Thursday, September 18, 2014
9

The Inequality Trap

WASHINGTON, DC – As evidence mounts that income inequality is increasing in many parts of the world, the problem has received growing attention from academics and policymakers. In the United States, for example, the income share of the top 1% of the population has more than doubled since the late 1970’s, from about 8% of annual GDP to more than 20% recently, a level not reached since the 1920’s.

While there are ethical and social reasons to worry about inequality, they do not have much to do with macroeconomic policy per se. But such a link was seen in the early part of the twentieth century: capitalism, some argued, tends to generate chronic weakness in effective demand due to growing concentration of income, leading to a “savings glut,” because the very rich save a lot. This would spur “trade wars” as countries tried to find more demand abroad.

From the late 1930’s onward, however, this argument faded as the market economies of the West grew rapidly in the post-World War II period and income distributions became more equal. While there was a business cycle, no perceptible tendency toward chronic demand weakness appeared. Short-term interest rates, most macroeconomists would say, could always be set low enough to generate reasonable rates of employment and demand.

Now, however, with inequality on the rise once more, arguments linking income concentration to macroeconomic problems have returned. The University of Chicago’s Raghuram Rajan, a former chief economist at the International Monetary Fund, tells a plausible story in his recent award-winning book Fault Lines about the connection between income inequality and the financial crisis of 2008.

Rajan argues that huge income concentration at the top in the US led to policies aimed at encouraging unsustainable borrowing by lower- and middle-income groups, through subsidies and loan guarantees in the housing sector and loose monetary policy. There was also an explosion of credit-card debt. These groups protected the growth in consumption to which they had become accustomed by going more deeply into debt. Indirectly, the very rich, some of them outside the US, lent to the other income groups, with the financial sector intermediating in aggressive ways. This unsustainable process came to a crashing halt in 2008.

Joseph Stiglitz in his book Freefall, and Robert Reich in his Aftershock, have told similar stories, while the economists Michael Kumhof and Romain Ranciere have devised a formal mathematical version of the possible link between income concentration and financial crisis. While the underlying models differ, the Keynesian versions emphasize that if the super-rich save a lot, ever-increasing income concentration can be expected to lead to a chronic excess of planned savings over investment.

Macroeconomic policy can try to compensate through deficit spending and very low interest rates. Or an undervalued exchange rate can help to export the lack of domestic demand. But if the share of the highest income groups keeps rising, the problem will remain chronic. And, at some point, when public debt has become too large to allow continued deficit spending, or when interest rates are close to their zero lower bound, the system runs out of solutions.

This story has a counterintuitive dimension. Is it not the case that the problem in the US has been too little savings, rather than too much? Doesn’t the country’s persistent current-account deficit reflect excessive consumption, rather than weak effective demand?

The recent work by Rajan, Stiglitz, Kumhof and Ranciere, and others explains the apparent paradox: those at the very top financed the demand of everyone else, which enabled both high employment levels and large current-account deficits. When the crash came in 2008, massive fiscal and monetary expansion prevented US consumption from collapsing. But did it cure the underlying problem?

Although the dynamics leading to increased income concentration have not changed, it is no longer easy to borrow, and in that sense another boom-and-bust cycle is unlikely. But that raises another difficulty. When asked why they do not invest more, most firms cite insufficient demand. But how can domestic demand be strong if income continues to flow to the top?

Consumption demand for luxury goods is unlikely to solve the problem. Moreover, interest rates cannot become negative in nominal terms, and rising public debt may increasingly disable fiscal policy.

So, if the dynamics fueling income concentration cannot be reversed, the super-rich save a large fraction of their income, luxury goods cannot fuel sufficient demand, lower-income groups can no longer borrow, fiscal and monetary policies have reached their limits, and unemployment cannot be exported, an economy may become stuck.

The early 2012 upturn in US economic activity still owes a lot to extraordinarily expansionary monetary policy and unsustainable fiscal deficits. If income concentration could be reduced as the budget deficit was reduced, demand could be financed by sustainable, broad-based private incomes. Public debt could be reduced without fear of recession, because private demand would be stronger. Investment would increase as demand prospects improved.

This line of reasoning is particularly relevant to the US, given the extent of income concentration and the fiscal challenges that lie ahead. But the broad trend toward larger income shares at the top is global, and the difficulties that it may create for macroeconomic policy should no longer be ignored.

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  1. CommentedMartin Erlic

    A tax on capital gains due to non-linear cumulative advantage is the way to go! All pre-21st century brick and mortar businesses are exempt.

  2. CommentedRobert Goldschmidt

    In my view inequality is a symptom of a shrinking wage-based demand pie. As the pie shrinks, there is ever fiercer competition for each group to get their "fair share". When there is contention for limited resources, the powerful, the moneyed get more and the weak, the poor get less.

    The underlying problem is the weakness of median wage-based demand. This has been eroded over the past three decades by a combination of outsourcing to extremely low labor rate countries, automation and increasing resource costs. These causes are structural and will not disappear simply by stimulus or austerity programs. They will require trade barriers with countries of order of magnitude lower wages, a reduced work week and the strengthening of unions so that wages can again track productivity.

  3. CommentedDallas Weaver, Ph.D.

    I don't understand these "lack of demand" type arguments. People rich and poor always want more than they have along with wanting ways to hedge against future risks. People then have to make decisions between options. Do they want that new car now and are willing to increase their fixed costs and risk of economic failure in the future or do they want to save enough to buy the car and not have payments when something goes wrong -- which it always will even for the luckiest people.

    Everyone knows that one of the universal truths is that "shit happens" at a personal/family level, but there are individual differences in how you hedge those real risks. You can buy insurance to cover some risks such as life insurance to protect your family, but rich or poor that contributes to the "saving glut" with investments decided by the same people who invest for the "rich". You can also save for the future and that money also goes into the "saving glut". You can demand that the government provide the insurance where you make payment into Social Security where that money, in theory, is invested by the government and becomes part of the "savings glut".

    It seems that overall the instabilities in the economy are less related to rich vs poor issues than cyclic instabilities in investment opportunities. Since there is always a desire for "more", the investment instabilities are tied up dynamic issues related to shifts in what people desire.

    With part of the desire for housing being the hedge value of inflation protection and possible appreciation created by prevention of supply creation via government regulatory limitations, this part of the housing demand will decrease once the supply is allowed to increase. In the past, this dynamic didn't create huge bubbles, when developers could fulfill any minor demand increase in less than one year. Now days with 6 year development permit cycles, you create an unstable dynamic system. With housing being a significant "investment" for the "saving glut", creating an excessive regulatory delay between demand increases and supply increases, the system becomes unstable.

    Control theory actually shows that any system where the response time of the system is about the same as the response time of the control system is inherently unstable. With the regulatory permits times (6 years or so) being similar to real estate normal price/demand variations, this investment system is unstable. Eliminating the regulatory permit time and having a 1 year construction cycle would make the system stable.

  4. Commentedjean nutson

    One certainty about inequality is that it will always be part of the human society which means it impact on the economy will always exist.

  5. CommentedSanford Russell

    100 per cent inheritance tax after surviving spouses are reasonably provided for. Children receive only tuition and living expenses while attending university and then must fend for themselves.

      CommentedMartin Erlic

      Yet those who succeed in the game of life will do everything they can to protect their victories. Why would any successful individual relinquish control over the potential life outcomes of their own posterity? The winners of the genetic gamut will cede no such powers. This kind of legal imposition would be too costly and difficult to combat.

      This is akin to telling everybody that they should change the way they act so that their conformity might prove true the theorems of the Neoclassical models of perfect competition. P=MC can be ensured through slavery!

      There should also be a tax on behavior where individuals who deviate from perfect rationality must pay those who do not a sum for their lack of obeisance. This will ensure that all markets will clear and large-scale irrational exuberance will never again take place.

      "No more recessions!", they will promise in boisterous promulgation, "on the condition that you put on this Vulcan mind control cap."

  6. CommentedJan Smith

    There are at least two causal paths from high income concentration to slow growth. Besides excess saving and insufficient aggregate demand, high income concentration causes low intergenerational occupational mobility and,hence, wasted talent and skill.

    Of course, the trend toward higher income concentration is not limited to the US. It is true of most nations. This worldwide trend is caused by both the freer international movement of capital than of labor, and the faster growth in the supply of labor than of capital (due to the demographic transition).

    In these circumstances, most national states try to increase their respective shares of world saving. The aggregate result is a larger world saving glut and, hence, more asset price volatilty and slower growth of output.

    Is there a way out of the trap? Last time around, we got out by destroying a very large fraction of the world's capital stock, which gave us 25 years of respite before the global economy began to go haywire again. This time around, some of our would-be leaders are focused on restraining banks while others want to starve governments. We might call them the port and starboard deck-chair parties.

  7. CommentedKir Komrik

    Thank you, I enjoyed your article very much.

    The issue of economic inequality has vexed and bedeviled philosophers for centuries. In all that time it seems that there has yet to advance an economic program that a majority of those subject to it believe is just. But in just the last couple of years a program known as General Federalism, as far as I am aware, appears to have addressed this problem for the first time.

    To describe the program we should first elaborate on the western notion of “equity in law”. This concept is a legal precept regarding the procedures by which judges render decisions. Once a legislature enacts a law the courts enter the picture when real-world events occur and an application of the statutory laws of the legislature must be interpreted and applied to them. “Equity in law” refers to the judge’s obligation to identify the statutory laws material to the real-world event, then reach a conclusion about what those statutory laws mean in the context of that event. This is because the legislature cannot write law detailed enough to address every possible event in the real world; so the full meaning of statutory law can never be provided by a legislature.

    General Federalism distinguishes statutory and natural law - which are euphemisms for law and economics –both of which are legitimate objects of the social contract. In both cases the normative role of the program is to assign value within society, whether by the application of equity in statutory law or equity in natural law or both. The justification for legitimizing equity in natural law as an object of the social contract lies in the concept of the deliberate Actor, something taken up in more detail at my site and others. But the point here is that equity in natural law usually extends in reasonable fidelity to equity in valuable consideration (roughly - the act of buying something using a defined currency).

    Thus the problem isn’t a disparity of wealth across the globe. There is nothing unjust about that in and of itself. The problem occurs when valuable consideration completes under conditions in which natural law alone applies; that is, equity in natural law does not issue (which is pretty much the status quo, universal standard in contemporaneous human society). This, not surprisingly, is the same thing as affirming that natural law understood generally lacks definition and justice requires consideration of natural law as a fully defined construct. The best way to understand this is by an example.

    A man is the victim of an injustice (a tort) by an abuser (a tortfeasor) and the man litigates against his abuser, seeking relief under law and equity. The victim is poor and the abuser extremely wealthy. In valuable consideration, the services of attorneys are secured by both parties. Due to the difference in wealth and income, the victim’s attorneys are vastly outclassed by the attorneys secured by the tortfeasor. Indeed, the mere act of dragging out the case and incurring great expense for the victim is often enough – and is too often used – to “win” a case. Being an adversarial system, justice (colloquial meaning, not legal) need not necessarily make in consequence of the due process afforded both sides. Therefore, the natural law that legitimately allows this vast difference in wealth does not imply that this advantage in wealth should extend to a determination of tort and remedy for some arbitrary matter. In other words, the matter of whether or not a tort has occurred should be independent of the natural laws that resulted in the difference in wealth between the two parties. The status quo is that they are de facto not independent and are strongly linked. Conversely, and for the first time in history, a program, General Federalism, guarantees independence and requires both equity in law and equity in economics; a combination called General Equity in this paradigm. All Specific Performance (roughly – a court order) rendered under General Federalism is by the application General Equity and the constitution requires its use.

    In the example given the court of original jurisdiction would require some means of equivalent representation (or a legislature could enact a law to achieve that generally) or an appellate court would set aside on the grounds of it denying the victim the equal protection of the law.

    The tragedy that is befalling the majority of the world’s population is not occurring because of differences in income in and of itself, but as a result of most of the collateral (and grossly unjust) effect of this income difference.

    You can read more about General Federalism at kirkomrik.wordpress.com
    - kk

  8. CommentedZsolt Hermann

    This inequality is inevitable. Humanity is settled into a pyramid system based on our basic desire for self fulfillment.
    All of us are motivated by the pleasure/pain principle, but we all differ according to the size of our desire: how far are we willing to go to get what gives us pleasure? And the ones with the greater desires usually make it to the top of the human pyramid to become political, financial leaders, CEO's and so on.
    None of us are happy just with our necessities we all want to fill ourselves form the world as much as we are capable of. Even Average Joe when he goes to the supermarket and has enough money buys two out of everything instead of just buying what he truly needs, and changes his iPhone every year, as the people around him even if he does not need to do so.
    Since this is based on our inherent nature it is a very hard thing to change even if it is just as destructive globally as a cancer cell in a living body as the studies mentioned in the article show.
    We are now in a trap, this excessive consumption, profit hoarding system is self destructing. What we need to figure out is how can we build a new system in which we can channel our inherent human nature, with the same pyramid system/differing talents and desires in a way that it is beneficial for all of us. It has to be a system that is mutual, and it is free, in other words people are not tricked or coerced to enter the system but they do it willingly by free choice.
    This can only happen by a full understanding of our closed, integral and totally interdependent world system, where the progress, prosperity and security of each individual is dependent on the well being and perfect function of the total system with all of its elements.
    In such system people with the greatest desire still contribute the most, and in exchange they still recieve the greatest rewards but instead of accumulating extra surplus, the surplus goes towards the sustanance of the system instead of hidden bank accounts. And the others also contribute their own maximum and receive their rewards accordingly.
    When such a system works harmoniously in a completely transparent manner nobody would protest or argue with it. Social equality means everybody contributes to their maximum capability and gets rewards accordingly. There is no other solution for inequality and any of our problems.

  9. CommentedProcyon Mukherjee

    The very fundamental question cannot be ignored, who would fund the massive investments needed to generate a flow of income for those at the bottom of the pyramid, when private investments pursue less loftier goals of profit seeking while public investments pursue the age-old rent seeking tendencies, which had led to massive under-funding of the pension liabilities or similar nature of predicaments. Either way there is no magic wand that could be directed towards lowering of income concentration while opening up income channels through enhancement of demand drivers; there is no control measure or a lack of it that could simply direct investments with a lofty ideal of tempering the income concentration. However the marginal propensity to consume at the top is feeble while at the bottom it is high, the trickling down in this area needs an intervention that is far more entrenched in the dogged pursuit of public-private partnerships that go far beyond the narrow interests that they currently serve.

    Procyon Mukherjee

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