The academic economics profession ought to have been most intimately involved in analyzing and debating a broken capitalist system whose deep crisis had confounded all its confident expectations. It has done nothing of the sort. Instead it proceeds as if — and indeed mostly still insists that nothing has happened to disturb its fifty-year celebration of capitalism’s efficiency and growth. A few professors of economics (e.g., Paul Krugman) and business (e.g., Nouriel Roubini) have commented on the absurdity of that insistence. But most of them could get no further than to recycle Keynes’ 1930s critiques of a depressed capitalism and his recommendations for deficit spending and monetary stimuli by government.  And, of course, the few right-wing economists who have taken the crisis seriously, utilized it to push yet again for less government economic intervention.  –  Richard Wolff [1] 

There is much truth in Wolff’s assessment of America’s celebratory attitude toward capitalism, especially within the academic community, and he properly links that attitude to our current predicament.  The idea that market economies are wonderful and efficient has been deeply ingrained in our thinking, so much so that efforts to understand why we are back in a depression, even for liberal economists who care deeply about the growth of inequality, have proceeded with a “business as usual” approach to economic analyses, even as we become aware of the urgent need for a fundamental rethinking of “business as usual” macroeconomics.

New generations of economists grow out of a culture in which there is much inertia on economic thinking.  The daily news reports on the latest stock market information are almost entirely useless; and the radio and TV discussions of economic and financial issues that flood the airwaves are at best superficial and confusing, and at worst wrong. There is a big advantage for people like me who learned economics in the early 1960s, for we are in a position to understand what has happened over the last fifty years; and those of us who have not been within the academic community can take a hard, objective look from the outside at everything that is going on. I have been conducting such an investigation of inequality growth over the last two and one-half years, and I have reached some startling conclusions.

“Economics” today evokes for me the image of a huge, disabled tanker drifting toward a major catastrophe. My tiny tugboat is unable to affect its course; and there are thousands of tugboats in the water, all pushing and pulling in different directions.

An Immature Science

Economics, as a social science, never matured enough to be helpful in countering serious decline and depression. It never got a complete handle on how market economies really work. John Maynard Keynes took the best shot at figuring it out, but in explaining why unfettered capitalist economies are unstable, he failed to account for the most influential factor, the distribution of wealth and incomes. [2]

He thought he had isolated three independent variables that together explain aggregate income and employment — the interest rate, the marginal efficiency of capital, and propensity to consume — and he even accounted for the dynamic “multiplier” effect of rising or falling demand, as changes in aggregate consumption change aggregate income. His General Theory, however, failed to account for the huge effect on demand of income redistribution. The “propensity to consume” and the “consumption function” are not independent of income distribution. As income concentrates more and more at the top of the income ladder, aggregate consumption declines sharply, creating a vicious cycle of contraction as increasing inequality causes further declines in consumption, production, and income (GDP) growth.

Thus, market economies are vastly more unstable than Keynes perceived them to be; concentration of income and wealth at the top causes income growth to decline more rapidly, with more chilling effects on employment and investment than those caused by the garden variety shifts in aggregate demand economists are used to contemplating. As Simon Kuznets warned in 1955, we could not become aware of the magnitude of such effects until the distributional data became available. We are now learning, unfortunately, that these effects are far greater than most of us could have imagined.

The last post in this series established that the progressiveness of taxation is directly, mathematically related to the degree of inequality in the distribution of wealth and incomes.  Just as a faucet controls the amount of water moving through a pipe, the progressiveness of taxation controls the amount of income and wealth concentrating at the top.

This previously well-understood fact has been all but forgotten today. No well-known economist (to my knowledge) has publicly joined in my argument that, after 30 years of growing inequality, closing the taxation faucet to curtail the flow of incomes and wealth to the top has become essential to recovery, and ultimately to the survival of our economy.

The Krugman Conundrum

Paul Krugman, America’s most influential Keynesian, has a tugboat of his own, much bigger than mine — but unfortunately it is not entirely pointed in the right direction.  His tugboat is preoccupied with battling an entire fleet of pirate ships that have seized and disabled the tanker, and he could use some help.  But while his colleagues have resorted to championing more progressive taxation on fairness grounds, Krugman himself has not even expressly acknowledged the relevance of progressive taxation to growth and recovery.  Here is a recent comment on tax progressiveness from his New York Times column:

Consider the question of tax rates on the wealthy. The modern American right, and much of the alleged center, is obsessed with the notion that low tax rates at the top are essential to growth. Remember that Erskine Bowles and Alan Simpson, charged with producing a plan to curb deficits, nonetheless somehow ended up listing “lower tax rates” as a “guiding principle.”

Yet in the 1950s incomes in the top bracket faced a marginal tax rate of 91, that’s right, 91 percent, while taxes on corporate profits were twice as large, relative to national income, as in recent years. The best estimates suggest that circa 1960 the top 0.01 percent of Americans paid an effective federal tax rate of more than 70 percent, twice what they pay today. [3]

This is a good comment as far as it goes, but it does not expressly connect the progressiveness of taxation to income growth; it merely rejects the false idea that lower taxes at the top will increase growth. Nor does it mention the casual conflation of taxation of top incomes with taxation of bottom incomes embedded in the “guiding principle” of lower tax rates, a gimmick used successfully to leverage the false promise of “trickle-down” into real economic analysis.

We owe Paul Krugman much gratitude, and a great deal of credit, for his own obsession with “austerity” and “trickle-down,” two insanely magical ideologies that have dragged economics back into the dark ages of the 17th Century, well before philosophers like Adam Smith and John Baptiste Say began to work some basic tautologies into coherent economic theories. [4]  As I said, he’s not getting enough help from other economists in those efforts. But perhaps especially for that reason, as America’s premiere warrior against economic insanity, Krugman has a responsibility to clarify the implications of progressive taxation.

Krugman is among those actively recycling the traditional Keynesian playbook, arguing that fiscal and monetary policy alone can accomplish recovery, and rather easily. [5] The next post will show that the Keynesian playbook cannot work today, because it does nothing to stem the transfer of wealth to the top in the normal course of the economy’s operation, and that “taxing the rich” is essential to escaping from our very serious inequality cycle.  Yes, I am saying that Paul Krugman is wrong on that score.  

Of course, he is right that the “austerity” hysteria must be subdued. But Krugman also argues:

The chances of a real turn in policy, away from the austerity mania of the last few years and toward a renewed focus on job creation, are much better than conventional wisdom would have you believe. And recent experience also teaches us a crucial political lesson. It’s much better to stand up for what you believe, to make the case for what really should be done, than to try to seem moderate and reasonable by accepting your opponents’s arguments. Compromize, if you must, on the policy — but never on the truth. [6]

So, I am encouraged to say, here is the uncompromising truth: The only time cutting government participation in the economy would make any sense would be when the economy is overheated, and it is a terrible idea to do it in a recession. Krugman, Reich, and the other opponents of “austerity” policy are absolutely right about that. But, as explained in the next post, we’re not in a situation where merely increasing government participation might thaw out the stalled economy sufficiently for a recovery.  We’re in an inequality-generated depression, which is sucking the life out of the economy faster than it could possibly be resuscitated by more government borrowing and spending. We need much more progressive taxation; it’s time to tax the rich.

Krugman’s Perspectives Revisited

Paul Krugman’s public influence on economic issues today is unmatched.  He is the premiere voice of American mainstream Keynesianism, providing his views to millions of readers every Monday and Friday in the New York Times, and he is the most followed and talked about economist in America. So understanding his views on inequality, and its causes and cures, is extremely important. When he became the lead New York Times correspondent in economics in 2007, he attributed the decline of inequality after WW II (the “Great Compression”) to Roosevelt’s New Deal policies, and he said this:

Because of “movement conservative” political dominance, taxes on the rich have fallen, and the holes in the safety net have gotten bigger, even as inequality has soared. And the rise of movement conservatism is also at the heart of the bitter partisanship that characterizes politics today. Why did this happen? Well, that’s a long story. . . . For now, though, the important thing is to realize that the story of modern America is, in large part, the story of the fall and rise of inequality. [7]

It appeared that inequality would be a major focus of his blog, and that we would become a major authority on the topic.  But as Timothy Noah reported [8] in 2012: 

In his 2007 book The Conscience of a Liberal, Paul Krugman concluded that there is “a strong circumstantial case for believing that institutions and norms. . . are the big source of rising inequality in the United States.” Krugman elaborated in his New York Times blog:

The great reduction in inequality that created middle-class America between 1935 and 1945 was driven by political change: I believe that politics has also played an important role in rising inequality since the 1970s.  It’s important to know that no other advanced economy has seen a comparable surge in inequality. [9]

The problem with this emphasis on an “institutions and norms” explanation for rising inequality is that it takes us “out of the game,” leaving us out of touch with real economic, distributional explanations.  When we focus on politics as an exclusive explanation for rising income inequality, we ignore important economic phenomena.  Just observing, as Krugman did, that the United States had the biggest advance in income inequality doesn’t tell us much; it is more important to know that no other advanced economy has seen a comparable decline in the taxation of top incomes: The Piketty and Saez data, as shown in the fourth post of this series, show that the United States economy has both the highest level of inequality and the lowest marginal income tax rates among all advanced economies.

Krugman already had this bias toward “institutions and norms” explanations back in 2007, and he never lost it. In 2012, he concluded that inequality is a “political” problem. [10] This implies a belief that income and wealth distribution do not have macroeconomic implications, a belief intimately connected with another perspective that also obscures the foundation for a better understanding of the economics of inequality — the “normality” presumption that economies are self-correcting, as described by James Galbraith in an earlier post in this series:

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. [11]

This assumption clearly masks the macroeconomic damage done by the concentration of income and wealth at the top.

The Rise of “Behavioral Economics”

Around the turn of the 21st Century, with inequality already a very serious problem and America about eight years from crashing into its next depression, the new field of “behavioral economics” was gaining traction in academic circles.  Camerer and Loewenstein explain the theory behind behavioral economics:

Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations. * * *  At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve economics on its own terms – generating theoretical insights, making better predictions of field phenomena, and suggesting better policy. This conviction does not imply a wholesale rejection of the neoclassical approach to economics.  [12]

It is a creditable idea, certainly, to use other social sciences to refine economic analysis “on its own terms,” but behavioral economics must be limited to that objective. It should only be used to enhance economic analyses, not to justify ignoring core economic concepts and relationships.

Consequently, the intersection of behavioral economics with the economics of inequality has had disastrous consequences. When economists should have been concentrating on the macroeconomic implications of the Piketty and Saez data series, many were focusing on social and political explanations for the growth income inequality. This trend overpowered consideration of fundamental macroeconomic explanations, and in some cases led to a “wholesale rejection” of economic analysis.

In Krugman’s case, turning to behavioral economics may have been related to his contemporary view, expressed in a June 10, 2009 lecture, that most macroeconomics of the past 30 years has been “spectacularly useless at best, and positively harmful at worst.” [13] Thus, even unprovoked by some breakthrough in behavioral economics, there already had been something of a wholesale rejection of traditional macroeconomics. As the Economist smugly put it:

These internal critics argue that economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out. [14]

The Economist didn’t provide any answers either. But while the confused economics profession was waiting for the emergence of a more complete macroeconomics, the answer was not to seek behavioral and psychological explanations for why incomes and wealth are concentrating high within the top 1% while most incomes are declining, poverty is rising, and the middle class is evaporating.  But that is essentially what has happened.

Political decisions and social considerations lie behind all of economics. But “behavioral economics” is only intended to enhance our understanding of economic theories and phenomena, not to replace them.  Unfortunately, as the field of economics has been near-fatally wounded by supply-side, pixie-dust fantasies, other social sciences have moved in to replace economics altogether in the inequality debate.  But in the process of taking over the inequality debate, such models have corrupted the basic premises of behavioral economics itself.

Joseph Stiglitz focuses more directly on the underlying economic aspects of the problem of inequality growth.  With respect to institutional, political and social causes and even some of the more directly economic causes like globalization and technological change, Stiglitz politely argues:

[T]here is a growing consensus among economists that it is hard to parse out cleanly and precisely the roles of different forces. * * * To me, much of this debate is beside the point. The point is that inequality in America (and some other countries around the world) has grown to where it can no longer be ignored. [15]

We cannot ignore the basic features of the inequality engine if we hope to fix it.

JMH – 4/20/2013

_________

[1] Richard Wolff, Occupy the Economy: Challenging Capitalism, City Lights Books, SF (2012), Introduction, pp. 9-10.

[2] Wall Street is the source of our biggest problem, as “Occupy Wall Street” properly understood. But from a purely economic standpoint, the private banking system is just represents a collection of private business practices that, far more than most, enables the extraction of pure economic rent from the bottom 99%’s economy.

[3] ”The Twinkie Manifesto,” by Paul Krugman, The New York Times, Op-ed, November 19, 2012 (here).

[4] The final post in this series will show how terribly, harmfully wrong “trickle-down” really is.

[5] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012) pp. 208-230.

[6] Id. at 224. 

[7] ”Introducing This Blog,” by Paul Krugman, The Conscience of a Liberal, The New York Times, September 18, 2007 (here).

[8] Timothy Noah, The Great Divergence, Bloomsbury Press , N.Y. (2012), pp. 113-114.

[9] “Introducing This Blog,” supra.

[10] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012), Ch. 5, “The Second Gilded Age,” pp, 71-90.

[11] James Galbraith, Presidential Address, Association for Evolutionary Economics (January 5, 2013).

[12] “Behavioral Economics, Past Present and Future,” by Colin F. Camerer and George Loewenstein, CalTech and Carnegie-Mellon University, 2002 (here).

[13] “What Went Wrong With Economics,” The Economist, July 16, 2009 (here).

[14] “The other-worldy philosophers,” The Economist, July 16, 2009 (here).

[15] Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, New York and London, W. W. Norton & Company, 2012, pp. 79-80.

Fairness requires that people who make more money pay a higher portion of their incomes in taxes than people with less money. That’s called a progressive tax system, and it’s been a foundation stone of America’s tax code. [1] – Robert Reich 

Each of the seven reforms that we have described yield a double dividend: enhanced economic efficiency and increased equality. But even after we do that, large inequalities will remain, and to provide revenues for public investment and other public needs, to help the poor and the middle class, to ensure the existence of opportunity for all segments of the population, we’ll have to impose progressive taxes and, most importantly, do a better job in closing loopholes. As we’ve seen, in recent decades, we’ve been creating a less progressive tax system. [2] – Joseph Stiglitz 

In Chapter 7, we saw that tax cuts didn’t create the Great Divergence, because changes in the distribution of pretax income were much larger than changes in the distribution of posttax income. Nonetheless, the federal tax system’s ability to mitigate income inequality has diminished. * * * A more progressive tax system would increase the government’s impact on income distribution, which was (and remains) substantial. [3] – Timothy Noah  

These statements are from the latest books, all published in 2012, of three of the leading participants in the effort to save our economy from the strangulation of growing inequality. These are the most influential books on inequality coming out in 2012, but unfortunately they have left us hanging on the question of taxation.  

This is not a small matter: All three support higher taxation at the top of the income ladder, but none of them acknowledge that tax progressiveness is fundamental to controlling income and wealth distribution. The inequality cycle that has landed America in another depression began in 1980, with the expansion in the Reagan administration of the profitability of corporations. The huge reduction in taxation of the corporations and people who have received these excess profits has allowed them to keep and hoard huge chunks of the money supply, forcing the bottom 99%’s economy into an ever-worsening depression.  

What I have been saying for the better part of the past two years, but have not seen anyone else argue, is that because inequality is an ongoing process with hundreds of billions of dollars of wealth transferring to the top every year, the survival of the U.S. economy depends upon increasing taxes at the top to their former degree of progressiveness.  Vastly more taxation is needed to counter the continuous redistribution of income and wealth to the top through excess profits and other forms of economic rent. 

To attribute the need for higher taxes on top incomes only to “fairness” as Robert Reich does, and President Obama has been doing, overlooks this macroeconomic need for higher taxation at the top. Yes, tax progressiveness is a foundation stone of America’s tax system, but Reich has not yet (so far as I am aware) argued that the degree of tax progressiveness controls the degree of inequality growth, and that a certain degree of progressiveness is essential to economic survival.  To implicitly concede that tax increases at the top are not essential to growth and recovery is to implicitly grant supply-side advocates like Grover Norquist and Paul Ryan their argument that further tax reductions will not harm the economy — and their corollary argument that taxes at the top must not be increased.       

Joseph Stiglitz has presented the best analysis of income inequality to date, and he has recommended seven reforms to increase efficiency and reduce the ability of corporations and their owners to collect economic rent, all excellent suggestions.  He acknowledges that his proposals will take time to become effective, and that they will not be sufficient.   That’s important, because as the facts and analysis in the last two posts in this series suggest, the holes through which excess profits and other economic rents are siphoned to the top can only be partially plugged.

“After we do that,” Stiglitz states, “we’ll have to impose progressive taxes and, most importantly, do a better job in closing loopholes.” Although Stiglitz may not be suggesting that we actually wait until his other proposed reforms are in place before implementing tax reforms, still this hardly seems like a ringing endorsement of progressive taxation. If Stiglitz agreed with me that more progressive taxation is essential to recovery and growth, why would he argue that closing loopholes is more important than raising tax rates?  

A Paul Krugman protégé, Timothy Noah puts tax reform at the front of his list, even though Paul Krugman himself does not even mention increased taxation in his latest book as a potential factor in economic recovery and growth. [4] Noah actually does emphasize the redistribution function of income taxation:

“The income tax is . . . directly redistributive.  The government takes money from one group of people (through taxes) and then hands it over to another group (through government benefits and appropriations).” [5]

His train quickly derails, however, with his conclusion that “tax cuts didn’t create the Great Divergence, because changes in the distribution of pretax income were much larger than changes in the distribution of posttax income.”  This conclusion is both incorrect and confusing: If a more progressive tax system “would increase the government’s [substantial] impact on income distribution,” how could a less progressive tax system (reducing the top income tax rate) fail to increase income inequality? We’ll review Noah’s reasoning after we review the relationship between taxation and income inequality.

Progressive Taxation and Inequality

Once the distributional effects of taxation are recognized, the causal relationship between taxation and inequality is apparent.  Concentrating income and wealth at the top, we noted earlier, restricts consumption and demand, constricting the 99%’s economy.  That’s why we’re in a depression.  The obverse proposition is also true: Reducing the concentration of income and wealth at the top expands the 99%’s economy.  

It is worth noting that this was obvious to Keynes and others of his day.  Immediately after he started his last chapter by identifying “the failure to provide for full employment” and the “arbitrary and inequitable distribution of wealth and incomes” as the two outstanding faults of the modern market economy, Keynes remarked:     

Since the end of the nineteenth century significant progress towards the removal of very great disparities of wealth and income has been achieved through the instrument of direct taxation — income tax and surtax and death duties — especially in Great Britain. [6]

In their 2007 study, Thomas Piketty and Emmanuel Saez provided this definition of “progressive” taxation:

[A] tax system can be defined as progressive if after-tax income is more equally distributed than before-tax income, and regressive if after-tax income is less equally distributed than before-tax income. [7]  

This is an excellent definition of tax progressiveness, because it depends on more than just tax rates: Increasing tax rates at the top and/or decreasing tax rates at the bottom will tend to make taxation more progressive, but given that today all income growth is going high within to the top 1% (121% to the top 1% in 2009-2011), much depends on how government spends incremental tax revenue so as to redistribute income back down. The distribution of after-tax income would not become substantially more equal if people were effectively required to spend their money at “the company store;” for example, if a huge increase in unemployment insurance payments all had to be spent at Walmart. 

In addition to higher taxation and government spending, dynamic changes in the economy are required, including improved employment, median incomes, and small business earnings, for the economy to work its way back to a healthy income distribution.  But no amount of stimulation will work, as I will show in this blog series, without sufficiently progressive taxation to stop the bleeding.  Recovery will be much more difficult than it was for reduced tax rates at the top to aggravate inequality and cause income decline over the last 30 years, as detailed in the last two posts in this series, while both insufficiently “progressive” taxes (as defined by Piketty and Saez) and a Walmart-style excess profit machine have been at work in the economy.  Why? Because regardless whether inequality is increasing or decreasing, an unfettered capitalist economy is constantly creating more excess profits and inequality. That’s what it does; it’s the ultimate objective of every for-profit enterprise:

This graph, which I have discussed extensively in other posts, including most recently “Amygdalas Economica: Perspectives on Taxation” (here), pretty much says it all. The authors explain their conclusions regarding the information presented on the graph:

Two important lessons emerge from this panel. Considering first the top income share excluding realized capital gains which corresponds roughly to income taxed according to the regular progressive schedule, there is a clear negative overall correlation between the top 1% income share and the top marginal tax rate: (a) the top 1% income share was high before the Great Depression when top tax rates were low (except for a short period from 1917 to 1922), (b) the top 1% income share was consistently low between 1932 to 1980 when the top tax rate was uniformly high, (c) the top 1% income share has increased significantly since 1980 after the top tax rate has been greatly lowered. * * *

Second, the correlation between the top shares and the top tax rate also holds for the series including capital gains.  Realized capital gains have been traditionally tax favored (as illustrated by the gap between the top tax rate and the tax rate on realized capital gains in the figure) and have constituted the main channel for tax avoidance of upper incomes. [8]

The authors did not present regression results to show the high inverse correlations between the top tax rate and capital gains tax rate and income inequality; the close correlations are apparent on close visual inspection.  

Their explanation of inequality growth has evolved considerably since their first paper in 2001, in which they suggested: (1) that “the ‘technical change’ view of inequality dynamics [suggested by Kuznets in 1955] cannot fully account for” the U-shaped pattern of income inequality change over the century; (2) that ”the large shocks that capital owners experienced during the Great Depression and World War II seem to have had a permanent effect;” (3) that ”a plausible explanation is that steep progressive taxation, by reducing drastically the rate of wealth accumulation at the top of the distribution, has prevented large fortunes to recover fully yet from these shocks”; and (4) as for the recovery of top wage shares since they “dropped precipitously” during WW II, “we emphasize the role of social norms as a potential explanation for the pattern of wage shares.” [9]

As an initial cut at explaining the strange new income distribution patterns they had discovered, this was a creative effort.  At least they acknowledged then that progressive taxation reduces the rate of wealth accumulation — although they only focused on how “steep”  progressiveness had “drastically” reduced wealth accumulation after WW II, when the middle class was growing and American prosperity was rising. Ten years later, they no longer suggest this favoritism toward wealth accumulation, so far as I am aware, but their “social norms” explanation was still being promoted in 2012 by Paul Krugman [10] as the best explanation for income inequality growth, while he ignored the macroeconomic effects of taxation they now emphasize.    

The Piketty and Saez data show that top income shares respond immediately to reductions in the effective taxation of top incomes. The reason for this seems straightforward: reducing taxation of top incomes immediately increases the conversion of economic rent into idle wealth, depressing the active economy. The after-tax incomes of the very wealthy are immediately increased by hundreds of billions of dollars, while the bottom 99% money supply is correspondingly shrunk, as a large portion of those billions are retired from active circulation.   

In November of 2012, the Congressional Research Service (CRS) published a regression study by Thomas L. Hungerford confirming the Piketty and Saez 2011 results.  His study shows a high correlation between the top 0.1% of incomes and the top tax rates, from 1945-2010: Although the import of these results is clear, Hungerford only cautiously reported them: “The top tax rate reductions appear to be associated with the increasing concentration of income at the top of the income distribution. * * * Tax policy could have a relation to how the economic pie is sliced — lower top tax rates may be associated with greater income disparities.” [11]  Maybe. 

It is startling to see this point hedged, since everyone from Keynes to Piketty and Saez have virtually taken it for granted that taxation redistributes income. Nonetheless, the CRS withdrew this report “against the advice of the agency’s economic team leadership,” after Senate Republicans “raised concerns about this paper’s findings and wording.” [12]

Hungerford’s study also confirmed that since 1945, and especially since 1980, the average effective tax rates for the highest-income taxpayers have declined significantly: [13]

Timothy Noah’s Mistake

Timothy Noah concluded, we pointed out at the top, that  ”tax cuts didn’t create the Great Divergence (the growing income inequality over the last 30 years), because changes in the distribution of pretax income were much larger than changes in the distribution of posttax income.”  The logic chain that leads to this confusion begins this way:

[T]ax brackets, including the top one, tell you only the marginal tax rate, that is, the rate on that portion of earnings exceeding a given threshold.  The percentage of total income that you actually pay in taxes is known as the effective tax rate.  And the effective income-tax rate on top incomes, you might be surprised to learn, didn’t change all that much. [14]

Noah is correct that what matters is the effective tax rate on top incomes, because it reflects the actual impact of taxation. However, his conclusion that the effective rate on top incomes has not declined much is wrong: As shown in the previous graph from the Hungerford study, the effective tax rates of both the top 0.1% and the top 0.01% have fallen dramatically since 1980.  The Hungerford study suggests that the U.S. needs effective tax rates in the 40-45% range from its top earners (along with a restoration of former corporate earnings tax levels) to counter inequality growth. 

For the effective tax rate not to decline when the marginal top rate was being slashed would have been nearly impossible; there would have to have been a major, continuous offsetting increase in tax loopholes, over the thirty years, as the top rate declined. 

Noah got off track during his review of the study of the progressiveness of the entire federal tax system Piketty and Saez published in 2007. [15] Whether federal taxes are high enough to be sufficiently progressive to retard inequality growth is an important question, but that’s a different question than whether effective income tax rates declined when the marginal rates did.

Noah’s erroneous conclusion that effective taxes on top incomes have not declined over the past thirty years appears to stem from a source of confusion in the Piketty and Saez 2007 study.  That was a study of all income-related taxation and, as they explained, the category “corporate tax” allocates among income classes corporate retained earnings using capital gains (computed from income tax returns in their data base) as a proxy. Capital gains were therefore excluded from the computation of “individual tax” amounts to avoid a double-count. 

This graph displays for both 1960 and 2004 the cumulative effective tax rate of each of the four federal taxes included in the study, over the entire range of income classifications:

“Capital gains” are shown here as “corporate tax,” so the graph shows the effective income tax rate on top incomes, including capital gains, declining from about 50% in 1960 to about 30% in 2004.  This history is entirely consistent with both the correlation between the top marginal rates and the top 1% share Piketty and Saez identified in their 2011 study, as well as the correlation between the top effective rates and the top 0.1% and 0.01% income inequality  shown by Hungerford.

Optimal Taxation of Top Incomes

The data from the studies reported in this post indicate that it is only when the top marginal income tax rate is at or above 70% and the effective tax rates on top 0.1% and 0.01% incomes are in the 40-45% range that we have not seen rapidly rising income inequality.  A capital gains rate of at least 35% seems essential. Of course, all taxation has income and wealth redistribution effects, and it would be an oversimplification to argue that income and capital gains taxes are the entire issue. However, those are the taxes that are applied to the money that the wealthiest among us take as excess profits and other forms of economic rent, so it should not be surprising to find that the progressiveness of top income taxation is so highly, and inversely, correlated to the growth of inequality and the decline of the economy.

Inequality is about the accumulation of wealth at the top when that wealth is not taxed back down. There is a continuous accumulation of transferred wealth to the top, perpetual income inequality growth, and a continuous decline for the bottom 99% whenever taxation of top incomes and wealth is inadequate to keep this process in check.

I find these conclusions inescapable: (1) The top economic responsibility of government is to regulate income and wealth distribution, and; (2) Maintaining a sufficiently progressive tax system is its primary tool in doing so. The high correlation Piketty, Saez and Stantcheva have shown among wealthy countries between their top tax rates and their top 1% income shares confirms that this is the reality we face.

Conclusion

So far, these conclusions are not materially shared within the economic community.  Stiglitz and Reich have come closest to this position.  However, Paul Krugman, America’s most influential Keynesian, continues to ignore the macroeconomic role of taxation.  The next post will address this lingering marginalization of distribution issues and explain how it is creating confusion and muddling the debate over appropriate policy, enhancing the effectiveness of the efforts by the “trickle-down” forces to prevent the policies needed for recovery and economic health.         

JMH – 5/15/2013

______

[1] Robert B. Reich, Beyond Outrage: What has gone wrong with our economy and our democracy, and how to fix them, Random House, Inc., NY, Kindle Edition, 2012, KL1151.

[2] Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, Norton, NY, Kindle Edition, 2012, p. 273.

[3] Timothy Noah, The Great Divergence: American’s Growing Inequality Crisis and What We Can Do about It,  Bloomsbury Press, NY, 2012, pp. 179-180.

[4] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012), Ch. 12, “What It Will Take,” pp. 208-223.

[5] The Great Divergence, supra, p. 110.

[6] John Maynard Keynes, The General Theory of Employment, Interest and Money, Signalman Publishing, Kindle Edition, 2010, p. 251.

[7] “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” by Thomas Piketty and Emmanuel Saez, Journal of Economic Perspectives, Volume 21, Number 1, Winter 2007,  p. 4 (here).

[8] “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities,” by Thomas Piketty,  Emmanuel Saez, and Stefanie Stantcheva, Centre for Economic Policy Research (CEPR), DP No. 8675, November, 2011, pp. 24-25 (here).

[9] “Income Inequality In the United States, 1913-1998,” by Thomas Picketty and Emmanual Saez,  National Bureau of Economic Research (NBER), Working Paper 8467, September, 2001, p. 1 (here).

[10] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012) p. 81.

[11] “Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945” by Thomas L. Hungerford, Congressional Research Service (CRS), September 14, 2012  (here).

[12] “Nonpartisan Tax Report Withdrawn after G.O.P. Protest,” by Jonathan Weisman, The New York Times, November 1, 2012, here.  The report was subsequently updated on December 12, 2012 (here).

[13] Id.

[14] The Great Divergence, supra, p. 111.

[15] “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” supra.

We scarcely have time to congratulate ourselves on [the victory of market economics over socialism] before confronting failures like the growing concentration of economic power, growing inequality of income and especially wealth, stagnant or falling real wage rates, homelessness and beggary, chronic unemployment, growing crime rates and personal insecurity, low domestic capital formation, obsolescence in the face of rising foreign competition, dangerous dependence on foreign oil, growing recourse to the underground economy, falling literacy and educational attainments, anomie and substance addiction, rampant self-seeking and predation, falling affordability of housing, and rising social divisions leading toward class warfare.

The thesis here is that the structural flaw in capitalism is our tolerance of unearned income and wealth. The idea of free markets is that income should go to incite and reward productive activity; wealth should incite and reward saving and capital formation. Unearned income and wealth do neither. Unearned wealth today (like slave-owning in the past) actually deters saving by the fairly obvious route of satisfying the owners’ need for the security of wealth, without their actually creating any capital. – Mason Gaffney [1] 

The above recitation of capitalist “failures” by the renowned Georgist economist Mason Gaffney emphasizes the interconnection between the “growing inequality of income and especially wealth” in America and its worsening depression-like economic woes. The last post showed that over the last thirty years U.S. income has become increasingly concentrated high in the top 1%, and that the growth of income inequality has been continuous and accelerating.  It has been a broad-based trend, with income concentration growing in all sectors of the economy, especially the business and corporate sectors. Although this trend encompasses both labor and capital income, the highest concentration growth has been in capital and business income. This indicates a broad-based transfer of income and wealth to the top 1% in the normal operation of the economy, a redistribution coming mainly from an increase in corporate profits; and the data show that, although both factors are at work, the higher profits and consequent inequality are generated more by the exercise of market power to generate “unearned income and wealth” than from direct suppression of labor’s share.

The core “Keynesian” factor in the mechanism of this inequality growth identified earlier is what we used to call, back in the 1960s, the “consumption function;” this is the expression of one of Keynes’s three independent variables, the propensity to consume. However, it is not the aggregate consumption function — that is, the overall economy-wide propensity to consume — with which we are concerned: When income and wealth are redistributed to the top, as discussed in the last post, it is the materially lower marginal propensity to consume from very large incomes that drives depressed growth and contraction, and that is the major source of instability and contraction in market economies. With the new distributed income data, economists can now develop distributed propensity to consume data and distributed consumption functions, although so far as I am aware none have yet done so.  

The other core aspect of inequality growth is the removal of this redistributed income from the active economy, to be salted away as idle savings without adding to the level of production. This is where the second part of the Gaffney quotation gets to the heart of the matter: What Gaffney calls “unearned income and wealth” — i.e., money acquired beyond the amount actually needed for the provision of productive activity and capital formation — provides a near-perfect explanation of the mechanism of growing inequality.  Put another way, it is money redistributed to the top in excess of the incremental production of real value. In fact, I will venture to argue that the accumulation of “unearned income and wealth” is the inequality problem; buyers are continuously receiving insufficient real value in exchange for their money, and losing ground relative to sellers; the result is a combination of reduced  production of real value and contraction of the active money supply.  

“Political and Social” Explanations

The public and professional discussion so far about the causes of inequality  has focused mostly on “the declining labor share,” including, “changes in technology, increasing globalization, changes in market structure, and the declining negotiating power of labor.” [2] These are all aspects of the decline but, as Stiglitz puts it, the identification of such proximate causes is mostly “beside the point.” [3] Focusing on such social and structural problems is not inappropriate, but that focus distracts from an understanding of the underlying mechanism of inequality growth, which is independent of its manifestations.  

Similarly beside the point is the argument that the sudden explosion of CEO pay relative to the incomes of typical employees relates to political and social acceptability of raising executive compensation.  Paul Krugman, as noted earlier, has argued that the growth of inequality should be thought of as mainly a “political” phenomenon:

Thomas Piketty and Emmanuel Saez, whose work I’ve already mentioned, have argued that top incomes are strongly affected by social norms.  * * * [That argument suggests] that changes in the political climate after 1980 may have cleared the way for the raw exercise of power to claim high incomes, in a way that wasn’t considered doable earlier. It’s surely relevant here to note the sharp decline in unionization during the 1980s, which removed one player that might have protested huge paychecks for executives. [4]     

With all due respect to these major players in the economic debates, this logic seems unrealistic: How often have American CEOs whose corporations are greatly increasing their profits actually not considered it “doable” to give themselves substantial raises?  And how often do they decline to give themselves raises even when company earnings are declining?  More importantly, it invites inattention to (or even dismissal of) the underlying question of how changing income distribution affects aggregate income growth; the perspective nicely mirrors the characterization Keynes made of the distribution of wealth and incomes as “arbitrary” when he created a full employment model without accounting for redistribution.  

We should be looking for such social and political explanations for the skyrocketing levels of CEO compensation only if changing levels of executives’ compensation do not affect the amount they spend and save, and the amount left over for everyone else to spend and save; that is, only if income and wealth distribution lack macroeconomic significance. But that is not the case. Recall what Keynes said about the difficulty of shedding the old ideas of classical economics that he challenged: “The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” [5] Today, many mainstream Keynesian economists appear to be facing this same difficulty in dislodging the presumption built into Keynes’s General Theory that wealth and income distribution, somehow, lack economic significance. 

Such “social and political” arguments also ignore the extreme and so far successful opposition of the very wealthy in the United States to paying higher taxes on whatever they do decide to pay themselves. The better argument seems to be that their corporations are making too much money and that these top executives are, as best they can (with perhaps a few exceptions), keeping as much of these excess earnings as possible. The following chart of major countries, plotting their top 1% income share against their top marginal tax rate in 2004-2008, was published by Piketty and Saez themselves: [6]   

Compared with top executives in other countries, this chart shows that in the years leading up to the Crash of 2008, the wealthy elite in the United States better overcame whatever reservations they might have had about increasing their incomes, and they succeeded more than the wealthy in those other countries in minimizing their marginal income tax rate (and hence their effective tax obligations).

The Reagan Revolution

The political and social factors affecting executive compensation and the institutional factors affecting labor’s share are certainly real, but I suggest we think of them as “secondary causes” — i.e., factors that come into play only as a consequence of, or independent of, these “primary causes” of increasing inequality and declining growth and prosperity. The 30-year decline in growth and prosperity was the direct result of two broad policy initiatives initiated during the Reagan Administration:

(1) Deregulation of business and finance, which allowed corporations to increase their profits and the wealthiest Americans to increase their incomes; and

(2) Reduced taxes on top household incomes and corporate earnings, which allowed the wealthiest Americans to keep a greater share of their higher incomes and accumulate greater wealth.

Certainly no set of policies could have been better designed to maximize inequality growth and minimize overall income (GDP) growth.  The next post will focus on taxation, and the balance of this post will focus on the elusive concept of “excess profit” or excess return to capital, a.k.a. “unearned income.”

“Unearned” Income and Wealth

How do we know when the wealthiest people are making and keeping too much money? When the time came to discuss that issue, Keynes offered only this:

For my own part, I believe that there is social and psychological justification for significant inequalities of incomes and wealth, but not for such large disparities as exist today. There are valuable human activities which require the motive of money-making and the environment of private wealth-ownership for their full fruition. * * * It is better that a man should tyrannize over his bank balance than over his fellow-citizens; and whilst the former is sometimes denounced as being but a means to the latter, sometimes at least it is an alternative. But it is not necessary for the stimulation of these activities and the satisfaction of these proclivities that the game should be played for such high stakes as at present. Much lower stakes will serve the purpose equally well, as soon as the players are accustomed to them. [7]

Beyond rejecting Marxist socialism, Keynes found no way to identify what might be insufficient inequality to motivate innovation and growth, and what would be too much inequality. His statement is reminiscent of the famous comment by Justice Potter Stewart in a concurring opinion in a 1964 obscenity case: “I know it when I see it.” [8]    

Today, with the income distribution of a century available, we can now do better than that. We have already seen that when inequality becomes too great, the economy is driven into a depression and everyone, except for the hyper-rich, are doing worse.  Disparities as great as that are clearly unacceptable.  A more precise standard lies in the concept of “economic rent,” which consists of payments for which no new value is created, including all unearned income and excess profits.  Stiglitz identifies the connection between economic rent and inequality:

[M]uch of the inequality in our economy was the result of rent seeking. In their simplest form, rents are just redistributions from the rest of us to the rent seekers.* * What is striking is the prevalence of limited competition and rent seeking in so many key sectors of the economy. [9]

Stiglitz’s new book is the first to broadly associate inequality growth with economic rent since the American economist Henry George published Progress and Poverty in 1879, two depressions and 133 years earlier.  George observed that “current political economy cannot explain why poverty persists in the midst of increasing wealth,” [10] George’s perceptive insight that the collection of “unearned” returns creates inequality provides a crucial factor still missing from mainstream theory:  Transfers of economic rent to the top converts money that could otherwise be used for productive activity into idle wealth.  When money (e.g., the unearned income of hedge fund managers) is redistributed upward without producing new value, resources are idled and growth is retarded.  Stiglitz elaborates:

To put it baldly, there are two ways to become wealthy: to create wealth or to take wealth away from others. The former adds to society. The latter typically subtracts from it, for in the process of taking it away, wealth gets destroyed. A monopolist who overcharges for his product takes money from those whom he is overcharging and at the same time destroys value. To get his monopoly price, he has to restrict production. * * * Today, over a century after the railroad barons dominated the economy, much of the wealth at the top in the United States – and some of the suffering at the bottom – stems from wealth transfers instead of wealth creation. [11]

If we define “excess earnings” as “profit” — i.e, all payments for goods and services in excess of their cost — then all excess earnings are economic rent.  Given that the primary objective of most corporations in a capitalist, market-based economy is to maximize profit, the objective of capitalism in effect is to maximize economic rent.  Thus, it is the profit motive that makes instability and decline basic features, as we have been discussing, built into the capitalist market system.  

Expanding Market Power

Since 1980, excess earnings have been enabled and expanded throughout the economy by lax anti-trust law enforcement, relaxed essential industry and financial transaction regulation, control of government contracting, and a new corporate culture that values financial gain over productivity and employment. These developments are well documented. [12] Barry Lynn gives a typical example of one of the most important trends, the concentration of market power in mega-corporations like Exxon Mobil, General Electric, Monsanto or Walmart:

Until we elected Ronald Reagan president, both Democrats and Republicans made sure that no chain store ever came to dominate more than a small fraction of sales in the United States as a whole, or even in any one region of the country.  Between 1917 and 1979, for instance, administrations from both parties repeatedly charged the Great Atlantic and Pacific Tea Company, the chain store behemoth of the mid-twentieth century that is better known as A&P, with violations of antitrust law, even threatening to break the firm into pieces.  Then in 1981 we stopped enforcing that law.  Thus, today Wal-Mart is at least five times bigger, relative to the overall size of the U.S. economy, than A&P was at the very height of its power (citation). Indeed, Wal-Mart exercises a de facto monopoly in many smaller cities, and it sells as much as half of all the groceries in many big metropolitan markets. [13]

The assumptions of classical economics that ensure a supply price for any product or service equal to its cost (i.e., there is no profit) are perfect competition and perfect knowledge.  These are the conditions necessary for absolutely efficient markets.  Of course, these conditions have never been met in the real world, and there are many things capitalist firms can do to thwart market efficiencies, enabling them to charge above-cost prices.    

One important point of intersection of Georgist and Keynesian theory lies with the “cost of capital,” a concept that has for decades been implicit in my profession, utility rate regulation.  Rate regulation is intended to provide a substitute for competition in the case of providers of essential services like telephone, natural gas, electric or water services. These are industries where monopolistic market power could easily produce excess earnings, if the firms are allowed to charge whatever they wish for the essential services they provide. Rates are set to include all of a company’s reasonable costs, including their costs of capital.  

Any excess of earnings above a regulated firm’s cost of capital would be “excess profit,” i.e., economic rent, and for decades, in the U.S., monopoly providers of regulated services have been allowed to charge rates that would allow no more than a reasonable opportunity to achieve earnings sufficient to attract equity capital in the financial markets – i.e., to earn their “cost of capital,” or the “fair rate of return” — while providing high quality service. This cost of capital is equivalent to one of the three independent variables in Keynes’s model — the “marginal efficiency of capital.” It is, in theory, the present value of all expected future returns on the common stock of regulated firms, and it is the cost of capital Keynes identified, across an entire economy, for full employment and growth.  

In a “rate case” the monopoly provider of regulated service justifies all of its costs, including labor and management compensation. Federal and state commissions charged with rate regulation have designed rates to allow for reasonable levels of executive and management compensation as part of the cost of providing good service.  Firms charging regulated rates can contribute to income inequality in their actual operation, however, by increasing executive compensation while cutting back on other operating costs.  It appears that the effectiveness of rate regulation has declined in recent years in this respect; for example, in the case of electric service:

Over a decade of deregulation, the frequency and duration of outages has crept up, maintenance of aging infrastructure has been deferred, line workers have been laid off — and CEOs’ salaries have risen an average of 150 percent nationwide, a Hearst Newspapers investigation has found. [14]

However ineffective the laws designed to promote competition and the minimization of monopolistic market power (anti-trust laws), or reasonable prices for service provided by natural monopolies (rate regulation) may have recently become, they do at least provide theoretical benchmarks for avoiding the severe growth of inequality witnessed in the United States over the last three decades.

Wealth Transfers

It is difficult to estimate the amount of wealth that has transferred to the top over the last 30 years.  The data provided by Edward N. Wolff, a leading authority on U.S. wealth distribution, [15] shows not only that wealth inequality was considerably higher than income inequality in 2007, but that the concentration of wealth at the top has not changed much over the last 30 years:

Top 1% Share

                    Year                                             Income             Net Worth     Non-Home Wealth                                        

                1983 (1982 for income)              12.8%                   33.8%                   42.9%

                2007 (2006 for income)            21.3%                   34.6%                   42.7%          

                2010                                                                            35.5%                   42.1%  

At the beginning of the Reagan Administration, significant income and wealth concentration already existed in the United States, and the top 1% owned about 43% of financial (non-home) wealth.  The concentration of reported wealth did not change much thereafter, despite a near doubling of the top 1% share of income.  The question arises, with the top 1% income concentration nearly doubling, why hasn’t wealth concentration increased noticeably?  

One part of the answer may be that because net worth is much greater than GDP (nearly four times larger in 2010), its rate of change in response to income inequality should be much lower; note, however, that since the Crash of 2008 U.S. wealth inequality data has begun to show some material growth. Another part of the answer appears to be that much of U.S. top 1% wealth in recent years is not reflected in these data because it is held in “offshore” accounts, a matter that in 2012 began to attract a great deal of new attention. [16] Thomas Piketty has observed: 

So far, we have not taken this (offshore money) into account in the World Top Incomes database.  We tried always to be very clear that [our results are] certainly a lower bound, not only for the level of inequality, but probably for the trend as well. [17]

This important topic needs more attention.

Conservatively assuming that the top 1% share of net worth has been a constant 34% (although according to the Wolff data it rose to 37-38% from the mid-1980s to the late 1990s), using Census Bureau net worth data and the GDP deflator provided by St. Louis Fed. Research, I have computed that the top 1% share of net worth, in 2010 dollars, grew about $11.8 trillion from 1982 to 2010.  According to census data, there were about 306 million people in 2010 in the bottom 99% of the U.S. population.  In 2010 dollars, this works out to a transfer from the bottom 99% to the top 1% of about $38,560 per capita. That’s nearly $1,400 annually of per capita economic rent, or “excess earnings,” going to the top 1%.

Conclusion

Governments in the U.S. cannot regulate the rates of all monopolies or near-monopolies, and it is impossible to prevent the taking of “excess earnings.”  The amount of reported wealth transfers to the top 1% since 1980 is startling and, quite frankly, sobering. This enormous redistribution of wealth from the bottom 99% has already caused substantial damage, and the process continues. The ultimate and crucial question is this: What are the basic income and wealth distribution requirements for U. S. survival? Fortunately, a market-based society can regulate the amount of excess earnings it allows the wealthy to keep: It can tax them back down.  But it must have the intelligence, and the will, to do so.

______

[1] “’Capital’ Gains and the Future of Free Enterprise,” by Mason Gaffney, Workpapers, rev. December, 1991 (here).

[2] The 2013 Economic Report of the President, p. 60 (here).

[3] Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, New York and London, W. W. Norton & Company, 2012, pp. 79-80.

[4] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012) pp. 81-82.

[5] John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1935, New York and London, Harvest/Harcourt, Inc., 1953, 1964 ed., 1991 printing, Preface, p. viii.

[6] “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities,” by Thomas Piketty,  Emmanuel Saez, and Stefanie Stantcheva, , DP No. 8675  (CEPR, November, 2011) (here), p. 50.

[7] The General Theory, supra, p. 374.

[8] Concurring Opinion in Jocobellis v. Ohio, 378 U.S. 184 (1964).

[9] The Price of Inequality, supra, pp.96-97.

[10] Henry George, Progress and Poverty, San Francisco 1879, Bob Drake, editor,  the Robert Schalkenbach Foundation, Fourth Edition, New York 2006, p. 28.

[11] The Price of Inequality, supra, p 32.

[12] See, e.g., Nomi Prins, It Takes a Pillage, John Wiley & Sons, NJ (2009); Jacob S. Hacker and Paul Pierson, Winner-Take-All Politics, Simon & Schuster, NY (2010); Barry C. Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, Wiley & Sons, NJ (2010); see also David Cay Johnston, The Fine Print, Penguin Group, NY (2012), and Free Lunch, Penguin Group, NY (2007).

[13] Cornered, supra, p. 6.

[14] “An industry in disconnect,” by Eric Nalder , Albany Times Union, January 13, 2012 (here).

[15] “Recent Trends in Household Wealth in the United States: Rising Debt and the Middle-Class Squeeze – an Update to 2007,” by Edward N. Wolff, Working Paper No. 589, Levy Economics Institute of Bard College, March 2010, p. 3 (here); 2010 data reported in “Wealth, Income and Power,” by G. William Dumhoff (here).

[16] See, e.g., ”The Price of Offshore Revisited: New Estimates for Missing Global Private Wealth, Income, Inequality, and lost taxes,”  by James S. Henry, the Tax Justice Network, 2012 (here) and “Wealth doesn’t trickle down  - it just floods offshore, research reveals,” by Heather Stewart, The Observer, July 21, 2012 (here); Paul Buchheit argues from the TJN study that an estimated $8-12 trillion of U.S. money could be “stashed in far-off hiding places” — “Ten Numbers the Rich Would Like Fudged,” by Paul Buchheit, Common Dreams, November 19, 2012 (here).

[17] “Inequality: You Don’t Know the Half of It,” by Nicholas Shaxson, John Christensen and Nick Mathiason, The Tax Justce Network, July 22, 2012, pp. 10-11 (here).

The Growth of U.S. Income Inequality

The United States has the highest level of income inequality among wealthy nations, and the highest level of correlated health and social problems, both by wide margins. [1]

This status was achieved by the United States over three decades during which the bottom 99% lost one-fifth of its share of total income (GDP).  As shown on the graph of the Piketty/Saez data shown in the previous post, the percentage of total GDP taken by the top 1% of income earners increased from 8.9% to 23.5% between 1976 and 2007, for a 14.6% reduction in the bottom 99%’s  share of total income. [2]  Total GDP in 2007 was $13.8 trillion, so the bottom 99% was getting $2.0 trillion less that year than if income were distributed as it had been in 1976.  That lost income averages, among the 111 million estimated 2007 U.S. households, $18,300 per bottom 99% household. And this considerable loss of the buying power of most Americans took place before the 2008 crash.

Over these three decades, income inequality has skyrocketed.  Some examples: from 1979 to 2007, total top 1% real household pre-tax income grew by 224%, and top 0.1% real household pre-tax income grew by 390%, while the entire bottom 90%’s real income grew by only 5%; [3] the multiple by which average corporate CEO pay exceeds a typical worker’s income rose from 42 times in 1980 to 343 times in 2010; [4] and in 2006 a group of 25 hedge fund managers “made three times as much money as [all of] the eighty thousand New York City schoolteachers.” [5]

Near the bottom, the 2009 median real incomes of Americans with high school diplomas ($32,900 for men and $25,000 for women in 2009) were below the poverty threshold for a household of eight ($35,300), while the median real incomes of college graduates ($51,000 for men and $40,000 for women in 2009) were only marginally above that poverty threshold; [6] when median incomes of college graduates are adjusted to net out the average cost of a college education, the 2009 median income for a female college graduate (about $35,000) was also below the $35,300 poverty threshold for a household of eight. [7] 

These remarkable statistics on increasing income inequality only begin to convey the true enormity of the distribution problem.

Inequality and Growth

As Kuznets anticipated, this significant contraction of the bottom 99% economy necessarily entails an extreme reduction of overall growth. Total per capita income grew 90% over the first of two comparable 30-year periods (1946-1976), but only 64% over the following 30 years (1976-2006). [8] Here is the distribution of average annual real income growth published by both the Economic Policy Institute and the President’s Council of Economics Chairman Alan Krueger: [9]

                              1947 to 1979                1979 to 2010

Lowest fifth                     2.5%                                -0.4%

2^nd fifth                            2.2%                                  0.1%

Mid fifth                           2.4%                                  0.3%

4^th fifth                             2.4%                                  0.6%

Top 5^th                              2.2%                                  1.2%

Why would rising income inequality cause overall income growth to decline?  The salient observation was made by Joseph Stiglitz, as quoted in the last post: “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.” Accordingly, as income becomes more concentrated at the top, aggregate consumption and income growth necessarily decline.

Because income inequality growth is a systemic problem, it has no natural tendency to correct itself or stabilize.  Indeed, the U.S. income contraction is now accelerating. All growth has ceased except within the top 1%. Saez reports [10] the following figures for the allocation of income growth between the top 1% and the bottom 99%:

Period                                        Top 1%                 Bottom 99%

1923-1929                                 70%                                     30%

1960-1969                                   11%                                   89%

1992-2000                                  43%                                   57%

2002-2007                                  65%                                   35%

2010                                               93%                                     7%

2009-2011                                  121%                                  -21%

The 65% top 1% share of income growth from 2002-2007 (before the Crash of 2008) is comparable to the 70% of growth that went to the top 1% in 1923-1929 before the Great Depression.  The 121% top 1% growth in 2009-2011 means that the only growth now taking place is high within in the top 1%.  This is reflected in the near-exponential inequality growth within the top 1%: [11] 

       Group           2010 share     2010 ave. income     2010 over 1980

Top 1%              19.8%                  $1,019,098               2.36x

Top 0.1%            9.52%               $4,906,513                3.34x

Top 0.01%         4.63%             $23,846,950                4.32x

Income concentration in the top 0.01% is now accelerating, and virtually the entire rest of the economy is losing ground.

Small Business Income 

Most of the discussion about inequality so far has focused on the reasons for labor’s declining share. The 2013 Economic Report of the President, for example, reports: “Proposed explanations for the declining labor share in the United States and abroad include changes in technology, increasing globalization, changes in market structure, and the declining negotiating power of labor.” [12] 

Direct labor share suppression is important, but except for the lowest quintile, it is a relatively minor part of the problem.  Lower 99% capital suppression — the suppression of small businesses within the middle class — is a bigger factor.  The bottom 99% has unavoidably experienced a severe decline in capital income as well as labor income.   

A 2011 Congressional Budget Office study of the major income sources [13] shows corporate and small business income concentrating faster than labor income from 1979-2007. “Corporate” income refers to the gains from distributed earnings of large corporations.  “Business” income refers to the earnings of small businesses —  partnerships and smaller,  apparently mostly privately held, corporations.  

The increase in the top 1% share of corporate income is not surprising, since the top 1% share of total income has been at or below 24% while the top 1% has held 42% or more of financial wealth over these three decades. But the concentration of small business income, which was also more highly concentrated in 1979,  also grew far more than the inequality of labor income: The top 1% share of small business income grew from less than 20% to more than 45% over these years.  

This shifting of small business income to the top 1% reflects the decline of local small businesses and of the middle class in general, as large corporations like Walmart have acquired their retail market shares.  Mega-corporations like Walmart and Home Depot have   consolidated their market power in producer, wholesale and and retail markets as they grew through mergers and acquisitions, after the demise of anti-monopoly law enforcement that began in earnest in 1980. [14]  

The most highly concentrated income source is capital gains, of which 75% were going to the top 1% by 2007.  Thus, while the bottom 99% income share plunges in 2013, many corporations have reported all-time record profits, and the stock market has posted all-time highs.  

Stagnation

In 2009, Paul Krugman wrote: “Over the past year, by a number of measures, the world has experienced a slump every bit as severe as the first year of the Great Depression.” [15]  A “depression” is an abnormally severe downturn lasting more than a few months, and the so-called U.S. “Great Recession” is now more than four years old.

With the steady contraction of the bottom 99% economy since the 1970s, not surprisingly, recessions have progressively become deeper and longer-lasting.  Using its Payroll Employment Index (PEI), the Bureau of Labor Statistics has charted the length and severity of the last six recessions: [16] 

By that measure, the latest downturn, which began in September 2008, is by far the worst since WW II. [17] Employment bottomed out in January 2008, two years into the “Great Recession,” with a -6.4 “percent job loss from peak,” and it has gradually improved since. But the economy must add 200,000 new jobs per month for employment to return to the pre-recession peak, not counting the additional new jobs needed for normal growth, [18] by February 2016, 6.5 years after the “Great Recession” began.

Although 181,000 jobs were added in January 2013, and over 200,000 in February, only 88,000 jobs were added in March.  The media focus has been on whether the contraction resulting from the $85 billion federal spending cuts mandated by the March 2013 “sequestration” has begun to kick in.  Regardless, severe sequestration impacts are expected, ranging from the CBO forecast of a 750,000 job reduction in 2013 [19]  to an Aerospace Industries Association (AIA) projection of 2.14 million job losses in FY 2012 and 2013, nearly half of which “would come from small businesses.” [20]  According to the AIA study, “the unemployment rate will climb above 9 percent . . . reducing the projected growth in 2013 by two-thirds.”

Many economists focus on the gradual decline of the unemployment rate (7.6% in March 2013) as a sign of gradual recovery to “normal,” but even mainstream media has reported that the “participation rate” – the percent of non-working people actively looking for work – has fallen to the lowest level since 1979.  It has become impossible to predict when, if ever, 2007 job levels will be restored.  

(May 3 update: I’ve added following graph to clarify this point:

The New York Times on Friday, May 3, reported that the unemployment rate had fallen to 7.5% in March. [21] But in a companion article, “Keeping Up, Not Getting Ahead,” the point illustrated by this graph of BLS data was made: “The American economy continues to add jobs in proportion to population growth. Nothing less, nothing more.” [22] In terms of the share of adults with jobs, there has been no improvement in three years and there is no apparent prospect in this trend of returning to the pre-depression level of the share of adults with jobs by February, 2016.)  

Perpetually high unemployment, however, is only part of the stagnation problem: As unemployment rose sharply in 2010 from about 5% to 10%, the median income fell by 10% during 2010 and 2011. [23] Reduced pay rates and hours worked translate into reduced income and growth, and less job creation. Other signs of growing depression since 2010 — reports of which are becoming increasingly common as 2013 unfolds — include growing poverty, an increasing foreclosure rate, declining construction and infrastructure, reduced educational opportunity and mobility, downsizing and closure of schools and essential government services, and the decline and bankruptcy of cities, towns and small businesses. 

Conclusions 

This review of the last thirty years of growing income inequality in the United States makes several things abundantly clear:

(1) Income distribution has enormous economic significance.  By 2007, the declining income share of the bottom 99% had reduced its purchasing power by $2 trillion per year, more than $18,000 per lower 99% household.  After the Crash of 2008, median income tumbled another 10% while unemployment jumped to 10%.  (I have mentioned without documenting other important indicia of depression, because we are all becoming increasingly aware of them, and a detailed review is beyond the scope of this post.) Declining purchasing power means lower consumption, and the lesson of Keynesian macroeconomics is that means lower investment and economic contraction;

(2) This is a destabilizing contraction: The faith of economists discussed in the previous post that a market economy will eventually return to full employment on its own is baseless.  The ever-widening income gap, and an accelerating growth of inequality, confirm that whatever stabilizing forces are imagined to exist, or that might exist if the problem was simply temporary swings in the “propensity to consume” out of a stable level of income, truly do not.  Recessions have become progressively worse since 1980, and we’re now in a depression with no end in sight;

(3) The increase in income inequality is directly linked to a severe decline in income growth which, as discussed in more detail in the next post, can only be explained by the removal of vast sums of money from the active economy of the bottom 99% and sequestered (as inactive wealth) within the top 1%. Moreover, over time the destination of the wealth transferred up from below has narrowed to individuals very high up within the top 1%, possibly mostly within the top 0.1%-0.01%.

The contraction of demand and income growth inherent in growing income inequality make it clear that the appearance of another depression has been no coincidence.  There are effectively two economies now, a “providing” economy and a “taking” economy, and the reports of aggregate income and other aggregate data, as Simon Kuznets warned back in 1955 (and as Joseph Stiglitz warns today), have become all but useless.  

The next post takes a closer look at theoretical aspects and policy ramifications of the inequality problem: Since vast quantities of money are now being siphoned up from the bottom 99% and a portion of the lower end of the top 1%, the proper response is not to stimulate demand through expansionary fiscal policy. When inequality is rapidly growing, that hasn’t worked.  People whose income share is declining have insufficient demand because of their inadequate and declining purchasing power; therefore, increasing government spending without correcting the causes of inequality growth can’t reverse the decline and stimulate growth.           

JMH – 4/29/2013; updated 5/3/2013; conclusion clarified 5/4/2013

______

[1] Richard Wilkinson and Kate Pickett, The Spirit Level, New York, Bloomsbury Press (2010).  The indexed health and social factors include life expectancy, math and literacy, infant mortality, homicides, imprisonment, teenage births, trust, obesity, mental illness (including addiction) and social mobility.  Wilkinson and Pickett also studied the individual relationship of the various factors to income inequality.  The measure of income inequality was the ratio of top and bottom 20% (quintile) average incomes, which shows a much less pronounced inequality level than the 1%/99% ratio.  These results have not been widely criticized, but not successfully challenged.

[2] See, e.g., “Income Inequality In the United States, 1913-1998,” by Thomas Picketty and Emmanual Saez, Working Paper 8467 (National Bureau of Economic Research, September 2001) (here);   “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” by Thomas Piketty and Emmanuel Saez, Journal of Economic Perspectives, Volume 21, Number 1, Winter 2007,  pp. 3–24 (here);  and “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities,” by Thomas Piketty,  Emmanuel Saez, and Stefanie Stantcheva, , DP No. 8675  (CEPR, November, 2011) (here).

[3] Economic Policy Institute (EPI) analysis of Piketty/Saez data (2008); “Snapshot: Incomes rising factest at the top,” by Arin Karimian, The EPI blog (October 20, 2011) (here).

[4] AFL-CIO study, reported at “CEOs earn 343 times more than typical workers,” by Jennifer Liberto, CNN Money (April 20, 2011) (here).

[5] Paul Krugman, End This Depression Now!, New York & London, W.W. Norton & Co. (2012), p. 82.

[6] These conclusions are based on a study I conducted in 2012 of trends in income levels for men and women with and without college and advanced levels of education.   Income data are from from Fast Facts, Institute of Education Sciences (IES), National Center for Education Statistics (here);  Poverty threshold data (updated for inflation) are from the U.S. Dept. of Commerce, Bureau of the Census (here).

[7] I used present value computations from a study by Skidmore economist Sandy Baum, U.S. News and World Report, October 30, 2008 (here).

[8] “Average Income in 2006 up $60,000 for Top 1 Percent of Households, just $430 for bottom 90 Percent: Income Concentration at Highest Level Since 1928, New Analysis Shows,” by Chye-Ching Huang and Chad Stone, Center on Budget and Policy Priorities (CBPP), rev. October 22, 2008 (here); “A guide to Statistics on Historical Trends in Income Inequality,” by Chad Stone, Danilo Trisi and Arloc Sherman, CBPP (rev. October 23, 2012) (here).

[9] EPI (updated, October 5, 2012); “Family Income Growth in Two Eras,” by Alan Krueger, Reuters, January 13, 2012 (here).

[10] “Striking it Richer: The Evolution of top incomes in the United States”, by Emmanuel Saez, March 2, 2012 (here); updated with 2011 estimates , January 23, 2012 (here).

The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes. – John Maynard Keynes [1]   

It was late in 2010 when I first saw a version of this graph showing changes in the share of total U.S. pre-tax income for the top 1% of incomes from 1913-2007. [2] It shows the top 1% share peaking in 1928 at 23.9%, one year before the stock market crash of October 29, 1929 ushered in the Great Depression.  Following WW II, that share gradually declined for three decades as prosperity grew, from 12% in 1946 to a low of 8.9% in 1976.  Then in 1980 the trend abruptly reversed and the top 1% share grew over the next three decades to 23.5% in 2007, one year before America’s worst-ever stock market crash on September 20, 2008 ushered in the “Great Recession.”

This kind of graph, and this kind of data, are new to economists, most of whom had not previously paid any attention to income distribution.  There has been a delayed response to the emergence of this data: It was not until 2012 that some of the most prominent U.S. economists even began to weigh in publicly on whether this correspondence between high income inequality and stagnation is more than just coincidental:  Nobel Laureate Paul Krugman, who did not address income inequality in his previous book on depression-era economics, [3] said this in his latest book, published in May of 2012: “The fact that a return to pre-Depression levels of inequality was followed by a return to depression economics could be just a coincidence.” [4] In his view, “rapidly rising incomes at the top” reflect “the same social and political factors that promoted lax financial regulation.” [5] Two months later, in his new book on inequality, fellow Nobel Prize winner Joseph Stiglitz remarked:  “It is perhaps no accident that this crisis, like the Great Depression, was preceded by large increases in inequality.” [6] Unlike Krugman, Stiglitz links inequality growth to aggregate demand and to overall income growth. 

The underlying question is whether the distribution of money within populations has macroeconomic significance, and the abundance of caution shown by economists in addressing that question shows how profoundly the emergence of detailed income distribution data has changed their world.  Phrasing these questions conversely may make them easier to answer: How could the amount of money most people possess lack macroeconomic significance? If income and wealth distribution does have material economic significance, how could the association of high inequality with depression be a coincidence?  

This graph reveals a close correspondence between growing income inequality and stagnation that was previously invisible: the growth of inequality was overlooked for years, because aggregate income (GDP) data hide income redistribution between the top 1% and the bottom 99%.  The income share data reveal a steady contraction of the bottom 99%’s share of the economy since 1980, suggesting that the increased concentration of income and wealth within the top 1% is related to the market crash in 2008 and the even worse decline that followed.  It further suggests that, unless the causes of this continuing inequality growth are reversed, the U.S. economy is headed inevitably for Great Depression II.  Hence, there is an urgent need to understand how inequality affects growth and prosperity.

As a career practitioner of regulatory economics, required by law to limit utility earnings to “reasonable returns” on investment, my initial impression was that excessive corporate profits have resulted in greater allocations of income and wealth to the top 1%, leaving too little money for everyone else.  Although that explanation is essentially correct, it has not been obvious to most economists.  

Those of us learning economics in the early 1960s were taught that Keynes had solved the depression problem, but as discussed in the previous post, Keynes’s General Theory took no account at all of wealth and income distribution, which he described in the above quotation  as “arbitrary.” Keynes’s “General Theory of Employment” included only determinants of demand and investment: (1) the interest rate; (2) the economy-wide “propensity to consume”; and (3) the “marginal efficiency of capital” (which is equivalent, over an entire economy, to the “cost of capital” used to set rates on regulated services).  

As noted in the previous post, Keynes expressly assumed that optimal demand would produce full employment, and that maintaining full employment would solve the “poverty” problem. But importantly, in Keynes’s model the levels of demand, employment, and investment do not depend in any way on the distribution of income and wealth; aggregate income (GDP) does not change with growing inequality. Accordingly, virtually all Keynesians have since ignored distribution presuming, as the Keynesian model effectively requires them to do, that growing inequality lacks macroeconomic significance.

One distinguished economist, however, believed otherwise.  When income inequality was falling in the 1950s, Nobel laureate Simon Kuznets, though hampered by an “extreme scarcity of relevant data,” argued insightfully that income distribution is a key determinant of growth:

Without  better knowledge of the trends in secular income structure  and of the factors that determine them, our understanding of the whole process of economic growth is limited; and any insight we may derive from observing changes in countrywide aggregates over time will be defective if these changes are not translated into movements of shares of the various income groups. [7] 

The data Kuznets (and Keynes) lacked is available today, however, and it offers a more complete understanding of how market economies work.

Instability and Growth

Keynes understood market economies to be inherently unstable, always tending toward decline and unemployment, and his explanation for this tendency revolutionized economics:  classical theory assumed that following a downturn an economy would always return to full employment “equilibrium” as savings and investment equilibrate; however, in a dynamic economy capital investment and job creation depend on expectations of future demand, and expected future returns on investment, which typically decline with falling consumption; thus, a decline in consumption leads to less, not more, investment and employment:

A decreased readiness to spend will be looked on in quite a different light if, instead of being regarded as a factor which will [all else equal] increase investment, it is seen as a factor which will [all else equal] diminish employment. [8] 

The central government could counter such slumps, Keynes argued, by stimulating demand and growth with monetary policy (lowering interest rates) or fiscal policy (deficit spending).

This “demand-side” explanation of how markets work, as the distinguished macroeconomist and Nobel Laureate James Tobin put it in 1997,  implies that “our market capitalist economy, left to itself, without government intervention,” does not “systematically return, reasonably swiftly, to a full employment state whenever displaced from it.” [9] Since the 1970s, however, mainstream economics has retreated back into the classical model, rejecting that conclusion:  “Most economists believe that a market economy is a self-correcting system,” Clifford W. Cobb wrote in 2009, [10] and James Galbraith recently concurred:

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. [11]

This dubious faith in an automatic return to full employment after a typical fluctuation in spending on consumption or investment, such as a mild recession, denies that the instability of growth Keynes identified as resulting from such fluctuations in demand will be anything but temporary.  As such, this view, especially when motivated by a desire to minimize central government action through fiscal or monetary policy, retreats to the classical theory’s assumption of automatic adjustment to full employment equilibrium.  

According to Tobin, whether modern capitalist economies, left on their own without government supervision, “systematically return, reasonably swiftly, to a full employment state whenever displaced from it,” is one of “the central questions before economists of our generation.”  [12]  As Cobb and Galbraith suggest, Keynes’s negative answer to that question has apparently been rejected by most economists.

Introducing the Inequality Factor   

That is unfortunate, for the instability created by normal fluctuations in demand and investment, self-correcting or not, is only a minor aspect of the instability problem.  The entire debate over The General Theory ignores the far more substantial effects of growing inequality. Inequality results from structural changes in an economy — such as the development of monopolistic market power, the decline of trade unionism, or the effects of technological change — that affect income levels and wealth accumulation.  Unlike aggregate demand, these factors do not appear to have arguable cyclical or ebb-and-flow tendencies; the consistently unfailing purpose of capitalism is to maximize profits.  

Growing income inequality also causes aggregate demand to decline. As Joseph Stiglitz explained:

[W]hen money is concentrated at the top of society, the average American’s spending is limited. * * * 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. [12]

Thus, when money transfers to people in the top 1% who have the lowest propensity to consume, the growing concentration of income itself reduces consumption and growth. People in the bottom 99% end up spending less not because they decide to spend less, but because they have less money to spend.  A depression, with its massive unemployment, poverty, and starvation, cannot be explained as an aggregate decision by the vast majority of households to reduce their consumption.  And because the distributional instability problem is declining income, not declining demand, its solution will be found not in Keynesian policies designed to stimulate demand and investment, but in measures that will reverse the growth of inequality.  

Keynes’s General Theory and demand-side model did provide part of the explanation for instability and stagnation, and that was an important first step.  But the second step — recognition of the inherent tendency of unfettered capitalism toward an unstable distribution of wealth and incomes — is far more important. Paul Krugman’s characterization of distribution issues as “social and political” is more semantic than real — all economic questions are fundamentally social and political in nature. But to dismiss distribution issues this way begs the questions posed by growing inequality: What happens when more and more of an economy’s money — its income and wealth — is transferred into the hands of a progressively smaller group of people? Why has so much money been transferring up over the last three decades? What are the transfer mechanisms, how are they created, and how can they be controlled?   

The answers to these questions reveal a major, and stunning, flaw in Keynes’s model. Recall this premise to Keynes’s model, cited in the previous post:

[T]he national income depends on the volume of employment, i.e. on the quantity of effort currently devoted to production. . . [T]here is a unique correlation between the two.  [14]

As discussed, Keynes intended to specify in his model the most important determinants of aggregate income, and his system of recommendations for government action is based upon using his model’s three determinants to maximize income (GDP).  As this quotation reveals, his approach depends on the assumption that “the national income” represents “the quantity of effort currently devoted to production.”  In other words, his model assumes that all income is compensation for actual production, for the creation of real value. This amounts to the assumption that there is no collection of excessive income or accumulation of extraordinary wealth by people at the top for which no real value has been created — i.e.,  that there is no collection of “economic rent.”  As discussed in a later post in this series, the collection of massive quantities of economic rent lies behind the inequality crisis.  This is the primary engine driving inequality growth and stagnation, and it explains why the Keynesian model fails to work.     

Not surprisingly, the newly available income share data reveal that traditional Keynesian demand stimulation offers both an inadequate level of response and the wrong kind of response to rising income inequality.  As income growth concentrates more and more at the top, even carefully targeted deficit spending may do little to counter the upward redistribution of wealth, and it will likely have minimal effect on the continuous and accelerating concentration of U.S. income.  

To determine the best policies for the United States today, it is necessary first to review the scope and nature of American inequality growth over the past thirty years.  The next post in this series provides such a review.

JMH – 4/27/2013

______

[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1935, New York and London, Harvest/Harcourt, Inc., 1953, 1964 ed., 1991 printing, p. 372. (For a fuller  understanding of Keynes’s General Theory  and his full employment model, see especially: pp. 30-32; Book 3, “The Propensity to Consume”; Book 4, “The Inducement to Invest,” esp. Chs. 11-14, and 18, “The General Theory of Employment Restated”; and Ch. 24.)

[2] Robert B. Reich, Aftershock: The Next Economy and America’s Future , NY, Alfred A. Knopf (2010), p. 21.  The graph is constructed from the database of Thomas Piketty and Emmanuel Saez: See, e.g., Journal of Economic Perspectives, Vol. 21, No. 1, Winter 2007, pp.3-24; and with Stephanie Stantcheva, DP No. 8675 (CEPR, November, 2011).

[3] Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, NY (1999, 2009).

[4] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012) p. 82.

[5] Ibid.

[6] Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, New York and London, W. W. Norton & Company, 2012, pp. 84-85.

[7] “Economic Growth and Income Inequality,” by Simon Kuznets, The American Economic Review, Vol. 45, No. 1, (March, 1955), p. 27.

[8] The General Theory, supra, pp. 184-185.

[9] “An Overview of the General Theory,” by James Tobin, Cowles Foundation Paper (here),  947 (1997) (here), p. 4.

[10] Clifford W. Cobb, Introduction, After the Crash: Designing a Depression-Free Economy - Selected Works of Mason Gaffney,  MA, Wiley-Blackwell (2009), p. 3.

[11] James Galbraith, Presidential Address, Association for Evolutionary Economics (January 5, 2013).

[12] James Tobin, op. cit.

[13] Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, supra at 84-84.

[14] The General Theory, supra, p. 246.

Introduction

John Maynard Keynes ended the preface to his monumental opus, The General Theory of Employment, Interest and Money, with this unusual confession:

The composition of this book has been . . . a struggle of escape from habitual modes of thought and expression.  The ideas which are here expressed so laboriously are extremely simple and should be obvious.  The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds. [1]

The “old ideas” Keynes referred to were some of the major, in his view erroneous, ideas of the classical theory of economics, which his new book intended to correct.  In 1935, Keynes was living in the Great Depression, and he had developed a more modern theory with insights into decline and instability that classical theory lacked.  Keynes knew he was playing with fire, and it was important to get it right:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. [2] 

But the economics profession was still immature, lacking data and the electronic processing tools we take for granted today.  The discipline of economics was still transitioning from philosophy to science.  Knowing how hard it can be to accept new ideas that force us to revise or discard old ones, especially when it is not possible to test the new ideas with factual evidence, Keynes also warned:

It is astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics (along with the other moral sciences), where it is often impossible to bring one’s ideas to a conclusive test either formal or experimental. [3]

Keynes hoped to persuade his fellow economists that the classical theory to which they, along with himself and his father before him, had clung so tenaciously for decades, was seriously flawed.  Indeed it was.  But he was determined to soften the blow:

Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world.  But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. [4] 

Still, he was attacking classical economics on the level of its core concepts, and this had to seem to classical economists like extremely faint praise.  For to argue that the classical model was merely a description of an economy at full employment was like arguing that a stopped clock is only correct twice a day:

For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation — a discrepancy which the ordinary man has not failed to observe. * * * The celebrated optimism  of traditional economic theory, which has led [economists to teach] that all is for the best in the best of all possible worlds  provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand.

For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates.  It may well be that the classical theory represents the way in which we should like our Economy to behave.  But to assume that it actually does is to assume our difficulties away. [5]

Here’s the irony: Keynes himself did not quite get it right.  Yes, he brilliantly explained the dynamic processes of demand-driven market-based systems, and that accomplishment, however controversial, was revolutionary.  Keynes gave the world a full employment model:

[T]he national income depends on the volume of employment, i.e. on the quantity of effort currently devoted to production. . . [T]here is a unique correlation between the two. * * * Our present object is to discover what determines at any given time the national income of an economic system and (which is almost the same thing) the amount of its employment. [6]

Keynes conceded at that point that because the study of economics is so complex that “we cannot hope to make completely accurate generalizations,” his objective was to find those factors that mainly (original emphasis) determine income.     

His full employment model overlooked, however, what would prove to be the most important factor: the distribution of wealth and incomes. To his credit, Keynes highlighted his awareness of the importance of distribution, and he discussed it intelligently, without speculating very much about it.  But he lacked the data needed to analyse it, and he had no model incorporating distributional variables.  The bottom line is this:  Keynesian economic models fail to account in any way for changes in the distribution of money.

Unavoidably, Keynes had overreached.  There are two key assumptions reflected in his theory, more express than tacit:

(1) optimal demand will produce full employment; and

(2) maintaining full employment solves the “poverty” problem; [7] 

And there is a third, tacit assumption in his model, one that like the assumptions in the classical model he rejected is “seldom or never satisfied:”

(3) the distribution of wealth and incomes either never changes, or it completely lacks economic significance.

Now that his model has been subjected to the “conclusive test” of experience, Keynes’s error of omission is shown to be so enormous as to have overwhelmed his claim to have solved the issues of instability, stagnation and depression. It turns out that the management of income and wealth inequality is far more important to growth and prosperity, and to the maintenance of full employment, than is the management of demand (expenditures on consumption and investment) levels.

This was no small oversight: the consequences of that omission, I will argue, have led to massive confusion and miscalculation and abetted the rapid decline of the United States economy and other economies around the world into the early stages of Great Depression II.  And this is not just about plugging the holes in Keynesian theory: it’s also about slaying the “trickle-down” dragon and discrediting the “austerity” doctrine, patently false and non-economic notions that have come to dominate popular ideology today, with scant professional challenge in the media beyond the valiant efforts of Paul Krugman. The recent flurry of discussion about the Reinhart/Rogoff econometric thesis, as explained in this series of posts, fortuitously helps to bring all of these points into sharper focus.

Much of my discussion, I am bold to say as Keynes did, “is extremely simple and should be obvious.” But this is an interesting and strange situation: economists have been slow to react to the emergence of vast databases of income distributions, covering very long time periods, in the United States and around the world.  That is not surprising: the import of those databases potentially changes everything.  The world of economics has been turned upside down.  

In support of the claim I am making — that economic theory has gone astray from the start — I humbly submit that with each passing month the facts I rely on are  are becoming ever clearer; and people are increasingly in a questioning frame of mind. Even four years ago, in the aftermath of the Crash of 2008, the relatively conservative periodical The Economist opined:

[T]there is a clear case for reinvention, especially in macroeconomics. Just as the Depression spawned Keynesianism, and the 1970s stagflation fueled a backlash, creative destruction is already under way.

And, it reported:

Paul Krugman, winner of the Nobel prize in economics in 2008, [recently] argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.” [8]

They did not, however, have my perspective in mind.  As my argument suggests, mainstream Keynesian traditionalists, as did Keynes himself, have likely missed the core problem with current economics, its marginalization of wealth and income distribution issues. Himself among that group, Krugman argued in his latest book that inequality is most likely just a “political” problem. [9]

You will want proof, and reasoned discussion. This is the first of several posts, drawn from my two and one-half years of research and writing on inequality, the PowerPoint presentation I have developed on the topic, and an expansion of an article encapsulating that presentation that has been submitted for publication.  I will publish these posts serially, and hope to be finished with this series in two to three weeks.

JMH – 4/25/2013

_____

[1]  John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1935, New York and London, Harvest/Harcourt, Inc., 1953, 1964 ed., 1991 printing, Preface, p. viii.

[2] Id. at 382.

[3] Id. at  pp. vi-viii.

[4] Id. at 378.

[5] Id. at 33-34. (Emphasis in original.)

[6] Id. at 246, 247. (For a fuller  understanding of Keynes’s General Theory  and his full employment model, see especially: pp. 30-32; Book 3, “The Propensity to Consume”; Book  4, “The Inducement to Invest,” esp. Chs. 11-14, and 18, “The General Theory of Employment Restated”; and Ch. 24.)

[7] Id. at 30.

[8] “What went wrong with economics,” The Economist, July 16, 2009 (here).

[9] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012), Ch. 5, “The Second Guilded Age,” pp. 71-90.

(Return to the Contents Topics page.)

(Pixie by Dawny Dawn)

The “science” of economics today is not merely and institutionalized form of neo-feudal philosophy, nor is it merely an ideology of darkness that erects institutions to promote more darkness. It has become a form of madness, a dream of human imagination we mistake for a pattern of the world.  It is a path not merely to serfdom but to death.

We do have an alternative, though.  We can believe what we see with our own eyes.     

(Barry C. Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, John Wiley & Sons, 2010, p.252)  

In recent months I have occasionally reflected on why, as a grad student at the University of Michigan, I decided to leave the PhD program in economics and to enroll in the law school. Mostly, I think, I was shying away from an academic career. But I had concerns about economics as well. Milton Friedman had just published Capitalism and Freedom the year before I entered college, and debates about the role of government in the economy were heating up in the late 1960s.  My professors at Oberlin had taken the Keynesian side, arguing that “supply-side” theory was unsupported and based on ideological opposition to government participation in economic affairs. I didn’t like wondering how a field like economics could be so political and still function objectively as a social “science.”

What I mostly recall today, however, are the troubling questions I had about the  ”microeconomic” supply and demand principles underlying most of the economics I was taught.  I remember feeling something like an Atlantic sockeye salmon, swimming upstream: The theories told me what “equilibrium” would look like, if I assumed “perfect knowledge” and “perfect competition” and a host of other assumptions, none of which were ever realized in the real world.  But I didn’t want to know what might happen in a hypothetical world; I wanted to know what actually happens in the real world.

A few years out of law school, as fate would have it, I was appointed to the position of Administrative Law Judge at New York’s Public Service Commission, a position I held for nearly thirty years. That job required me to decide cases involving a lot of – you guessed it – economic issues.  Instead of becoming a professional economist, ironically, I had become a practicing economics professional. My job required finding answers to sometimes difficult factual and policy issues, both legal and economic, from the bottom up. It was my job not to prejudge or speculate, but to try to find the truth, and I took that responsibility seriously, refusing to respond to political pressure. For a number of years, most of the big cases involving economic and antitrust issues, like the AT&T divestiture and the Bell Atlantic-NYNEX merger, came my way.  It was not clear to me that the Bell Atlantic-NYNEX merger was entirely in the public interest as proposed.  It was approved in New York and Washington, however, and the result was Verizon.

None of us can claim to be right about everything.  All of us may, from time to time, take comfort from some “pixie-dust” ideas, notions that are created through the application of top-down psychological preferences instead of through verifiable, bottom-up factual analyses.  This is mostly harmless when the ideas are reasonably inconsequential, and we do not firmly believe them to be true, like the wonderfully entertaining superstitions in “Silver Linings Playbook” about what it takes for the Philadelphia Eagles to win football games.

There is danger, however, when we form unfounded beliefs about important things.  Ironically, it is those ideas we hold by faith, without real-world factual support, that we are least willing to challenge or change in the face of contradictory evidence.  Alas, the “science” of economics is riddled with such ideas.

I have long believed that market economies are unstable, and have long suspected that unfettered market economies will eventually disintegrate, succumbing to the influence of growing stagnation. One recent morning I awoke, with a strong feeling of conviction, thinking this:

Unrestrained capitalist economies are virtual inequality machines, relentlessly creating and compounding dysfunctional distributions of wealth and incomes; and the rest is pretty much inconsequential window dressing.

It dawned on me, as I thought about it, exactly how I had arrived at that conclusion.  This “revelation” comes to me as I organize my materials and thoughts for a PowerPoint presentation on inequality, and consider theories on the mechanisms of economic decay.  I would have no basis, of course, to offer such a remarkable claim as a scientific one, without reference to the reports and studies on detailed income and wealth distribution data which have become available over the past two or three years.  Otherwise, how could I claim any more credibility for this idea than has been claimed for the economics Barry Lynn condemns as “neo-feudal philosophy”?

I told my sister about my epiphany.  ”Do you think this is a new idea?” she asked, a bit impatiently.  ”Read Barbara Tuchman’s A Distant Mirror.”

Okay, but what about modern economic theory?  You may react as my wife did when I told her about my revelation: “Have you been watching MSNBC?” she asked. “That’s what everybody’s been saying.” Well, no, not exactly: Certainly there has been much discussion recently, thanks to inputs from experts like Joseph Stiglitz and Robert Reich, about how dangerous inequality is and is how it is hurting our economy, but that’s about it.

This is not an issue upon which the economics profession has taken the lead. Eighteen months ago Americans in great numbers took to the streets to Occupy Wall Street and communities all over America, seeming implicitly to understand that the dividing line in the growing income inequality gap is almost exactly the line between the top 1% and the bottom 99%.  It was only six months ago, however, in July of 2012, that Stiglitz published The Price of Inequality: How Today’s Divided Society Endangers Our Future, and the likely implications of his observations are only now starting to emerge in media and professional discussions.  And just a few months earlier, in May of 2012, another distinguished American Keynesian, Paul Krugman, published End This Depression Now (May, 2012), in which he tentatively argued that income inequality may be essentially a “political” problem, presumably lacking material macroeconomic consequences.

Stiglitz’s book, to the best of my knowledge, is the first significant economic text since Henry George’s Progress and Poverty (1879) to describe what I now feel is capitalism’s basic flaw.  No, not even Keynes did that.  Almost no one, so far as I know, has looked at instability in modern economies quite that way – not even Joseph Stiglitz, even now.

I am inspired by the reasoning of Georgist economists Mason Gaffney and, recently, Mary Manning Cleveland, an environmental and inequality economist who is a supporter of the work of Barry C. Lynn (here).  This short list must also include Clifford Cobb and James Galbraith, who in a recent speech (here) skewered the notion of “normality,” and the associated belief that after each crisis “the economy will recover,” adding: “It was never made quite clear why.”

As someone whose interest and expertise comes not from academia, but from real-world experience, it is exciting to get a glimpse, in James Galbraith, of someone I might have been very much like had I gone down the academic road in life. Referring to the gap between Keynesians and supply-siders, Galbraith colorfully alludes to a “saltwater-freshwater pseudo-divide, maintaining an illusion of discourse, of conversation, yet always centered on the perfect competitive, perfect information, rational actor type,” which he calls “a form of scientific regress” and “a useless abstraction.”

What I have learned over the last two years, to my dismay, is that far too many Americans subscribe to beliefs about economics that are flat-out wrong, some of them absurdly so. Most people, including those with no economics background at all, would upon reflection likely reject ideas that are so ridiculous as to violate fundamental common sense.  But when perceived truth is inconsistent with their underlying interests, those in control of the media have been able to convince people of false ideas that are not so obviously wrong.

Here is my effort to summarize the major difficulties in one blog post.  This is essentially a view from a mile up, specifically designed to avoid the details over which so much debate and distraction leads to trouble.  Let’s try to see, in broad strokes, where economics has gone wrong.

The flawed “classical” paradigm of “equilibrium”:

The “neo-feudal philosophy” Barry Lynn speaks of so colorfully seems to me to be a regressive outgrowth of “classical” economic theory.   Galbraith reports in his wonderful lecture that ideas we think of as “classical” have been repackaged and recycled so much in different contexts that one loses sight of the original ideas.  So let’s go back to the beginning.  

Influenced by Adam Smith (1723-1790), the French philosopher Jean-Baptist Say (1767-1832) popularized what has become known as “Say’s law,” the idea that “supply creates its own demand.”  Every sale is also a purchase, but that tautology in itself provides no useful information. The more useful idea was, and is, that aggregate supply creates aggregate demand. Here, however, is where  the trouble begins: The idea that, through markets and the use of a viable medium of exchange,  aggregate demand will clear aggregate supply is not a tautology.  Here is a basic supply and demand curve:

All it does is describe the idea that at higher prices lower quantities are demanded and greater quantities are provided.  The slopes and locations of these curves vary among circumstances.  The point of intersection of these curves is known as a point of “equilibrium.”  Inherent in any supply-demand analysis is the need to meet certain assumptions, like perfect knowledge and perfect competition, to actually “find” the hypothetical equilibrium point for a given product or a given market.  But supply-demand analysis offers, at best, a fleeting description of a market, as these curves change location and shape over time.

The basic problem is that “equilibrium” has never been more than just a hypothetical point, especially for an entire economy.  In what I conclude was Keynes’s main contribution to economic theory, his General Theory of Employment,  he showed that the achievement of a market-clearing aggregate supply and aggregate demand of goods and services for an entire economy cannot even theoretically be achieved by a continuous, linear, aggregation of individual supply-and-demand equilibria, pursuant to Say’s Law.

Keynes developed a simple model with three independent variables: (1) the interest rate; (2) the propensity to consume; and (3) the marginal efficiency of capital (cost of capital).  He observed that output is divided between goods and services for current consumption, and investment in the means to provide for future consumption.  On the demand side, total income consists of total current consumption and total saving.  On the supply side, production consists of total current consumption and total investment.

These two amounts are equivalent (Say’s Law), but as Keynes explained this equivalence led to the erroneous “classical” assumption that savings always equals investment.  No law of economics, said Keynes,  requires monetary savings to be immediately applied to the provision of physical investment.  Savings can be hoarded.  So, if the aggregate propensity to consume declines for some reason (say, increased regressivity of the taxation system), and demand falls, investors would likely perceive from the decline in demand reasons to expect lower demand in the future.  Thus, Keynes famously reasoned, a decline in demand, instead of leading to more investment, would lead to higher unemployment!

In this observation, Keynes recognized the tendency of market economies to decay.  No reason has since been advanced to expect demand to grow again on its own, when an economy is left to its own devices. Not ever — not unless demand is revived extrinsically and abnormally, say, by warfare.  Household consumption requirements, which are spiraling down in response to declining investment and jobs, simply won’t recover on their own.  In a depression, moreover, the interest rate can fall all the way to zero without providing for a schedule of the marginal efficiency of capital sufficient to promote investment and growth.  And if demand is falling because of rising income inequality, as Mary Cleveland has suggested, the resulting “liquidity trap” becomes something even more debilitating, something we might call an “inequality trap” (here).

The presumption of normality:

The late James Tobin wrote in 1997 (“An Overview of the General Theory,” (here), Cowles Foundation Paper 947 ( here))  that the central economic questions of our generation are whether a market capitalist economy, left to itself, will fully employ its labor and other productive resources without government intervention, and whether it will return to full employment reasonably swiftly once displaced from it.  ”The answer of the General Theory,” he said, “is ‘no,’” adding: “I argue that Keynes still has the better of the big debate.”

James Galbraith, as noted, discusses how mainstream economics is enthralled by the presumption of normality, which postulates that an economy will always recover from a slump; it may take a little longer, but economies will eventually bootstrap themselves back to “equilibrium.”  As Galbraith points out, no one has ever specified how that is supposed to happen.  It is a matter of faith, maintained with a liberal application of pixie dust.

Inequality in the spectrum of economic thought.

Here is a brief listing of four categories of economic thought I have identified, ranging  in my assessment from the craziest to the most accurate.  I assign each a “pixie dust rating” (PDR) on a scale from zero to ten:

1. Supply-side ideology: (PDR = 10)  

This is a collection of ideas that range from the preposterous to the simply wrong.  These are ideological notions that dominate the tea party, the Republican Party, our national and many state governments.  No amount of pixie dust could make any of these ideas work:

- Tax reductions for the rich pay for themselves. (Even if lowering taxes on top incomes stimulated investment and growth, it couldn’t possibly stimulate enough growth to provide for the revenues lost.  And if it could, why would more tax reduction still be needed with taxes on top incomes and corporations already at their lowest point in about three generations?);

- Tax reductions for the rich stimulate growth. (No, they don’t.  From 1979 to 2007, these tax cuts made enough additional revenue available to the rich to accumulate about $14-15 trillion in net worth while the federal government ran up more than $12 trillion in debt.  Top 1% net worth increased nearly $12 trillion above the per capita allocation of wealth growth.  Meanwhile, the overall rate of GDP growth dropped by one-third, and income inequality skyrocketed.);

- Income inequality is the difference between what someone can make with a college education and what they can make without it. (This is according to the CATO Institute, Ben Bernanke, and even the 2012 Economic Report of the President. What can I say? “We can believe what we see with our own eyes.”)

2. Monetarism: I’ll use this broad term for want of a better one for this category. (PDR = 7)

- Milton Friedman, Frederick Hayek, and others argued that Keynesian fiscal policy would be self-defeating because, to the extent it  would increase the money supply, it would led to inflation.  (I don’t think there’s anything wrong with this logic, assuming there is a steady level of demand.  However,  over thirty years of federal borrowing from 1979-2007, during which some $14 trillion of national debt was incurred, there there was no runaway inflation, no inflationary spiral; instead we got steadily declining demand, ending in a depression.);

- The interest rate can be lowered enough to induce jobs and investment in a downturn.  (Evidently not in a depression. – One virtue of this line of reasoning, though, is that it acknowledges the Keynesian point that the level of aggregate demand is important, flatly contradicting the supply-side ideology that asserts growth stems from rich people saving, not from everyone else earning and spending.);

- After a downturn, the economy will always return to full employment on its own, with no need for government help.  (Really?);

-  Inequality is not a problem; there’s plenty of opportunity, if people are willing to work.  (No – unemployment rose to extreme levels (10%) after the Crash, is still at about 8%, and is expected to stay there for several years, under mainstream assumptions.  Many working people in the lower middle class, often with college degrees, are living at or near the poverty level.  The decline in demand from inequality growth, in effect, ruled out any chance of runaway inflation.)

3. Mainstream Keynesianism: (PDR = 4)

- Government is a part of the economy, so its level of activity and spending affects the level of jobs and growth. (Yes) ;

- Austerity, that is reducing government spending, reduces demand, jobs, and growth. (Yes);

- Government deficit spending stimulates growth (It can, in some circumstances, but not if the countervailing force of inequality growth is depressing growth to a greater degree);

- There is no inequality or poverty problem at full employment. (Wrong – Keynes believed this, but the data show that reduced growth is accompanied by higher levels of income and wealth inequality; In a depression, high levels of inequality probably prevent a return to full employment.);

- The U.S. can stimulate the economy now through deficit spending, and pay off its huge debt once the economy is rolling again at full employment. (No – There has been constant deficit spending for more than 30 years, running up $16 trillion of debt by 2013; all of that “stimulus” merely landed the U.S. in a depression, and added commensurate levels of wealth transfers. The degree of continuous growth of inequality is now greater than any stimulus that might be gained by even well-placed federal spending and investment.);

- Inequality is a symptom of unemployment. (No. Inequality is the underlying problem, and regulating the distribution of wealth and income is government’s most important function.)  

4, Georgist-Keynesianism: (PDR= 0)

- Income and wealth distribution, not employment, is the fundamental driver of prosperity and decay;

- As Stiglitz argues, inequality growth has already gone way to far in America.  The U.S. is the worst among industrial countries, and suffers the worst consequences.  93% of all new income goes to the top 1%, which holds nearly half of all financial wealth.  An estimated $300-500 billion of wealth (my estimate) is transferred up to the top 1% annually;

- Incomes of the top 0.01% tripled from 1979-2007, and the top 1% average income doubled, while the per capita real income of all categories in the bottom 80% declined;

- The middle class is drifting into poverty as poverty levels rise drastically; Almost all small business income left in the U.S. economy is now going to the top 1%, and wealth concentration has apparently nearly reached its practical limit;

 - The majority of income and wealth going to the top 1% is economic rent, that is, income received for no productive output.  Much of that, Galbraith asserts, is taken through financial transactions that are basically fraudulent;

- The economy is structured today in ways that keeps money flowing to the top (Lynn), and substantial economic regulation and re-regulation is essential to stop that process (Stiglitz, Galbraith). The economy is also threatened with potential collapse from the institutional failure of monopolistic structures (Lynn);

- Taxation must be revised to produce government revenues (as a percent of GDP) equivalent to those taking place in the 1970s. Land and resource rents, and income from non-productive activities, must be taxed more heavily and work and consumption less heavily. Government spending must be redirected into the kinds of investments for America’s future proposed by the President in the recent State of the Union Address;

There are billionaires like Warren Buffet and Howard Schultz, and the “Patriotic Millionaires,” who argue for progressive taxation and for federal budgets that preserve the middle class and promote growth, based on their understanding that their business success depends on the success of the entire economy. Such views, however, are poorly represented in Congress.  America is doomed to Great Depression II unless and until Republicans, and others not fully committed to preventing such an outcome, are excluded from the halls of Congress.

JMH – 2/13/14 (ed. 2/14/14)

(Return to the Contents Topics page.)

(Return to the Contents Topics page.)

(Illustration from “Study: As Income Inequality Grows, Middle Class Areas Shrink,” The Liberal Curmudgeon, November 20, 2011, here.)

In America today, we have the most unequal distribution of wealth and income of any major country on earth, and more inequality than at any time period since 1928. The top 1 percent owns 42 percent of the financial wealth of the nation, while, incredibly, the bottom 60 percent own only 2.3 percent. One family, the Walton family of Wal-Mart, owns more wealth than the bottom 40 percent of Americans. In terms of income distribution in 2010, the last study done on this issue, the top 1 percent earned 93 percent of all new income while the bottom 99 percent shared the remaining 7 percent. 

Despite the reality that the rich are becoming much richer while the middle class collapses and the number of Americans living in poverty is at an all-time high, the Republicans and their billionaire backers want more, more, and more. The class warfare continues.  - Vermont Senator Bernie Sanders, “The Soul of America” (here).

This is the second of three posts highlighting my perspective on the economics of inequality after the last two years of studying this emerging field.  The first, “Falling Off the Inequality Cliff” (here), was designed to demonstrate, through a discussion of Paul Krugman’s analysis of budget and debt issues, how ignoring the macroeconomic impacts of growing income and wealth inequality results in seriously underestimating what will be required to reduce deficits and national debt, reduce unemployment, and stimulate recovery.  This second post puts meat on the bones of that argument, developing crucial points about the current dangerous situation and the unavoidable need for greater appreciation of the negative impact of inequality on growth, and of the role of taxation of top incomes and wealth to prevent further decline and deeper depression.  The third and last post will discuss the disintegration of the science of economics as four wildly divergent notions about the economic effects of taxation hopelessly confuse issues crucial to the recovery of the U.S. economy.

Senator Sanders’ observations about the current state of the U.S. economy and its growing inequality are factually accurate and can be easily verified.  In his recent book (The Price of Inequality: How Today’s Divided Society Endangers Our Future, 2012, p. 25) Joseph Stiglitz provided this, very similar summary list of “uncomfortable facts about the U.S. economy”:

(a) Recent U.S. income growth primarily occurs at the top 1 percent of the income distribution; (b) As a result there is growing inequality; (c) And those at the bottom and in the middle are actually worse-off today than they were at the beginning of the century; (d) Inequalities in wealth are even greater than inequalities in income; (e) Inequalities are apparent not just in income but in a variety of other variables that reflect standards of living, such as insecurity and health; (f) Life is particularly harsh at the bottom— and the recession made it much worse; (g) There has been a hollowing out of the middle class; (h) There is little income mobility— the notion of America as a land of opportunity is a myth; (i) And America has more inequality than any other advanced industrialized country, it does less to correct these inequities, and inequality is growing more than in many other countries.

The U.S. economy got this way over a thirty-year period of gradual and nearly invisible decline.  We can be aware of inequality and its implications today only because in the last few years, for the first time in the history of economic science, the necessary data has become available, in income distributional databases compiled by the federal government (Congressional Budget Office) and by economists Thomas Piketty and Emmanuel Saez;  This familiar graphic of Top 1% income shares in the United States plots Piketty/Saez data:

In 1935 John Maynard Keynes began the last chapter of his book The General Theory of Employment, Interest, and Money with this statement: “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.”  His General Theory, however, designed only to explain how full employment can be achieved, failed to account for the macroeconomic implications of income and wealth distribution. Unfortunately, because the data that can explain those implications are only now becoming available, such an explanation becomes possible only late in the current inequality growth cycle, just at the onset of the second “Great Depression.”

By 2007, income inequality (in terms of the top 1% share of all income) had deteriorated to the point it was at when the stock market crashed in 1929 and the first Great Depression began.  Notably, that was all before the “Crash of 2008.”  That crash and the “Great Recession” were logically predictable, given this history, but they were different: A real estate bubble burst and a great deal of wealth (net worth) evaporated, but following the bailout of big investment banks, pretty much only the middle and lower income classes (people whose principal assets are their homes) were permanently hurt, as the wealthy classes fully recovered and the growth of income and wealth inequality continued at an accelerating rate.

The entire episode consisted of a huge increase in the unequal distribution of wealth and incomes.  When the stock market crashed in 2008, the volatile top 1% income share fell, but it has rebounded to about the 2007 level, reflecting recovery of capital gains; the recovering value of securities investments, together with the decline in real estate values, represents a major increase in the inequality of wealth. The “Great Recession” (which has actually become a depression) witnesses, over the last four years, the continuing implosion of small businesses and middle class decline, rapidly falling median income, and a continuing high level of unemployment. The median household income has declined over the past four years by nearly ten percent.  These developments reflect an accelerating growth of income inequality.

A big crash that will see top 1% income share decline as it did so drastically in the 1930s (as shown on the graph) has yet to arrive.  Economic science has yet to offer a plausible explanation for what will arrive at the end of this inequality growth cycle, but as overall prosperity continues to decline, the possibility suggested by Robert Reich in Aftershock: The Next Economy and America’s Future (2010) of a complete collapse, greatly harming the entire bottom 99%, is all too real.  It is preventable, however, if we recognize and learn to understand the relationship between growing inequality and economic decline, and start addressing the problem.

We must start by recognizing that the factors making this happen over the last 30-40 years have not been corrected. Income inequality is still growing, and that growth is accelerating. Saez has reported these figures for the split between the amount of new income (growth) going to the top 1% and the amount going to everyone else:

       Period                Top 1%           Bottom 99%

1923-1929                    70%                    30%

1960-1969                    11%                     89%

 1992-2000                   43%                    57%

   2002-2007                  65%                    35%

  2010                               93%                      7%

Saez reported (here) that in 2010, the first full year of “recovery,” while average (mean) real income per family grew by 2.3%, top 1% incomes grew by 11.6% and bottom 99% incomes grew by only 0.2%.  Hence, the top 1% captured 93% of growth in 2010, a considerably higher rate of inequality growth than existed in the six years before the Crash of 1929 that ushered in the Great Depression.  He reported this trend continuing into 2011, predicting “that the Great Recession will only depress top income shares temporarily and will not undo any of the dramatic increase in top income shares that has taken place since the 1970s.”

Importantly, income and wealth inequality had already reached very extreme levels before the Crash of 2008 and the Great Recession, and the U.S. economy, despite recent growth in private sector jobs, is actually in a depression.  Collapsing tax revenues of state and local governments, as well as at the federal level, have caused draconian budget cuts, reducing public sector jobs and associated retailer incomes, offsetting private sector job gains. (For the Upstate New York example, see “Job losses erode gains,” by Eric Anderson, Albany Times Union, January 18, 2013, here.)

This is a dangerous situation.  The structural mechanisms for income growth below the top 1% — that is, the ability to achieve growth below the top 1% — have mostly been eliminated. What passes for economic recovery these days is almost entirely income growth at the top.  This makes stimulation of bottom 99% income growth by government essential, but also far more difficult to achieve.   

Changing Economic Perspectives

The Obama Administration, so far, has taken a conservative approach to inequality. In his inaugural acceptance speech, President Obama endorsed reducing government spending to reduce the budget deficit.  He has made it clear he is aware that a general “austerity” policy aimed at reducing the budget deficit would be disastrous and must be avoided at all costs, as strenuously argued by Paul Krugman for months (See my previous post “Falling Off the Inequality Cliff,” here).

He has not, however, addressed the implications of inequality growth for federal taxation and fiscal policy.  Indeed, the 2012 Economic Report of the President does not acknowledge any macroeconomic effects of inequality growth.  Its explanation of the income inequality problem is limited to the conservative supply-side position of Ben Bernanke and the Cato Institute that the income inequality problem consists of nothing more than the ability of people with college and graduate degrees make to more money than people with less education. That position would be laughable, were it not so widely endorsed: Not only is the extreme cost of higher education today making it uneconomical for many young people today to obtain or even consider going to college, but many college graduates and even people with graduate degrees (especially women) are living at or close to the poverty level, despite their education.  Obviously, income inequality is a far deeper problem: In End This Depression Now!, Paul Krugman underscored the absurdity of that argument, pointing out that educational differences cannot explain how a small handful of Wall Street hedge fund managers raking in over $1 billion per year can take home more income than all of New York City’s public school teachers combined.

Unfortunately, Krugman also implied in that discussion that income inequality is essentially a “political” problem, lacking significant macroeconomic consequences and not materially affecting growth. He declined to recommend increased taxation of top incomes and corporate earnings, either for reducing inequality or for achieving recovery and growth, and recommended instead stimulating growth and investment through deficit spending and monetary approaches.  He appeared, at least then, to believe (as did Keynes) that full employment solves the inequality problem.

Neither Paul Krugman nor the Obama Administration can afford to continue taking income and wealth inequality so lightly. As argued in “Falling Off the Inequality Cliff,” with the downward spiral of income inequality continuously depressing the economy Obama cannot revive the middle class as he has vowed to do just by reducing or even by eliminating unemployment.  He cannot just put people back to work, he must do so in ways that do not keep contributing to the concentration of wealth at the top and to the decline of median real income.  Nor will he be able to avoid an ultimate economic collapse, or even significantly reduce unemployment, without substantially increasing taxation of top incomes and corporate earnings.

Two months after Krugman published his book, Joseph Stiglitz published The Price of Inequality, providing a macroeconomic explanation of the income and wealth distribution problem. Stiglitz stressed the same Keynesian (declining propensity to consume) and Georgist (growing transfers of economic rent) factors that had appeared to me to be the primary factors behind the decline associated with inequality growth. Stiglitz has been relatively silent since then, but two days ago, in an article in the Sunday New York Times of January 20, 2013  entitled “Inequality Is Holding Back the Recovery” (here), he said this:

Politicians typically talk about rising inequality and the sluggish recovery as separate phenomena, when they are in fact intertwined. Inequality stifles, restrains and holds back our growth. When even the free-market-oriented magazine The Economist argues — as it did in a special feature in October — that the magnitude and nature of the country’s inequality represent a serious threat to America, we should know that something has gone horribly wrong.

He argued further that: (1) Our middle class is too weak to support the consumer spending that historically has driven economic growth; (2) The hollowing out of the middle class since the 1970s leaves the middle class unable to invest in their future, by educating themselves and their children or by starting or improving businesses; (3) The recent modest agreement to restore Clinton-level marginal income-tax rates for individuals making more than $400,000 and households making more than $450,000, given the weakness of the middle class and the facility with which those at the top avoid taxation, are inadequate for “the vital investments in infrastructure, education, research and health that are crucial for restoring long-term economic strength;” and (4) “The International Monetary Fund has noted the systematic relationship between economic instability and economic inequality, but American leaders haven’t absorbed the lesson.

“The dream of a better life that attracted immigrants to our shores,” he concluded, “is being crushed by an ever-widening chasm of income and wealth.”

Thankfully, Stiglitz’s perspective is beginning to gain serious attention: In The National Journal (September 28, 2012, here) Jonathan Rauch reported Stiglitz’s conclusion that “[w]idely unequal societies do not function efficiently, and their economies are neither stable nor sustainable in the long term.”  A few weeks later in Forbes (“How Income Inequality Is Damaging the U.S.,” October 2, 2012, here) the magazine’s leadership editor, Frederick Allen, said this:

New research indicates that growing income inequality isn’t just unpleasant; it is seriously hurting the U.S. economy. And economists are figuring out just how the damage is done, according to a fascinating new article by the journalist Jonathan Rauch in National Journal.

Allen’s acknowledgment that income inequality has macroeconomic significance is especially remarkable, given that the editor-in-chief of Forbes Magazine, Steve Forbes, has long been a leading protagonist of the supply-side ideology, which holds that individuals can always achieve success and certainly avoid poverty if they apply themselves, and that there is no inequality problem.

On October 16, 2012, the New York Times (here)  reported  a study published on April 8, 2011 by the International Monetary Fund (Andrew G. Berg and Jonathan D. Ostry, IMF Staff Discussion Note, “Inequality and Unsustainable Growth: Two Sides of the Same Coin?,” here), a study that has gained the attention of both Krugman and Stiglitz.  Inequality can be “destructive to growth,” the authors said:

It has long been recognized that the quality of economic and political institutions, an outward orientation, macroeconomic stability, and human capital accumulation are all important determinants of economic growth. This note argues that income distribution may also – and independently – belong to this “pantheon” of critical growth determinants.

Then in November, Paul Krugman (“The Twinkie Manifesto,” New York Times, Op-ed, November 18, 2012, here) commented on the relationship between taxation and growth:

Consider the question of tax rates on the wealthy.  The modern American right, and much of the alleged center, is obsessed with the notion that low tax rates at the top are essential to growth. * * * Yet in the 1950s incomes in the top bracket faced a marginal tax rate of 91, that’s right, 91 percent, while taxes on corporate profits were twice as large, relative to national income, as in recent years. The best estimates suggest that circa 1960 the top 0.01 percent of Americans paid an effective federal tax rate of more than 70 percent, twice what they pay today.

* * * And the high-tax strong-union decades after World War II were in fact marked by spectacular, widely shared economic growth: nothing before or since has matched the doubling of median family income between 1947 and 1973.  * * * [E]conomic justice and economic growth aren’t incompatible.

It is gratifying that Krugman is not only emphasizing the relationship between inequality and growth, but also acknowledging the connection between the taxation of top incomes and the level of income inequality.  In his book, he discounted the high correlation between these factors revealed by the Piketty/Saez data as possibly coincidental.

On that same day, Daniel Altman (“To Reduce Inequality, Tax Wealth, Not Income,” New York Times, November 18, 2012, here) shifted the focus from income to wealth:

Often decried for moral or social reasons, inequality imperils the economy, too; the International Monetary Fund recently warned that high income inequality could damage a country’s long-term growth. But the real menace for our long-term prosperity is not income inequality — it’s wealth inequality, which distorts access to economic opportunities.

Trends in the distribution of wealth can look very different from trends in incomes, because wealth is a measure of accumulated assets, not a flow over time. High earners add much more to their wealth every year than low earners. Over time, wealth inequality rises even as income inequality stays the same, and wealth inequality eventually becomes much more severe.

This is exactly what happened in the United States.

Altman recommended a major shift in the United States from taxing income to taxing wealth, which he says would improve distribution.

Another important economic theorist recently lining up behind Stiglitz is Neil Buchanan (“A Mismatch Between Tax Politics and Deficit Rhetoric,” Verdict Justia, 1/3/13,  here):

Increasing taxes on the wealthy is an important policy goal, no matter what the situation with the federal budget may be.  As the economist Joseph Stiglitz argues (here), the level of inequality that we have reached in this country not only is immoral, but also actually harms the economy, reducing growth and making it harder to employ workers in modern jobs.

Therefore, even though the President and his Democratic colleagues have been treating minimal tax increases on the wealthy as part of an effort to bring down long-term deficits, the important reality is that income redistribution is both morally and practically essential.

Finally, in another excellent Op-ed (“The Big Fail,” The New York Times, January 7, 2013, here), Krugman refers again to the presentation by the IMF economists cited above, characterizing it as  a “major rethinking” of economic policy:

For what the paper concludes is not just that austerity has a depressing effect on weak economies, but that the adverse effect is much stronger than previously believed. The premature turn to austerity, it turns out, was a terrible mistake. (Emphasis added.)

Krugman, engaged as he has been in the war against “austerity” around the world, perhaps tends to analyze new information mainly in terms of its relevance to that issue.  But the IMF study argued, as noted, that the adverse effect of inequality is so strong that income and wealth inequality should itself be considered an independent cause of decline. This, I believe, is also Stiglitz’s perspective.

Inequality and Growth

It is gratifying that in the last few months the relationship between inequality and growth has suddenly gained so much more attention.  The Piketty/Saez data show clearly that when inequality started to rise in the U.S. in recent decades, overall growth declined sharply:

This chart shows that in the three decades after 1976 the aggregate cumulative growth was reduced by about one-third of what it had been in the three previous decades.  Meanwhile, the income inequality trend was turned on its head.  The cumulative percent growth for the top 1% of households increased astronomically, from 20% to 232%, while growth for the bottom 90% plummeted from 83% to 10%. It is this growth differential (the difference from 1976 to 2006, in this example, between a 232% cumulative growth for the top 1% and a 10% cumulative growth for the bottom 90%)  that boosted the top 1% share of total income from under 10% to nearly 25%.

Soon, hopefully, there will no longer be lingering doubts that the growth of income and wealth inequality depresses growth, and that controlling the distribution of income and wealth must be government’s top priority.  However, any understanding of what exactly governments should do depends upon understanding why this happens.

The Role of Taxation

One of the main things the new U.S. income distribution databases show is a very high degree of correlation between the top income tax rates (as well as effective tax rates) and the degree of income inequality.  Income inequality was reasonably low in the 1950s and into the 1970s, the period of middle class prosperity and greater overall growth, when effective income taxation at the top and taxation of corporations was twice as high as it is today.

It is important to understand why taxation and income inequality are correlated, and I’ll offer my opinions on that issue in my next post.  Meanwhile, given that it is true, for whatever reasons, this fact provides a very reasonable expectation that the United States economy can recover by returning to those former levels of taxation and tax progressiveness.  What is more difficult to understand, however, is the likelihood that the United States economy cannot avoid depression and return to prosperity unless it reinstates such a sufficiently progressive tax structure.

It may be just that very intriguing possibility that is drawing so much attention to the IMF study, which languished for 18 months before its discovery by the New York Times, and which is actually far less informative than the Piketty/Saez or the CBO databases of implications for the United States. What seems to be most important about the IMF study is the authors’ macroeconomic perspective.  Until we recognize income and wealth distribution itself as causal factors that control and limit growth and prosperity, as people evidently are starting to do, we may not be able to make any real progress.

The “Inequality Trap”

That thought was foremost in my mind when I read a fabulous blog post by Mary M. Cleveland, an adjunct professor of environmental economics at Columbia University, that was recently called to my attention (“Is Paul Krugman’s Liquidity Trap Really an Inequality Trap?”, January 16, 2013, here).  She argues:

Krugman cares deeply about unemployment and inequality, as did John Maynard Keynes before him. Yet like Keynes, Krugman seems caught in the inequality-free neoclassical paradigm. * * *

During the Great Depression, to his credit, Keynes bucked his colleagues by claiming that government spending could revive a depressed economy. But, caught in the neoclassical paradigm, he got the mechanism wrong. Keynes argued, as does Krugman today, that the problem is a lack of consumer demand. Consumers want to save instead of spend. Lacking demand, businesses won’t invest. So there’s a “savings glut” or “liquidity trap” — billions in cash sloshing around seeking in vain for investment opportunities. The solution: government should borrow some of that loose cash and spend it, no matter on what: war, high-speed rail, fixing potholes, or education. Deficits be damned.

In my view, we don’t have a “liquidity trap”; we have an “inequality trap”. What’s that? An “inequality trap” happens in a downturn, when the One Percent, big corporations and banks hoard cash, starving small businesses for capital: The greater the inequality and deeper the downturn, the tighter the trap.

Data published by the Congressional Budget Office (CBO), “Trends in the Distribution of Household Income Between 1979 and 2007,” October 2011 (here) does show that “small” business income has been significantly absorbed by the top One Percent, evidence of a decline in small businesses:

This Lorenz curve shows that between 1979 and 2007 the bottom 95% of the population saw its share of small business income reduce from about 55% to about 30%.  The bottom 99% of the population share was reduced from over 90% to about only about 55%. Nearly half of small business income was going to the top 1% by 2007.  This greatly increases the proportion of small business income going to the top.

I would add to Cleveland’s hoarding of capital at the top, as another explanation for the critical decline of small businesses in the U.S., the exercise of monopoly power and destructive financial consolidation exercised by mega-corporations. (See Barry Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, 2010.)  However it has happened, the “inequality trap” concept importantly highlights the structural and macroeconomic impediments to investment below the top 1% that contribute to increasing decline.  The bottom 99% is compressed into a smaller economy as wealth is removed from active circulation, dooming (these days) all below the top One Percent to lower real incomes.  Thus, Keynes did get the mechanism wrong: It’s not that the bottom 99% has decided to reduce its spending and increase saving; rather the bottom 99% has been forced to reduce spending as its incomes have been reduced, and it has reduced saving and increased borrowing to try to stay afloat.

I don’t believe Keynes’ General Theory is wrong in arguing that liquidity preference causes the pace of investment to falter: The experience of my own career in regulatory economics has led me to perceive “the marginal efficiency of capital,” or the cost of capital, to be central to decisions by firms to make real investments, and to their ability to finance their operations. (Money is not invested automatically just because it is saved.) Nor is there error in Keynes’s perception that reduced demand for consumption does not result in increased demand for investment in the means of production, but results instead in lower expected returns from such investment and consequently in reduced growth and increased unemployment. The proposition based on Keynes’ “propensity to consume” that an increasing concentration of income at the top necessarily reduces aggregate demand, endorsed by Stiglitz and only now gaining public attention, also seems indisputable to me.  It’s just that the ballpark in which The General Theory is playing out today seems to have been limited pretty much to the top 1-5% income classes.

Regardless, these fundamental Keynesian principles, when coupled with the consequences of economic rent recognized by the 19th Century American economist Henry George, provide a potent description of the loss of both money and real value when resources are idled through inequality growth.  Keynes did establish, after all, that market economies are inherently unstable, and no necessary impetus to return to full employment “equilibrium” has ever been identified.

Mary Cleveland’s concept of an “inequality trap” captures the reality of this instability for me. Because it is always unstable, it would seem, the economy is always caught in Cleveland’s “inequality trap.” All of the relevant Keynsian and Georgist factors (notably land value speculation) appear to push an economy away from “equilibrium,” and disequilibrium is left to run its course, wherever it may lead.  At the most basic level, market capitalism appears to be locked in a constant redistribution struggle, with a core principle as fundamental as gravity: What goes up must come down.

For me, it all keeps coming down to this: “Tax the rich.” Taxation is the only saving grace, governments’ fail-safe mechanism.  Tax the hoarders — the One Percent, the banks, and the big corporations — the very entities that today because of their overwhelming market power have been able to extract trillions of economic rent to hoard, and because of overwhelming political power have been able to push the tax burden they avoid onto the losers in the inequality battle (the 99%).

Keynes, to his credit, took it for granted that progressive taxation was the uncontroverted remedy for inequality growth. Now we have quantitative proof from Piketty and Saez (here) that insufficiently progressive taxation of the incomes of the “hoarders” is causally related to the growth of extreme income inequality, and to deterioration into depression.

So yes, Keynes did miss the underlying mechanism; the fundamental determinant of economic health is not employment; it is the distribution of wealth and incomes, the factor Keynes described as “arbitrary.”

The End of the “Fiscal Policy” Rope

One final point: These considerations mean that Krugman’s insistence on following the Keynesian playbook — fiscal policy (deficit spending) when monetary policy is inadequate  – is doomed in the face of extreme inequality growth, confirming Mary Cleveland’s perspective that “Krugman seems caught in the inequality-free neoclassical paradigm.”

Consider this: Every year for the last thirty years our federal government has run up budget deficits, effectively engaging in deficit spending.  Over this period, about $16 trillion of debt, in current dollars, has been incurred.  A major argument back in the 1930s, between Keynes and the Austrian economist Friedrich Hayek was about the degree to which the economy would overheat from such stimulation, as demand exceeded supply, leading potentially to a runaway cycle of inflation. (See Nicholas Wapshott, Keynes Hayek: The Clash That Defined Modern Economics, 2012), and for years, Milton Friedman and the Chicago school opposed deficit spending for basically this reason.  But what happened over the last thirty years?

This $16 trillion of borrowing caused no runaway inflation.  What’s more, it didn’t even succeed in stimulating the economy. Instead, following major reductions in the top income tax rate (from 70% down to 28% then back up to 35%), the U.S. economy experienced a much reduced GDP growth rate accompanied by a huge increase in income inequality (along with more wealth concentration at the top).  The end of that road was the Crash of 2008, a new depression, and a mountain of national debt that now exceeds the nation’s annual GDP.

In other words, the stagnating effect of inequality growth on economies, which economists seem astonished today to discover from a recent IMF study, has continuously more than offset the potential stimulation of the U.S. economy over thirty years of continuous deficit spending!  The entire Keynes/Hayek debate, in effect, was “caught in the inequality-free neoclassical paradigm;” thus, to paraphrase Krugman, “the adverse effect of [inequality] is much stronger than previously believed.”

What must be done?

The lesson in this light seems obvious:  The only thing governments can do to prevent capitalist market economies from destroying themselves is to maintain a sufficiently progressive tax structure to tax back down the excessive levels of wealth that are continuously transferring up.  And because 93% of all new income is currently recycling back to the top 1%, government will have to dismantle the major structural mechanisms that have been set up over the past thirty years to ensure that wealth and incomes siphon up to the top 1%.

The tax increases now contemplated in Washington are not nearly adequate to that end. The New York Times on New Year’s Day reported the agreement in the Senate to raise the top tax rate to 39.6% from 35% for individual incomes over $400,000 and couples over $450,000, while “tax deductions and credits would start phasing out on incomes as low as $250,000, a clear win for President Obama.”  (See “Tentative Accord Reached To Raise taxes on Wealthy,” The New York Times, 1/1/13, here).

The Tax Policy Center estimated in November (here) that: “If all Mr. Obama’s tax proposals for wealthy Americans were enacted, they would raise $1.6 trillion over the next decade.”  That’s an average of $160 billion per year, but starting at less and growing over the decade.  There is no final budget resolution yet, so “final” estimates are not yet available.

Anything in that ballpark, however, would be far less than required to reduce the deficit or the debt, or even avoid an eventual plunge over the “inequality cliff.” The additional revenues may begin to slow the rate of inequality growth a bit, but the top rate at around 40% is still far below the 70% top rate that was in effect when income inequality was relatively stable in the 1970s, and the task of reviving corporate taxation lies ahead.

According to my computations from federal net worth data, over the last thirty years the top 1% has gained more than $10 trillion of wealth (in 2010 dollars) in excess of its per capita share of the growth in the nation’s net worth.  That’s an annual average of more than $300 billion of wealth moving to the top.  The economy is much larger today, so a better estimate of the current transfer rate would be above the average, perhaps around $500 billion.  Thus, the projected annual revenues expected from these tax increases will not be enough for recovery, deficit improvement, or debt reduction.

Conclusion

Many thanks to Mary Cleveland for her beautiful new concept of the “inequality trap.” There is a clear need to incorporate the continuing depressive effects of income inequality growth and increasing concentration of wealth in all economic reasoning, and now, especially, in the economic growth models that are used for tax policy and budget planning purposes.

My next and final post in this series will undertake a review of competing economic theories on the impacts of taxation: These competing theories have expectations so diverse and contradictory as to render the application of almost any economic theory virtually useless for informing public policy.

JMH – 1/23/2013, ed. 1/24/2013

(Return to the Contents Topics page.)

(Return to the Contents Topics page.)

(Illustration found at “‘Fiscal Cliff’ = Economic Blackmail?” by Bombshell Betty, Palomino Road, here)

The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.  - John Maynard Keynes

I’ll start 2013 with the first of two posts dealing with my understanding of the economics of inequality based on what I have learned over the last two years.  On April 10, 2011 I posted in this blog a summary of the extreme extent of income inequality in the United States that has developed over the last thirty years: The Thirty-Year Growth of Income Inequality. Over the following twenty months, that extreme situation has worsened, as inequality growth and economic decline in the United States have continued. Indeed, the growth of income inequality is apparently accelerating.

The above cartoon is not my favorite inequality graphic, but it is possibly the most apt. Technically, with four years of falling median incomes and high unemployment, we’re now in a depression. (See Paul Krugman, End this Depression Now!, 2012; The Return of Depression Economics and the Crash of 2008, 2009.) Krugman retreated during the presidential election campaign to the official position that the U.S.  has recovered from but is close to sliding back into a recession.

Although private sector unemployment edged below 8% late in 2012, however, poverty levels continue to rise and median real income continues to fall. The sad news is that for some time the U.S. has been headed gradually toward the “inequality cliff,” toward the next Great Depression, and there has been no significant course correction.

Over the past two years, this blog has endeavored to identify and explain the causes and effects of economic inequality.  The comprehensive databases now available of income data over the last century, and gradually accumulating analyses, reveal that income inequality and the concentration of wealth are far more important macroeconomic factors than has generally been perceived, leading to some remarkable conclusions:

(1) Market economies are unstable, and without government intervention inequality tends to continue growing, through an upward redistribution of wealth and incomes, until depression sets in;

(2) Inequality growth reduces the potential level of overall growth and prosperity, and the  macroeconomic consequences of high levels of inequality are more severe than previously imagined.  Stopping inequality growth and controlling the levels of income and wealth distribution should be considered government’s most important economic responsibility;

(3) Sufficiently progressive taxation moderates the concentration of incomes and wealth at the top, enabling higher levels of growth and prosperity. As we are only just discovering, however, insufficiently progressive taxation aggravates inequality and reduces growth, perhaps to an even greater degree. The huge reduction of effective taxes on top incomes and corporations over the last thirty years is the engine that has generated the huge surge in inequality.

Such conclusions are of course rejected by conservative economists, and they have yet to be accepted by “mainstream” economics.  There is a deep American aversion to suggestions that “free market” capitalism does not efficiently provide for the general welfare.  Deeply ingrained economic ideology argues that: (a) market economies are stable and tend to return automatically to full employment equilibrium; and (b) when the wealthiest people are doing well, their success will trickle down, stimulating growth and improving the opportunities and fortunes of everyone else. Although these ideologies have been proven wrong, indeed the opposite of the truth, they have inhibited appreciation of the full macroeconomic implications of economic inequality.

The lead-in quotation from Keynes is the statement that opens the last chapter of his groundbreaking book, The General Theory of Employment, Interest, and Money (1935), in which he suggested potential policy implications of his General Theory. Keynes developed a macroeconomic model, the “general theory of employment,” that predicted (explained) the level of employment. However, although he identified the unequal distribution of wealth and incomes as the second major fault of a market economy, Keynes did not develop a “general theory of distribution.” Because he had not reasoned out an extension of his model to include the income and wealth distribution variables, he merely described the development of inequality as “arbitrary.”  The data now show, however, that although several potent institutional, technological, and geographic factors cause greater inequality, its growth is not entirely arbitrary. The distribution of wealth and incomes is causally interrelated with overall economic growth and taxation, and is therefore a major component of macroeconomic reality. Helping to better understand that reality has been a major focus of this blog.

Towards a new perspective

Here’s the point: If the consequences of inequality growth are as draconian and inexorable as we are discovering them to be, it is crucial for the field of economics not only to discard the false “conservative” ideologies mentioned above and return to a Keynesian understanding of how the economy works, but also to develop the “general theory of distribution” that Keynes fell short of providing.  The data are in, and economists can do it, but they are divided in their thinking. This division in thinking has significant consequences.

In the introduction to his recent book (Occupy the Economy, 2012, pp. 9-10), economist Richard Wolff made a penetrating observation.  When the Occupy movement began in the fall of 2011, he argued:

The academic economics profession ought to have been most intimately involved in analyzing and debating a broken capitalist system whose deep crisis had confounded all its confident expectations.  It has done nothing of the sort.  Instead it proceeds as if – and indeed mostly still insists that – nothing has happened to disturb its fifty-year celebration of capitalism’s efficiency and growth.  A few professors of economics (e.g., Paul Krugman) and business (e.g., Nouriel Roubini) have commented on the absurdity of that insistence.  But most of them could get no farther than to recycle Keynes’ 1930s critiques of a depressed capitalism and his recommendations for deficit spending and monetary stimuli by the government.  And, of course, the few right-wing economists who have taken the crisis seriously, utilized it to push yet again for less government intervention as the panacea. (Emphasis added.)

The emphasized part of the  statement accurately describes Paul Krugman’s perspective. In his own book published in May of 2012 (End This Depression Now!, Ch. 5) Krugman expressed alarm over the extent of the income inequality problem, and indicated that his thinking is in flux. However, he at least tentatively held to his long-held mainstream belief that income inequality is a “political” problem, not a macroeconomic one. His recommendations for stimulating the economy are, just as described by Wolff, from the traditional Keynesian playbook of fiscal policy (deficit spending) and monetary policy.  He did not even discuss the “tax the rich” option.

It was not until August of 2012 that Joseph Stiglitz became the first well-known economist to sketch out and support a macroeconomic perspective in his book The Price of Inequality.  Stiglitz described inequality growth as a process of “rent-seeking” in which income consisting largely of economic rent is increasingly concentrated at the top, at the expense of real production, income and growth elsewhere in the economy.  His recommendations include dismantling the mechanisms, constructed over recent decades, through which extreme economic rent extraction has become possible, and also substantially increasing taxation of top incomes and wealth.

The issue of the macroeconomic implications of inequality, ignored for centuries in the development of economic theory, is only now gaining attention.  The income distribution data for the last century has only recently been compiled, and economists are only just beginning to analyze it.  The topic was off the radar screen from 1935-1970, when Keynes’ revolutionary concept of fiscal policy dominated the economic conversation. Thus, in his new book (Keynes Hayek: The Clash that Defined Modern Economics, 2012), Nicholas Wapshott’s detailed account of the controversies between Freidrich Hayek and John Maynard Keynes contains almost no reference to inequality or distribution issues. Wapshott notes Hayek’s philosophical aversion to attempts to make everyone equal, including this quotation: “The rapid economic advance that we have come to expect seems in a large measure to be the result of inequality and to be impossible without it” (p. 219).  This, however, was a point on which Keynes agreed.  Neither of them was a “communist” – the argument was (and still is) whether capitalism works best without government interference, or whether it needs help.

With the topic of wealth and income distribution only just now emerging from the hallowed halls of philosophy and entering the scientific field of economic analysis, Krugman and other economists participate today in the “fiscal cliff” debate without a Keynesian general theory of distribution, and lacking even a comprehensive macroeconomic perspective on how income inequality relates to growth, taxation, budgets, and public debt. The implications of the difference between the Stiglitz and Krugman perspectives on inequality are enormous: If Stiglitz is correct that inequality growth is greatly harming the U.S. economy, prescriptions for recovery and growth that do not account for its continuously growing  impact will prove to be inadequate.

Confusion on the  budget, the debt, and the “fiscal cliff”

As of the beginning of 2013, we now have federal tax changes in place, but the debt limit remains unchanged and the “fiscal cliff” problem persists.  Budget battles loom as Congressional Republicans continue to fight for cuts in government programs and lower taxes for the rich.

Amid much confusion, commentators like Paul Krugman and Robert Reich, the author of Aftershock (2010) and Outrage (2012), have over the last few months stressed that our immediate problems are not with the deficit and national debt; they are with stimulating real recovery and growth.  But it was Krugman’s New Year’s Eve op-ed article in The New York Times, “Brewing Up Confusion” (here), that prompted this post. In that article Krugman was highly critical of Starbucks CEO and billionaire Howard Schultz for an open letter to employees promoting fiscal bipartisanship: “All he did,” Krugman said, “was make himself part of the problem.”

I found confusing Krugman’s strained (and dubious) condemnation of Schultz’ campaign in his strenuous effort to explain that, while the “fiscal cliff” should be avoided because it contains recessionary tax increases and budget cuts, attempting to “fix the debt” too quickly in such a manner must also be avoided.  Of course it is not Krugman’s fault that the public debate has thus far been dominated by anti-government, trickle-down ideologues. But to the extent that Krugman fails to explain the difference between taxing the rich and taxing everyone else, and fails to point out that higher taxes on top incomes can both “fix the debt” and stimulate the economy, unfortunately he becomes part of the problem.

Krugman read into Schultz’s call for fiscal bipartisanship the inference that he was “blaming both sides equally,” and a suggestion that it is the President who must now compromise and “come together,” after having already made considerable concessions:

The reality is that President Obama has made huge concessions. He has already cut spending sharply, and has now offered additional big spending cuts, including a cut in Social Security benefits, while signaling his willingness to retain many of the Bush tax cuts, even for people with very high incomes. Taken as a whole, the president’s proposals are arguably to the right of those made by Erskine Bowles and Alan Simpson, the co-chairmen of his deficit commission, in 2010.

Krugman is correct on this point: As a proponent of recovery and growth, the president should not make any concessions to the forces of stagnation and decline without a stiff fight, and many feel he’s already made too many.

It was unfair to Schultz, however, to suggest that he had any particular position on the merits of budget issues.  I have detected nothing in Schultz’s political statements over the last 17-18 months suggesting any position beyond his frustration with Washington gridlock. In a letter to Starbucks employees (11/8/11, here), for example, he said he was “growing more and more frustrated at the lack of cooperation and irresponsibility among elected officials as they have put partisan agendas before the people’s agenda.”  In another letter to fellow business leaders (8/15/11, here; see also, “Starbucks CEO Howard Schultz calls for boycott of political cash,” here), he called upon them to withhold campaign contributions until “incumbents in Washington … strike a bipartisan, balanced long-term debt deal that addresses both entitlements and revenues,” and “to hire and accelerate employment now.” In that letter he argued:

[O]ur long-term business success depends on our national elected leaders doing their jobs, and on tens of millions of unemployed Americans getting jobs. We have it in our power to influence both factors.

This effort is not concerned with helping or hurting one party or another; it’s about applying pressure on all those now in office to compromise for the good of the country. It does not spell out detailed instructions for either a debt deal or a jobs push.”

In the summer of 2012, Peter S. Goodman of the Huffington Post met with Schultz and reported  (“Starbucks CEO Issues Open Letter, Calls for Job Creation,” 6/29/12,  here):

[W]hen I met with Schultz, he left me convinced that his letter reflects genuine apprehension about the state of the nation. ”We all sense one thing in common: something is wrong,” he told me. “The country is drifting and we’re not addressing significant issues. This is not about marketing. This is about conscience. I’m concerned about the state of the country.”

Goodman reported that Schultz said the decline of the U.S. economy, and of opportunity and upward mobility in America, is “personal” to him.

Schultz has demonstrated no more than an intense concern about the need for economic recovery and job growth, which makes him Krugman’s ally.  His belief that jobs and recovery are good for both management and labor makes Schultz’s message all the more compelling. (And although I do not know that Schultz has joined Warren Buffett and the Patriotic Millionaires in arguing for higher taxes on top incomes, throughout 2012, ironically, neither has Krugman.) Ignoring all that, Krugman offers only faint praise for Schultz, allowing only that he “has a reputation as a good guy, a man who supports worthy causes.”

I found it extraordinary that Krugman would come down so hard on an ally like Schultz, just to argue that he was “brewing up confusion.” Krugman’s concern with Schultz’s statements is actually a narrow one, traceable to a recent public letter (“Let’s Come Together, America,” 12/26/12, here), in which Schultz merely said this:

As many of you know, our elected officials in Washington D.C. have been unable to come together and compromise to solve the tremendously important, time-sensitive issue to fix the national debt. You can learn more about this impending crisis at www.fixthedebt.org.

Krugman’s real beef, it turns out, is with Fix the Debt.  ”The people at Fix the Debt,” Krugman said, “have been doing their best to muddle the issue.”  Krugman argued:

First of all, it’s true that we face a time-sensitive issue in the form of the fiscal cliff: unless a deal is reached, we will soon experience a combination of tax increases and spending cuts that might push the nation back into recession. But that prospect doesn’t reflect a failure to “fix the debt” by reducing the budget deficit — on the contrary, the danger is that we’ll cut the deficit too fast. * * *

[I]n a new fund-raising letter Maya MacGuineas, the organization’s public face, writes of the need to “make hard decisions when it comes to averting the ‘fiscal cliff’ and stabilizing our national debt” — even though the problem with the fiscal cliff is precisely that it stabilizes the debt too soon. Clearly, Ms. MacGuineas was trying to confuse readers on that point, and she apparently confused Mr. Schultz too.

Wow!  Here again, Krugman unloads on another, at least potential, ally.  I am sure that Fix the Debt was incensed about being told they were “trying to confuse readers.”

Krugman seems to be wrong about Fix the Debt: They are not one of those partisan right-wing groups, as he put it, “more concerned with cutting Social Security and Medicare than with fighting deficits in general.” Its founders are Erskine Bowles (D) and Alan Simpson (R), co-chairs of the President’s National Commission on Fiscal Responsibility and Reform (here).  Moreover, the  current Chairmen of Fix the Debt (Michael Bloomberg, Judd Gregg, and Edward Rendell) are not exactly hard-core tea party members.

The Simpson-Bowles plan (Ezra Klein, The Washington Post, 12/4/12, here), which included proposals for significant tax increases on top incomes and capital gains, was according to Krugman himself (see earlier quotation), arguably to the left of President Obama’s own plan.  What’s more, the core principles of Fix the Debt, which Krugman takes to task, agree with his fundamental point that “the plan should be implemented gradually to protect the fragile economic recovery.”

Avoiding deeper depression

It troubles me that Krugman went to such great lengths to denigrate erstwhile allies about views that I really don’t think they actually hold just to emphasize that government, in avoiding going over the “fiscal cliff,” must avoid “a combination of tax increases and spending cuts that might push the nation back into recession.” Another article (“Fix the Economy, Not the Debt”?) might have done that in a more straightforward, less contentious way.

What troubles me more, though, is that he missed a perfect opportunity to emphasize that, in combination with  spending cuts, it is only the tax increases required on lower incomes that threatened economic health, if we tumbled over the “fiscal cliff.” Although increasing taxes on lower incomes causes more stagnation by reducing demand, increasing taxes at the top both improves growth and prosperity and ”fixes the debt.”

At no time in 2012 that I am aware of, however, has Krugman acknowledged the importance of taxing the rich, and given his stature, he should.  One of the concerns he mentioned in his article was that in its list of ”core principles” Fix the Debt “actually calls for lower tax rates.”  Fix the Debt’s core principles (here) merely call for “comprehensive and pro-growth tax reform, which broadens the base, lowers rates, raises revenues, and reduces the deficit.”  It’s not reducing taxes at the top that would achieve such results — that’s the “trickle-down” argument — and Krugman should make that clear. These objectives call for higher taxes at the top and lower taxes on middle class incomes and the poor.  This is all fundamental to Keynesian demand-side thinking, as Krugman himself emphasized in a debate with Arthur Laffer on the Bill Maher show on Memorial Day, 2012 (See my post It’s the Marginal Efficiency of Capital, Stupid!, 5/28/12).

Keynesian economists need to clarify the importance to growth and prosperity of taxation of top incomes sufficient to counter the continuous transfers of wealth to the top and the growth of inequality.  Failing to make that clear only plays into the hands of the “trickle-down” camp. This isn’t just about the richest Americans paying “a little bit more” or paying a “fair share” of the cost of government.  If the Stiglitz perspective on inequality is correct, it’s about taxing back down enough of the excessive amount of wealth that is constantly transferring up to stop the spiral down into Great Depression #2.

Paul Krugman is certainly correct that we must not allow austerity policies designed to fix the debt push us deeper into this recession/depression; but we must not let insufficiently progressive taxation in the face of rapidly growing inequality send us there either. It will take much more to counter stagnation, unemployment, and rising debt than most people now understand.  We will need much higher tax revenues from the rich and from corporations.

The dangers posed today by a fall from the “fiscal cliff” are minor compared to the devastation waiting for us, in a few years, in that deep chasm beneath the “inequality cliff.”

JMH – 1/1/13 (rev. 1/10,12/13)

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