government expenditure. Reduce government expenditure and offer large tax cuts, and the economy shall thrive.


      CommentedDavid Elvira

      I agree with you: getting out of the euro is not the best solution. But is the default way if Europe does nothing or almost nothing. The best solution is to get fully integrated and to invest on depressed areas. But it takes time that we don't have.
      Austerity policies have too faces: cleaning inefficient state expenses and creating economic depression by killing demand. The first is good for the long term, the later just generates more debt and more risk of not being able to pay this debt.
      The achievements on deficit/debt reduction by austerity policies are too little compared to what can be done on the macroeconomics scale by Keynesian policies.

      CommentedGary Marshall

      Hello David,

      So if the European nations partnered in the Euro were free to leave it and recreate their own currencies, inflate them, and make their citizens all the poorer, how much better off Europeans will be!

      Sounds like a great Keynesian solution.

      Why not just impose hefty tax increases without all the intermediary steps? It all works out to the same result.

      Or how about governments start cutting all that squander they are gleefully prone to, then cut taxes, enriching their citizens and creating a more productive economy?


  21. CommentedA. T.

    Inequality does inhibit growth, but one must make sure to look at the right inequality. Income inequality is largely irrelevant – income is largely an outcome of economic structure, not a cause of it (though it can act to reinforce the structure). The growth-inhibiting inequality is the inequality of wealth, both on the individual and the business level, which is a type of inequality of fungible power.

    The tendency of power inequalities to limit growth has been well-studied. Indeed, both democracy and free-market principles were, at their core, motivated by trying increase growth by decreasing inequalities in power. Democracy decentralised political power, while free markets tried to break the link between political power and economic power.

    However, due to the self-reinforcing nature of power (the more powerful one is the easier it is for one to maintain one's power, as well as to grow more powerful at the expense of those less powerful than oneself), mature economies are trending back towards wealth and power centralisation. In this way, the USA is little different from Japan – both have a small number of very wealthy individuals and an economy dominated by a small number of huge companies. This contrasts with flatter wealth distribution in the Nordics, or the Mittelstand of the German economy. It is in such structures that growth lies, for the very same reason that a large number of economic actors with limited influence over the economy generate more growth than a few empowered central planners.

  22. CommentedFelipe Filomeno

    This article comes from finance and was written for finance. Inequality has risen in the U.S. AND in the E.U. (see below). It's hard to think it has no relation to the crisis.

    From "Income Inequality in the European Union" by
    Kaja Bonesmo Fredriksen, OECD Economics Department Working Papers, 2012:

    "Towards the end of the 2000s the income distribution in Europe was more unequal than in the average OECD country, albeit notably less so than in the United States. It is the within-country, not the between-country dimension, which appears to be most important. Inequality in Europe has risen quite substantially since the mid 1980s. While the EU enlargement process has contributed to this, it is not the only explanation since inequality has also increased within a "core" of 8 European countries. Large income gains among the 10% top earners appear to be a main driver behind this evolution."

  23. CommentedGary Marshall

    And how does income inequality lead to lower or little growth?

    Not much of an explanation. Might it be taxation that has lowered growth, sending jobs overseas? Perhaps onerous regulation that stifles companies from investing in new plants? Perhaps needless rules that drive up production costs?

    So the solution is to tax the rich! And how much greater should they be taxed knowing that wealth of such people is mobile.

    The government will then take this money and spend it as wisely as it has in the US, Greece and most of Europe with similar returns?

    This from a professor of finance! I expect it from Keynesians. I thought business people had better sense.


      CommentedGary Marshall

      Hello Charles,

      And in all those big government economies, which drive income inequality through re-distribution to such low levels, do we find great growth?

      In an economy with little income re-distribution, do we find stagnant economies?


  24. CommentedChristopher Allen

    I agree with some of the other commenters that this article is misnamed -- a better title would be "Is a Focus on Inequality Inhibiting Growth?"

    That said, I'm not sure this is a present concern as much for Europe as it is for the US at the moment, given the argument between the Presidential candidates' arguments whether to give priority economic "fairness" or economic growth given the impact of the 2008 recession.

    An increase in inequality, US-style, may be an aspect of structural adjustments in Europe, but I think that's several questions ahead of where we are now, namely, how does Europe move forward at all at this point?

  25. CommentedErnest Dautovic

    The article is called:"Is inequality Inhibiting Growth?" Nevertheless, the author fails to say anything about the connection btw these two concepts.

    He just compares U.S. and EMU growth models in the last 2 decades, quite a task in a post! The result is very poor.

  26. CommentedErnest Dautovic

    This is just a tiny of the EU story and does not recall the fact that in Germany transfers to households are indeed massive if compared to the U.S. and that the tax system in Germany, and EU, is by far more progressive than in the U.S. This paragraph forgets also to say that Germans SMEs can finance their activities at much lower rates than the southern EMU countries because of the sovereign spreads.

  27. CommentedPaul Jacobson

    This is the challenge facing all modern economies. The issue is whether we have good policies to cushion the impact. However, you cannot avoid the impact of such changes.

  28. CommentedN R

    The article fails to explain what the appropriate response should be to ensure that the average citizenry that cannot adapt to an innovative and globalized world, not fall into the gutter. Unfortunately, there are a lot of people in the world who are good at mundane repetitive tasks and who probably are not the best and the brightest. A certain amount of transfer of wealth should hence be allowed. What should be the quanta, that is debatable. The efficiency argument (complete labor flexibility and deregulation) will lead finally to structural inequality and the death of a nation.

      CommentedN R

      Kevin, I would like to believe your view. But, my personal experiences with a variety of people in many countries has led me to believe otherwise. While humans at large are adaptive, there are differences in skills and abilities that we simply cannot ignore. This capability difference includes the ability to learn throughout your life. Also, when you retrain a janitor, it is highly likely that the person ends up in another minimum pay job. Our sense of equality has reinforced that all people are equal. It is my empathy for the lower class that has led me to believe that some amount of wealth transfers is a must for a just society. We can try allocation on retraining on an additional basis. Even if you don't agree with regular folks, what do you do with people who are autistic, visually impaired, morbidly obese, handicapped, unhealthy etc.? I would like to believe that Forest Gump becomes well off and adapts to the changing world. In today's world, we are heading to a situation where a vast set of people are relegated to minimum wage jobs while the small elite would like to believe that the world is fair and rewards the deserving.

      CommentedKevin Lim

      I think thats unfair. It is not that the average joe cannot adapt to "an innovative and globalized world". Humans are remarkably adaptable if given the tools to adapt. The problem is that the modern capitalist system does a poor job of encouraging skill diversification. The "haves" tend to have jobs where constantly updating one's skills is part of the job description (e.g. doctor). The same cannot be said of the "have nots" (e.g. janitor). That imbalance can be addressed with minimal cost to the taxpayer (e.g. making welfare payments conditional upon attendance and certification with skill diversification programmes)

      What I think is the REAL problem is the prejudice of employers. For a mundane data entry position, who do you think is more likely to get hired - the 20yr old fresh on the workforce who knows how to use MS Excel, and the 40yr old former contractor who's been out of work for 3 years but has upgraded his skills to include MS Excel?

      So I say instead of wealth transfers, lets have some decent funding for skill programs for the unemployed, and more tax incentives to hire the long-term unemployed.