Welcome to “A Civil American Debate”

(This welcoming page was initially posted in March of 2011. It was updated in early 2014 to reflect our recent concentration on the economics of wealth and income distribution.)

The Economics of  Wealth and Income Inequality  

Go here for a chronological list of all posts addressing the economics of America’s most fundamental problem: the continuing and accelerating growth of income and wealth inequality, the decline of the “middle class” and the entire bottom 99%, and inequality’s causes and solutions. These posts describe and develop the essential features of the dynamic causes and effects of income and wealth redistribution in a modern market economy, with a primry focus on the U.S. economy. 

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Our Executive Summary on economics (April, 2011) contains an early look at our views on the American economy. These views have expanded considerably, are now more refined, and are accounting in more detail for changes in the field of economics that have taken place over the last two centuries. The essential features of America’s economic problems has not changed, but our intent has been to expand on the failure of the economics profession to comprehend how market economies really work.

Our discussions of other topics are listed on the Contents Topics page. We have left the following introduction unchanged from when it was first posted in March of 2011.

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Introduction 

When we started this project after the Tucson tragedy, we were determined to chronicle America’s past, identifying and discussing major problems, and hoping to help America find ways to work its way out of the current crisis.  By then, we were already gravely concerned about the results of the mid-term elections and a rapidly deteriorating situation.

Our plans to conduct a relatively leisurely series of fact-based discussions and debates quickly gave way, with the facts we are discovering and the current events that are unfolding, to a sense of urgency.  We now intend to provide a broad, fact-based information and analysis service.  We want to join others who are encouraging all Americans to get involved and stay involved in the political process.  Our primary focus for now will be on detailing the stunning economic and social facts and analysis that explain how we arrived at this crisis situation, and what can be done to turn things around.

Most Americans are probably unaware of how dangerous the current situation is for everyone but the very wealthy.  Large corporations and very wealthy people mostly have it their way in Washington, and through control of the media they are able to shape public opinion in ways that serve their interests.  We will show how they are hurting the American middle class and all Americans in the economic bottom 99% , and explain why major concepts in their self-serving ideology and propaganda are wrong.

Today the middle class is shrinking, unemployment hovers around 10%, housing foreclosures and bankruptcy rates remain extremely high, and adequate health care and education are falling more and more out of the reach of middle class Americans.  The middle class is in decline, and poverty is on the rise.  In September of 2010, CBS News Reported that one in seven Americans (43.6 million people) were living in poverty, up 8 million from August of 2004.  In sharp contrast, the rich have been steadily getting richer, and the top 1% holds the majority of America’s wealth.  This is nearly the same inequality in wealth distribution that existed in 1928, just before the beginning of the Great Depression.   Within the top 1%, a small group of multi-billionaires has achieved astronomical wealth, and they are now working to expand their control of federal, state, and local governments.  Their agenda amounts to an all-out attack on what is left of a dwindling middle class.  This grew out of disastrous policies started 30 years ago in the “Reagan Revolution,” but it is not what Reagan wanted.

The Last Two Years

After the Bush Administration ended with an economic collapse into the Great Recession and a massive Wall Street bailout, we could only share America’s guarded hopefulness that the newly elected President Obama could turn things around.  His administration appeared to stem the tide of economic collapse, stemming job losses and avoiding a deeper recession or depression.  Despite his party’s majorities in both houses of Congress, however, Obama was unable to achieve any real Wall Street reform or even produce much health care reform.

Chillingly, Congressional Republicans had become the party of “no,” openly opposing the President’s recovery efforts with filibuster after filibuster and revealing a political strategy of blaming him for the failure of those efforts. We would have expected everyone in Congress to want and to work for economic recovery, but we were sadly disappointed.

When in January 2010 the Supreme Court decided in Citizens United v FEC that corporations had constitutionally protected speech permitting them to spend as much as they desired in election campaigns, a whole new level of concern set in.  Sure enough, in the November elections corporations and billionaires spent millions of dollars, often anonymously, in support of Republican and tea-party candidates.  Consequently, voters provided the party of “no” and its new tea-party allies with a House majority and gains in the Senate, insuring that Obama would not be able to advance his recovery and jobs creation agenda in the next two years.

Exit polls revealed that voters were mainly concerned about economic recovery and jobs.  Many had been persuaded that Obama’s policies were failing and that the new members of Congress they voted for would do a better job of accomplishing his goals.  The voters had been seriously misled: the radical right has no intention of accomplishing these goals.

Instead, the radical right immediately pursued its agenda of advancing the interests of America’s most wealthy people, in opposition to those of all other Americans.  Currently (March of 2011) the radical right seeks to slash spending for federal programs that benefit ordinary Americans by some $60 billion,  including funding for low-income housing, early childhood, Low Income Home Energy Assistance grants, community health centers, and other services for the poor, asserting a politically false and economically impossible “goal” of thereby eliminating deficit spending and reducing the growing federal debt.

These cuts would be counterproductive, serving only to eliminate 700,000 to a million more jobs, worsening the economy and increasing the deficit.   Closing the deficit, however, is not the radical right’s real concern.  They served notice in December of their indifference to budget deficits and the federal debt when they forced renewal of the Bush tax cuts for the wealthy.

Our  Mission

Too many people in the middle class and below, we believe, are not yet sufficiently aware of the dramatically increased consolidation of wealth and income within the top 1% of Americans over the past 30 years, and this group’s steadily increasing control of government and the media.   Nor,  we suspect,  do they yet realize how significantly that consolidation of wealth has hurt them economically.  We were not aware when we started studying these issues of how incredibly serious the economic situation had become, but we believe we have identified and explained the major economic consequences of the last thirty years of the “Reagan Revolution,” and they are stunning.  Nobel prize-winning economist Paul Krugman and Robert Reich, among others, have convincingly argued that the radical right is leading America into another depression, destroying the prosperity and freedom of everyone in the economic bottom 99%.  We too believe that a serious depression is imminent,  but can be avoided if America changes course now.  But there is no margin remaining for political error.

Today a minority group of right-wing radicals within the wealthiest top 1%, which as noted has been given the right to buy elections, seeks to advance a very radical political agenda of privatization and corporate control of government.  This threat has emerged suddenly this year in states like Wisconsin, Michigan and Ohio, where democracy and democratic self-government are now themselves under direct attack.

This site is dedicated to demonstrating the true gravity of the current situation. Within the various categories on this site you will find analyses and findings presented in bite-sized chunks, and we will be continuously adding more details and facts.

You will find this Welcome note both as a page and as a post.  A  Summary post, also posted on the menu bar as a page, summarizes our major conceptual conclusions.   We have also prepared an Economic Summary which contains our stunning conclusions about the effect of the “Reagan Revolution” on the economy over the past 30 years, cross-linked to the relevant posts.

We provide a Resources category listing recommended reading, action groups, and information sources.  Finally, we will develop a Recommendations category where we intend to post suggestions and discussions (our own and from others) about what the bottom 99% can do to turn things around.

Our most important purpose right now is to encourage everyone to get involved and stay involved until our lives, our democracy, and our American way of life are safe from the corporate attack.  We urge everyone to organize, join political action groups, learn about what is happening in America, learn the truth and broadcast it far and wide, as we are trying to do.  We can’t do this alone.

The Future Is at Stake

We especially encourage young people, the so-called “lost generation” that is finding it progressively harder to get a good education as funding and programs evaporate from elementary school all the way up to graduate school.  You are fully aware of what is happening to you: Most students like you are finding it increasingly difficult to get higher education without incurring huge debts it may take a lifetime to repay, and even to find jobs once they have their degrees.  Increasingly, only the very rich can afford high quality education.

We graduated from high school fifty years ago, and you can take it from us:  It hasn’t always been this way.  What is happening today to education in America is outrageous.  Among the most important freedoms in America are your freedoms to get a quality education, to provide economic security for yourselves and your families, and to find fulfillment in life.  Now you must work hard to preserve those freedoms. You all are the keys to regaining your freedoms and making sure that you will have a real future, so please get started.

Here is a recent tape of a political action by Coffee Party USA  that took place at Wesleyan University, to which all young people can (and should) relate.

The huge push-back in Wisconsin against the overt attack on public-sector workers and their unions shows that once they became aware of the sinister hidden agenda of the tea-bagger plutocrats, Wisconsin citizens reacted immediately and decisively.  Here is a video of a Wisconsin farmer explaining how Scott Walker’s tax-cuts-for-corporations and spending-cuts-for-people agenda will devastate Wisconsin communities.

All Americans in the bottom 99% must continue to support the people of Wisconsin as they struggle for justice and attempt to recall legislators and a governor that won election on false pretenses.  It’s not just about unions, and it’s not just about Wisconsin.  What happens in Wisconsin, Michigan, Ohio, and Florida – anywhere in America – affects us all.

There is no doubt that the American people can defeat the power of the radical right, their wealthy patrons and their corporations, once they are aware of the truth and are galvanized into action.   Many progressive organizations and unions are fighting these suddenly very extreme attacks, and they are gaining in strength.

To be sure, the right-wing media has the ability to cause many people to act against their own interests.  But these people are in the minority, and we all have the power to ignore the radical media and disregard their propaganda and their distortions.  If we remain calm and confident, through hard work we can win this class struggle.  It is up to us.

As Michael Moore pointed out recently in Madison, Wisconsin, the 400 wealthiest people in America have as much wealth as the entire lowest half of the population, 155 million people!  But we all need to remember and stay focused on this: They don’t have anywhere near as many votes.  It’s the top 1% against the bottom 99%, so make democracy work and take back your country.

Please send our link to everyone you can.  And bookmark it for our updates! Constructive comments, questions, and information are welcome.

(We invite you next to read our Summary page, where we outline our major conceptual conclusions so far, and our Economic Summary.  Mike’s initial post, The American Bad Dream, reflects on the major developments that have affected his views and concerns over the past 50 years.)

ARC, JMH – 3/16/11

(Contents Topics)

Posted in Welcome | 3 Comments

False Forecasts and Dangerous Delusions

The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, 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 so is to assume our difficulties away.

– John Maynard Keynes, The General Theory of Employment, Interest and Money (1935), Signalman Publishing. Kindle Edition, 2010, p. 23.

These are the concluding remarks from Keynes’s seminal Book I, Chapter 3, “The Principle of Effective Demand.” The crucial fact he noted is “the drag on prosperity which can be exercised by an insufficiency of effective demand.” Importantly, this was not his own original idea. He found the essence of it in his considerable review of the history of political economy. It was through T.R. Malthus, in his early 18th Century Debate debate with David Ricardo, that: “the notion of the insufficiency of effective demand takes a definite place as a scientific explanation of unemployment.” (The General Theory,  p. 240):

I distinctly maintain that an attempt to accumulate very rapidly, which necessarily implies a considerable diminution of unproductive consumption, by greatly impairing the usual motives to production must prematurely check the progress of wealth.

By wealth, as the term was used in classical economics by Smith, Ricardo and Mill, Malthus meant tangible output. Keynes quickly turned to the 1889 text by J.A. Hobson and A. F. Mummery, The Physiology of Industry, which Keynes hailed as a reawakening of “theories of under-consumption” (Id.)

Though it is so completely forgotten to-day, the publication of this book marks, in a sense, an epoch in economic thought. (p. 241)

They attacked the premise in the theory of Smith and Ricardo that:

Saving enriches and spending impoverishes the community along with the individual, and it may be generally defined as an assertion that the effective love of money is the root of all economic good. Not merely does it enrich the thrifty individual himself, but it raises wages, gives work to the unemployed, and scatters blessings on every side (pp. 241-242).

This, you may recognize, is the familiar “trickle-down” theory. Hobson and Mummery rejected that idea, arguing instead:

Our purpose is to show that these conclusions are not tenable, that an undue exercise of the habit of saving is possible, and that such undue exercise impoverishes the Community, throws laborers out of work, drives down wages, and spreads that gloom and prostration through the commercial world which is known as Depression in Trade.

In other words — and this was the main point of Keynes’s General Theory — depression is the proximate result of declining effective demand. But Keynes’s correct view did not survive the 1960s and 1970s. I say this to anyone uncertain about the invalidity of the classical and neoclassical rejection of the principle of effective demand: I can find no valid evidence — any evidence at all in modern economic history — supporting either Say’s Law (“supply creates its own demand”) or the trickle-down theory (accurately re-framed thus: “more wealth at the top automatically increases supply, which then creates its own demand”).

CBO Adopts “Trickle-Down” Ideology 

Re-posted here is the discussion of CBO forecasting from my last post. Before getting to that, I want to remind the reader that CBO in its July 2014 Outlook (Ch. 6, p. 70) formally adopted the trickle-down and austerity doctrines as articles of faith (For a fuller discussion, see my recent post “Breaking News: CBO Infected with Trickle-Down Disease”):

  • “Higher debt crowds out investment in capital goods and thereby reduces output relative to what would otherwise occur”;

This is the now discredited Reinhart/Rogoff theory supporting the “austerity doctrine,” a trickle-down variation asserting that reduced national government spending (effective demand) promotes growth (i.e., “creates its own demand.”) 

  • “Higher marginal tax rates discourage working and saving, which reduces output.”

This is the “Laffer Curve” argument, the converse of the trickle-down myth (i.e., because more wealth at the top from reduced taxation automatically increases supply, which then increases demand, it follows that less wealth at the top caused by higher taxation, reduces growth.)

Let’s be clear about this: The agency charged with providing objective advice to the U.S. Congress about future income growth expectations has formally concluded that demand has no effect on growth, and adopted the even more fanciful myth that growing demand is created by the mere existence of supply.

We must remember how dramatically the trickle-down fantasy has been disproved. This is from my post “Amygdalas Economicus: Perspectives on Taxation,” January 24, 2013:

In their April 27, 2001 report “The Economic Impact of President Bush’s Tax Relief Plan” (The Heritage Foundation, Center for Data Analysis Report #0101, April 27, 2001, here), D. Mark Wilson and William Beach predicted that the Bush plan would significantly increase economic growth and family income while “substantially reducing federal debt.” In fact, they predicted, the Bush plan would greatly increase government revenue, so much so that “the national debt would effectively be paid off by FY 2010.” In other words, they argued that the Bush tax cuts would more than pay for themselves, by an incredible amount.

What actually happened, however, is that the federal debt, which was at about $6 trillion in 2001, increased to about $13.6 trillion by the end of 2010 (Treasury Direct, here).  The Heritage Foundation’s estimate of supply-side “stimulation” was off by almost $14 trillion, nearly one year’s GDP.

To make that forecast a reality, the deficit would have to have been converted into a surplus, which meant that by a wide margin the tax cut would have to have paid for itself. Not only that, but the surplus would have to have been sufficient to retire over $6 trillion of debt in 8 years. It is difficult to accept that anyone could be stupid enough to believe that propaganda, so we can only assume its conjurers simply hoped to fog it by an ignorant, inattentive public.

But the propaganda continued when Paul Ryan issued the House Budget Committee’s Fiscal Year 2012 Budget Resolution on March 20, 2012, entitled “The Path to Prosperity: A Blueprint for American Renewal” (here), and an endorsement of the plan was released on the same day by James Pethokoukis of the American Enterprise Institute (here). As I discussed:

The proposal was to keep the Bush tax cuts, and reduce taxes on top incomes even more (there would be only two tax brackets, 10% and 25%) and reduce the corporate rate from 35% to 25%, while funding these cuts by slashing federal programs.  There was no explanation of how, exactly, this austerity program would stimulate growth, but the prediction was graphically displayed that, without these tax cuts, debt would rise to 300% of GDP by 2050, yet with them the entire federal debt, which was then over $16 trillion, would be paid off by 2050:

Pages from pathtoprosperity2013bThis time, the degree to which the proposed tax cuts would allegedly more than pay for themselves became astronomical:  Without those cuts, the graph predicts, the debt would rise to about 300% of GDP by 2050. So these tax cuts would produce additional government revenues on the order of $45-50 trillion!  

 CBO’s False Forecasting

With this background in mind, let’s review the discussion of CBO forecasting from my last post:

Of course, no one has a crystal ball, and CBO in its “Budget and Economic Outlooks” suggests that we not regard its “projections” as forecasts. But we do, because we think they are capable of making at least short-run forecasts. Paul Krugman confirms that expectation when he says (in “The Fiscal Fizzle”) things like this:

The budget office predicts that this year’s federal deficit will be just 2.8 percent of G.D.P., down from 9.8 percent in 2009. It’s true that the fact that we’re still running a deficit means federal debt in dollar terms continues to grow — but the economy is growing too, so the budget office expects the crucial ratio of debt to G.D.P. to remain more or less flat for the next decade.

And he relies entirely on the CBO to claim this:

I’m not sure whether most readers realize just how thoroughly the great fiscal panic has fizzled — and the deficit scolds are, of course, still scolding. They’re even trying to spin the latest long-term projections from the Congressional Budget Office — which are distinctly non-alarming — as somehow a confirmation of their earlier scare tactics.    

All that supply-side “forecasting” can hope to accomplish, however, is guess the degree to which future growth will track the economy’s “productive potential,” which no macroeconomic forecaster actually has any way of identifying. We saw that in spades in our review of Thomas Piketty’s book “Capital in the Twentieth Century,” which attempted to resurrect an antique, controversial production-function model as the “Second Fundamental Law of Capitalism.” (See my post series “Picking Piketty Apart,” including “His Contribution,” 6/14/2014, “His ‘Laws of Capitalism’,” 6/21/2014, and “Time’s Running Out,” 6/23/2014). He candidly conceded that the model could not be used for forecasting, and explained it was only “valid” in the long run, which left me and others at a loss to explain why he decided to write a book about it.

What’s more, income (GDP) data contain a great deal of economic rent, which has zero tangible value. The point is, the only hope for making any predictions for the future is to follow trends in aggregate demand, and supply-side forecasters do not do that. Thus, the entire neoclassical paradigm unravels as we drift deeper and deeper into recession and depression.

What CBO does, it turns out, is first decide how much optimism it can sell, then unveil numbers for a basic ten-year forecast reflecting that degree of optimism. In its February, 2014 “Outlook”, for example, it projected a rapid return to an indefinite continuation of 2.1% annual growth, even though (by S&P’s calculation) growth has averaged only 1.4% over the last decade. Then it generated numbers for the intervening years which were then presented as if they were the product of some sort of prognostication.  In other words, CBO is actually backcasting, not forecasting!

Here’s the proof: From its “Budget and Economic Outlook, 2014-2024″ (here), pdf (here) we can extract the following data (in $billions) :

Baseline Outlook

Item                                                          2013      . . . .        2017    . . . .      2022

1. Y-E debt, as a % of GDP [1]          72.1                        72.3                     76.8

2. Publicly held debt  [2]                 11,982                    14,507                 19,001

3. GDP   [2]                                             16,627                   20,054                 24,746

4. Computed GDP (l 2/l 1)               16,619                   20,065                 24,740    

[1]  Table 1-1, p. 9            

[2]  Table 1-2, p. 12

The numbers check. There is no reason to suspect, reading these numbers, that CBO isn’t using algorithms that project either publicly held debt or GDP as dependent variables. However, when we go back two years and look at data from “The Budget and Economic Outlook: 2012-2022″ (here) pdf (here), we see that it does no such thing:

Baseline Outlook

Item                                                          2013      . . . .        2017    . . . .      2022

1. Y-E debt, as a % of GDP [1]          75.1                         68.5                    62.0

2. Publicly held debt  [1]                 11,945                    13,509                15,291

3. GDP   [2]                                            15,914                    19,708                24,665 

4. Computed GDP (l 2/l 1)              15,905                    19,721                 24,663  

Alternative Fiscal Scenario 

Item                                                          2013      . . . .        2017    . . . .      2022

1. Y-E debt, as a % of GDP [1]          77.8                        84.0                     94.2

2. Publicly held debt  [1]                 12,374                    16,560                23,232

3. GDP   [2]                                            15,914                    19,708                 24,665 

4. Computed GDP (l 2/l 1)              15,905                    19,714                 24,662

[1] Table 1.7, p. 22

[2] Table 1.3, p. 10. Note: No separate GDP was provided for the A.F.S.

.   .   .   .   .   .   .  .

The entire outlook revolves around a judgmentally presumed amount of growth that will take place over the next ten years  no matter what else happens. In its February 2014 report, CBO presumed a GDP of $24.7 trillion  in 2022. This is up slightly, but still rounding to $24.7 trillion it used in its January 2012 outlook two years earlier.

Incredibly, this GDP number was not allowed to change, whether the debt was seen as rising to $15.3 trillion or to $23.2 trillion! This preposterous approach renders the entire “outlook” meaningless and nonsensical. The amount of debt is integrally related to GDP — at a very minimum, income tax revenues vary with GDP, so an additional $8 trillion of debt needed in the A.F.S. automatically implies a gigantic decline in GDP, and the associated need for more borrowing. 

This approach is fatally pernicious: For any given higher A.F.S. level of “projected” debt, GDP is necessarily lower than presented in the report. 

There is no indication that CBO believes debt might go up because the federal government will grow substantially, or that if it did there would be no stimulus, and the constant presumption of GDP growth invalidates the figures for debt as a percent of GDP. But Because CBO is backcasting from a presumed GDP ten years down the road, its numbers simply bear no relation to what may happen in the next few years, and will obscure the likelihood of impending crisis.  

CBO has conceded it made as optimistic an assumption for growth as it could for the next ten years.  But it’s only playing “pin the tail on the donkey,” then waiting around to see what actually happens. In the meantime, from the perspective of its economic “outlook,” no actual changes in the rate of growth, no amount of decline in  income or consumer and investment demand, are allowed to modify the ultimate expectation of growth built into the GDP presumed for the end of a decade. [Note #1 - omitted here]

CBO might protest that it is constantly revising it projections to reflect real changes in economic conditions. It appears not, but if so, that is all it is doing. It should stop pretending to see ten years into the future, certainly not 35 years into the future, and then disclaiming its work as non-forecasting.

Some immediate points:

It’s unclear why the amount of public debt, which now officially exceeds $17 trillion, is reported at much lower levels by CBO. Perhaps the $17 trillion number includes some debt not held by the public? This needs clarification. [Note #2 - omitted here];

CBO’s long-range “Outlook” in July of 2014 said debt would reach 100% of GDP finally in 2039. In 2012, Reinhart and Rogoff reported it was almost already there;

Regardless, CBO has no handle on the growth rate of debt because it does not account for changes in spending and demand, only potential production;

Its assumption of 2.1% annual growth instead of 1.4% or less is unfounded, admittedly optimistic, and dangerously over-optimistic because we’re in an unacknowledged depression.

Although we do not need to worry about the national debt itself causing decline,  we now know that the inequality caused by the high level of debt does, and the escalating inequality spiral will continue to depress growth even more rapidly than would the operation of Keynesian dynamics alone.

The one factor that any forecaster should be most certain of, at least in the short run, is the amount of debt and debt interest. As my letter to the Times Union reported, even under its optimistic scenario for GDP growth, CBO had debt interest exceeding the entire defense budget by 2021. It further covered up its expected growth of debt interest in the July report. There has to be some reason or reasons why CBO is unwilling to frankly discuss the debt problem any more. Could that reason possibly relate to the reason(s) that S&P suddenly surfaced a week or so later with the warning that inequality depresses growth? 

_______

The Perverse Bias in CBO’s Approach

I noted late yesterday (10:30 p.m. on 8/27) that CBO had just released “An Update to the Budget and Economic Outlook: 2014-2024″ (August 2014, here), which I have yet to thoroughly review. I did make a couple of initial observations:

  • CBO said it has reduced its estimate of the 2014 budget deficit. But on p. 6 it also stated: “The agency has significantly lowered its projection of growth in real GDP for 2014, reflecting surprising economic weakness in the first half of the year. However, the level of real GDP over most of the coming decade is projected to be only modestly lower than estimated in February.” This sentence, I noted, re-enforces the false impression CBO gives of actually projecting GDP over ten years (or more) as a dependent variable, and obscures its actual method of forecasting.
  • I noted that this latest report has 2022 GDP at $24,565 billion, just $181 billion lower than its February 2014 projection of $24,746 billion, cited above. So even though CBO has “significantly lowered its projection of growth in Real GDP for 2014″, it has not allowed any modification of the presumed level of ten-year growth.

We need to be clear about the implications of CBO’s approach. Like its Alternative Fiscal Scenario in 2012, this change in growth expectation does not impact the final expected GDP at the end of ten years. That is because this ending level of GDP was never forecast, it was presumed:

  • Perversely, no reductions in growth expectations are allowed to alter this final expectation. Because lower growth entails lower government revenues, a revised baseline would show higher deficits, debt and debt interest throughout the decade. Instead, CBO somehow arranges for additional growth later in the decade so that the amount of GDP at the end does not change.
  • Misrepresenting the state of the economy and the budget this way is certainly irresponsible. It would seem to meet the political requirements of a Republican Congress that is concerned in this election year about pressure for more progressive taxation. After the election, if the Republicans take over both the House and the Senate, they can proceed unmolested with bills to reduce taxes, and continue to attack President Obama’s vetoes with charges that he is interfering with the “path to prosperity.”
  • The approach requires the continuing acceptance of trickle-down ideology by an uninformed and unwary public.  

Worse, using this trickle-down approach prevents CBO from making anywhere near accurate baseline projections in the first instance, thus further covering up the pace at which grave danger may be approaching:

  • While it is busy obscuring the effects of any budget changes on growth, and vice-versa, CBO neglects to inform either its baseline or alternative scenarios with the impacts of changing levels of consumer or investor demand. Unless Keynesian insights are restored, the next great depression will blow in as unanticipated as the last one.
  • Already, CBO has ignored the fact that for the last ten years average growth has been 1.4%, simply desiring to be as optimistic as they think possible; the world is led to believe CBO has some legitimate reason to believe that growth will improve, but that belief is founded on nothing more than neoclassical ideology.
  • The most severe demand-side cause of decline is growing income and wealth inequality, because the effect of hundreds of billions of dollars of wealth transfers annually to the top is to impoverish the active economy, to a degree vastly exceeding the effect of business cycle swings in savings and investment. Neoclassical supply-side forecasting is blind to these developments.
  • CBO has now been alerted by S&P of something we already knew — that inequality suppresses growth. If CBO does not respond soon by renouncing its adoption of trickle-down economics, we can only assume that its bias and deception are intentional and will continue.   

So far as I am aware, CBO has made no serious effort to counter the public perception that it is actually forecasting future growth:

  • Paul Krugman, as noted above, actually has the impression that CBO has a factual basis for projecting “the crucial ratio of debt to G.D.P. to remain more or less flat for the next decade.” CBO has made no such finding. It has simply decreed that it will;
  • The political Right has wasted no time reaffirming that perception. The Wall Street Journal, on the same day the report was released (“Deficit Forecast Trimmed as Rates Stay Low,”  by Damian Paletta, WSJ, August 27, 2014, here), highlighted the updates along with this graph showing the deficits “projected” out through 2024:

federal deficit projections 8-27-14 wsj- cbo

The WSJ presents these projections as if they were the product of actual forecasts, not numbers derived from a presumed level of growth. Paletta presented a middling assessment similar to Krugman’s, opening with “The agency now expects growth of 1.5% [in 2014] reflecting ‘the surprising weakness in the first half of the year’.” CBO is said to have  “an upbeat view on economic growth in the next few years,” and: “The darkest clouds . . . for the next decade came in its warning about the continued growth of the federal debt.”

There is no sense of alarm in this report, even though CBO does not foresee any year for the rest of the decade when the deficit will be outside of the $500-$1,000 billion range. CBO has said this is a trend that cannot be “indefinitely” sustained, which is obvious, but it it has expressed no concern about the prospects of the trend being sustained through 2024, and in the July report it even pretended to believe the trend could be sustained to 2039. But how could that be even remotely possible? How long might we expect this trend to last, and why? In its July report, CBO clearly covered up the implications of its February “forecast,” as discussed in my letter to the Albany Times Union, and that is not a good sign. 

Given what we now know about CBO’s false “forecasting,” we should have no confidence any more in any of its pronouncements. Even its rosiest, handpicked scenario for the next decade looks bleak. Paul Ryan and CBO should be called out now on their trickle-down games — before the election. 

JMH – 8/28/2014

 

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Inequality and Debt, Dysfunctional Forecasting, and the Discomfort Zone to the Left.

For much of the past five years readers of the political and economic news were left in little doubt that budget deficits and rising debt were the most important issue facing America. Serious people constantly issued dire warnings that the United States risked turning into another Greece any day now. President Obama appointed a special, bipartisan commission to propose solutions to the alleged fiscal crisis, and spent much of his first term trying to negotiate a Grand Bargain on the budget with Republicans. That bargain never happened, because Republicans refused to consider any deal that raised taxes. Nonetheless, debt and deficits have faded from the news. And there’s a good reason for that disappearing act: The whole thing turns out to have been a false alarm. — Paul Krugman, “The Fiscal Fizzle: An Imaginary Budget and Debt Crisis,” The New York Times, July 20, 2014, here.

[W]hen economic myths persist, the explanation usually lies in politics — and, in particular, in class interests. There is not a shred of evidence that cutting tax rates on the wealthy boosts the economy, but there’s no mystery about why leading Republicans like Representative Paul Ryan keep claiming that lower taxes on the rich are the secret to growth. Claims that we face an imminent fiscal crisis, that America will turn into Greece any day now, similarly serve a useful purpose for those seeking to dismantle social programs. – Paul Krugman, “Hawks Crying Wolf,” The New York Times, August 22, 2014, here.

As often happens, on a day I sit down to write a post, Paul Krugman publishes an Op-ed that helps me focus. Let’s get Krugman’s points from July 20 and today (August 22) freshly in mind: In today’s Op-ed, on the topic of monetary policy, Krugman opened by pointing out that the political right bases its case for lower taxes on top incomes and corporations on Paul Ryan’s false “trickle-down” argument while arguing that, because we face a fiscal crisis, we must “dismantle social programs.” A month ago, Krugman challenged the warnings from the right that there is a fiscal crisis, citing the “distinctly non-alarming” July 2014 report from the Congressional Budget Office (CBO). I.e. — there is no fiscal crisis, hence no need to dismantle social programs.

Krugman is correct about the Republican Party in Congress consistently seeking budget cuts and also seeking to cut top tax rates and taxes on giant corporations. The problem is, there actually is a demonstrable fiscal crisis, one that CBO inexplicably saw fit to cover up in its July Report. (See my post “Breaking News: CBO Infected With Trickle-Down Disease,” July 27, here.)

A brief summary of the data revealing this cover-up was included in a letter to the editor of the Albany Times Union, here. In that letter, with no reference to any implications or motivations (letters to the editor have to be short), I merely observed that CBO’s published baseline ten-year “outlook” (a projection that assumes current “laws” remain unchanged) had debt interest increasing 278% by 2024, while discretionary spending would go up by only 16%, the defense portion of that by 19%, and non-discretionary spending by 77%. By 2021, the cost of the debt would exceed the entire defense budget.

In its July “Outlook,” however, CBO presented  graphs (no data) representing that debt interest will remain well below, and grow roughly parallel to, major medical programs and Social Security, not only out to 2024, but for another 25 years as well. This directly contradicted it February projections, which CBO said it was re-endorsing. My only inference from these facts, apart from CBO’s gross misrepresentation, was this: “Obviously, mushrooming debt and interest are squeezing out financing for government programs.” The cited facts, well vetted by the TU, stand in direct contradiction to Paul Krugman’s assertion in July, based on CBO’s July report, that the “alleged fiscal crisis … turns out to have been a false alarm.”

The Discomfort Zone on the Left

Although such a letter to the editor would get support from the “Left” if, for example, it was accompanied by a request for higher taxes on the wealthy and corporations, merely asserting there is a fiscal crisis makes it look like I am siding with the “Right.” That is because Paul Krugman, instead of arguing that higher taxes on the rich are required, has opted instead to contend that there really is no looming fiscal crisis and because, since Krugman’s views dominate progressive thinking, people tend to believe him. 

Thus, my letter was not welcomed by the Left. One former colleague in mediation services, who never fails to provide supportive reactions, sent an e-mail saying: “It’s a dense subject that, I have to admit, I have not fully appreciated.” He suggested I should have emphasized up front that government programs are being squeezed out. 

Another former colleague sent me this e-mail message: 

Michael, I am stunned. You are a traitor to the left. Haven’t you been reading Paul Krugman, telling us how the deficit hawks are nuts, it’s not a problem? 

There it was: the argument that, given Krugman’s proclamation that there is no fiscal crisis, I must be aiding and abetting the Right. Many progressives who read my article may have had that reaction. When I explained that I thought Krugman was wrong about that, he responded:

Oh. Sorry, I guess I didn’t get that Krugman is just not left enough for you!! 

This former colleague, by the way, is a “conservative” who said he agrees with my assessment of the budget problem. Hence, he was merely chiding me for taking issue with Krugman. He happens to agree with Krugman’s perspective that inequality is merely a non-economic, political issue: Indeed, it is this perspective, attractive to the Right, that has taken Krugman out of the game. Without appreciating how inequality affects growth and decline, neither Paul Krugman nor my “conservative” friend can get beyond moral considerations pertaining either to inequality or to taxation. If inequality is presumed to have no economic consequences, the debate is an inconclusive one over moral and philosophical issues, and this is emotional turf on which the Right has held its own.  

This leaves my perspective — that inequality is a dangerous economic condition — in a no-man’s land I’ll call: “The Discomfort Zone to the Left.” By that, I mean, to the “left” (for those inclined to see economics in terms of a left/right continuum) of Paul Krugman, and of the neoclassical economists whose world-views still have not allowed them to understand the mechanics of growth and decline. So far, it’s been fairly lonely in the Discomfort Zone. Robert Reich and Joseph Stiglitz are here, along with a handful of heterodox economists. If Paul Krugman would expand his perceptions, he could narrow the Discomfort Zone, but so far he has pointedly rejected Stiglitz’s analysis.  

Unfortunately, in conceding the economics of inequality to the “Right,” Krugman has given up an enormous amount of territory, indeed most of it. As I have increasingly emphasized over the past three years, because his views are taken as gospel by most of the “Left,” he endangers us all. So I’ll review my perspectives on growth and inequality again, with emphasis on political considerations, to explain the grave danger Krugman’s perspectives have put us in.

The Inequality Problem 

As shown in my last post (“Inequality Suppresses Growth: A Serious Problem?”, here), income inequality began to grow quickly in the U.S. during the Reagan presidency, when deregulation and lax enforcement of anti-monopoly laws allowed corporations to consolidate and greatly increase their profits, and the wealthiest Americans correspondingly to greatly increase their incomes. Simultaneously, a trend of reduced taxation of their income and wealth enabled them to keep increasingly more of these profits, and wealth concentration grew commensurately.

Here in the Discomfort Zone, I have found no one other than myself willing press this point strongly, although as the decline continues economists like Reich and Stiglitz appear to be increasing the call for progressive taxation. I can only assume that others demure for political or professional reasons. But these tax reductions lie at the heart of the inequality problem: The redistribution of wealth and income to the top has greatly reduced productivity and income growth, to the point of depression. The financing of a stunningly substantial portion of the increased wealth at the top with government credit has greatly amplified the inequality problem, and it has created what has become an intractable budget crisis.

Simply put, here is what has happened: Our government, and the entire bottom 99% of income earners, have been pressed to the task of further enriching the top 1% with money borrowed by the federal government, implicitly agreeing to eventually pay for that enrichment. Wealth of such a magnitude could not have come directly from existing bottom 99% income and wealth, but the bottom 99% has effectively been given an open-ended deferred payment plan: We have been allowed to pay off later our “debt” to those few high within the top 1% whom we  have made inconceivably wealthy.

To be sure, the top 1% does contribute some tax revenues, but they are increasingly depositing vast sums (conservatively estimated at about $8 trillion) off-shore, out of reach of U.S. taxation; and their corporations, which are now operating with an ever-growing array of First Amendment rights, are optimizing the social and political power of their money here while they are “legally” declared to be “citizens” of some other country that will not require as much taxation on the earnings they collect here. They do not pay enough taxes here to prevent the interest on the government’s debt from growing exponentially, and that interest has for decades provided a perpetual annuity for the holders of government bonds.

These powerful few are poised for a potentially complete takeover of the U.S. government. Among the thugs in their employ are those who would “shrink” the U.S. government until it is small enough to “drown in the bathtub” (Grover Norquist). However else we may choose to describe this obscene program, it is a prescription for the increasingly less gradual decline, and the ultimate destruction, of the United States and its economy. Let me put it somewhat more mildly:

From the standpoint of maximizing tangible productivity and optimizing social welfare, a more mismanaged economy can scarcely be imagined.

The perception of this reality exists mostly to the Left of Krugman’s perspectives, for he has not recognized any such economic implications of income inequality, which, in his 2012 book End This Depression NOW!, Ch. 5, he wrote off as a “political” problem with no macroeconomic consequences. The Discomfort Zone to the Left of Paul Krugman is, indeed, a vast territory.

The Reign of Ideology

This blog is replete with the details of the critique of neoclassicism and its fanciful ideological offshoots, so I’ll just summarize them here. The core tenet of neoclassical faith is that market economies will always, following a downturn or crisis, return fairly rapidly to a state of full employment “equilibrium.” This belief grew out of the static classical image of an economy in full employment, with current income either spent on current consumption or invested in “capital stock” for additional production. Because economic outcomes are said to be governed by “laws,” moreover, they are presumed to be fair and equitable. There is no such thing as unreasonable inequality.

This ideology, although growing out of the static classical model, conflicted directly with the ideas of classical economists who maintained that wealth distribution was not a result of natural law, but of Society’s choices (e.g., John Stuart Mill) and who observed that much of income and wealth was “economic rent” — payments to landowners whose mere ownership of land contributed nothing to the production of tangible wealth (e.g., Adam Smith, T.R. Malthus, Henry George). With the development of capitalism in the mid-19th Century, corporations began to take over most or all of the means of production, and “rent” increasingly became an element of “profits” which, like land rents, necessarily declined over time (Karl Marx). The only way to keep profit levels up, over time, was to distribute less value down.

New arguments emerged to respond to these well-established contradictions to the perfect efficiency presumed in the neoclassical system. For example: (a) Preserving economic “freedom” will protect incentives for investment and growth, while effective market competition will continuously provide optimal efficiency (e.g., Milton Friedman); (b) Attempts to reduce inequality by redistributing income and wealth back into the active economy would entail a “trade-off” with the optimal efficiency and growth provided by the “invisible hand” of Adam Smith  (e.g., Arthur Okun); and (c) Inequality is only the addition of growth at the top with no diminution of the income or wealth of anyone else (e.g., Martin Feldstein’s “magic bird” argument).

Friedman, Okun, and Feldstein were active in the 1960s and 1970s, and influential in the movement to marginalize Keynesian economics. An outgrowth of Okun’s trade-off and Feldstein’s magic bird arguments was the “trickle-down” myth that dominates political discourse today: Simply put, it is the idea that income and wealth transfers to the top create growth, as the “job creators” automatically expand their investments. A related idea, the “austerity doctrine,” is that if central government, to balance its budget, refrains from taxing the rich, but instead cuts back its spending, the economy will grow. These perverse ideologies simply deny both Keynes’s “principle of effective demand,” the truth of which has been repeatedly verified ever since the Great Depression and  WW II, and the fundamental logic of the risk/reward assessments underlying investment decisions.

Krugman has repeatedly denounced the trickle-down myth, as in the second quotation above, but has treated it as a plausible factual proposition lacking real-world verification, not as a logically unsound idea. And he has not yet clearly rejected the corollary proposition that higher taxation at top incomes diminishes growth, by reducing investment incentives. This reverse trickle-down myth fails for the same reasons. 

Inequality and Growth

In my last post, I discussed Standard & Poor’s recent conclusion that income inequality reduces growth (“How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide,” August 5, 2014, here). I provided evidence of the validity of this conclusion. It’s enormous significance lies in establishing that the distribution of wealth and income is the basic determinant of prosperity and decline, and that falling growth is a huge problem that cannot be countered by merely stimulating demand and employment.   

Those of us in the Discomfort Zone, including Reich and Stiglitz,  have explained for several years, in terms of Keynes’s “marginal propensity to consume,” that aggregate consumption declines when income concentrates because wealthier people spend a lower percentage of their income on consumption than do middle class and poor people.  This wisdom has been lost on neoclassical economics, which has discarded Keynes’s principle of effective demand and rejected Keynesian “demand-side” economics in favor of full reliance on “supply-side” ideas.

In the context of America’s extreme inequality, this Keynesian reality should now be intuitively obvious: How in the world could the U.S. maintain the same level of consumption, and therefore production and income, after the income share of a mere 1% of the population increased from 9% (1979) to almost 25% of the income (2007)? The income share of the other 99% is correspondingly reduced, and aggregate consumption and growth necessarily declines substantially, as shown in my previous post. Martin Feldstein’s opposing “magic bird” hypothesis would require that, somehow, higher inequality itself magically expands the money supply. Regardless, the ultimate proof lies in the facts of experience:

US GDP 10-year moving average

This graph shows the decline since 1968 of the U.S. GDP ten-year rolling average growth rate. The curious factor here is the long period (about 1975-2005) of roughly 3% annual growth. The decline to about 1.5% average growth after the Crash of 2008 is substantial, and it has stumped mainstream economists, who have termed the trend “secular stagnation,” or “the new normal.” The most likely explanation for the Crash itself seems to be the collapse of effective demand driven by the steadily increasing income inequality, and perhaps by some degree of exhaustion of the support to the active money supply given by the creation of federal debt. This entire topic is rife with important research topics. 

Even small swings in the GDP growth rate, which varies within a narrow range, can be quite significant. During the period after WW II when prosperity was rising and income inequality declining, GDP growth averaged over 4%.  By the mid-1970s, the average growth rate had declined to about 3%, where it remained until the Crash. The U.S. population is now growing only about 0.7% annually, close to the slow population growth in the depression years, and down from 1.2% growth rate of the 1990s, “a decade of economic expansion” (The Guardian, December 31, 2013, here). But the 1990s was also a decade of rapid income inequality growth as well, with real median income growth well below the 3.0% average GDP growth.  The average of 1.4% aggregate growth since the Crash, as computed by Standard and Poor’s, likely represents declining per capita income for most of the bottom 99%: Yet another area brimming with research topics for Raj Chetty’s legions of “scientific” economists for whom, he says, the mysteries of growth “remain elusive.”

As a rough rule of thumb, we can probably think of aggregate GDP growth rates of 4.0% and higher as representing prosperity, 2.0% and below as reflecting depression, and 2-4% as representing average prosperity. The Crash of 2008 marked the end of period of steady average prosperity (rapidly increasing inequality supported by government debt) and the beginning of a gradually deepening depression. The new depression era has been a bizarre period with high inflation for top 1% luxury items — yachts, penthouses, antiques, fine art, etc. — generated by surplus financial wealth (see “Welcome to the Everything Boom, or Maybe the Everything Bubble,” by Neil Irwin, New York Times, July 7, 2014, here) and the more modest inflation below the top 1% for everyday consumer products, generated not by excessive consumer demand but by monopolistic market power, through excess profits.      

Growing inequality must be understood as separating the aggregate economy into two ever-increasingly independent economies, and failure to see the aggregate economy in such distributional terms leads to political error. For example, an editorial from The Orange County Register, “Student loans only inflate the U.S. debt,” was recently reprinted in The Albany Times Union (August 23, 2014, here), and it began:

Perhaps we should not be surprised that the Obama administration’s solution to a problem of high debts is to incur even more debt. This was the thinking with the economy as a whole, which has languished for more than five years since the official end of the 2007-09 recession, and now the administration is doubling down on this strategy to address student loan debt.

The editorial correctly notes that the more than $1.1 trillion of student loan debt is “the worst credit risk of any major debt category.” The author could only think of the cost to taxpayers, however, blaming the Obama administration for extravagant spending, with no awareness of the relevance of income and wealth inequality to the issue.

Here is the neoclassical mistake: The taxpayers who should be footing the education bill are those who have been enriching themselves at everyone else’s expense for three decades, depleting student resources and thereby directly causing the enormous student debt. Nor was there any appreciation that the enormous “bubble” may soon pop, creating still more inequality and reduced growth, if this debt is not properly managed by the government. Declining education, like declining health care, decaying infrastructure, failing municipal governments, and environmental decline, and so forth, is a direct consequence of the impoverishment of America caused by rising inequality.    

As explained above, the controlling factor is Keynes’s groundbreaking “principle of effective demand.” Keynes excluded income and wealth distribution from his full employment model in 1935, and the data needed for a distributional application of Keynesian macroeconomics has only recently become available: It’s worth reading a key passage from Keynes’s crucial Chapter 3, “The Principle of Effective Demand,” (Sec. II), updated to include [in brackets] references to inequality:

This analysis provides us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.

Moreover the richer [more unequal] the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor [highly unequal] community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy [the wealthy segment of a highly unequal ] community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until . . . its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

But worse still. Not only is the marginal propensity to consume weaker in a wealthy [more highly unequal] community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate.

This should resonate with anyone familiar with what has been happening in the U.S. since 1980. Notice that Keynes appeared to assume that full employment would be a sufficient response to the “paradox of poverty in the midst of plenty.” Extreme inequality, however, introduces the circumstance where money diverted from commerce to idleness and hoarding at the top vastly exceeds the shifts in the propensity to consume associated with the business cycle.

Notice, too, that the last two sentences of this quotation actually describe the anatomy of a depression. It describes what Paul Krugman calls a “liquidity trap,” but as Polly Cleveland has deftly noted, the liquidity trap may more accurately be described as an “inequality trap.” Above all else, it describes an economy shrinking deeper into depression. Keynes failed to note only that an inequality cycle will continuously worsen if the circumstances giving rise to it are not corrected.

Inequality and Debt

The federal debt now exceeds $17 trillion, and following graph, which I constructed more than a year ago, shows that the national debt has been rising faster than GDP since 1980:

chartgoHere, GDP (income), top 1% net worth (wealth) and the national debt are shown from 1982 through 2010, and GDP and the debt out to 2012. The national debt has grown steadily, exponentially over the last 20 years,  until 2010 when it was poised to reach the level of real GDP.  (NOTE: I have no definitive explanation of how CBO has computed the debt at only 73.6% of GDP in 2014 and 79.2% in 2024, but see the discussion of forecasting issues, below.)

Because the national debt is the major source of the rising concentration of wealth, and because income is concentrating high within the top 1%, top 1% wealth is also necessarily growing faster than GDP. Before the Crash of 2008, top 1% net worth reported to the Census Bureau (i.e., excluding unreported off-shore wealth) had grown by about $19 trillion. Remember, this stunning development is entirely due to the tax reductions on top incomes.

Politically, the effort by Republicans to regain control of the Senate in 2014 and to regain the presidency after 2016 entails the time-honored strategy of blaming the president for current economic woes.  That strategy is likely to work, even though the national debt was over $10 trillion when Obama took office (Treasury Direct, here), and interest has been compounding in perpetual annuity during the “Great Recession,” drastically reducing bottom 99% incomes and exacerbating the deficits ever since. Here’s a chart of the growth of the debt (as a percent of GDP) by administration (Wikipedia, here):

US_Federal_Debt_as_Percent_of_GDP_by_President_(1940_to_2012)


Debt grows exponentially, all else equal. So this chart shows the Reagan/GHW Bush years to be the worst from the standpoint of federal borrowing in excess of GDP growth. During the Clinton Administration the “dot.com” boom enhanced GDP growth and government revenues, and taxes on top incomes were increased, so debt as a percent of GDP declined. The GW Bush years were marked by extensive spending on the Middle East wars, collapse of the dot.com boom, and massive tax cuts for the rich, so debt as a percent of GDP again rose.

The Obama years have seen the sharpest increase in the debt/GDP ratio since the early years of the Roosevelt presidency. A different circumstance back then was that heavy borrowing was needed to finance America’s entry into WW II whereas, as noted, the current steep increase results from society’s decision to finance the exponentially increasing income inequality, and the unimaginable, depression-level income and wealth wealth concentrations at the top; after WW II the debt/GDP ratio fell with the redirection of war-time spending toward domestic recovery and infrastructure rebuilding, and the maintenance of very high marginal income tax rates. Over the last 35 years, however, the tax structure that is driving wealth to the top has not been corrected; the Republican Party will not allow reestablishment of the necessary level of taxation.

None of this is expressly recognized by neoclassical economists, however, whose deficient understanding of how the economy works permits them to ignore these tragic developments. It’s an incredibly huge gap between an appropriate distributional economics and this bankrupt neoclassical view — it’s the broad wasteland of the Discomfort Zone.

Reinhart, Rogoff, and Ryan

Consider the case of the study by Carmen Reinhart and Kenneth Rogoff “Growth in a Time of Debt” (GITD) a study seemingly transported to the Discomfort Zone from the Twilight Zone! The authors had run regression analyses of many decades of national income against national government (public) debt for several countries, and regarding the United States they reached the conclusion that as the PD/GDP ratio approaches 1.0, growth declines. This was music to the ears of Paul Ryan, the 2012 vice-presidential candidate and potential 2016 Republican nominee for the presidency. Ryan is on a quest to cut federal spending without increasing taxation at the top. 

GITD was the sole economic study cited in his 2012 budget proposal, “The Path to Prosperity.” When errors in the Reinhart/Rogoff study forced them to withdraw their hypothesis, that should have been the end of the austerity doctrine — but firmly-held ideological beliefs die hard. Ryan still hopes to ride the twin fantasies of trickle-down economics and the austerity doctrine to his version of “prosperity.”

While reviewing the graphs presented with the Reinhart/Rogoff study, I noticed something that no one else seems to have noticed: If, as the Piketty/Saez data have demonstrated, depressions are stagnation caused by high levels of income inequality, and if as I maintain high levels of income inequality are also the immediate consequence of high levels of public debt, the Reinhart/Rogoff study should reflect that high income inequality is present at high levels of public debt. In fact, I found it to do just that:

Once it is understood that the public debt has essentially financed the enrichment of the wealthiest Americans, it becomes clear that the increase of the PD/GDP ratio to over 90% today is also attributable to that enrichment. That fact is inherently reflected in the Reinhart/Rogoff data. Here again is the chart of the U.S. results for growth provided by Reinhart and Rogoff in their initial workpaper on their “Growth in a Time of Debt” (GITD) study (here). (Chart omitted: Go to “Finding a New Macroeconomics: (10) Reinhart, Rogoff, and Redistribution,” June 30, 2013,  here. )

The Reinhart/Rogoff chart shows that over the 200 or so years covered in their database, growth has been slightly lower on average when the national debt was 30-60% of GDP than when it was below 30%, and lower still when PD/GDP was between 60-90%. It also shows that when the PD/GDP ratios were higher than 30%,  the average (mean) of aggregate income growth was lower than the median aggregate income growth; this confirms that a higher level of income inequality is embedded in the GDP data for these periods of higher PD/GDP ratios. And, of course, the income growth (GDP) data at any point of time would reflect the degree of income inequality present at that time. Notably, these relationships are present in the data for all periods, both when debt was growing and when it was declining, and the Reinhart/Rogoff data cover a 200-year period.

For these reasons, that these factors are reflected so strongly in a regression of contemporaneous observations of PD/GDP and growth, as opposed to a time-series study, is really not surprising, despite the many factors that affect growth. But it is telling: * * * The Reinhart/Rogoff corrected study confirms the relationship between growing income inequality and declining growth.

Here is another fabulous opportunity for scientific research. Indeed, I have suggested running regressions of the PD/GDP ratios against both top 1% income and bottom 99% income.

“Forecasting” in the Blind 

So far this post has clarified that the neoclassical supply-side paradigm has thoroughly covered up the basic nature of how the economy works. Income and wealth distribution data have shown us, beyond doubt, that aggregate growth and prosperity depend upon maintaining adequate demand throughout the economy, and that depends upon optimizing the distribution of income and wealth, and that, in turn, depends upon maintaining a sufficiently progressive level of taxation. Neoclassical economics comprehends none of that. Because we continue to drift down into a deeper depression, unable to recover from the “Great Recession,” mainstream forecasters are befuddled, and I’ve been following that befuddlement closely.

Prompted by Krugman’s report on the “mutilated economy” last November, I reviewed the Fed’s angst about long-term unemployment. (“The Neoclassical Boondoggle and the ‘Mutilated Economy,’ Part 1, 11/15/2013), Part 2, 11/16/2013, and Part 3, 11/19/2013). We have seen as well that IMF economists who pitted the proposition that income inequality depresses growth against Okun’s contradictory theory that there is a “trade-off” between inequality and growth found (apparently to their surprise) that Okun was wrong (“Inequality and Growth – Two Sides of he Same Coin,” 3/28/2014). A year earlier, as just mentioned, we watched the Reinhart/Rogoff claim that their study “Growth in a Time of Debt” (GITD) showed that high levels of public debt depress growth backfire when errors forced them to withdraw their thesis. (There are three posts on this topic in the Finding a New Macroeconomics Series, “Reinhart, Rogoff and Reality,” 5/30/2013, “Reinhart, Rogoff, and Ideology,” 6/6/2013, and “Reinhart, Rogoff, and Redistribution,” June 30, 2013.) 

In July, I responded to Krugman’s Op-ed “The Fiscal Fizzle: An Imaginary Budget and Debt Crisis” (7/20/2014), in which he declared the entire budget scare to be a false alarm, with “The Fiscal Fiasco: A Real Budget and Debt Crisis (7/23/2014) , and “Breaking News: CBO Infected With Trickle-Down Disease” (7/27/2014). Finally, when Standard & Poor’s, a conservative rating agency, felt compelled to announce its awareness of the growing evidence that income inequality depresses growth, I reacted to Krugman’s cautious, somewhat negative response to the S&P announcement with “Inequality Retards Growth: A New View?” (8/9/2014), and my previous post, “Inequality Suppresses Growth: A Serious Problem.”   

CBO’s “Forecasts”

Of course, no one has a crystal ball, and CBO in its “Budget and Economic Outlooks” suggests that we not regard its “projections” as forecasts. But we do, because we think they are capable of making at least short-run forecasts. Paul Krugman confirms that expectation when he says (in “The Fiscal Fizzle”) things like this:

The budget office predicts that this year’s federal deficit will be just 2.8 percent of G.D.P., down from 9.8 percent in 2009. It’s true that the fact that we’re still running a deficit means federal debt in dollar terms continues to grow — but the economy is growing too, so the budget office expects the crucial ratio of debt to G.D.P. to remain more or less flat for the next decade.

And of course, he relies entirely on the CBO to claim this:

I’m not sure whether most readers realize just how thoroughly the great fiscal panic has fizzled — and the deficit scolds are, of course, still scolding. They’re even trying to spin the latest long-term projections from the Congressional Budget Office — which are distinctly non-alarming — as somehow a confirmation of their earlier scare tactics.    

All that supply-side “forecasting” can hope to accomplish, however, is guess the degree to which future growth will track the economy’s “productive potential,” which no macroeconomic forecaster actually has any way of identifying. We saw that in spades in our review of Thomas Piketty’s book “Capital in the Twentieth Century,” which attempted to resurrect an antique, controversial production-function model as the “Second Fundamental Law of Capitalism.” (See my post series “Picking Piketty Apart,” including “His Contribution,” 6/14/2014, “His ‘Laws of Capitalism’,” 6/21/2014, and “Time’s Running Out,” 6/23/2014). He candidly conceded that the model could not be used for forecasting, and explained it was only “valid” in the long run, which left me and others at a loss to explain why he decided to write a book about it.

What’s more, income (GDP) data contain a great deal of economic rent, which has zero tangible value. The point is, the only hope for making any predictions for the future is to follow trends in aggregate demand, and supply-side forecasters do not do that. Thus, the entire neoclassical paradigm unravels as we drift deeper and deeper into recession and depression.

What CBO does, it turns out, is first decide how much optimism it can sell, then unveil numbers for a basic ten-year forecast reflecting that degree of optimism. In Its February, 2014 “Outlook”, for example, it projected a rapid return to an indefinite continuation of 2.1% annual growth, even though (by S&P’s calculation) growth has averaged only 1.4% over the last decade. Then it generated numbers for the intervening years which were then presented as if they were the product of some sort of prognostication.  In other words, CBO is actually backcasting, not forecasting!

Here’s the proof: From its “Budget and Economic Outlook, 2014-2024″ (here), pdf (here) we can extract the following data (in $billions) :

Baseline Outlook

Item                                                          2013      . . . .        2017    . . . .      2022

1. Y-E debt, as a % of GDP [1]          72.1                        72.3                     76.8

2. Publicly held debt  [2]                 11,982                    14,507                 19,001

3. GDP   [2]                                             16,627                   20,054                 24,746

4. Computed GDP (l 2/l 1)               16,619                   20,065                 24,740    

[1]  Table 1-1, p. 9            

[2]  Table 1-2, p. 12

The numbers check. There is no reason to suspect, reading these numbers, that CBO isn’t using algorithms that project either publicly held debt or GDP as dependent variables. However, when we go back two years and look at data from “The Budget and Economic Outlook: 2012-2022″ (here) pdf (here), we see that it does no such thing:

Baseline Outlook

Item                                                          2013      . . . .        2017    . . . .      2022

1. Y-E debt, as a % of GDP [1]          75.1                         68.5                    62.0

2. Publicly held debt  [1]                 11,945                    13,509                15,291

3. GDP   [2]                                            15,914                    19,708                24,665 

4. Computed GDP (l 2/l 1)              15,905                    19,721                 24,663  

Alternative Fiscal Scenario 

Item                                                          2013      . . . .        2017    . . . .      2022

1. Y-E debt, as a % of GDP [1]          77.8                        84.0                     94.2

2. Publicly held debt  [1]                 12,374                    16,560                23,232

3. GDP   [2]                                            15,914                    19,708                 24,665 

4. Computed GDP (l 2/l 1)              15,905                    19,714                 24,662

[1] Table 1.7, p. 22

[2] Table 1.3, p. 10. Note: No separate GDP provided for A.F.S.

.   .   .   .   .   .   .  .

The entire outlook revolves around a judgmentally presumed amount of growth that will take place over the next ten years  no matter what else happens. In its February 2014 report, CBO presumed a GDP of $24.7 trillion  in 2022. This is up slightly, but still rounding to $24.7 trillion it used in its January 2012 outlook two years earlier.

Incredibly, this GDP number was not allowed to change, whether the debt was seen as rising to $15.3 trillion or to $23.2 trillion! This preposterous approach renders the entire “outlook” meaningless and nonsensical. The amount of debt is integrally related to GDP — at a very minimum, income tax revenues vary with GDP, so an additional $8 trillion of debt needed in the A.F.S. automatically implies a gigantic decline in GDP, and the associated need for more borrowing. 

This approach is fatally pernicious: For any given higher A.F.S. level of “projected” debt, GDP is necessarily lower than presented in the report. 

There is no indication that CBO believes debt might go up because the federal government will grow substantially, or that if it did there would be no stimulus, and the constant presumption of GDP growth invalidates the figures for debt as a percent of GDP. But Because CBO is backcasting from a presumed GDP ten years down the road, its numbers simply bear no relation to what may happen in the next few years, and will obscure the likelihood of impending crisis.  

CBO has conceded it made as optimistic an assumption for growth as it could for the next ten years.  But it’s only playing “pin the tail on the donkey,” then waiting around to see what actually happens. In the meantime, from the perspective of its economic “outlook,” no actual changes in the rate of growth, no amount of decline in  income or consumer and investment demand, are allowed to modify the ultimate expectation of growth built into the GDP presumed for the end of a decade. [Note #1]

CBO might protest that it is constantly revising it projections to reflect real changes in economic conditions. It appears not, but if so, that is all it is doing. It should stop pretending to see ten years into the future, certainly not 35 years into the future, and then disclaiming its work as non-forecasting.

Some immediate points:

  • It’s unclear why the amount of public debt, which now officially exceeds $17 trillion, is reported at much lower levels by CBO; This needs clarification. [Note #2]  
  • Regardless, CBO has no handle on the growth rate of debt because it does not account for changes in spending and demand, only potential production;
  • Its assumption of 2.1% annual growth instead of 1.4% or less is unfounded, admittedly optimistic, and dangerously over-optimistic because we’re in an unacknowledged depression;
  • CBO’s long-range “Outlook” in July of 2014 said debt would reach 100% of GDP finally in 2039. In 2012, Reinhart and Rogoff reported it was almost already there;
  • Although we do not need to worry about the debt itself causing decline, we now know that the inequality caused by the high level of debt does, and the escalating inequality spiral will continue to depress growth even more rapidly than would the operation of Keynesian dynamics alone.

The one factor that any forecaster should be most certain of, at least in the short run, is the amount of debt and debt interest. As my letter to the Times Union reported, even under its optimistic scenario for GDP growth, CBO had debt interest exceeding the entire defense budget by 2021. It further covered up its expected growth of debt interest in the July report. There has to be some reason or reasons why CBO is unwilling to frankly discuss the debt problem any more. Could that reason possibly relate to the reason(s) that S&P suddenly surfaced a week or so later with the warning that inequality depresses growth? 

Conclusion

It’s still very lonely here in the “Discomfort Zone to the Left of Paul Krugman.” I know this all seems very complicated to the average untutored mortal, which is why we are susceptible to believing one ideology or another.  And we like to believe that we can trust the “experts,” especially those who can boast a Nobel Prize. We also tend to believe that the more radically extreme an idea seems, the more likely it is to be wrong. The Chicken Little story would have a perverse moral, wouldn’t it, if the sky actually was falling?

Well, my Chicken Little story is based entirely on logical and demonstrable facts, and the deniers are beyond redemption. I don’t get off on negativity and pessimism: I have been trained my entire life and career, however, to look for and accept reality. Those of you who insist on forming your opinions on the basis of “argument by authority,” let me remind you that Joe Stiglitz also has a Nobel Prize. You can check with him, but mainly you should decide for yourself. Read, and think, and pay very close attention to what is happening in your world. The truth really isn’t that difficult to understand. 

I only hope that I’ve disabused you of the notion that I am a “traitor to the Left.” I don’t have a crystal ball, but I do have a gut feeling that we’re just a stone’s throw away from Great Depression #2.

Shall we not go there?

JMH — 8/27/2014

_______

[Note #1, posted 10:30 p.m. on 8/27] CBO has just today released “An Update to the Budget and Economic Outlook: 2014-2024″ (August 2014, here), which I have yet to thoroughly review. CBO says it has reduced its estimate of the 2014 budget deficit. But on p. 6 it also states: “The agency has significantly lowered its projection of growth in real GDP for 2014, reflecting surprising economic weakness in the first half of the year. However, the level of real GDP over most of the coming decade is projected  to be only modestly lower than estimated in February.” That last sentence continues the impression CBO has been giving of actually projecting GDP over ten years (or more) as a dependent variable, obscuring its actual method of forecasting GDP. Note that this report has 2022 GDP at$24,565 billion, just $181 billion lower than its February 2014 projection of $24,746 billion, cited above.

The world (certainly the “conservative” world, here) takes CBO at its word and actually believes (or argues) there is some sophisticated basis for forecasting growth to continue at over 2% for ten years! That, however, is nothing more than neoclassical optimism.

[Note #2, posted 3:00 p.m. on 8/30] Treasury Direct (here) reports “total public debt outstanding” inclusive of “intergovernmental holdings”: E.g., on August 29, the total of total public debt outstanding was $17.7 trillion, and the total of intergovernmental holdings was just over $5 trillion. This explains CBO’s figure of $12.4 trillion for publicly held debt at y.e. 2013. 

The impact of intergovernmental debt is not accounted for at all, however, and that is not only a source of confusion (see Michael D. Tanner’s July 23, 2014 report “D.C. Forgets about the Debt” (here) which focuses on gross public debt. Although CBO is not responsible for any public confusion on this, it is noteworthy that CBO assumes that intergovernmental debt has no budget implications. In the short run, perhaps not, but CBO purports to make forecasts going out 35 years. Here’s the explanation of debt held by federal accounts from the National Priorities Project (here):

Debt Held by Federal Accounts is money the federal government borrows from itself.  It results from the Treasury using surpluses from some accounts – for instance, Social Security – to buy Treasury bonds, and thus finance current government spending. Borrowed funds ultimately need to be repaid to the original account, with interest.

The process of borrowing, for example, current Social Security payments for current government spending is problematic, because either this interest will ultimately have to be included in the budget (incurring more taxes or borrowing) or if it is not repaid at all the value will have been taken directly from the Social Security fund, a major tax on Social Security and redistribution of wealth, given our current tax structure. CBO’s narrower definition of the budget problem concedes the loss of this value, imparting a more favorable budget outlook.

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Inequality Suppresses Growth: A Serious Problem?

The math is easy: the federal budget over the next decade cannot be made to square without raising a lot more money. The nonpartisan Congressional Budget Office estimates that if we stay on our current path, federal debt held by the public will grow from about two-thirds of gross domestic product today to roughly 100 percent in a decade and twice that much by 2040. It is unlikely that even the most committed Republicans could reverse the trend without higher taxes.

But an equally compelling reason relies on a new understanding of the economics of taxation. For 30 years, any proposal to raise taxes had to overcome an unshakable belief that higher taxes inevitably led to less growth. The belief survived the Clinton administration, when taxes rose and the economy surged. It survived George W. Bush’s administration, when taxes were cut yet growth sagged.

But now, a growing body of research suggests not only that the government could raise much more revenue by sharply raising the top tax rates paid by the richest Americans, but it could do so without slowing economic growth. Top tax rates could go as high as 80 percent or more.

Admittedly, it seems inconceivable that our political system could stomach a tax increase that big. Today, the richest 1 percent of Americans pay a top federal rate of 29 percent, according to Emmanuel Saez, an economist at the University of California, Berkeley. That’s because almost a third of their income derives from capital gains and dividends — which are taxed at a 15 percent rate — while the rest is ordinary income taxed at a top marginal rate of 35 percent.

Nonetheless, the research suggests there is much more money available to close the budget deficit than we previously thought, if only we were willing to raise tax rates to where they were back in the early ’70s, in the administration of Richard M. Nixon.

Taxpayers always want to pay less to the tax man. Still, there’s nothing inevitable about low taxes. In the early 1950s, coming out of World War II, the top federal income tax rate exceeded 90 percent. In 1980, the top marginal rate was 70 percent for families making more than $215,400 — about $587,000 in current dollars. And these families pocketed a much smaller share of the nation’s income than they do now. Today, people earning over $200,000 a year capture more than a third of national income. 

– Eduardo Porter, “The Case for Raising Top Tax Rates,” The New York Times, March 27, 2012 (here), linking “The Budget Message Paul Ryan Really Sent,” by Howard Gleckman, The Tax Policy Center, March 22, 2012 (here). Emphasis added.

This post follows up on my initial discussion of the economics associated with Standard & Poor’s (S&P’s) recent recognition that income inequality reduces income growth, and Paul Krugman’s assertion that this is a “new view” of economics. I will occasionally refer back to points made in that post, but here I set forth evidence demonstrating the correctness of this view of inequality, and showing that inequality poses  a serious, ongoing danger for the United States economy.

To set the stage for that review, let’s connect some important dots: The opening quotation, to which I called immediate attention in this blog nearly two and one-half years ago (here) is presented for its observation that tax increases on top incomes needed to balance the budget have been blocked by the ideological belief that raising taxes on top incomes reduces growth. This is a form of the “trickle-down” argument against taxation, which incorrectly asserts that lowering taxes on top incomes enhances growth. The truth is the opposite: higher taxes at the top serves to redistribute income and wealth to people who spend a greater share of their incomes, thereby increasing investment, jobs, production, and growth.

What may appear to be a different topic — the effect of inequality on growth — really is a the same topic: Inequality is the measure of the concentration of wealth and income, and it occurs naturally in a market economy. The progressiveness of taxation is the measure of the degree to which society allows income and wealth concentration to develop; the immediate effects of reducing the effective taxation of the wealthiest people are to reduce central government’s tax revenues and to increase inequality; and by suppressing income growth, income inequality further suppresses tax revenues. 

That is why saying that increasing growth requires reducing inequality is virtually the same as saying that increasing growth requires higher taxes on top incomes. Likewise, the “trickle-down” myth that progressive taxation has no effect on growth is therefore intrinsically linked to the myth fostered by neoclassical economics, discussed in my last post, that inequality has no macroeconomic consequences. It occurred to me several years ago, as it more recently occurred to the IMF economists whose work is cited by S&P, that inequality and growth are “two sides of the same coin.” It’s a bizarre variation of this metaphor, but given the intrinsic relationship between inequality and tax progressiveness we can say that tax progressiveness, inequality, and growth are “three sides of the same coin.”   

Inequality and Taxation  

To start, let’s pin down the point that reducing taxes on top incomes causes inequality growth. Intuitively, this has to be the case, because doing so instantly increases the incomes of wealthy people relative to the incomes of everyone else. This was obvious to Keynes (see the last chapter to his General Theory), and presumably to all thoughtful people at the turn of the 20th Century when the contrary mythologies were being developed. There is no longer any question, for now there is an ironclad factual record:

DP8675a

This graph was presented by Thomas Piketty, Emmanuel Saez, and Stephanie Stantcheva in their November 2011 CEPR discussion paper “Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities,” Working Paper 17616 (DP8675, here). It shows that the top 1% share of income and capital gains has varied inversely with the top marginal income tax and capital gains tax throughout the century, ever since income taxation was adopted.

In his book End this Depression NOW! (2012, p. 82) Paul Krugman mentions this evidence, but sees in it no implications for aggregate income:

As Piketty and Saez note, there is a fairly close negative correlation between top tax rates and the top 1 percent’s share of income, both over time and across countries.  

What I take from all of this is that we should probably think of rising incomes at the top as reflecting the same social and political factors that promoted lax financial regulation. 

Well, across countries it is purely a matter of correlation, but for an individual country, over time, its a matter of causation. To be sure, the causal relationship is between income distribution and effective taxation, not marginal income tax rates; but this graph shows that the top marginal rates track inequality closely. The relationship is so tight that, so far as I know, the researchers did not even bother to confirm it with regression analysis.

Recall (from the previous post) that mainstream economists are said to have universally accepted Arthur Okun’s alleged trade-off between inequality and “efficiency” (a basic element of growth), which postulated that efforts to reduce inequality by reducing after-tax income at the top would backfire, reducing growth, even though the only cited support for the proposition was the false mythology developed from Adam Smith’s “invisible hand” metaphor. Mainstream economics is still in the grip of that fantasy: It permeates the S&P report and its call for a cautious approach to curing inequality. It permeates Congressional Budget Office (CBO) forecasts. And this has to be the main reason why the cornucopia of potential research projects available to pin down the real world relationships between effective taxation, inequality and growth were not included by Raj Chetty in his list of ongoing research projects in “scientific” macroeconomics.   

Paul Krugman’s perspectives remain a significant part of our problem: Unfortunately, two and one-half years since the alert sounded by Eduardo Porter, Krugman still fails to sense America’s continuous decline, and continues to express his doubts about the economic implications of inequality, openly rejecting Stiglitz’s perspectives. In his Op-ed in today’s New York Times (“The Forever Slump,” August 15, 2014, here), he opens with this:

It’s hard to believe, but almost six years have passed since the fall of Lehman Brothers ushered in the worst economic crisis since the 1930s. Many people, myself included, would like to move on to other subjects. But we can’t, because the crisis is by no means over. Recovery is far from complete, and the wrong policies could still turn economic weakness into a more or less permanent depression.

Following reiteration of his familiar neoclassical assessment, he then concludes that compared to some other countries “things don’t look that dire in America.” I, too, would like to move on to other subjects: but among “liberal” economists, Paul Krugman holds perhaps the biggest megaphone and bears a heavy responsibility. And he is spreading dangerous misconceptions.   

Mainstream economics has no way to distinguish between a weak recovery from a prolonged cyclical downturn and a steadily worsening depression. Today the situation is being labeled “secular stagnation” and “the new normal.” From a neoclassical perspective, these seem like obvious explanations, but there is a better explanation based on a proper understanding of the effect of inequality on growth, and on the active money supply, as revealed through trends in the national debt (see below). In neoclassical ideology, the storm clouds are always on the horizon, and the horizon keeps receding — until the next big crash. Thus, the responsibility for all this confusion lies with the economics profession.

Inequality and Growth

The Standard & Poor’s report (“How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide,” August 5, 2014, here) is an important summary of the transitional thinking now taking place on the income inequality issue. I feel compelled to vet the entire report. Here’s a summary of its discussion:

*     *     *     *     *

  • (1) S&P concludes that “the current level of income inequality in the U.S. is dampening GDP growth, at a time when the world’s biggest economy is struggling to recover from the Great Recession and the government is in need of funds to support an aging population;”
  • (2) S&P places heavy emphasis on education, arguing:

a. In line with the rate of educational achievement seen from 1960 to 1965, adding another year of education to the American workforce from 2014-2019 would likely increase U.S. potential GDP by $525 billion, 2.4% higher than the baseline forecast; and

b. “If education levels were increasing at the rate they were 15 years ago, the level of potential GDP would be 1%, or $185 billion higher in five years”;

  • (3) U.S. growth has averaged “a mere 1.4% over the last 10 years, through 2013;
  • (4) In recent years, forecasting entities have been reducing their projected growth:

a. S&P has reduced its 10-year U.S. growth forecast to a 2.5% annual rate, down from 2.8% five years ago;

b. S&P has reduced (again) its expectation to 2.0% in 2014; but expects over 3% in 2015;

c. The Fed long-run forecast has drifted down even more, from 2.65% five years ago to 2.2% (mid-point of 2.1-2.3 range);

  • (5) The cited reasons for declining growth rates include:

a. The Fed’s explanations are: (1) the aging population; (2) more modest prospects for productivity growth; and (3) the leveling off of growth in women’s participation in the workforce;

b. S&P now cites extreme inequality as well, which it associates causally with the decline in educational achievement;

  • (6) S&P quotes Robert E. Hall of Stanford: “The years since 2007 have been a macroeconomic disaster for the [U.S.] of an unprecedented magnitude since the Great Depression,” with output in 3013 falling “about 13% below what the previous trend had suggested. Hall does not believe that a sudden surge in output can recover lost ground;
  • (7) S&P notes that income inequality is increasing:

a. Emmanuel Saez reported in 2013 that U.S. income inequality is growing and “has now reached levels not seen since 1928″ in similar circumstances: “a boom in the financial sector [together with] the two worst economic slumps in U.S. history — the Great Depression and the Great Recession;”

b. More recently, the Congressional Budget Office (CBO) reported that in one year, from 2009-2010, after-tax income soared 15.1% for the top 1% but grew less than 1% for the bottom 90%;

c. From the distribution of income among the five quintiles (20 percent groupings) “CBO estimates that the dispersion of market income grew by one-quarter from 1979-2007, but the dispersion of after-tax income grew by one-third”;

d. A Federal Reserve Survey of consumer finances shows that the average household wealth of the top 10% (as shown on Chart #7) grew from about $1.07 million to $1.2 million from 2004 to 2010;

  • (8) S&P notes arguments against concluding that inequality reduces growth:   

a. “To be sure, it seems counter-intuitive that inequality is associated with less sustainable growth, since some inequality by providing incentives to effort and entrepreneurship, may be essential to a functional market economy”;

b. S&P mentions and briefly discusses the related Okun “trade-off” theory;

c. Kristin Forbes (MIT, 2000) argued that “in short and medium terms an increase in inequality has a significant positive effect on expansion — but that was weakened over longer periods of growth;” moreover, a World Bank study found that this positive effect was “almost exclusively reserved for the top end of the income distribution;”

  • (9) S&P reports IMF statistical studies indicating that inequality reduces growth: “Do societies inevitably face a choice between efficient production and the equitable distribution of income? According to IMF economists Andrew Berg, Jonathan Ostry, and Jeromin Zettelmeyer, the answer is no;”
  • (10) S&P argues for restraint and caution in efforts to reduce inequality, in particular by raising taxes at the top and increasing the minimum wage.   

*    *    *    *    *

This presentation constitutes a fairly comprehensive summary of the main arguments concerning inequality issues that have been raised by mainstream, “neo-Keynesian” economists, and it begins to cast doubt on these arguments by observing that growth is being suppressed. I’ve previously discussed the IMF studies on this blog, and review them again below. A discussion about the alleged need for caution in dealing with inequality is called for as well. First, though, let’s fact-check S&P assertion by comparing trends in income inequality with a selection of contemporaneous trends in average GDP growth, over various time periods:   

1. S&P reported average growth of 1.4% from 2003-2013;

2. The Center on Budget and Policy Priorities (CBPP) in 2009 (here) computed cumulative per capita growth over two adjacent 30-year periods, shown on this bar graph, which averaged about 3% annual per capita growth from 1946-1976, and roughly 2.2% per capita growth from 1976-2006:

uneven ditribtion of gains

3. The Pinnacle Digest, in August of 2013 (here) includes a graph of the rolling 10-year average of GDP growth, which provides a different look at changing GDP growth. It shows rolling averages of roughly 4.4% from 1967-1973, 3.3% from 1977-1979, about 3.0% from 1987-1997 and 2002-2005, and about 1.7% from 2009-2012. 

US GDP 10-year moving average4. One final source of data is CBO’s “The Budget and Economic Outlook: 2014 to 2024″ (here), Table 2-2. p.41. CBO reports 4.0% average annual growth for 1950-1973, 3.3% for 1974-1981, 3.2% for 1982-1990 and 1991-2001, and 2.2% for 2002-2013.  

Piketty, Saez, and Stantcheva included, in their in their November 2011 CEPR discussion paper, p. 49 (DP8675, here), the following graph comparing both top 1% and bottom 99% real income shares per adult, from 1913-2008, with the top marginal income tax rate. Each share’s growth rate is indicated by the slope of the trend line. Aggregate income is not shown. For comparison, the trends in aggregate income percentage average annual growth rates listed above are roughly aligned below the graph, by year:

DP8675b

S&P                                                                                                                      |  1.4     |

CBPP                                           |                 3.0               |             2.2                   |      

Pinnacle Digest                                                |4.4|     |3.3|      |  3.0  |  | 3.0 |  | 1.7|

CBO                                                 |           4.0              |  3.3  |          3.3           |  2.2    |

*    *    *    *    *

These numbers are all consistent, except for the CBPP figures, which display per capita growth. (This may be a dubious approach, because growth is a “flow” statistic, and per capita distributions are appropriate for “stock” items. Per capita growth tends to be lower than aggregate growth.) What these numbers show is a steady decline in the income growth rate beginning in the 1970s, remaining steady until the Great Recession when growth was substantially further curtailed. Annual differences are, of course, precisely shown on the Pinnacle Digest graph. Note the consistent correlation since WW II of three causally connected factors – annual income growth, income inequality, and income tax progressiveness.  

It was in this report, incidentally, that Piketty, Saez, and Stantcheva reported their comprehensive study (NBER Working Paper 17626, 2011, here) of the income elasticity of the top income tax rates. That study simply eviscerates the ideologically-conceived “Laffer Curve,” and with it the “trickle-down” myth. Here is their graph:

dp4937

The IMF Study

Earlier in 2011, in “Inequality and Unsustainable Growth: Two Sides of the Same Coin?,” IMF Staff Discussion Note, April 8, 2011 (here), Andrew G. Berg and Jonathan D. Ostry reported their statistical study directly testing the effect on income growth of income inequality. They used multiple regressions of growth against inequality and other factors that might explain growth, and across countries. S&P included this chart of the factors included in the study:

imf study -- factors affecting growth

A follow-up IMF Staff Discussion Note, “Redistribution, Inequality, and Growth,” was reported by Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides in February 2014 (here).

The authors’ found in the 2011 study that inequality is “one of the most robust and important factors associated with growth duration” (pp. 13-14). Judging from their discussion, this finding had not been expected. They timidly concluded: “The main contribution of this note may be to push slightly the balance of considerations towards the view that attention to inequality may serve both equity and growth at the same time.” (p. 18) Translation: Abject faith in the the Okun “trade-off” theory is probably unjustified.  

The report on the second study acknowledged a significant connection between inequality and growth, and the results were reported a bit less timidly: 

First, inequality continues to be a robust and powerful determinant both of the pace of medium-term growth and of the duration of growth spells, even controlling for the size of redistributive transfers. Thus, the conclusions from Berg and Ostry (2011) would seem to be robust, even strengthened. It would still be a mistake to focus on growth and let inequality take care of itself, not only because inequality may be ethically undesirable but also because the resulting growth may be low and unsustainable.

And second, there is surprisingly little evidence for the growth-destroying effects of fiscal redistribution at a macroeconomic level. (pp. 25-26)

In short, inequality leads to low and likely “unsustainable” growth; and, by the way, there is “surprisingly little evidence” supporting Okun’s theory. The implication is that their mainstream colleagues, including those at S&P, should not be so reluctant to aggressively correct the inequality problem.

A Recap of Inequality Economics

There has always been inequality in market economies and, so long as civilization continues to flourish, there always will be. Wealth naturally concentrates, and concentrated wealth entails income concentration. Given the utter failure of planned “communist” economies, market economies offer a superior system, so long as they can be kept under control. Absolute equality is an impossible and unworthy goal for a modern economy. But central government’s control of income and wealth distribution, by retarding the growth of income and wealth concentration and redistributing money into the active economy, is essential for the optimal functioning of a market economy.

This conclusion requires an understanding of the “principle of effective demand” Keynes introduced in 1935: optimal growth requires consumer spending and, therefore, optimal inequality. Keynes, however, assumed away the inequality problem when he focused on cycles occurring when society collectively increases its saving relative to its spending. Economics ever since Keynes has focused on avoiding the inflation resulting from too much consumer spending when government over-stimulates an economy; but everyone, including Keynes himself, ignored the much greater problem of decline when the active money supply is sequestered from the active economy through income and wealth concentration. We are only now discovering the stunning swiftness with which unfettered capitalism can destroy itself through this mechanism.

Inequality grows through the collection of “economic rent,” i.e., payments made beyond any contribution to the growth of tangible, “real” production of consumer goods and service. Early economists focused on land rents, but corporations have come to control or dominate all of the factors of production (including labor), so “unearned” profits are effectively the main vehicle for increasing inequality while reducing actual production, and real income. This is the mechanism through which inequality reduces growth.

A number of factors determine the ability of corporations to make unearned profits, including monopolistic market power, suppression of wages, and tax avoidance. Beginning with the Reagan administration, efforts to unshackle corporate profiteering through deregulation, already underway, were enhanced. The wealthiest people were making a lot more money, and to keep as much of their gains as possible, they reduced their income tax rates, as shown above.

People still don’t comprehend the enormity of those tax reductions. The enormous national debt, now over $17 trillion, was raised to replace the revenue losses resulting from those tax reductions. That is to say, government debt was used to make the rich richer — to finance income inequality and a vastly higher concentration of wealth.

One reason why the full extent of the damage has been obscured is that analysts continue to evaluate income inequality, as demonstrated by the S&P report, by comparing top 20%, top 10%, or top 5% incomes to those below. To be sure, all of these segments have been growing faster than other incomes below them, but such comparisons drastically understate the true magnitude of transfers of income and wealth to the top. The tipping point is in the top 1%, and wealth and income moves into the top 1%, for example, from the rest of the top 10%: Thus, the transfers to the top 1% are much greater than the net transfers into the entire top 10%. Put another way, top 10% inequality growth is the average of the much lower inequality growth (or even decline) in the second 9% with the extremely high rate of inequality growth in the top 1%.

The stunning fact is that all of that $17 trillion has ended up in the hands of the top 1%, with exponential concentration within the top 0.1% and the top 0.01%. Not finding such an analysis anywhere, I undertook more than a year ago to calculate the growth of top 1% wealth (net worth), using Census Bureau net worth tables and wealth concentration data published by economist Edward Wolff, and others.  These are my results, in constant 2005 dollars:

my graph 1952-1982 c

The volatility of top 1% net worth corresponds to the volatility of top 1% income shown by Piketty and Saez above. Top 1% wealth is growing faster that GDP, at roughly the pace of the national debt. This is what we would expect: as explained, the national debt has effectively financed growing top 1% net worth.

The more or less continuous 3.0% annual growth of GDP from roughly 1985 to 2005, despite declining median income, appears to be accounted for by the increase in the money supply provided by the federal debt; that additional money mainly accounts for this massive wealth concentration. But this is not a full accounting. Left out is American income and wealth at the top that is not reported in the U.S. This is a difficult assessment to make, but European analysts have for some time been estimating the amount of “off-shore” wealth in the world, and the amount attributable to Americans (See “Inequality: You Don’t Know the Half of It,” Tax Justice Network, July 2012, here).

My best estimate is that top 1% net worth has increased by an unimaginable $22-25 trillion between 1980 and 2012. Consequently, as much as $9 trillion, by my rough estimate, has been transferred to the top 1% from the bottom 99% over these years. My sense of it is that the top 1% had already sequestered the new money associated with the national debt by 2008 and, with the Crash the hollowed out middle class had to collapse, with the consequences for growth we have seen. Obviously, this is a crucial topic, sorely in need of further investigation.

Meanwhile, as I explained in my recent posts on the national budget crisis, the woefully underfunded federal government is, more rapidly than the Republican-influenced CBO is willing to allow, approaching the point that the growth of debt and debt interest is ultimately “unsustainable” (February 2014 CBO report, p. 26). But the CBO baseline forecast remains essentially unchanged since March 2012 (here). It now projects about 2.1% growth continuously into the future, out to 2039, shrugging off the fact that growth has only averaged 1.4% for the last decade. It not only expects a magical, automatic return to full employment “equilibrium,” but in conformity with neoclassical dogma, it has never adjusted its forecasts for growth reduction due to inequality, which continues to rise and will have an ever increasing impact on future growth.

CBO seems unlikely to react sensibly to the guarded warning from S&P. It has, as I reported in my earlier posts, projected debt interest to rapidly outgrow other categories of federal spending, surpassing the entire defense budget by 2021. Yet in its July “Long-term Budget Outlook” (here) it failed to reflect that growth on its graphs, and continued to project this “unsustainable” trend out to 2039!

CBO may well take comfort in S&P’s overly cautious analysis. E.g.:

  • “A cautious approach to reducing inequality would benefit the economy, but extreme policy measures could backfire;”
  • “Any clear-headed consideration of these options must recognize that heavy taxation–solely to reduce wage inequality–could do more damage than good. While the IMF studies found that some redistribution appears benign, extreme cases may have a direct negative effect on growth;”
  • “Heavy taxation solely to equalize wages may reduce incentives to work or hire more workers. A number of studies have indicated that losses from redistribution are likely to be minimal when tax rates are low but rise steeply with the tax or subsidy rate.(fn.)”

Again, the second IMF study found no evidence at all supporting the Okun “trade-off” idea, which has basically been refuted anyway by the history of the American economy from WWII until the late 1970s. Only two studies were cited by S&P (Barro R.J., “Government Spending in a Simple Model of Endogeneous Growth,” Journal of Political Economy, 1990 (here); and Jaimovich, N. and S. Rebelo, “Non-Linear Effects of Taxation on Growth,” NBER, 2012 (here), but they do not make even a colorable showing of support for the trade-off argument:

Jaimevich and Rebelo presented a mathematical model, not a study: It makes the theoretical representations behind the Laffer Curve thesis, which have been disproved. [1] The Barro article also presented a model, not a study, but it has no bearing at all on our issue. Even Thomas Piketty — who many of us have argued improperly relates short-term inequality issues to supply-side models of growth in long-term equilibrium — has no use for Barro’s model. [2] Such is the confused state of neoclassicism. 

The bottom line: S&P has come up with no reason to believe that returning to the tax policies in effect when the economy was working well and flourishing, or that aggressively increasing the minimum wage,  would be “extreme policy.”

Conclusion

Inequality issues are nowhere near as difficult to understand as modern neoclassical economics has made them appear.  Once the fundamental importance to stability and survival of the control of income and wealth distribution is understood, the rest should follow in a reasonably straightforward manner. The economics profession, however, long ago abandoned the search for scientific truth in favor of result-oriented mythology. A three-dimensional view of macroeconomics is now available, and economists can for the first time understand how the economy really works, but “scientific” economics still has not recovered from its fantasies.

Our immediate concern has got to be that the continuing concentration of income and wealth within the top 1%  spells imminent trouble for our government and our society. The next crisis will come much sooner than CBO wants to believe. All supply-side growth forecasts, which take no account at all of the gradual but exponentially increasing effect of income inequality on growth, are vastly overoptimistic. Indeed, the problem is worse than that: CBO’s forecasts proceed from a “baseline” forecast of GDP which does not change with alternative scenarios varying factors like government spending and revenues, in which the levels of economic activity and GDP necessarily must change. (More on that later.)

We certainly cannot survive until 2039. The consequences of the next bursting “bubble,” or a default on the national debt, if history is any guide, would likely be a decline to 0.0-0.5% growth, another great depression.

JMH – 8/17/2014 (ed. 8/18/2014)

____

[1] The intent of the model is to reflect that: “Taxes have a small impact on long-run growth when taxes rates and other disincentives to investment are low or moderate. But, as tax rates rise, the marginal effect of taxation also increases.” That’s not illogical: No one would work for nothing, or invest with no prospect of a fair return. But it’s a factual question as to how much opportunity people are willing to give up in exchange for no opportunity at all. That question was answered by the Piketty, Saez, Stantcheva study which showed that the high levels of taxation in effect in the U.S. from WW II until 1980 not only optimized government revenue, but sustained the higher growth rates that the U.S. experienced then. 

[2] “Since the 1970s, analyses of the public debt have suffered from the fact that economists have probably relied too much on the so-called representative agent models, that is models in which each agent is assumed to earn the same income and to be endowed with the same amount of wealth (and thus to own the same quantity of government bonds). * * * In the case of public debt, representative agent models can lead to the conclusion that government debt is completely neutral, in regard not only to the total amount of national capital but also in the distribution of the capital burden. This radical reinterpretation of Ricardian equivalence, which was first proposed by American economist Robert Barro, fails to take account of the fact that the majority of the public debt is in practice owned by a minority of the population.”  – Capital in the 21st Century, p. 135  

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Inequality Retards Growth: A”New View”?

For more than three decades, almost everyone who matters in American politics has agreed that higher taxes on the rich and increased aid to the poor have hurt economic growth.

Liberals have generally viewed this as a trade-off worth making, arguing that it’s worth accepting some price in the form of lower G.D.P. to help fellow citizens in need. Conservatives, on the other hand, have advocated trickle-down economics, insisting that the best policy is to cut taxes on the rich, slash aid to the poor and count on a rising tide to raise all boats.

But there’s now growing evidence for a new view — namely, that the whole premise of this debate is wrong, that there isn’t actually any trade-off between equity and inefficiency. Why? . . . American inequality has become so extreme that it’s inflicting a lot of economic damage. And this, in turn, implies that redistribution — that is, taxing the rich and helping the poor — may well raise, not lower, the economy’s growth rate. 

You might be tempted to dismiss this notion as wishful thinking, a sort of liberal equivalent of the right-wing fantasy that cutting taxes on the rich actually increases revenue. In fact, however, there is solid evidence, coming from places like the International Monetary Fund, that high inequality is a drag on growth, and that redistribution can be good for the economy. 

Earlier this week, the new view about inequality and growth got a boost from Standard & Poor’s, the rating agency, which put out a report supporting the view that high inequality is a drag on growth. The agency was summarizing other people’s work, not doing research of its own, and you don’t need to take its judgment as gospel (remember its ludicrous downgrade of United States debt). What S.& P.’s imprimatur shows, however, is just how mainstream the new view of inequality has become. -Paul Krugman, “Inequality is a Drag,” The New York Times, August 8, 2014 (here).

These are the first five paragraphs of Krugman’s reaction to the crucial recognition by Standard & Poor’s, a securities rating firm, that rising income inequality reduces income growth. This recognition is crucially important because: (1) S&P has explicitly identified the core connection between growth and income (and wealth) distribution that has eluded mainstream economics for well over a century; (2) This connection directly refutes the neoclassical position that inequality lacks economic significance; and (3) It re-validates John Maynard Keynes’s “demand-side” perspective on how economies work which mainstream “neoclassical” economics has rejected for more than fifty years, instead conceptualizing growth as a “supply-side” phenomenon; and (4) It implicitly comprehends the role that inequality itself plays in stagnation and depression, a role that Keynes himself had not perceived or articulated. 

So this is a big deal. We need to consider why Paul Krugman presents the perception as uncertain, gradually emerging from “growing evidence,” and suggests that the perception might logically be seen as a “liberal equivalent” of the most extreme version of the trickle-down “fantasy.” Given the overriding importance of this matter, and Krugman’s lofty status in the economics community, a careful examination of his presentation is warranted.

This Is Not a “New View”

First, this is not a “new view.” Income inequality has been rising in the United States for 35 years, and although the data has only been available for about a decade, it has been well-established for several years that gradually growing income inequality is associated with gradually falling aggregate income growth. And although the connection between the two is not readily comprehensible to those indoctrinated in the neoclassical, “supply-side” ideology, it is not difficult to understand by anyone, especially among the laity, who can approach the question of growth with an open mind, unencumbered by the supply-side mindset.

The staff at MSNBC, for example, is aware of it: In reporting this S&P study on August 7, 2014 on his MSNBC program, Ed Schultz said, in effect: “Tell us something we don’t already know.” I do not regularly watch TV news programs, but I have seen Rachel Maddow correctly note that income inequality suppresses the growth of even the top income percentiles. 

A few economists whose perspectives are grounded in John Maynard Keynes’s General Theory – such as Krugman’s fellow Nobel Prize winner Joseph Stiglitz and, as cited by S&P, Robert Reich (producer of the movie “Inequality for All”) — have been explaining for several years not only that growing income inequality reduces income growth, but also that it does so by reducing consumer demand and spending and, consequently, investor expectations, per Keynes’s General Theory. See Reich’s clear and informative recounting of the insights of FDR’s Treasury Secretary, Marriner Eccles, regarding the economics of the Great Depression (Aftershock: The Next Economy and America’s Future, 2010, Chs. 1 & 2). Stiglitz, in his 2012 Book The Price of Inequality,  summed it up this way:

[T]his book shows that both the magnitude of America’s inequality today and the way it is generated actually undermine growth and impair efficiency. Part of the reason for this is that much of America’s inequality is the result of market distortions, with incentives directed not at creating new wealth but at taking it from others. (K.Ed., p.6) * * *The simple story of America is this: the rich are getting richer, the richest of the rich are getting still richer, the poor are becoming poorer and more numerous, and the middle class is being hollowed out. (K.Ed. p. 7);

And he explained why growing inequality entails lower growth:

[W]hen money is concentrated at the top of society, the average American’s spending is limited, or at least that would be the case in the absence of some artificial prop, which, in the years before the crisis, came in the form of a housing bubble fueled by Fed policies. (K.Ed., pp. 84-85) * * * 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 (K.Ed., p. 85).

The Erroneous Neoclassical Perspective on Growth 

Krugman’s views, however, which I have monitored closely over the past several years, are locked into the neoclassical mindset. As set forth in his most recent book (End This Depression NOW!, 2012, ch 5., pp. 71-90), Krugman believes that income inequality is a political problem, not an economic one.  This has been the mainstream position on inequality for more than  a century.  

He has pointedly disagreed with Stiglitz. (See the BBC interviews of both Krugman and Stiglitz, November 21, 2013, here), and in this Op-ed, after acknowledging S&P’s position that there is “strong evidence” of the relationship between growth and inequality, he reiterates the standard neoclassical explanation of the effects of inequality:

[T]here’s no evidence that making the rich richer enriches the nation as a whole, but there’s strong evidence of benefits from making the poor less poor. But how is that possible? Doesn’t taxing the rich and helping the poor reduce the incentive to make money? Well, yes, but incentives aren’t the only thing that matters for economic growth. Opportunity is also crucial. And extreme inequality deprives many people of the opportunity to fulfill their potential.

Actually, there is strong evidence that high taxes do not, over a broad range of marginal income tax rates that includes the top rates in the United States from the end of WW II until the Reagan presidency, reduce the incentive to make money. The “Laffer curve” has, in my view, been decisively disproved, as I will discuss in my follow-up to this post.

But don’t stop there, Mr. Krugman: Incentives and opportunity are not the only requirements for growth. Both of these factors require the availability of a sufficient money supply, and neoclassical macroeconomics, with its focus on microeconomic (individual firm) theories, has consistently ignored this critical factor for well over a century. Income inequality reflects a shrinking of the active money supply and an associated concentration of wealth at the top. Failing to consider the availability of actively circulating money is a hallmark of the trickle-down myth. Both Krugman and Stiglitz have condemned trickle-down as a clearly false ideology, but look at the divergence between the way they view the relationship of inequality and growth, in comparison to the trickle-down fantasy:

Krugman: You might be tempted to dismiss this notion as wishful thinking, a sort of liberal equivalent of the right-wing fantasy that cutting taxes on the rich actually increases revenue. (Opening quotation)

Stiglitz: What America has been experiencing in recent years is the opposite of trickle-down economics: the riches accruing to the top have come at the expense of those down below. (K. Ed., p. 6)

Who is Krugman writing to here? His audience might be right-wing economists and politicians running our government who, even if they understand the absurdity of the myth that cutting taxes on the richest people’s incomes will help the economy grow, nonetheless also believe that lower taxes at the top and increasing inequality haven’t really hurt the economy either. Stiglitz’s view, however, is that inequality has hurt the economy. I might have thought that Krugman was trying to gently inform these people that the S&P report supports Stiglitz’s perspective — but he disagrees with Stiglitz.

Krugman seems to be backpedaling now, forced to acknowledge that income inequality cannot be merely a political problem. But old ideas die hard, especially when nearly everyone else shares those ideas, so Krugman provides only a limited endorsement of the S&P report: He implies that the relationship between inequality and growth is more controversial and difficult than it actually is, and he endorses S&P’s scaled-back assertion that the infliction of economic damage is limited to only “extreme” inequality. 

He further characterizes “redistribution” as “taxing the rich and helping the poor,” ignoring the competing perception that the persistent growth of income inequality reflects a massive upward redistribution of income and wealth that persistently reduces income growth. His perspective also overlooks the “hollowing out” of the middle class described by Stiglitz; indeed, given that the bottom 60% of income earners collectively have zero net worth, the increasing wealth at the top can only have come from depleting the income and wealth of the declining middle class. (In my follow-up post, I’ll present facts showing that this process has been consistently taking place since 1980, causing considerable economic damage all along.)

Curiously, Krugman also maintains that the S&P report shows “just how mainstream” this “new view” has become. However, it is anything but: The mainstream view continues to be that the economy is growing again, recovering from the Great Recession, and conventional economists continue to ignore redistribution entirely in their analyses of growth. See the CBO’s February 2014 and July 2014 “Budget and Economic Outlooks,” (here) and (here). If, as S&P reports, the facts show that inequality suppresses growth, these forecasts will prove to be overoptimistic out to 2024, and there is no chance that the national debt will fail to reach 100% of GDP before 2039. (See my last two posts.) 

Beyond that, Krugman gratuitously (and inexplicably) criticizes S&P for unrelated reasons, casting doubt on its credibility because its judgment, after all, is anything but “gospel.” I can think of no reasonable explanation for Krugman treating this crucial topic so disingenuously. It is almost as if, as he watches his own firmly held belief system unravel, he is reflexively “killing the messenger.” I am confident, however, that once the full extent of the danger becomes better understood Krugman will be among the first to heartily endorse the “new view.” 

Mainstream Neoclassicism Is Ideology 

Cracks in the neoclassical edifice have over the last few years been cropping up all over, and they have been plastered over by such concepts as “the new normal” and “secular stagnation.” The criticism of mainstream economics has increased so much in the past couple of years that Harvard economist Raj Chetty — the winner of the 2013 John Bates Clark Medal given to the young (under 40) economist making the most significant contribution to the economics discipline — last year rose passionately to the defense of his profession (“Yes, Economics is a Science,” The New York Times, October 20, 2013, here):

I’m troubled by the sense among skeptics that disagreements about the answers to certain questions suggest that economics is a confused discipline, a fake science whose findings cannot be a useful basis for making policy decisions. * * * That view is unfair and uninformed. It makes demands on economics that are not made of other empirical disciplines, like medicine, and it ignores an emerging body of work, building on the scientific approach of last week’s [Nobel Prize] winners, that is transforming economics into a field firmly grounded in fact.

To illustrate his assertion that economic research is unusually difficult to do, he then makes this telling concession:

It is true that the answers to many “big picture” macroeconomic questions — like the causes of recessions or the determinants of growth — remain elusive. But in this respect, the challenges faced by economists are no different from those encountered in medicine and public health. Health researchers have worked for more than a century to understand the “big picture” questions of how diet and lifestyle affect health and aging, yet they still do not have a full scientific understanding of these connections.

And he goes on to assert:

If we could randomize policy decisions and then observe what happens to the economy and people’s lives, we would be able to get a precise understanding of how the economy works.

I have discussed Chetty’s assertions several times, and I continue to find them incredible: The causes of recessions and the determinants of growth are the core questions of macroeconomics, comparable in biology and medicine to questions like how the heart, lungs and central nervous system work. That answers to such fundamental questions should still be “elusive,” i.e. impervious to factual analysis, after more than 250 years of the development of “scientific” economics, is hardly credible; our continuing ignorance of how market economies work must be attributable, instead, to the trumping of scientific inquiry by political influences.

Modern neoclassical macroeconomics is grounded in ideology and philosophy, not in material fact, and despite Keynes’s attempt to alter the history of economic thinking it has remained so for over 150 years. These core questions are the very questions that distinguish macroeconomics from microeconomics, i.e., issues relating to the behavior of individual firms. Modern neoclassical macroeconomics has finessed growth issues, in large measure, by directly applying the microeconomics synthesis developed by Alfred Marshall and Arthur C. Pigou, among others, to aggregate data. 

Notably, Chetty identifies no ongoing research on the effects of income or wealth distribution on growth. It is true that until ten years ago distributional data adequate to understand “how the economy works” was unavailable. But the topic of income inequality, threatening to the interests of the wealthy, was ignored by the “science” of economics from the mid-19th Century until 1955, when Simon Kuznets complained of “the extreme scarcity of relevant data” and warned that “without better knowledge of the trends in secular income structure and the factors that determine them, our understanding of the whole process of economic growth is limited.” (The American Economic Review, Vol. 45, No. 1, March, 1955, p. 27).

Early classical economists like Adam Smith, David Ricardo, and T.R. Malthus, writing around the turn of the 19th Century, placed heavy emphasis in their “Principles of Political Economy” on economic rent, i.e., payments that did not return tangible value to an economy. The creation and redistribution of rent is clearly a matter of extreme importance to any realistic understanding of inequality, growth, idleness, and depression. Indeed, that is the very consideration Stiglitz refers to when he identifies, as the key factor in declining growth and growing inequality, “incentives directed not at creating new wealth but at taking it from others.” Economic rent, however, has been essentially ignored by mainstream economics, in both Europe and the United States, since the mid-19th Century. For an excellent short summary of the attention paid to inequality by philosophers and economists over the centuries, see Polly Cleveland’s article, “Piketty’s Model of Inequality and Growth in Historical Perspective, Part 1,” The Dollars and Sense Blog, July 15, 2014 (here).

Economics and Power

It is understandable that holders of wealth and political power would seek to eradicate factors that might constrain their ability to amass ever more wealth. Other than market regulation, taxation is the primary tool available to governments for controlling the accumulation of rents, so the wealthy and powerful have striven to reduce their taxes. On this matter, Arthur Okun, whose views on efficiency and inequality were alluded to by Krugman above, underscored the obvious forty years ago:

It does not take a research project . . . to identify misplaced — socially unproductive –efforts devoted to tax minimization. High tax rates are followed by attempts of ingenious men to beat them as surely as snow is followed by little boys on sleds. (Equality and Efficiency: The Big Tradeoff, 1975, p. 97) 

Far better, perhaps, to gain sufficient control of government and simply set favorable rates for themselves. Beyond that, control of academia would allow, over time, the eventual perversion of “scientific” economics in order to obscure the truth about growth, and about how the economy really works, behind an ideological smokescreen.

Far-fetched? In 1873, in the Afterward to his Second German Edition of Das Capital, Karl Marx objected that since 1848 in Europe “the bad conscience and the evil intent of apologetic” had replaced “genuine scientific research.” In America, the idea promoted by John Bates Clark that economic outcomes are the inevitable result of rigid, neoclassical “laws” further polluted the atmosphere for scientific research. As Polly Cleveland explains (“Piketty’s Model of Inequality and Growth in Historical Context, Pt 2,” The Dollars and Sense Blog, July 23, 2014, here):

John Bates Clark of Columbia University, for whom is named the prestigious John Bates Clark Medal, transformed economics into an inequality-free abstraction.

Writing in the 1890’s, Clark merged land into physical capital, thus obliterating the classical understanding of land. In the new neoclassical world, capital (including land) originates solely from productive investment. There is no unearned “rent”, only legitimate “profit.” (Ironically, Marx merged rent into profit because he considered both illegitimate.)

Clark reduced economics to only two “factors of production”, capital and labor. In Clark’s model, “supply and demand” in a free market ensure that capital and labor each earns its “marginal product”, that is, the contribution of the final amount supplied. This outcome is supposedly both fair and efficient. 

I could not agree more: Clark, like his European “microeconomic” counterparts,  effectively assumed away the important macroeconomic questions to which, Chetty now tells us, the answers remain elusive. Beyond that, he trivialized the work of the classical economists by burying the one economic consideration most central to income and wealth distribution — economic rent.

My review of Clark’s principal work (The Distribution of Wealth: A Theory of Wages, Interest, and Profits, 1899, 1908, here) revealed a distinctly non-scientific approach to economics. He began his book by proposing to show that “the distribution of the income of society is controlled by a natural law,” which, “if it worked without friction, would give to every agent of production the amount of wealth which that agent creates.” Moreover, “however wages may be adjusted by bargains freely made between individual men, the rates of pay that result from such transactions tend, it is here claimed, to equal that part of the product of industry which is traceable to the labor itself.” This boiled down to the assertion that “so far as it is not obstructed,” a market economy “assigns to everyone what he has specifically produced.” This can only mean one (or both) of two things: (1) As Cleveland put it, all outcomes are presumptively fair and efficient, or (2) Human activities, decisions, and behavior are, somehow, trumped by “natural law.”

Whatever this is, it is not science. 

The Okun “Trade-off”

While we are on the subject of ideology, a brief discussion of Krugman’s beginning oblique reference to Athur Okun’s “trade-off” argument (Equality and Efficiency: The Big Tradeoff, the Brookings Institution, 1975) is in order. I’m sure Krugman has not forgotten his March 9, 2014 New York Times Op-ed, “Liberty, Equality, Efficiency” (here), where he discussed how one source of evidence that income inequality reduces income growth cited by S&P (discussed in my follow-up to this post) has undermined, indeed refuted, Okun’s idea that there is a trade-off between inequality and efficiency. Note that if the “trade-off” theory was correct, at high levels of income inequality, reducing inequality would decrease growth, not increase it. 

Krugman does not condemn Okun’s idea here, although he more tentatively alludes to “growing evidence that the whole premise of the debate is wrong,” and preserves the inference that it seemed reasonable because, allegedly, even most “liberals” believed it. The S&P report also approvingly cites Okun’s book, under the heading “Striking a Palatable Balance”:

In his influential 1975 book “Equality and Efficiency: The Big Tradeoff,” economist Arthur Okun argued that pursuing equality can reduce efficiency. He claimed that not only would more equal income distribution reduce work and investment incentives, but the efforts to redistribute wealth — through, for example, taxes and minimum wages — can themselves be costly.

This would be, of course, in each instance a question of fact. If we are talking, for example, about attempting to reduce inequality by raising the minimum wage or increasing the progressiveness of income taxation, the tradeoff theory in my view boils down to the claim that “trying to increase incomes of working people is likely to reduce total work” (“Inequality and Growth — Two Sides of the Same Coin”, March 28, 2014, here). At best, that is an anti-Keynesian “people are lazy” notion that can make sense only to supply-side ideologues such as those who endorsed the idea in CBO’s July 2014 report on the “Economic and Budget Outlook.”

I have yet to learn of any circumstance in which Okun’s argument actually does make sense. After reading Krugman’s March 9 Op-ed, I quickly ordered a copy of the Okun book, and read it immediately upon arrival. The book is philosophical and ideological in character, and I found that Okun had no factual basis, either general or specific, for the idea that capitalist market economies have any abundance of efficiency to trade off. This he readily conceded: 

The case for the efficiency of capitalism rests on the theory of the “invisible hand,” which Adam Smith first set forth two centuries ago. Through the market, greed is harnessed to  serve  social purposes in an impersonal  and seemingly automatic way. (p. 50)  

Unfortunately, here Okun was merely repeating a myth about Adam Smith developed by the neoclassical school, as I documented in detail in “The Cult of the Invisible Hand,” December 22, 2013 (here). Working on theories in the 1970s, before the internet, Okun and other economists lacked the ability to investigate such ideas that we have today: The truth is that Adam Smith was actually a fairly extreme socialist, with no apparent illusions about market efficiency, who held pre-Keynesian views about how market economies work:

It can never be the interest of the unproductive [landlord] class to oppress the other two classes. It is the surplus produce of the land, or what remains after deducting the maintenance, first, of the cultivators, and afterwards of the proprietors, that maintains and employs the unproductive class. * * * The maintenance of perfect justice, of perfect liberty, and of perfect equality, is the very simple secret which most effectually secures the highest degree of prosperity to all three classes. (Wealth of Nations, 1776, Prometheus Books, Great Minds Series, 1991, p. 454. Emphasis added.)  

The idea of a trade-off between increased inequality and efficiency, such that reducing inequality could hamper growth, never had a basis in fact. In fact, the false notion of perfect efficiency, as we have discussed, owes much to the presumptuous ideology of John Bates Clark. So we should not be at all surprised to learn that growing inequality suppresses growth.

The S&P Report

The Standard and Poor’s report (“How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide,” August 5, 2014, here), takes a different approach to discussing this obviously monumental issue. Its basic take on the inequality problem reflects Keynesian perspectives: “Despite the tendency to speak about this issue in moral terms,” it says, “the central questions are economic ones.” Moreover, it says: “Higher levels of income inequality increase political pressures, discouraging trade, investment, and hiring.” This reasoning is straight from Keynes’s playbook.

Obviously, S&P has much professional skin in this game, but it likely employs mainstream economists who are just as skeptical about how inequality reduces growth as Paul Krugman. Given how controversial this report must have been internally, it seems unlikely that S&P would have released unless it without conviction, and material concerns about the U.S. economy’s declining growth.   

Regardless, this report misrepresents economic history in an apparent attempt to imply that this is a difficult issue which emerges now after centuries of careful scientific focus on inequality. The Report begins: “The topic of income inequality and its effects has been the subject of countless analysis stretching back generations. . .” And: “Given the decades–indeed, centuries–of debate on this subject, it comes as no surprise that the answers are complex.” As discussed above, however, the topic of income inequality has actually been ignored for decades, even suppressed at the hands of ideological influences. 

S&P also maintains:

Keynes first showed that income inequality can lead affluent households (Americans included) to increase savings and decrease consumption, while those with less means increase consumer borrowing to sustain consumption…until those options run out. When these imbalances can no longer be sustained, we see a boom/bust cycle such as the one that culminated in the Great Recession.

Actually, no, he did not. Although S&P’s analysis is theoretically sound, it is important to recognize that it did not come from Keynes. His General Theory (1935) consisted of a three-variable full employment model that took no account whatsoever of income or wealth distribution, which he characterized in his last chapter as “arbitrary.” Keynes discussed the support in his day for the obvious approach of progressive taxation of the highest incomes and wealth, to redistribute the concentrating revenues and wealth back down, but that was virtually the full extent of his discussion of distribution.  

Keynes did identify a “boom/bust cycle” in growth, caused by variations in the aggregate propensity to consume from aggregate income — but his model assumed a given distribution of income and wealth. He believed that fiscal and monetary policy could control market instability, and therefore solve the “poverty” problem.

This is important because Keynes overlooked what recent experience has shown: The impacts on growth of excessive income and wealth concentration dwarf, even over a period as short as 20-30 years, the impacts of narrower decisions about whether to consume or save.

S&P also theorized:  

A degree of inequality is to be expected in any market economy. It can keep the economy functioning effectively, incentivizing investment and expansion — but too much inequality can undermine growth.

As discussed above, the claim that changes in inequality affect people’s incentives to make money is a murky, dubious one. It is also important, moreover, that the operation of redistribution mechanisms can undermine growth at any level of inequality. That is, in fact, what happened after 1980 when income inequality was at its lowest level since WW II.   

Conclusion

S&P’s recent report is correct that excessive income inequality causes declining growth. This fact has been obscured by mainstream economics, which has ignored inequality ever since the middle of the 19th Century, pretty much precisely when capitalist market economies began to develop in both Europe and America.

Today mainstream economists and forecasters, who are becoming increasingly at sea on growth issues, are beginning to discover this relationship. The powerful grip of old ideas — especially those ideas that inherently obscure the truth about growth — can make it impossible to embrace new ideas and perspectives.  It seems to me that the analysts at S&P must have detected reasons for serious concern, or they would not have issued their warning. 

In a follow-up post I will review some of the sources cited by S&P and other information, including the IMF studies in particular, and present factual information from various sources to develop a sense of he severity of the problem and of the implications for the CBO projections of the national debt and debt interest that I discussed in my previous two posts.

JMH – 8/14/2014 (ed. 8/14,16/2014)

Posted in - FEATURED POSTS -, - MOST RECENT POSTS -, Decline in America, Economics, Wealth and Income Inequality | Leave a comment

Breaking News: CBO Infected with Trickle-Down Disease

In a recent Op-ed (“The Fiscal Fizzle: An Imaginary Budget and Debt Crisis,” The New York Times, July 20, 2014, here), Paul Krugman argued that the “fiscal panic has fizzled,” citing the most recent Congressional Budget Office “Long-term Budget Outlook,” July, 2014, (here). That report extends through 2039 CBO’s February 2014 presentation of “The Budget and Economic Outlook: 2014 to 2024″ (here). Because only the February report contained the budget details necessary for a sensible review of the budget/debt issue, I limited my analysis in my last post to the February report, deferring to this post a review of the July report.

In my post I explained how the February 2014 report revealed the rapidly increasing danger in the federal budget/debt situation posed by the exponential growth of the interest on the national debt, and by the continuing increase in income and wealth inequality not accounted for by CBO.  In particular, the data showed that debt interest is projected to grow much faster than any other expense category through 2024, as follows:

  • Total mandatory outlays are projected to increase from $2,1 trillion in 2014 to $3.7 trillion in 2024, a 77% increase;
  • Total discretionary outlays are projected to increase from $1.2 trillion in 2014 to $1.4 trillion in 2024, a 16% increase;
  • The defense budget portion of discretionary outlays is projected to increase from $604 billion in 2014 to $719 billion in 2024, a 19% increase;
  • Interest on the national debt is projected to increase from $233 billion in 2014 to $880 billion in 2024, a 278% increase.

[Correction (8/15/2014)  - The interest increase was originally posted as a 378% increase. The percentage increases shown for the other items were computed from the full un-rounded numbers; using the rounded figures shown above produces percentage increases that are slightly different: 76%, 17% and 19% respectively.]

The July report contains no such table, avoids the topic of debt interest, and effectively contradicts these facts in its presentation. Here is a step-by-step review of CBO’s approach and conclusions. 

The Forecast that Isn’t One

CBO begins (opening Notes, p. ii) by contending that the extension of its earlier baseline projections out to 2039 is not a forecast. Indeed, it says, neither the baseline (through 2024) nor the extended baseline through 2039 are meant to be predictions:

CBO’s long-term projections extend beyond the usual 10-year budget window to focus on the 25-year period ending in 2039. They generally reflect current law, following the agency’s April 2014 baseline budget projections through 2024 and then extending the baseline concept into later years; hence, they constitute the agency’s extended baseline. The baseline and the extended baseline are not meant to be predictions of future budgetary outcomes; rather, they represent CBO’s best assessment of how the economy and other factors would affect revenues and spending if current law generally remained unchanged. Thus, they serve as benchmarks for measuring the budgetary effects of proposed changes in law regarding federal revenues or spending. (Emphasis added)

Thus, according to CBO, it is not giving us a forecast, merely “benchmarks” for measuring the effects of proposed changes. However, in its initial Summary (p. 2) it says: 

If current laws remained generally unchanged in the future, federal debt held by the public would decline slightly relative to GDP over the next few years, the Congressional Budget Office (CBO) projects. After that, however, growing budget deficits would push debt back to and above its current high level. Twenty-five years from now, in 2039, federal debt held by the public would exceed 100 percent of GDP, CBO projects. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely.

In other words, although an increasing debt/GDP ratio is a trend CBO acknowledges cannot be sustained indefinitely, “if current laws remain generally unchanged” CBO is aware of no reason to suspect that the trend in the growth of debt will not be sustained at least until 2039, when according to its algorithm the debt/GDP ratio debt will reach 1.0. That, of course, is a forecast: a particularly useful forecast for anyone not wanting to change current laws, especially laws increasing taxation.

Misrepresenting Debt Interest Growth 

CBO 45471-Long-TermBudgetOutlook - july 2014 - debt as a percent of GDP

This graph is presented on p. 9 of the July 2014 report, where CBO states:

CBO projects that, under current law, debt held by the public will exceed its current percentage of GDP after 2020 and continue rising. By 2039, under the extended baseline, federal debt held by the public would reach 106 percent of GDP —equal to the percentage at the end of 1946 and more than two and a half times the average percentage during the past several decades—and would be on an upward path. That trajectory ultimately would be unsustainable. Moreover, the long-term projections of federal debt presented in this chapter and the next few chapters do not incorporate the negative economic effects of higher debt. Projections that account for those effects show debt reaching 111 percent of GDP in 2039 (see Chapter 6).

I’ll return to the reference to “negative economic effects of higher debt” shortly. For now, we need to consider how CBO projected that federal debt would not exceed its current percentage of GDP until after 2020, and would not continue the rapid rise established after the Crash of 2008. The reduced rate of debt growth shown requires either a slower rate of growth of debt or an increased rate of GDP growth, or both. Here is the first figure, taken from p. 2 of the report:

CBO 45471-Long-TermBudgetOutlook - july 2014 - federal debt spending and revenues

From the bottom up, it shows (a) the undistributed sources of federal revenue, (b) components of total spending, and (c) the national debt (with an overlay trend line of spending and revenues, showing spending gradually rising faster than revenues.

Our immediate concern is with the middle chart, which shows components of federal spending. Net interest on the debt is predicted to rise faster than other categories of spending until 2019, then flatten out thereafter rising at a lower rate until 2039, staying well below and roughly parallel to the other categories — notably “major health care programs” and “social security” — until 2039. This forecast appears inconsistent on its face with CBO’s February 2014 budget analysis which, as reported above, showed total mandatory outlays increasing by 77%, total discretionary outlays increasing by 16%, and debt interest increasing by 378%, through 2024.

In fact, it is greatly divergent from the budget forecast. Here are the relevant data for outlays in 2014, 2019, and 2024 ($billions):                                  

Year    (a) Net Debt Int.    (b) Soc. Sec.          a/b        (c) M’care + M’caid               a/c 

2014                  233                       846               28%                        901                      26%

2019                  569                     1,116               51%                     1,223                      47%

2024                 880                     1,056              83%                     1,661                       53%

________________________________                  

Obviously, debt interest (which compounds) continues to grow faster than other categories of federal spending after 2019, and interest continues to grow faster than do the other categories through 2024. Nonetheless, CBO’s graph shows interest to grow at about the same rate as these other categories after 2019  all the way through 2039.

This is a major misrepresentation of fact, and it seems to explain why CBO neglected to discuss debt interest in the July report, barely mentioning it at all. CBO used to have a reputation for honesty and objectivity, but with this kind of chicanery, which has to be intentional, CBO has lost its credibility.

Why would CBO lie? One likely explanation is that, with the general impression that the national debt will not pose a material problem for another couple of decades, The Republican majority in Congress will have more time to use austerity budgeting to chip away at “entitlement” programs without endangering the public’s acceptance of their trickle-down myth, and without incurring higher taxes. It may face less political risk in 2016 as well if the interest on debt that has built up over 35 years, which cannot properly be blamed on the current administration, can be obscured. If the economy fails much sooner than 2039 — as it simply must, because such an extreme trend of unsupportable national debt is admittedly “unsustainable” — CBO will point to its assertion that its 2014 reports presented merely benchmarks, not forecasts.

Trickle-Down Nonsense

This report has Paul Ryan’s fingerprints all over it. Here is the lead-in graphic to the July report:


CBO 45471-Long-TermBudgetOutlook - july 2014 - debt as percentage of GDPDoes that look familiar? Compare it to the graph that has been emblematic, since 2012, of Paul Ryan’s budget plans. They are virtually identical for the past 15 years or so:

Pages from pathtoprosperity2013b

Although Ryan imagined the national debt rising to almost 300% of GDP by 2039, and even 800% by 2060, neither of which is actually possible, the austerity/trickle-down ideology behind his program is the same as that now propounded by CBO. For a review of Ryan’s mystical argument that cutting federal spending rather than increasing tax progressiveness will lead to “prosperity,” see my recently republished post “Amygdalas Economicus: Perspectives on Taxation,” originally posted January 24, 2013 (here). 

The sole economic support Ryan cited for his ideology, you may recall, was the Reinhart/ Rogoff theory that as the ratio of national debt to GDP approaches unity, growth is depressed. If that were true, the converse of that theory would in such circumstances support the “austerity” doctrine, namely, that cutting government spending will increase income growth. (Note that cutting spending instead of increasing tax progressiveness to reduce the debt is also promoted by the companion trickle-down fantasy that taxing the rich discourages investment and growth.)

Notice the absurd idea glaring up from Paul Ryan’s graphic that cutting spending without increasing taxation of top incomes and corporations will quickly reduce the national debt, eliminating it by 2050 (the green “Path to Prosperity”). CBO could not get away with making such a ludicrous claim, but it can get away with endorsing the trickle-down myth and uses it to inflate its growth projections.   

In a series of posts, I sifted through the complexities of the Reinhart/Rogoff controversy in some detail, concluding that their idea that increased government debt (reflecting greater spending) reduced income growth lacked theoretical support, and was refuted by their own study (GITD) once its statistical errors were corrected. (See “Reinhart, Rogoff, and Reality,” May 30, 2013, here; “Reinhart, Rogoff, and Ideology,” June 6, 2013, here; and “Reinhart, Rogoff, and Redistribution,” June 30, 2013, here.) I also argued, in the last of these posts, that the declining growth at high levels of national debt in the United States is due to growing income and wealth inequality. (Because of the complexity of the competing arguments, I extended my discussion to three posts. My conclusions, although not concisely presented, remain intact.)

CBO’s new ideological/political  bent:

Although Ken Rogoff and Karmen Reinhart withdrew their conclusions, their argument still sways right-wing ideologues. [Note: Stressing the point that the debt interest/GDP ratio is much higher now "than at any time since WWII" sets up the bogus, Ryan-like argument that, pursuant to the Reinhart/Rogoff thesis, the slow pace of growth is the fault of the Obama Administration's policies.] 

The July CBO report is candid about endorsing, and using for forecasting purposes, Paul Ryan’s supply-side and “trickle-down/austerity” perspectives. In Chapter 6 (p. 70) CBO discusses its perception of “the economic and budgetary effects of various fiscal policies.” According to CBO, these include:

  • Higher debt crowds out investment in capital goods and thereby reduces output relative to what would otherwise occur; [Reinhart/Rogoff and the austerity doctrine]
  • Higher marginal tax rates discourage working and saving, which reduces output. [The "Laffer Curve," which is the converse of the trickle-down myth.]
  • Larger transfer payments to working-age people discourage working, which reduces output. [People are lazy.] 
  • Increased federal investment in education, infrastructure, and research and development (R&D) helps develop a skilled workforce, encourages innovation, and facilitates commerce, all of which increase output. [Education, research, and infrastructure are important to growth.]

In each of those cases, the opposite change in policy has the opposite effect; for example, lower marginal tax rates increase output relative to what would otherwise occur.

The “trickle-down” component of CBO’s thinking has been repeatedly discredited by the facts, which demonstrate that it is the progressiveness of taxation that determines the amount of effective demand, for the most part, and accordingly output. Piketty/ Saez/Stantcheva published a study in 2011 across a broad database of the income elasticity of the top income tax rate which showed that federal income tax revenues are optimized at a marginal tax rate over 80%. This study fully refuted the Laffer Curve theory that lower tax rates increase investment and output. No rational theory of investment supports that claim; regardless, if you can effectively tax rich people more, it is simply wrong to argue the converse of the Laffer Curve argument — that refraining from such taxation allows income and wealth to “trickle down” from above. In any event, we know that wealth and income has not trickled down as inequality has continued to grow over the last few decades. The result has been lower growth and higher inequality.

The Inequality Factor

As discussed in the previous post, although the conceptual flaws in CBO’s supply-side analysis are hugely consequential, ignoring the major factor determining growth — the distribution of wealth and income — is almost certainly more significant. Not only has CBO corrupted the budget issue by factoring out the growth of debt interest, it has also failed to reflect the continuing absorption of some $500 billion or more annually into top 1% net worth. This factor ensures continuing reductions in government revenues, and the need for even more debt than CBO otherwise computes will be needed.

Looking again at the following portion of Figure 1.1, it does not seem unreasonable to expect a continuing sharp rise in debt in the 2015-2018 period: Growth in the national debt reflects the continuous financing of the regressive tax reductions enjoyed at the top; and each billion dollar increase in the national debt is matched by an off-setting reduction in bottom 99% wealth. 

CBO 45471-Long-TermBudgetOutlook - july 2014 - growth of debt after 2014

The CBO study has materially misrepresented the growth of debt interest, and beyond that it is corrupted by false ideological influences. It is therefore worthless for predicting when the debt will reach the level of GDP. All we can be certain of is that CBO’s assessment is wrong, and far too optimistic. The dynamics of redistribution are brutal, and there is no reason to assume that the debt/GDP ratio cannot reach 1.0 before 2016-2017; it is growing inequality, primarily, that depresses growth, and as the debt raised to finance that inequality rises exponentially, we move closer and closer to a deep depression. And as we have discussed, there is no magic in the 1.0 debt/GDP ratio: If another bubble pops, such as the $1.4 trillion student debt bubble, we can only guess at the severity of the consequences. 

Again, I disagree with Krugman’s strategy, if it is his strategy, to endorse this bogus CBO study and its assertion that everything will be all right for another 25 years “under current laws.” We’re beyond the point where a political gambit like that, with the stakes so high, can make any sense at all. We’re skating on extremely thin ice, and the entire structure could collapse, just as it did in 2008, on very short notice.

JMH — 7/27/2014 (ed. 7/28, 29/2014)

Posted in - FEATURED POSTS -, - MOST RECENT POSTS -, Economics, Federal Budget and Spending, Federal Debt, Wealth and Income Inequality | Leave a comment

The Fiscal Fiasco: A Real Budget and Debt Crisis

‘What Good Are Economists Anyway?’ asked Business Week’s cover story for 16 April 2009, noting that though the world is ‘simply too complicated’ for ‘exactitude’ in prediction, it is distressing that ‘seven decades after the Depression, economists still haven’t reached consensus on its lessons’. An even harsher rebuke came from within the profession when Paul Krugman asked, in the pages of the New York Times Magazine, ‘How Did Economists Get It So Wrong?’ (here). Despite his title, Krugman did not have all economists in mind, but only those who followed recent neoclassical fashion (he left undiscussed the reasons why Keynesian theory fell into disrepute in the 1970s). * * * Krugman dismissed the approaches dominating academic economics over the last 30 years as fundamentally misguided and called for a return to Keynesian theory as part of a recognition of the fundamental ‘messiness’ of the economy.

Writing in the Financial Times (August 5, 2009), Robert Skidelsky (best known for his authoritative biography of Keynes) similarly noted that the efficient-market hypothesis’s collision with the iceberg of economic reality had ‘led to the discrediting of mainstream macroeconomics’ and given the lie to economists’ claim to practice a predictive science. Such shock at the predictive failure of economics is surprising, given the dismal record of professional forecasting. — Paul Mattick, Business as Usual: The Economic Crisis and the Failure of Capitalism, Reaktion Books. Kindle Edition, 2011 (pp. 19-20).

In his second-most recent Op-ed (“The Fiscal Fizzle: An Imaginary Budget and Debt Crisis,” The New York Times, July 20, 2014, here), Paul Krugman argued that the “fiscal panic has fizzled,” citing the most recent Congressional Budget Office “Long-term Budget Outlook,” July, 2014, (here):

I’m not sure whether most readers realize just how thoroughly the great fiscal panic has fizzled — and the deficit scolds are, of course, still scolding. They’re even trying to spin the latest long-term projections from the Congressional Budget Office — which are distinctly non-alarming — as somehow a confirmation of their earlier scare tactics. 

The “deficit scolds” Krugman refers to are right-wing economists and politicians who argue that deficit reductions are needed to avoid the serious crisis that will eventually develop with the continuing federal deficits and exponential growth of the national debt. There are two ways to cut the deficit: reducing federal spending or increasing federal revenues. Krugman has been consistently critical of Alan Simpson, Erskin Bowles and the National Commission on Fiscal Responsibility and Reform (here), a conservative group that includes the premier Congressional budget slasher, Congressman Paul Ryan (here). The Republican Party and the economic right generally want lower taxes, and favor the budget slashing approach to reducing the deficit. Indeed, the Washington Post editorial cited by Krugman (here) simply presumes that raising more government revenues by increased taxation of the rich and corporations is out of the question. 

The economic right has little incentive to actually help relieve the Budget and Debt crisis. Ideologically, they express a broad aversion to government, and many powerful “conservatives” today simply want, as Grover Norquist puts, it to “shrink” the federal government “down to the size where we can drown it in the bathtub.” Politically, their agenda is to blame the Obama Administration for our economic woes,  and perfect their control of the national government so they can finish this job. 

Krugman has repeatedly campaigned against “austerity” budgeting, correctly arguing that cutting taxes and government spending has disastrous consequences for recovery and growth, both at home and abroad. In his most recent Op-ed (“Left Coast Rising,” The New York Times,  July 24, 2014, here), Krugman points to the latest confirmations of Keynesian theory from the states of Kansas (whose tax cuts resulted in fiscal crisis and less growth) and California (which has increased taxes without such negative impacts). The lessons are clear: austerity cannot work, and the “trickle-down” fantasy is a hoax. The key to improving the economy, therefore, will be to remove the budget slashers and tax reducers from their positions of control.

To tackle the deficit problem, increasing tax revenues from the wealthy and corporations is a must, but it also appears to be a political impossibility right now. It appears that Krugman, in these circumstances, has opted to argue that there is no need to worry about the deficits right now, in an attempt to disarm the deficit scolds. Although the “fiscal fizzle” argument is a logical  approach to pursuing that political objective, analysis of the CBO forecast shows there actually is a serious budget crisis, and we are running out of time to correct the problem. In my view, facing the truth is preferable to continuing to play a political game. Billionaires like Nick Hanauer (see my last post) deserve to know the urgency of the danger for them in the current situation: We cannot rely on politics, so Hanauer’s initiative remains the best hope for America’s future. So far, however, too few politicians and economists recognize (a) the proven failure of mainstream, neoclassical forecasting, and (b) the brutal consequences of the accelerating inequality of income and wealth.  

The CBO Forecast

Paul Krugman, referring to CBO’s July report, makes this argument:

The budget office predicts that this year’s federal deficit will be just 2.8 percent of G.D.P., down from 9.8 percent in 2009. It’s true that the fact that we’re still running a deficit means federal debt in dollar terms continues to grow — but the economy is growing too, so the budget office expects the crucial ratio of debt to G.D.P. to remain more or less flat for the next decade.

The July report extends through 2039 its presentation in February of 2014 of “The Budget and Economic Outlook: 2014 to 2024″ (here). My analysis here is based entirely on the February report, for two reasons: (1) The February report contained a detailed budget budget forecast but the July report does not, and there is crucial information in the details that are omitted from the July report; (2) I need more time to review the July report for its consistency with the 2024 forecast, and to study the extended projection through 2039.  (I will present a follow-up post as soon as I have completed that review.) 

Here, from the February report (p. 2) is the Summary Table of CBO’s baseline projections, in which both deficit and debt estimates are presented in actual dollars and as a percent of GDP:

CBO budget outlook 45010-Outlook2014_Feb

Note that the real (inflation-adjusted) deficit is projected to grow from -$514 billion in 2014 to -$1,074 billion in 2024.  The national debt is projected to grow from $12.7 trillion in 2014 to $21.3 trillion in 2024. This enormous growth in the debt, however, only results in a projected increase in the debt/GDP ratio from 73.6% to 79.2%. This reflects, of course, a similarly substantial increase in projected GDP.

GDP (income) is projected to grow at a little over 3.1% on average through 2017, and to increase at an average rate of 2.2% in the 2018-2024 period (Summary Table 2, p.6). The data in Table 1 produce rounded GDP figures of $17,278 trillion in 2014 (12,717/.736), and $26,843 trillion in 2024 (21,260/.792). (CBO’s actual estimates are shown on Table 3-1, p. 50, as shown below.) 

Notably, this amounts to a 55% increase in total income through 2024. It is also noteworthy that the U.S. Census Bureau (here) projects the U.S. population to increase at a much slower rate, from 318.9 million in 2014 to 343.9 million in 2024, an increase of 7.9%. The CBO forecast therefore implicitly reflects substantial projected increases in per capita income and in productivity through 2024.

Our first observation must be that the CBO forecast takes no account of future impacts of the ongoing growth of income inequality, and concentration of wealth. CBO acknowledges the substantial decline in GDP (income) growth that has taken place since the late 1970s, reporting (p. 41) the following average annual growth rates: 4.0% (1950-1973); 3.3% (1974-1981) and; 2.2% (2002-2013). The projected average from 2014-2024 is 2.1%. The CBO offers no explanation for this steady decline. As detailed in this blog, that decline in income growth is associated both logically and statistically with increased income inequality. 

Its forecast of growing productivity and per capita income through 2024 simply ignores the 10% decline of median income that has taken place since the Crash of 2008 (while top 1% incomes have grown dramatically); CBO offers a “supply-side” forecast, in fact, that does not account at all for consumer demand. Although the past impacts of inequality growth are reflected in its low income growth expectations, it makes no adjustment for the continuing massive transfers of wealth to the top 1% or the continuing decline in bottom 99% income. I’ll return to this later.

Again, Krugman emphasized this point: “The budget office predicts that this year’s federal deficit will be just 2.8 percent of G.D.P., down from 9.8 percent in 2009.” CBO presented (p. 4) the following graph of revenues and outlays since 1974, as a percentage of GDP: 

CBO 2014_Feb total revenues and outlays

This graph displays the record high (since 1974) ratio of the federal deficit to GDP of 9.8% in 2009, but this huge, unprecedented deficit clearly reflected the Crash of 2008 and the consequent loss of government revenues, as well as the huge outlays expended to bail out investment banks and other financial institutions. That the ratio has fallen again does not indicate that we are out of trouble; indeed, the situation is considerably worse because the debt and interest on the debt is much higher than before the Crash. It is more noteworthy that, while CBO projects rising government revenues, the increase in real outlays projected through 2024 is considerable, and larger. In general terms, the explanation for this rising deficit (p. 74) is clear, as revealed by the following table:  

CBO budget outlook 45010- outlays

  • Total mandatory outlays are projected to increase from $2,1 trillion in 2014 to $3.7 trillion in 2024, a 77% increase;
  • Total discretionary outlays are projected to increase from $1.2 trillion in 2014 to $1.4 trillion in 2024, a 16% increase;
  • The defense budget portion of discretionary outlays is projected to increase from $604 billion in 2014 to $719 billion in 2024, a 19% increase;
  • Interest on the national debt is projected to increase from $233 billion in 2014 to $880 billion in 2024, a 378% increase.

The interest on existing debt is increasing exponentially, because no debt is being retired and all debt holders own a “perpetual annuity” on their bonds. While the interest on existing debt is compounding, moreover, the government is continuing to borrow to cover each year’s new deficit, adding to the balance of debt. Notably, under these projections, sometime in 2020 the interest on the debt surpasses the entire defense budget.

The increase in debt interest is the most certain of these projections, and because as discussed below the forecast is extremely optimistic, this represents a best case scenario for debt interest: These projections do not include any allowance for additional income and wealth concentrations over the next few years: Monopoly-driven excess profits are providing well over $500 billion per year in additional net worth for the wealthiest Americans and their corporations. As mentioned above, the CBO’s projected increase in income obscures the related decline of the median income of the bottom 99%, and fails to recognize that more than 95% of all new income, as reported by Emmanuel Saez, has gone to the top 1% since 2010.

In these circumstances, we are confronted with the very real likelihood that the national debt and the deficits will be be substantially higher in 2024 than projected by CBO, and that the debt interest will surpass the defense budget before 2020.

CBO’s Forecasting Uncertainty

CBO acknowledges the tenuous nature of this situation:

Over the next decade, debt held by the public will be significantly greater relative to GDP than at any time since just after World War II. With debt so large, federal spending on interest payments will increase substantially as interest rates rise to more typical levels (see Chapter 2 for a discussion of the economic outlook). Moreover, because federal borrowing generally reduces national saving, the capital stock and wages will be smaller than if debt was lower. (p. 7) 

Regarding economic growth, its statements maintain guarded optimism. For example: “The CBO projects that … economic activity will expand at a solid pace in 2014 and the next few years,” and that “federal fiscal policy will restrain the growth of the economy by much less than it has recently.” CBO, nevertheless:

. . . estimates that the economy will continue to have considerable unused labor and capital resources— or “slack”— for the next few years. According to the agency’s projections, the unemployment rate will decline gradually but remain above 6.0 percent until late 2016. The labor force participation rate (the percentage of people in the civilian non-institutionalized population age 16 or older who are either working or are available for and actively seeking work), which has been pushed down by an unusually large number of people deciding not to look for work because of a lack of job opportunities, will move only slowly back toward the level it would be without the cyclical weakness in the economy. (p. 27)

CBO’s actual projection, however, reflects the standard neoclassical presumption that an economy will always rebound to full employment “equilibrium,” reflecting the “full potential” of the capital stock:

By the second half of 2017, CBO projects, real GDP will return to its average historical relationship with potential (or maximum sustainable) GDP, which implies that GDP will be slightly below its potential. (p. 27)

The basis of its projection of the rate of income growth through 2024 is said to reflect “long-term trends”:

Over the next decade, potential output is projected to grow by 2.1 percent per year, on average, which is much lower than the average rate since 1950. That difference primarily reflects long-term trends, particularly slower growth of the labor force caused by the aging of the baby-boom generation. (Id.)

This CBO forecast hedges, though, as have all other mainstream forecasts I have reviewed in the last two years: CBO implicitly concedes that it lacks confidence in its projections, reminding us of the element of uncertainty:

The economic recovery has had unusual features that have been hard to predict, and the path of the economy in coming years is also likely to be surprising in various ways. (Id.)

And:

Economic forecasts are always uncertain, but the uncertainty surrounding CBO’s forecast for the next several years is probably greater than it was during the years following previous recessions because the current business cycle has been unusual in a variety of ways. (p. 39)

In these circumstances, CBO simply makes the most optimistic forecast of GDP growth it possibly can (p. 5), given its forecasting techniques:  

CBO budget outlook 45010-Outlook2014 - gdp and potential gdp

CBO assumes the economy rapidly returns to what economists have been calling the “new normal” growth rate, and then continues at that rate, which is termed the “maximum sustainable output of the economy.” This, of course, is pure guesswork.

CBO discusses distribution of income, but only draws inferences from the trend in labor income (wages and salaries), without accounting at all for the concentration of income (p. 43). Thus, CBO produces this graph (p. 43) of “Labor Income”:

CBO budget outlook 45010-Outlook - labor income

The flaw here is that data for”labor income” include the salaries paid to very wealthy people. Thus, CBO ignores other forms of compensation and wealth transfers, ignoring the distribution of income between wealthy and other people, and without considering how growing income inequality affects demand, consumption, and consequently income growth, taxation, and budget deficits.

I’m not picking on CBO in particular here: All of this reflects the bankrupt state of macroeconomic forecasting analysis today. CBO tries to predict the future, but cannot do it any other way than by projecting supply-side “trends” —  i.e., by guesswork. Its projection of household net worth (wealth) highlights the fact that its main problem is reliance on aggregate (as opposed to distributed) data:

CBO budget outlook 45010-Outlook2014 household net worth

This graph has the familiar contours of the top 1% wealth graph, because it fully includes and mainly reflects top 1% wealth. After the Crash of 2008, as is now increasingly common knowledge, wealth lost by the top 1% (mainly stock market values) rebounded, while housing values did not. The bottom 99%, on the other hand, lost a large share of the $3.7 trillion of net worth reduced from the collapse of the housing bubble. 

This forecast, therefore, is basically a projection of the growth of income and wealth of the wealthiest Americans and their corporations. When income and wealth are rapidly redistributing to the top, which has been true for three decades, aggregate net worth data and aggregate “labor income” data are all but useless. Economic science has yet to appreciate that the distribution of income and wealth, in terms of its concentration at the top, is a primary determinant of income growth. Economists have yet to implement distributional forecasting, accounting for the effects on growth of depressed demand.

With that in mind, here’s one more graph from the CBO forecast:

CBO budget outlook 45010-Outlook2014 - federal debt

This is CBO’s first graph (p. 3), and it tracks the national debt as a percentage of GDP. As discussed earlier, CBO identifies that percentage as 73.6% for 2014, and 79.2% for 2024. Notice that from 2007 on out, from the last year or so of the Bush administration, debt has skyrocketed; so has unemployment. After the Crash debt has continued to grow rapidly until the last year or so, when signs of modest growth have appeared that have been eagerly interpreted as “recovery.” (It must be noted, though, there was zero growth in the Q 1 of 2014, speculatively attributed to cold weather.)

It cannot be overemphasized that economists have no good reason to suppose that the national debt will not continue its sharp upward climb after this year. So long as income and wealth continue to concentrate at the top, income will grow ever more slowly, and there is no good reason to imagine that income growth can be sufficient to counter the acknowledged, rapid increase in debt interest. In these circumstances, to mechanically project a near-immediate return to something called “maximum sustainable output” is an exercise in extremely wishful thinking. And remember: even under its own postulated conditions of “maximum sustainable output,” CBO has projected that debt interest will mushroom out of control.

Summary and Overview

Since the early years of the Reagan Administration, income and wealth inequality have grown steadily. Natural inequality growth was heightened by reduced regulation of monopoly profits and increased taking of economic rent at the top, beginning in earnest with the Reagan Administration. Also beginning in earnest with the Reagan Administration was the reduction of federal tax revenues collected from the wealthiest Americans and their corporations. The federal government was not deterred from staying in business, and much of its business turned to the enhancement of wealth. Thus, it incurred massive debt in order to finance these tax reductions.

Today, the interest on that debt is growing exponentially, forcing government to either raise more taxes or cut spending even more drastically than it already has in the last few years. The latter course is actively pursued by the right-wing economists and advocates for the wealthy, who continue to hunger for more wealth with almost no regard for the consequences. They are gradually destroying the U.S. economy and American prosperity, for all but a select few.

Extremists have justified this course of action with a pathological hatred of government, and by the objective, as Grover Norquist puts it, of shrinking the government down to a small enough size to “drown it in the bathtub.” There are less extreme “deficit scolds,” like the Washington Post editors, who expressly only want to socialize banks and too-big-to-fail corporations and financial institutions, making sure that government at least has enough revenue collected from other taxpayers to bail them out again, should there be another crisis like the Crash of 2009.

Paul Krugman has been opposing these hideous, antisocial agendas for some time. In current circumstances, however, in which the full extent of the peril posed by the growing debt interest burden and by the continuing growth of income and wealth concentration are not well understood, he has opted to promote the idea that we have nothing to worry about from the national debt and the growing budget deficits. That strategy, unfortunately, relies on the bankrupt mainstream, neoclassical mindset which has continuously produced unreliable forecasts and which he himself has forcefully challenged.

The CBO forecast reveals the flaws in that mindset, and demonstrates that the danger from our growing debt and budget deficits is real, and growing exponentially. The possibility of not making it to 2024 without a fatal catastrophe is real. In the next post I’ll review a CBO inference which seems absurd on its face: that we might somehow make it to 2039. 

In current circumstances, where threats to the sustainability of our planet’s ecosystem, and the frightfully escalating warfare among nations, can make economic matters seem trivial by comparison, we should ask ourselves how our country, and the rest of the world for that matter, would cope with any of those other problems with a collapse into another great depression. We really need to save the American economy and the federal government.

JMH — 7/25/2014 (ed. 7/26)

Posted in - FEATURED POSTS -, - MOST RECENT POSTS -, Economics, Federal Budget and Spending, Federal Debt, Wealth and Income Inequality | Leave a comment

It’s the Wealth Transfers Stupid

In 1980, the top 1 percent controlled about 8 percent of U.S. national income. The bottom 50 percent shared about 18 percent. Today the top 1 percent share about 20 percent; the bottom 50 percent, just 12 percent.

But the problem isn’t that we have inequality. Some inequality is intrinsic to any high-functioning capitalist economy. The problem is that inequality is at historically high levels and getting worse every day. Our country is rapidly becoming less a capitalist society and more a feudal society. Unless our policies change dramatically, the middle class will disappear, and we will be back to late 18th-century France. Before the revolution.

And so I have a message for my fellow filthy rich, for all of us who live in our gated bubble worlds: Wake up, people. It won’t last.

If we don’t do something to fix the glaring inequities in this economy, the pitchforks are going to come for us. No society can sustain this kind of rising inequality. In fact, there is no example in human history where wealth accumulated like this and the pitchforks didn’t eventually come out. You show me a highly unequal society, and I will show you a police state. Or an uprising. There are no counterexamples. None. It’s not if, it’s when. – Nick Hanauer, “The Pitchforks Are Coming. . . For Us Plutocrats,” Politico Magazine, July/August, 2014 (here)

To begin, a word about my title: It alludes, of course, to James Carville’s famous slogan “It’s the economy stupid,” meant to remind Bill Clinton’s campaign workers that voters’ top concern is always their pocketbooks and the economy.  I’m not fond of that quotation, but I use it because it was recently paraphrased in connection with the principal subject of this post — The Crash of 2008.  The crash and its aftermath were addressed in a recent Op-ed by Paul Krugman entitled “Build We Won’t” (New York Times, July 3, 2014, here). Later, posting that Op-ed in Reader Supported News, editor Marc Ash changed the title to “It Was the Housing Bubble Stupid,” a seemingly innocent endorsement of the argument Krugman made about the Crash of 2008.

When it comes to the economy, I would not call any economist stupid, certainly not a Nobel Prize winner, and especially not Paul Krugman. Every economist has her or his customized framework, or model, of how the economy works, through which facts are filtered and interpreted. There is great variety in these perspectives, and it is not surprising that they have provided a number of  competing explanations for the causes and consequences of the Crash of 2008. It is a complex topic.

The brashness of Ash’s endorsement of Krugman’s Op-ed may have been invited by Krugman’s statement, in his opening paragraph, that:

The basic story of what went wrong is, in fact, almost absurdly simple: We had an immense housing bubble, and, when the bubble burst, it left a huge hole in spending. Everything else is footnotes. 

To accentuate that point, he added in his linked note: “This wasn’t hard or unconventional economics; it was not much beyond Econ 101.”

Ash knows that Krugman must try to explain economics to everyone. But this is not a topic that can properly be reduced to simplistic explanations. The problem is, many of us have never been satisfied with “conventional” explanations of why the bubble existed in the first place, and do not believe that everything else is footnotes. In “The Neoclassical Boondoggle and the ‘Mutilated Economy’,” Part 1 (November 15, 2013, here), Part 2 (November 16, 2013, here), and Part 3 (November 19, 2013here), I provided an in-depth review of Krugman’s conventional analysis of the aftermath of the Crash, which had been set forth, with alarm, in his discussion of the “mutilated economy,” and I find it helpful to review those posts again now. In Part 3, I argued that a far more straightforward explanation of what went wrong was “completely obscured” by “conventional” economics:

It is noteworthy that, nearly six years since the Crash of 2008, mainstream conventional economists meeting at an IMF conference on economic crises agonized over the completely unexpected failure of the U.S. economy to rebound. Even more telling is their growing suspicion that their supply-side perspective is missing an important part of the picture. Most importantly, it does not yet appear to have occurred to them to consider the implications of income and wealth redistribution.

Part 3 discussed Krugman’s analysis, in which he laid out the theory of a “new normal,” a theory which not only presumes the existence of a “normal” state but implies that a huge crisis like the Crash simply ratchets down, permanently, the “old normal.” Krugman pointed out that, up until just now, it has been considered “radical” to believe that the economy does not automatically adjust back to a vigorous full employment, however long it takes:

A number of economists have been flirting with such thoughts (here) for a while. And now they’ve moved into the mainstream. In fact, the case for “secular stagnation” — a persistent state in which a depressed economy is the norm, with episodes of full employment few and far between — was made forcefully recently at the most ultrarespectable of venues, the I.M.F.’s big annual research conference. And the person making that case was none other than Larry Summers (here). Yes, that Larry Summers.

And if Mr. Summers is right, everything respectable people have been saying about economic policy is wrong, and will keep being wrong for a long time. Mr. Summers began with a point that should be obvious but is often missed: The financial crisis that started the Great Recession is now far behind us. Indeed, by most measures it ended more than four years ago. Yet our economy remains depressed.

The elaborate theory of “secular stagnation” does in fact imply, as Krugman now puts it, that “when the bubble burst, it left a huge hole in spending,” and that “everything else is footnotes.” But in that discussion, he did not endorse the simplistic “conventional” theory he presents now; he did not deny that Summers might be right.   

The story of the Crash, however, is not as carved in stone as even Summers makes it seem: My perspective is that the rising concentration of wealth and incomes in the prior 30 years was largely responsible for the huge hole in spending, and that the collapse of housing prices can logically be regarded as a symptom of declining middle class wealth, and thus as a consequence of the ongoing, accelerating decline of bottom 99% wealth and incomes: The problem is inequality, not secular stagnation. 

Hanauer’s Perspective

This apparently has become Hanauer’s perspective too. Our current concern about the future of America’s economy arises after “neoclassical” macroeconomics, for more than a century, has failed accurately to perceive how market economies actually work. Hanauer perceives a clear connection between America’s high level of wealth inequality and its rapidly declining prosperity, and he asserts that we’re all in the same boat, so that he and his fellow “plutocrats,” in their own self-interest, need to stop the inequality growth and reverse the decline that is taking place beneath them.

But, you may ask, isn’t that obvious? Many of us believe that it is, and our numbers are growing. But that has not been obvious to neoclassical economics which has, over the last 150 years or so, treated inequality as irrelevant to growth and prosperity.  The review in my last three posts of Thomas Piketty’s new book “Capital in the Twenty-First Century” explains how the mainstream “supply-side” theories of growth have blunted our recognition of the true nature of market dynamics. Hanauer’s broad perspective is correct, I submit, but it raises questions Hanauer cannot answer: How serious has the inequality problem become in the United States? And how much time does the American economy have left before it succumbs to the collapse he senses is coming?

When I began working on inequality issues over three years ago, I was convinced that if such a pessimistic assessment is truly valid, it would be politically necessary to convince billionaires like Hanauer that their own interests are indelibly linked to those of everyone else beneath them. The publication of Joseph Stiglitz’s book “The Price of Inequality” in 2012, and the release of Robert Reich’s movie “Inequality for All” in early 2014, have helped raise awareness of the contours of the inequality problem, although these two have not been able to answer the second of these two questions. 

That question is not easy to answer, because income and wealth are interconnected in both directions: Wealth produces incomes (returns and profits) and high-end income produces wealth (savings and hoarding). In the first instance, income concentration is determined by institutional factors (market power, taxation, etc.) as well as by the degree of wealth concentration, but as wealth continues to concentrate, the additional returns it produces become a growing contributor to income inequality, accelerating the growth of both income and wealth inequality. 

Robert Reich has, no doubt, influenced many in the top 0.1% with his recent Aspen Lecture (July 3, 201 4, video here). The last question posed to him in the Q&A at the end of that lecture was a big one: What is more important, income or wealth inequality? Reich responded that, despite Piketty’s overall emphasis on wealth inequality, income inequality seems more important in the U.S. today; This is not surprising, for Piketty’s own discussion of the U.S. problem was based on income inequality in the U.S., and his treatment of wealth as “capital” made wealth accumulation in the U.S. seem to be a relatively innocuous long-run problem, as my previous posts explained. Notably, Hanauer stresses wealth inequality as the main concern: Is Reich correct that, for the U.S. economy, income inequality is the primary concern? 

Wealth concentration in the United States, which has gotten far less attention here than income inequality has, I believe, reached dangerously high levels. The concentration of reported net worth has been rising exponentially. That does not diminish the importance of Reich’s emphasis on the debilitating effects of income inequality, which alone is sufficient cause for concern. Reich points out that the (former) middle class has now exhausted the three “coping mechanisms” for dealing with falling median real household income: (1) increased female workforce participation (1980s-1990s); (2) Increased hours worked (1990s); and (3) “Turning our homes into piggy banks,” i.e., borrowing on our home equity. Consumer demand is 70% of the U.S. economy, he says, and that demand continues to decline with declining median incomes. With the coping mechanisms used up, declining demand must accelerate.

Despite the lack of formal economic theoretical support, many wealthy Americans could see what the bursting real estate “bubble” entailed, and began to share Hanauer’s concerns. In 2010, a group calling themselves “The Patriotic Millionaires” (here) began to press for increased taxes on their incomes, stressing the importance to them of a viable economy. Other billionaires, such as Warren Buffett and Bill Gates, spoke out on social and moral concerns and taxation. The majority of the top 0.1% and the top 0.01%, however, apparently remain unconvinced that inequality poses a serious economic problem for them, or a threat to their fortunes. And neoclassical economics continues to be a major impediment to understanding how serious the problem has become or how rapidly it is undermining our society and our democracy.

The Mainstream Perspective

Neoclassical economics, in fact, could not imagine that any collapse will take place, ever, because of its slavish belief in an overall full employment “equilibrium” toward which market economies are always driving. Unfortunately, the equilibrium was never more than a hypothetical state, but as neoclassical theories have been taught over and over again for decades, hypothetical notions have become presumptive. A few contemporary economists, including James Galbraith and Mason Gaffney, have pointed out that most economists simply believe as a matter of faith in an automatic return to full-employment equilibrium. Paul Mattick explains this problem nicely in his 2012 book Business as Usual: The Economic Crisis and the Failure of Capitalism (Reaktion Books, Kindle Edition, pp. 17-18):

In the later nineteenth century the ‘classical’ political economy of Smith, Ricardo, and their followers was replaced by a new ‘neoclassical’ mode of theorizing that was in many ways quite different. It emphasized not, like classical theory, the division of income among social classes, but the decision-making of individuals. Borrowing the concept of ‘equilibrium’ from physics, along with the mathematics of static mechanics, the new economics continued to insist that capitalism by its nature tended to settle in a stable state in which each individual is maximally satisfied, given the constraints set by his or her relations to the rest of the system. (How this idea was to be reconciled with the equally basic dogma that capitalism tends to grow as a wealth-producing system was left for future thinkers to resolve.) From this point of view too, therefore, breakdowns of the market system, as opposed to imbalances in particular markets, are out of the question; what general difficulties do occur must be the effects of some non-economic factor, such as the weather, human psychology or mistaken government policies.

I opined in my last post that macroeconomics was likely led astray from the beginning by the development of theory, over the centuries, from a “supply-side” perspective. Krugman has consistently condemned its extreme formulation, namely, the so-called “trickle-down” fantasy designed to counter proposed taxation of the wealthy and corporations (“Charlatans, Cranks, and Kansas,” The New York Times, June 30, 2014, here). As Krugman’s report on the “mutilated economy” last November shows, moreover, faith in “supply-side” reasoning may now be loosening its grip on fundamental mainstream economics as well. 

And, as Krugman also discussed (with disgust) in this Friday’s Op-ed (“Who Wants a Depression,” The New York Times, July 11, 2014, here) economics is intensely political:

One unhappy lesson we’ve learned in recent years is that economics is a far more political subject than we liked to imagine. Well, duh, you may say. But, before the financial crisis, many economists — even, to some extent, yours truly — believed that there was a fairly broad professional consensus on some important issues.

This was especially true of monetary policy. It’s not that many years since the administration of George W. Bush declared that one lesson from the 2001 recession and the recovery that followed was that “aggressive monetary policy can make a recession shorter and milder.” Surely, then, we’d have a bipartisan consensus in favor of even more aggressive monetary policy to fight the far worse slump of 2007 to 2009. Right?

Well, no. I’ve written a number of times about the phenomenon of “sadomonetarism,” the constant demand that the Federal Reserve and other central banks stop trying to boost employment and raise interest rates instead, regardless of circumstances. I’ve suggested that the persistence of this phenomenon has a lot to do with ideology, which, in turn, has a lot to do with class interests. And I still think that’s true.

He goes on to explain that while lowering interest rates are supposed to spur investment and growth, wealthy people get higher returns when interest rates are high, so their wealth increases faster. The greater the share of top incomes that consists of returns on wealth, the more this factor can potentially influence monetary policy, and accordingly the greater effect monetary policy can have on inequality and depression. 

Market Optimism, and the Bubble Phenomenon

Meanwhile, the growth of income and wealth concentration naturally promotes rosy and impressionistic financial analyses. Take, for example, the most recent Fisher Investments “Stock Market Outlook, 2014: Part 2″ (April, 2014, here). From the report’s Executive Summary:

The bull market turned five during the quarter, prompting many to question how much longer stocks can keep climbing.  (Appendix I) While bull markets can die for many reasons, age, magnitude and gravity aren’t among them. Unless a bull is truncated early by a sweeping, under-appreciated negative force (we can’t identify any such large, stealthy forces on the horizon currently), it will typically run on until sentiment becomes euphoric to the point reality can’t possibly live up to investors’ expectations.

This isn’t the case today. While sentiment has improved somewhat in recent months, a cloud of skepticism remains. Fear of heights, jitters over geopolitical tensions in Eastern Europe and anxiety over future Fed moves have helped keep expectations low. Investors broadly still don’t appreciate how favorable the current landscape is. (Appendix III) Even as final data showed the U.S. economy grew 2.6% in Q4 2013, with corporate profits and business investment hitting new all-time highs, folks fretted growing cash stockpiles and rising stock buybacks as signs businesses aren’t “investing in the future,” robbing the economy of future growth opportunities. (p. 1)

In his e-mail distributing this report, Forbes columnist Ken Fisher asked: “Could this bull market be a bubble in disguise?”, a question the report promised to address. The report progresses thus:

A bull market is like a vector: It will keep running until it loses steam or hits a wall – fundamental negative big enough to put a dent in the global economy that surprises markets. We don’t see any walls within the next 12-18 months. * * * Nor does the bull appear likely to run out of steam in the foreseeable future. Economic and corporate conditions typically exceed  investors’ expectations through most of a bull market — a powerful force pushing stock prices even higher. This bull market has been no exception. It’s no secret US and global economic growth have been lackluster, but even slow growth has exceeded dour “new normal” growth expectations, and fears of global economic doom have proven unfounded. (pp. 6-7). 

The report adds: “Price-to-earnings ratios have been rising, an expected feature of maturing bull markets.” (p. 21) 

In case investors are worried about record stock prices in the face of “lackluster” growth, the report continues:

Lastly, the notion that this bull market is reserved from “reality” is a perception problem. There is no greater reality in equity markets than corporate profitability. As we detailed in Appendix III, profits are high and rising, underpinned by increasing sales. The global economy seems poised to continue growing — an excellent backdrop for continued profit growth ahead. (p. 22)

But might this long bull market just be “a bubble in disguise”?

Bubble fears aren’t likely to exist when a true bubble does — their existence signals still-prevalent skepticism. Bubbles are events of mass psychology: When inflated, few folks fear a bursting bubble. Headlines tend to proclaim the arrival of a virtuous new economy — “it’s different this time” — as they have throughout history. That sentiment seems far removed from today.

Growing wealth inequality reflects the availability of more money to invest, and that bids up equity market prices, but there is necessarily declining wealth below, and a reduction of earnings support for the rising stock prices. Thus, bubbles today are much more than events of mass psychology. They have monetary antecedents and consequences. Similarly, high price-earnings ratios today in U.S. stock markets are much more than just reflections of bull market optimism, and “lackluster” earning and consumption growth in the U.S., together with record corporate profits and corporate earnings, indicates that corporations are collecting substantial amounts of economic rent.

Fisher Investments simply overlooks the growing concentration of wealth and income in America, the factor that ensures the continuing record-setting pace of American securities markets in the face of bottom 99% stagnation. It is irrelevant for America that “fears of global economic doom have proven unfounded”: The U.S. economy has by far the highest inequality among wealthy nations, and whatever happens to the rest of the world, Hanauer’s fears of a collapsing U.S. economy are not unrealistic. 

Importantly, Ken Fisher is one billionaire who seems unlikely to be swayed by Hanauer’s appeal anytime soon.  His firm may be influential enough to influence other plutocrats as well. So we need to keep reminding them, “It’s the wealth transfers stupid.”

Boom or Bubble?

The only sensible answer to Fisher’s question — “boom or bubble?” — seems to be that so long as wealth continues to concentrate at the top, bubbles and crashes are inevitable. Consider the recent view of Neil Irwin (“Welcome to the Everything Boom, or Maybe the Everything Bubble,” Investor Outlook, The Upshot, The New York Times, July 7, 2014, here):

Welcome to the Everything Boom — and, quite possibly, the Everything Bubble. Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals. The inverse of that is relatively low returns for investors.

The phenomenon is rooted in two interrelated forces. Worldwide, more money is piling into savings than businesses believe they can use to make productive investments. At the same time, the world’s major central banks have been on a six-year campaign of holding down interest rates and creating more money from thin air to try to stimulate stronger growth in the wake of the financial crisis.

This is more ominous than it might at first blush appear. Rising investment prices likely translate, in fairly short order, into rising consumer prices. This is not the classical image of inflation driving up prices because of an excess of consumer demand, which as Reich has observed has been depressed because of rising inequality. Such inequality-driven inflation can only hasten the development of an “everything bubble.”     

About the Crash

Hanauer’s identification of wealth inequality as the incipient cause of decline and potential depression is confirmed by all of this. There is no reasonable basis for expecting a continuing level of “secular stagnation,” for there is no reason to expect no further bubbles and crashes, as wealth continues to concentrate. My computations show an increase in reported top 1% net worth of between 1980 and 2008 of $18 trillion, in 2010  dollars. (See “Inequality and the National Debt,” April 9, 2014, here.) This figure, which does not include estimates of off-shore wealth owned by Americans, amounts to an average top 1% wealth increase of more than $600 billion/year. Since the economy was growing over this period, in the years just before the Crash the amount was greater than this average. Although this much money could not have come directly from bottom 99% wealth, the amounts coming from money created “from thin air” to which Irwin refers impact the bottom 99% through additional inflation, reducing the real value of the bottom 99%’s remaining wealth and incomes. 

Now the significance of the exhaustion of Reich’s three “coping mechanisms” for the bottom 99% looms large. The last of the three, in which houses were converted into “piggy banks” as people borrowed on their equity to obtain needed cash, was in effect a final act of desperation: for the vast majority of wealth holders beneath the top 1%, their primary marketable asset is their homes. Reich has, in fact, accurately described the process through which declining median income facilitates transfers of wealth to the top. The “housing bubble” was a big one:

The U.S. lost $3.4 trillion in real estate wealth from July 2008 to March 2009 according to the Federal Reserve. This is roughly $30,300 per U.S. household (Pew Charitable Trusts, April 28, 2010, here).

Because it does not consider wealth transfers, “conventional” economics misses the essential nature of decline and depression. The conventional view is that the Crash blasted a hole in the economy that merely created a “new normal” of lower growth, and “secular stagnation.” The numbers prove otherwise, however. The Crash of 2008, the subsequent chronic long-term unemployment, the foreclosure epidemic and the sharp decline in median incomes, together with the record gains in stock prices and, indeed, investment prices generally, all tell a different story. It is the story of the enormous power of income and wealth concentration to bring a market economy to its knees.

Two things are occurring now that suggest the U.S. economy is approaching the brink of Great Depression II: (1) The middle and lower classes are running extremely low on collateral to secure the loans they need to meet everyday living expenses; and (2) The federal government has exhausted its ability to finance, with fiscal expansion, the continuing rapacity of profits at the top.

Conclusion

What the supply-side perspective has missed by ignoring inequality altogether is the major role that income and wealth redistribution plays in decline and depression. In fact, inequality growth has proven to be, by far, the most significant determinant of stagnation and declining growth.  So, yes, above all else: “It’s the wealth transfers stupid.” 

JMH – 7/13/2014  

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Picking Piketty Apart — Part III: Time’s Running Out

The principles which have been set forth in the first part of this treatise, are, in certain respects, strongly distinguished from those on the consideration of which we are now about to enter. The laws and conditions of the Production of wealth partake of the character of physical truths. * * * The opinions, or the wishes, which may exist on these different matters, do not control the things themselves. * * * But howsoever we may succeed in making for ourselves more space within the limits set by the constitution of things, we know that there must be limits. We cannot alter the ultimate properties either of matter or mind, but can only employ those properties more or less successfully, to bring about the events in which we are interested. 

It is not so with the Distribution of Wealth. That is a matter of human institution solely. The things once there, mankind, individually or collectively, can do with them as they like. They can place them at the disposal of whomsoever they please, and on whatever terms. * * * Even what a person has produced by his individual toil, unaided by any one, he cannot keep, unless by the permission of society. Not only can society take it from him, but individuals could and would take it from him, if society only remained passive. * * * The distribution of wealth, therefore, depends on the laws and customs of society.  * * *

We have here to consider, not the causes, but the consequences, of the rules according to which wealth may be distributed. Those, at least, are as little arbitrary, and have as much the character of physical laws, as the laws of production. * * * Society can subject the distribution of wealth to whatever rules it thinks best: but what practical results will flow from the operation of those rules, must be discovered, like any other physical or mental truths, by observation and reasoning. - John Stuart Mill, Principles of Political Economy, Part II, first published 1848, Oxford U. Press, 1998, pp. 5-6.

This is an excerpt from Mill’s amazing introduction to his discussion of “distribution” and “poverty”, with which he divided Books I and II of his Principles of Political Economy. Book I related to his concepts of classical economics, and Book II related to the topic of primary concern to most of the classical philosopher/economists (including Adam Smith, T.R. Malthus, and Jean-Baptiste Say), namely, how a society can function in an optimal and reasonably egalitarian way. In 1848, there were only rudimentary and still largely untested theories explaining how the primarily agrarian economies of Europe and North America worked. Mill (1806-1873) is known for having provided a clear restatement of the deterministic principles of a recent predecessor in political economy, David Ricardo (1772-1823); The conceptual framework that Mill advanced consisted of “laws” and “physical truths” seen to control production. Political economics would soon have to face great change in economies, as industry developed and the ownership of land and the means of production consolidated in the hands of fewer and fewer owners. 

The Ricardian perspective, as it continued to develop through Alfred Marshall and into the 20th Century, was popular with “conservative” economists because it suggested that market economies are stable and will always return to full employment equilibrium after a crisis. Mill was the favorite of one such economist, J. Laurence Laughlin (1850-1933), who became the department-head of the new economics department of the University of Chicago from 1892-1916. In 1885, Laughlin published an abridged version of Mill’s “Principles of Political Economy” (see e-book at Project Gutenberg, here) which included notes, and a rare “history of political economy.” Mill’s polished-up Ricardian perspectives still dominate neoclassical thinking today, and their popularity at the University of Chicago paved the way for the “no holds barred” philosophy of Milton Friedman and the “Chicago School” of economics.

The quoted passage contains a rare insight which ranks, in my opinion, among the most important insights in economic history: Mill perceived the existence of “physical truths” controlling the process of the production of wealth that cannot be altered by anyone’s perception or understanding of them. The distribution of wealth, on the other hand, is determined by the laws and customs of society. And, most poignantly, once society has established its rules of distribution, the resulting consequencesare as little arbitrary, and have as much the character of physical laws, as the laws of production. This perspective seems remarkable for 1848, a time when economic science was just getting started, even for a philosopher of Mill’s caliber. It is an insight that has been largely missing from economic reckoning ever since. It boils down to this:

Our policy choices determine how wealth is distributed and, once established, these choices have inexorable consequences.  

This is the first of three important insights which have formed the basis of my own perspectives on economics, and the framework from which I perceive and interpret the nature of economic reality. The second is Simon Kuznets’ remarkable perception in 1955 (as quoted in the first post of this series) that:

[O]ur 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.    

In other words, we cannot hope to understand economic change on the basis of changes in “countrywide aggregates.” We must study the effects of changing distribution.

The third is a fundamental insight underlying John Maynard Keynes’ General Theory of Employment, Interest and Money (1935), namely, his understanding that classical and neoclassical theory was not dynamic at all, but founded on a description of an economy in “full employment equilibrium” to which deterministic properties were improperly assigned:

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 so is to assume our difficulties away. (Ch. 3)

There are reasons why economies nearly always function sub-optimally, and Keynes identified some of the most important, primarily the “principle of aggregate demand.” To the extent we feel compelled to regard political economics as a search for what Mill envisioned as “physical laws,” I would start with “The Law of Aggregate Demand.”

I believe that the overall perspective, or model, these insights provide meets the test of “model-dependent realism” developed by Stephen Hawking and Leonard Mladinow, as discussed in my previous post in this series; It provides a “lens” through which our observations of economic facts and experience can provide a correct understanding of our shared reality. In broad strokes, the reality I have perceived is that capitalist market economies are unstable and tend naturally to decline (Keynes), that such decline is greatly and increasingly exacerbated by the growing wealth and income inequality that society’s choices have allowed in the U.S. economy (Mill), and that we have no hope of understanding these consequences and their mechanisms except through the study of the trends in distributional data (Kuznets).

It does not matter that none of these three great theorists never ultimately found a “unified field theory” of economics, or even that their own theories about how economies work were, at best, only partially correct. After all, they did not have the data Kuznets understood that we needed. What does matter is that consistently applying a distributional perspective to the analysis of facts and theories opens the door to a much deeper, and considerably different, understanding of reality than had previously been possible.   

The Slow Pace of Learning

Convinced that distributional data was extremely important, the French economists Thomas Piketty and Emanuel Saez devoted years to accumulating the long history of income tax returns of the major developed countries of the world, and in doing so, they changed the course of economic history. It is, however, a very slowly developing change. They first published their database in 2003, and when their findings came out in 2011, a perplexed economics profession did not know what to make of them. Their data demonstrated that income inequality grows in lockstep with a decline in the progressiveness of taxation; indeed, they identified the progressiveness of taxation as the degree to which it inhibits inequality growth. And others have documented the extreme effect of the growth of income inequality on aggregate income growth. But no one, including themselves, grasped the full import of their data.

The economics profession gradually began to address the questions presented by the increasingly unequal distribution of income and wealth, but progress was slow, for these were issues that mainstream economics had ignored ever since John Stuart Mill addressed them philosophically and his contemporary, Karl Marx, began to address them theoretically.

It took a decade for either Piketty or Saez to weigh in substantively with anything more than a very good study of the income elasticity of top income tax rates. Piketty’s publication in 2014 of Capital in the 21st Century, though, has mostly contributed to the existing high level of confusion about inequality issues. The attention his book is getting in the United States is almost entirely limited to his subjective evaluation of the obviously advanced deterioration of the U.S. economy, which among wealthy nations is by far the most inequality-afflicted economy in the world.

The plight of the U.S. economy virtually guaranteed a high level of attention in the United States to any book Piketty published. It is remarkable, then, that Piketty published a book in which substantive discussion of inequality was preceded by a nearly 300-page anecdotal and theoretical presentation supporting a production function-based growth model which, as demonstrated by the comprehensive technical review of his two “fundamental laws” presented in my previous post, is seriously flawed. As quoted in the last post, Piketty conceded that the record of the accumulation of a country’s productive capital is fundamentally unrelated to the distribution of its wealth and income among its citizens; this is a corollary of the point Mill made nearly 170 years ago. Why, then, did Piketty publish this book? That even Thomas Piketty himself has been unable to arrive at a better understanding of inequality speaks volumes about the threadbare inadequacy of the neoclassical framework in which he was trained.

History Repeats Itself

John Stuart Mill, despite the attraction of his deterministic model to “conservative” economists, was an avid socialist, as was Adam Smith before him. (See my extensive review of Smith’s views in “The Cult of the Invisible Hand,” December 22, 2013, here.) The flavor of Mill’s deep concern for the general welfare was revealed in his Chapters on Socialism, first published posthumously in 1879:

Since the human race has no means of enjoyable existence, or of existence at all, but what it derives from its own labour and abstinence, there would be no ground for complaint against society if everyone who was willing to undergo a fair share of this labour and abstinence could attain a fair share of the fruits. But is this the fact? Is it not the reverse of the fact? The reward, instead of being proportioned to the labour and abstinence of the individual, is almost in an inverse ratio to it: those who receive the least, labour and abstain the most. * * * The very idea of distributive justice, or of any proportionality between success and merit, or between success and exertion, is in the present state of society so manifestly chimerical as to be relegated to the regions of romance.  (Oxford University Press, 1998, p. 382.)

Piketty, for obvious reasons, is less forthright about his views on economic justice. In his concluding remarks, he encourages us to loosen up on political perspectives on wages and wealth:

The clash of communism and capitalism sterilized rather than stimulated research on capital and inequality by historians, economists, and even philosophers. It is long since time to move beyond these old controversies and the historical research they engendered, which to my mind still bears their stamp. (Capital in the Twenty-First Century, p. 5 76)

Amen. As a Frenchman, Piketty does not shy away from discussing Karl Marx, whose theories on capital accumulation, he says, paved the way for his own. Amongst the knowledgeable, Marx is routinely acknowledged as one of the best and most prescient theorists in economic history. Marx believed, as Piketty observes, that a top-heavy capitalist system would ultimately collapse of its own over-concentrated weight. That possibility, unfortunately, still exists.

In the last paragraph of his book, however, Piketty merely hints at the lopsided balance of intellectual power attending inequality:

[I]t seems to me that all social scientists, all journalists and commentators, all activists in the unions and in politics of whatever stripe, and especially all citizens should take a serious interest in money, its measurement, the facts surrounding it, and its history. Those who have a lot of it never fail to defend their interests. Refusing to deal with numbers rarely serves the interests of the least well off. (Id. at 577 )

Yes, indeed: But a Wall Street Journal article has successfully downplayed Piketty’s contribution in this respect. (“Thomas Piketty, a Not-So-Radical French Thinker,” by Pascal-Emmanuel Gobry, May 22, 2014, here.) The headnote says Piketty “may be causing a stir in the U.S., but his views are ho-hum in his own country.” According to Gobry, Piketty argues that “capitalism creates a vicious cycle of inequality,” whenever “the rate of return on assets is higher, over the long run, than the rate of overall economic growth,” and asserts the need (quoting Paul Krugman) “to restrain the growing power of inherited wealth.” Gobry’s ultimate point, of course, is that inequality is no big deal.

My counterpoint is that inequality is a very big deal, but the evidence for that is in the second part of Piketty’s book, not the first. Despite his strong stance regarding inequality in the United States, Piketty has led with his chin. In that regard, my overall concern is that Piketty himself has not properly framed the inequality issue. By wrongly lumping together the issues of “capital and inequality,” Piketty has perpetuated a much brighter image of our future than we should be expecting. NYU economist Debraj Ray supports this conclusion: 

It is unclear that the story of rising inequality in the US is one of physical (or financial) capital coming to dominate. Rather, inequality in the United States appears to be propelled by incredibly high returns to human capital at the top of the wage spectrum. This points to a very different set of drivers, and also shows that the physical capital story is not pervasive. (“Nit-Piketty: A comment on Thomas Piketty’s Capital in the Twenty First Century,” by Debraj  Ray, May 23, 2014, here

Others have reportedly begun to raise concerns about Piketty’s theory similar to mine, regarding the concepts of “capital” and “wealth” (See, Ed Conard, Unintended Consequences, May 30, 2014, here). The most important point, in my mind, is the relatively innocuous nature of the trend in capital accumulation, compared with the concentration of wealth itself. Conard provided this chart of 200 years of changes in top 1% wealth and top 10% wealth in the United States. Piketty’s numbers appear fairly similar to Edward Wolff’s for the last decade or so, and this chart reflects the increasing concentration of top 1% wealth since 2000 that Wolff has reported.

US-WEALTH-INEQUALITY-piketty 1810-2010

The significance of this long run series to Piketty was that it was supposed to represent a long-run equilibrium condition of the stock of productive capital. That flawed idea, apparently, is beginning to collapse in the public debate. 

As I have explained, my “heterodox” (non-mainstream) perspective on wealth concentration in the U.S. arises from direct analysis of distributed wealth, and its relationship with distributed income: A smattering of attention has been paid to the concentration of wealth in the United States over the last few years, but not nearly as much as has been paid to income inequality. As soon as I began working on American inequality I began to investigate wealth inequality, presenting my initial findings in two posts: “Growth in Inequality of Wealth: 1979-2007,” 4/11/2011, here), and “Growth of Inequality of Wealth: After 2007,” 4/13/2011, here).

Initially, I found that the top 1% of U.S. wealth holders had improved their reported net worth by about $8.8 trillion between 1979 and 2007. That figure, however, was first reported in nominal dollars and, as I began reporting in 2013, the top 1%’s reported net worth had improved by nearly twice that much, in current (2010) dollars, and with the addition of post-2007 wealth accumulated by the top 1% and estimates of its unreported wealth accumulating in “offshore” (overseas) accounts, the total top 1% increase in net worth through 2012 (1979-2012) can reasonably be estimated at $22-25 trillion. (See, e.g., “Finding a New Macroeconomics: (10) Reinhart, Rogoff, and Redistribution,” 6/30/2013, here, and “Inequality and the National Debt,” 4/9/2014, here.) Here is the graph I prepared a year ago comparing the growth of top 1% wealth in the United States, using Edward Wolff’s wealth concentration data, with the U.S. national debt and the GDP, all in 2010 dollars:

my graph 1952-1982 cThis shows clearly the extent of the inequality problem in the United States. Top 1% wealth has been concentrating rapidly since 1980, as a result of society’s choices which allowed wealthy people to make more money (market deregulation) and which allowed them to keep increasingly greater shares of their improved incomes (via tax reductions), as demonstrated by the Piketty/Saez income distribution data. The result — accumulating wealth at the top funded by federal borrowing needed to replace the revenues lost by the tax cuts — has been breathtaking.

Wealth concentration at the top has exceeded the growing national debt by an amount I have estimated in the $5-8 trillion range. That is money sucked up from the bottom 99%. And as lower 99% incomes decline, their tax contributions to the federal government also decline substantially and the deficit increases accelerate, requiring greater interest payments to the wealthy people who hold federal debt. Currently, interest on the debt is the fastest rising category of federal debt, projected by the CBO to exceed the entire defense budget by the end of this decade.

Lessons Learned

Conservatives will seek to have the invalidaton of Piketty’s growth model serve to persuade us to dismiss outright his concerns about growing wealth concentration. But that would be an incredibly bad mistake. We must learn from his conceptual mistakes. We must remember his acknowledgement that the neoclassical approach to understanding growth does not explain changes in income and wealth distribution:

[A]part from the question of short-term volatility, such balanced growth does not guarantee a harmonious distribution of wealth and in no way implies the disappearance or even reduction of inequality in the ownership of capital. (p. 232)

He has also identified two fundamental realities that we will need to incorporate into a distributional macroeconomics: “The law of cumulative growth” and the related “law of cumulative returns” (Capital in the 21st Century, pp. 74-75). These laws go a long way toward establishing the reasons for astronomically growing wealth inequality in the United States. Interest bearing obligations, such as federal bonds, increase wealth exponentially if held for extended periods. Properly depreciated factories and machines, however, do not. In other words, inequality growth is in large measure a financial problem; and it is a problem related to the ownership, but not the concentration, of capital stock.

We need to acknowledge right now that the inequality problem is much worse than envisioned by Piketty. In the long run, he envisions a U.S. economy with a reasonably stable aggregate production function through 2030. However, the long-run prospects for U.S. economic recovery are extremely bleak, even if the capital-to-labor ratio in the production function falls (perhaps especially if it does.) Top 1% wealth is increasing by about $300-400 billion per year. Saez and Piketty have both confirmed that at least 95% of all income growth now accrues to the top 1%. The question now is whether the U.S. economy can even make it to 2020 without a complete collapse into Great Depression II.

We know from direct observation what is happening in the United States: Every day we are confronted with news reports of falling prosperity, increasing poverty, record numbers of unemployed and of homeless children, declining wages and stagnant employment, declining food quality and health care, a rapidly growing student debt problem, and the bankruptcy of cities like Detroit, which is exercising widespread foreclosures and shutting down residential water service to a great many homes for nonpayment of bills. It is obviously a problem of insufficient money in the economy of the bottom 99%; a problem of money being steadily sucked up to the top 0.1% and 0.01%. And even the most rudimentary statistical tests, as recently found (to their apparent surprise) by IMF economists, show that growing inequality is the most important factor determining growth. (See my essay, “Two Sides of the Same Coin,” March 28, 2014, here.)

And we know what has to be done: Increase the minimum wage, increase the progressiveness of taxation across the board. Tax wealth, but without waiting for the inheritance cycle to gradually reduce estates. And re-regulate businesses to cut back on the vice-like grip monopolistic market power has established across most consumer and producer markets.

As it happens, Paul Krugman’s Op-ed in today’s New York Times, “Charlatans, Cranks, and Kansas” (June 30, 2014, here ) highlights the crux of our problem.  Krugman reports that two years ago Kansas enacted the largest percentage tax cut in one year that any state has ever enacted:”Look out, Texas,” proclaimed Governor Brownback, predicting that  the cuts would jump-start an economic boom. Instead, Kansas has plunged deep into debt, and its debt has been downgraded. Krugman asks:

Why, after all, should anyone believe at this late date in supply-side economics, which claims that tax cuts boost the economy so much that they largely if not entirely pay for themselves?

The Kansas tax cut, Krugman observes, closely follows the blueprint of the American Legislative Exchange Counsel (ALEC), a right-wing group that supports the interests of the wealthy:

And I do mean for the wealthy. While ALEC supports big income-tax cuts, it calls for increases in the sales tax — which fall most heavily on lower-income households — and reductions in tax-based support for working households. So its agenda involves cutting taxes at the top while actually increasing taxes at the bottom, as well as cutting social services.

But how can you justify enriching the already wealthy while making life harder for those struggling to get by? The answer is, you need an economic theory claiming that such a policy is the key to prosperity for all. So supply-side economics fills a need backed by lots of money, and the fact that it keeps failing doesn’t matter.

The time has come to recognize that all of neoclassical theory, the theory that still dominates academic economics today, is essentially a supply-side construction. It is, moreover, a retrograde version of the original classical economics. Smith and Ricardo, for example, agonized over the definitions of economic rent — money collected without providing anything of value in return — an important concept ignored by mainstream economics today. We need a renewed focus on the long-suppressed doctrines of Henry George (Progress and Poverty, 1879) and on taxing economic rent.

Now that we understand the irrelevance of the production function to aggregate growth, we’ll need to banish production functions from macroeconomics, just as Keynes attempted to banish Say’s Law (the notion that supply creates its own demand) in the 1930s. 

“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,” wrote Keynes in the last chapter of his General Theory:

But it is not necessary . . . 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.

I wonder if that was ever true and, if so, whether it is still true today in the United States: The top billionaires here, and everywhere else, seem to have no endgame in mind. 

We find ourselves in essentially the state of economic theory development that faced John Stuart Mill in 1848. If we are ever going to improve our understanding, we had better get started now, and move a whole lot more quickly.

Time is running out.

JMH – 6/30/2014 (ed. 7/1/2014)

 

 

 

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Picking Piketty Apart — Part II: His “Laws of Capitalism”

Regarding the laws that govern the universe, what we can say is this: There seems to be no single mathematical model or theory that can describe every aspect of the universe. * * * Though this situation does not fulfill the traditional physicists’ dream of a single unified theory, it is acceptable within the framework of model-dependent realism.” – Stephen Hawking and Leonard Mladinow, The Grand Design, Bantam, N.Y. 2010 (p. 58)

According to model-dependent realism, it is pointless to ask whether a model is real, only whether it agrees with observation. * * * We make models in science, but we also make them in life. Model-dependent realism applies not only to scientific models but also to the conscious and subconscious mental models we all create in order to interpret and understand the everyday world. There is no way to remove the observor — us — from our perception of the world, which is created through our sensory processing and through the way we think and reason. Our perception – and hence the observations upon which our theories are based  – is not direct, but rather is shaped by a kind of lens, the interpretive structure of our inner brain. — Hawking and Mladinow, supra (p. 46)

The above quotations are taken from an early chapter entitled “The Nature of Reality,” a chapter dealing mainly with describing how science works. The core concept is “model-dependent realism.” We are reminded that, as in the natural sciences, no theory in the social sciences can be said to describe “reality” except to the extent that it is supported by observation.

Unlike the models and theories describing the physical universe, those pertaining to economic science relate to how we “interpret and understand the everyday world.” Most of the time, we might think, the workings of the everyday world are much easier to interpret and understand than the vast, mysterious cosmos. Thus, it is hard to believe that geniuses like Newton and Einstein developed their theories through the same (or similar) processes of perception and interpretation that we ourselves use to develop our more mundane, everyday theories. Nonetheless, the problem of understanding “reality” is the same in both cases.

Economic theories fail when the assumptions on which they depend do not comport with reality, or when they are incomplete, overlooking facts that must be observed and accounted for before our “everyday world” can properly be understood. A major problem in economics has been that theories are developed under strict sets of assumptions (like “perfect competition” or “full employment”) that are never met, yet we keep on applying the theories anyway, because they are all we’ve got to go on.

This gives rise to a subtle problem highlighted by the above quotation:

Our perception – and hence the observations upon which our theories are based  – is not direct, but rather is shaped by a kind of lens, the interpretive structure of our inner brain.        

Our interpretive structures are framed by what we are taught and, accordingly, what we think we know. Over time, our minds hold on to them, as we live and work with them, and their elaborate constructs become part of the interpretive structure of our brains — the “lens” we use to interpret our observations of the world. Thus, our perceptions persist, even when the world won’t support them, controlling our thought processes. There is only one way out of this conundrum: We must constantly challenge our beliefs, and abandon them when they are not working. Of course, to do that, we need observations and relevant data. But if we don’t do that, when important new information arrives we simply get confused.   

This is a problem, I suggest, that has always plagued economic science. Over the past several years I have been startled by the degree to which the application of mainstream economic theory to the multitude of new information on income and wealth distribution has resulted in a high level of acknowledged confusion. That confusion is best explained, I submit, as a failure of model-dependent realism. Economists are using decades-old models, with insufficient regard for the limiting assumptions under which these models were originally developed. One key assumption, of course, is that these models properly specify all of the factors which actually determine the data we interpret. When we ignore or overlook the constraints reality imposes on our models, our use of them leads to mistaken interpretations of reality, and the perpetuation of wrongful perspectives. 

The Neoclassical Sidetrack

That, I would argue, is the crux of what has happened to economic science over the last 50-100 years, and why mainstream, neoclassical economics, as recently conceded by its leading young superstar, Raj Chetty (“Yes, Economics is a Science,” The New York Times, October 20, 2013, here) still cannot explain the mechanics of growth. This problem plagues Thomas Piketty as well, as he has bravely set forth a growth model, characterized as “the second fundamental law of capitalism,” which traces back to the “Harrod-Domar” growth model and other production function-based models developed more than a half-century ago. In effect, this “neoclassical” framework has created a lens that frames all macroeconomic issues in specific, constrained ways, rendering minds trained to understand the economic world from within that constrained framework nearly incapable of considering, or even perceiving, alternative perspectives.   

Piketty has earnestly and carefully developed two “fundamental laws of capitalism” that emerge from that limited perspective. He then attempts in the last portion of his book to apply those “laws” to understanding the inequality problem but finds, perhaps to his own surprise, that they are of no help in this regard. His application of the model to existing data sources, including those he himself has painstakingly compiled, has also highlighted important concerns about how we use data to understand growth.

Specifically, “capital” is a concept in classical and neoclassical economics that generally means “capital stock,” or investment in the physical plant needed to produce output. The growth models at issue here originally focused on the growth of capital stock, as Piketty well knows. However, to use available data sources, he has resorted to a long-run “equilibrium” model in which “capital” can be thought of as equivalent to the broader concept of “wealth.” That shift from “capital” to “wealth” contains a major key to understanding why mainstream supply-side growth models cannot help understand the inequality problem, and more generally why the attempt to understand growth via aggregate production functions has been a dismal (and still generally unrecognized) failure. 

The extreme redistribution of wealth, and consequently income, in my view, is the real inequality problem, and it is a problem not comprehended by tracing, as Piketty attempts to do, the growth of the productive capital capacity over many decades:

The central thesis of this book is precisely that an apparently small gap between the return on capital and the rate of growth can in the long run have powerful and destabilizing effects on the structure and dynamics of social inequality. (Capital in the Twenty-First Century, Belknap/Harvard, 22014,  p. 77)

His is a hybrid thesis, an ultimately misleading attempt to connect mainstream growth theory with “the dynamics of social inequality.” It is not an entirely straightforward matter to understand what this conclusion means, or how he reached it. 

To make any real progress in reading Piketty’s book, it is essential to understand the nature of his model and his perspective on growth. In this first of two posts on the substance of his book, I endeavor to explain his “laws” and the model they represent. In a second post, I will shift the focus to the issue of wealth and income inequality, discussing the disconnects between production function-based growth models and the models needed to properly explain the growth of distributional inequality, and how the limitations of the neoclassical framework demonstrate the need for a new distribution-based framework for macroeconomics.

Piketty’s presentation is somewhat disorganized and confusing., and his approach to measuring growth has had a complex and controversial history, which he presents only in part. Therefore, I believe, the best way to piece together a coherent picture of his model is to work from (and with) his equations:      

THE FIRST FUNDAMENTAL LAW OF CAPITALISM

Piketty’s “First Fundamental Law of Capitalism” is expressed in the equation α = r x β, where:

α = the share of income from capital in national income

r = the rate of return on capital, and

β = the capital/income ratio, i.e., the “stock” of capital (C) divided by the annual income of the economy (I)  (pp. 50-51).

The underlying proposition is fairly straightforward: The percentage of all income attributable to capital (as opposed to labor) equals the total amount of (productive) capital times its rate of return. However, the “capital/income ratio,” which introduces the total amount of productive capital as a percentage of income (output), presents some conceptual difficulties:

The Capital/Income Ratio

The derivation of the capital/income ratio can be the source of some confusion, so let’s break it down:

If we let “R” represent the annual income from capital, then

R = r x C

Dividing both sides of this equation by I, we get:  

R/I  =  (r x C)/I  =  r x (C/I),  or

α =  r x β

Piketty asserts that this formula is “a pure accounting identity” (p. 52). “Though tautological,” he reasons, “it should nevertheless be regarded as the first fundamental law of capitalism, because it expresses a simple, transparent relationship among the three most important concepts for analyzing the capitalist system: the capital/income ratio, the share of capital in income, and the rate of return on capital.” (Ibid.)

Here are my main concerns about the “First Law”:  

False Meaningfulness

One would think that an “accounting identity” would not give rise to differences in perspective, or fundamentally conflicting perceptions of reality. However, in this instance it can do just that:

A “law,” as Hawking and Mlodinow define it, is a model that is found to agree with observation. That means that it must always be true, or at least true in certain specified circumstances. But a law derives its meaningfulness only from its ability to explain reality. If it represents no more than a mere “identity,” it has no explanatory power; to say anything is “itself” provides no useful information. Unfortunately, calling this equation a “law” implies that it may be thought of as more than just a mere accounting identity. Piketty suggests as much when he says the formula expresses a “relationship” among the three variable, implying that the variables are functionally related. 

Although each of these variables reflects data recorded in accounts, the capital/income ratio is a ratio of accounts that are not functionally related. As Piketty acknowledges, the “capital” (and wealth) accounts are “stock” accounts, meaning that they are records of “net worth” existing at given points in time.  National Income (and GDP) accounts, however, are “flow” accounts, representing amounts of transactions over time. The capital/income ratio therefore does not express a “relationship;” it represents merely a comparison of the order of magnitude of accumulated capital with a distinctly different, and independent, concept used to represent the overall size of the economy.

In Macroeconomic Theory (MacMillan, 1963), Gardner Ackley’s preeminent textbook of the early 1960s, Ackley emphasized almost before discussing anything else the importance of the distinction between stock and flow data: 

We need not here list the variables in which macroeconomics is interested. But it is useful, right at the beginning, to stress some characteristic types of variables, and their differences. The most important such distinction (the neglect of which has been the cause of infinite confusion) is between stock and flow variables. A stock variable has no time dimension. A flow variable does. The weight of an automobile is a stock variable; its speed is a flow variable. The population of cars is a stock variable; traffic is a flow. 

* * * All this may seem very obvious; but almost no other source of confusion is more dangerous in economic theory — not only to beginners but sometimes to advanced students in the field. Money is a stock; expenditures or transactions in money a flow; income is a flow, wealth a stock. Saving is a flow. . .; savings is a stock. . . Investment is a flow. . .; the aggregate of investments is a stock; * * * only the context can show whether the author means the flow or the stock.   

Piketty’s bestselling book is meant for, and has apparently reached, a much broader audience than just fellow economists. He cannot have expected the average reader to understand the importance Ackley attributed to the distinction between stocks and flows. Given Piketty’s own recognition of that distinction, however, his use of the terms “relationship” and “identity” to describe an equation in which a stock/flow ratio is a major variable is especially misleading; these are the very descriptions that, he says, argue for characterizing the equation as a “law” of capitalism. Thus, he has conceptually transformed the equation into something is is not: an actual “law.”

Piketty does not shy away from this confusion. He entitled the entire Part Two of his book “The Dynamics of the Capital/Income Ratio,” raising an obvious question: How could a mere “accounting identity” possess dynamic properties? This careless use of terminology engenders significant confusion about the true “model-dependent realism” represented by this stock/flow ratio.   

In a perceptive recent comment (“Nit-Piketty,” May 25, 2014, here), economist Debraj Ray made the point in a more summary fashion:

Piketty’s Laws 1 and 2 can, alas, be dismissed out of hand. (Not because they are false. On the contrary, because they’re true enough to be largely devoid of explanatory power.) 

This is certainly true of Law 1: This equation merely introduces a yardstick (the capital/income ratio) against which the order of magnitude of accumulated capital can be measured. It has no explanatory value, and no dynamic properties. (I’ll get to Law 2 in a moment.)

The Narrowness of Perspective

Piketty’s opinion that this equation contains “the three most important concepts for analyzing the capitalist system” is conclusory, and it preempts all other, competing perspectives. Notably, it prohibits consideration of the impact of wealth concentration itself on growth, and on the concentration of income from capital. It directly and unjustifiably narrows the neoclassical perspective on the macroeconomic significance of inequality. This demonstrates the major shortcoming of neoclassical perspectives I have been pointing out for more than three years. 

Data Reconciliation

Attending this equation is a host of unresolved conceptual issues regarding data: Wealth data for the United States are taken from U.S. net worth accounts which present household assets net of liabilities. These include ownership of corporations and, hence, all of the means of production traditionally referred to as “capital stock,” but they include much more. Wealth is broken down into financial and other assets, which include homes and real estate.

This problem has broad implications for Piketty’s “laws.” Accounting “identities” that begin with overly broad definitions of wealth and income run into serious difficulties when introduced into production function-based growth models: To make an assessment of a nation’s productive capacity, a stock measure including all marketable wealth, including assets that do not produce tangible income and wealth such as mansions, yachts, valuable art works, etc., is far too broad.  Similarly, National Income account data cannot be assumed to be limited, even over the very long run, to amounts spent on consumption and investment. U.S. income account data include trillions of dollars every year that are received as “income,” but do not compensate for tangible value produced or received.

To assess economic growth using models that purport to trace the growth of “capital,” it is essential to isolate active wealth from inactive wealth, and productive from non-productive income. This brings us to Piketty’s 2nd Law, but it is important to leave our discussion of the Piketty’s “First Fundamental Law of Capitalism” with an understanding that standard aggregate income and wealth accounts are not sufficiently specific for this assigned task.    

THE  SECOND FUNDAMENTAL LAW OF CAPITALISM          

Piketty’s “Second Fundamental Law of Capitalism” is expressed in the equation  β = s/g, where:

β = the capital/income ratio [C/I], i.e., the “stock” of capital divided by the annual income of the economy. (This is identical to the ratio used in the first equation above.)

=  The percentage of saving out of income.

= the rate of growth of productive capital (or alternatively, in the long run, the rate of growth of income).

It is not immediately intuitive why this might be so. “In the long run,” Piketty asserts, this formula expresses a “simple and transparent” relationship among the three variables. It reflects, he says, “an obvious but important point: a country that saves a lot and grows slowly will over the long run accumulate an enormous stock of capital (relative to income), which can in turn have a significant effect on the social structure and distribution of wealth.” (p. 166)

Nor is it transparently clear how the accumulation of the stock of productive capital, over the long run, affects the distribution of wealth. It certainly does not, all by itself, determine the distribution of wealth, as Piketty carefully explains:

To be sure, the law β = s/g describes a growth path in which all macroeconomic quantities – capital stock, income and output flows [note again, what started out as asset net worth has ended up as capital stock] – progress at the same pace over the long run. Still, apart from the question of short-term volatility, such balanced growth does not guarantee a harmonious distribution of wealth and in no way implies the disappearance or even reduction of inequality in the ownership of capital. (p. 232).

Solving for Growth

Note that there are two equations defining the capital/income ratio. As a matter of “accounting identity”:

α = x β,  therefore  β = α/r  

The hypothesis of the Second Law, that β = s/g can therefore be expressed as an accounting identity, thus:   

 s/g = α/r

In words, this equation tells us that the ratio of the percent of income that is saved to the rate of growth of capital stock is equal to an accounting identity: the ratio of the percentage of total income that is attributable to capital (capital’s share) to rate of return on capital. We can also solve for g, multiplying both sides of the equation by the two denominators:

g x α  =  r x s   

       Hence g = s (r/α),  or

g = r (s/α)

Here is what this formulation means in words: An economy’s income (output) will grow at a rate equal to the rate of return on capital times the savings rate divided by the percentage of total income that is attributable to capital. This is certainly hard to visualize: Technically, the model specifies that g equals the rate of growth of capital stock, not the rate of growth of income (output). But this is a model, thanks to Law #1, in which saving is used as a proxy for investment. It is a bit more comprehensible if we substitute investment (i) for saving (s):

(i/α)

In words, this equation says that an economy’s income (output) will grow at a rate equal to the rate of return on capital times the rate of investment divided by the percentage of total income that is attributable to capital. This is a little more understandable (we’re no longer comparing apples and oranges). 

But here’s the rub: Substantively, this specifies an equilibrium condition where capital resources are fully employed, i.e., an economy in full-capital-stock-utilization equilibrium. Moreover, Piketty warns us that Law #2 is only valid in the long run. And that is true because the neoclassical concept of long-run equilibrium presumes that all savings are eventually invested in productive capital, and it is only this long-run equilibrium state that meets the model’s requirement that

the rate of growth of capital stock necessarily equals the rate of growth of income. 

Confused? Notice that what started out as an “accounting identity” (the capital/income ratio) has blossomed into a rigid “law” that is necessarily valid only in the long run. There are two important points:

1. It has become an empirical proposition that must be verified, but because it is merely hypothetical it cannot be verified. Thus, we have not escaped our concerns about model-dependent realism. (More on this in the next post);

2. Because it is only valid in the long run, the formula is necessarily invalid in the short run, unless we assume that all economic variables grow at exactly the same rate over time. (Don’t laugh — some early, rudimentary aggregate production functions were based on exactly this assumption.) This makes the elusive distinction between the long run and the short run critically important: How are we to account for the fact that any point in time necessarily exists in both the short run and the long run? And if growth rates do in fact vary, how would we ever recognize “long-run equilibrium,” were it ever achieved?

At this point in the review, the import of the “Second Fundamental Law of Capitalism” seems anything but “simple and transparent.” Indeed, as in the famous Buddhist parable of “The Tiger and the Strawberry” (here), there is no apparent way out of these dilemmas.

The Model’s Description of Long-Run Equilibrium   

But also as in the parable, the “strawberry” is sweet. The model presents an image of an observable equilibrium state. And the model has arithmetic consequences: moving from one equilibrium position to another (by whatever means, or hypothetically), reveals that the mechanics of the formula have specific implications for distribution and growth.

Consider the numerical example Piketty presents of his two laws, in which he uses a number for β of 600%, which is near the high end of observed capital/income ratios in recent years:

Accumulated capital is equivalent to six times an economy’s annual income. If for a given country  β = 600%, and the rate of return on capital is 5%, then the portion of the country’s income that comes from capital is 5% x 600% = 30% (Law #1, p.  52). Similarly, if β = 600%, and the rate of saving from income is 12%, then average annual growth of income in the long run is 12% /600% = 2% (Law #2, p. 166).

If the hypothetical country is assumed instead to have a greater volume of accumulated capital, such that β = 800%, at a 5% rate of return the portion of income coming from capital is 5% x 800% = 400%. Given a 12% rate of saving, the long-run growth rate is lower, 12%/800% =  1.5%. 

Given the presumed equivalency in long-run equilibrium not only of savings and investment, but also of capital and wealth, a higher capital/income ratio entails a higher equilibrium level of wealth, which in turn entails higher income inequality. Thus, ceteris paribus (all else equal), this model requires that a higher equilibrium concentration of wealth will entail both higher income inequality and lower growth — for any given level of income.  

But we do not need this elaborate, long-run equilibrium model to reach that conclusion: That higher wealth concentration entails lower growth is a fact that can be directly observed. It has been clear for some time that rising wealth and income concentration in the United States necessarily entails lower growth. Piketty’s model merely measures the trending relationship of accounting identities over time, and that is only helpful if, like Piketty, we regard very long trends of the capital/income ratio (over periods of, say, 100 or 150 years or more) as representing some sort of long-run equilibrium β. But such a focus obscures our perception of the short run growth problem, which averages out as growth varies over time. For the shorter run analysis that we need, of course, the model is superfluous.     

The Model’s Oversimplifications

A production function-based growth model is a vast over-simplification of how an economy actually works. Many more variables are at work determining levels of capital, income, and wealth than are reflected in these simple formulas. Piketty candidly acknowledges such shortcomings of his model. First, he says, “The law β = s/g represents a state of equilibrium toward which an economy will tend if the savings rate is and the growth rate g, but that equilibrium state is never perfectly realized in practice.” (p. 169)

Second, he points out that the law is applicable “only if certain crucial assumptions are satisfied”:

1. The law is “asymptotic, meaning that it is valid only in the long run.” Piketty provides no criteria for knowing where in the “long run” we now are, but appears to assume we are at the beginning: “[I]t will take several decades for the law  β = s/g to become true.” (p. 168);

2. The law is invalid if a significant portion of national “capital” consists of pure natural resources, independent of human improvement. Note that the concept of capital (which is the equivalent of wealth only in long-run equilibrium) is now said to include natural resources, contrary to the basic classical concept of wealth (p. 169);

3. And the law is invalid, Piketty says, if asset prices do not evolve on average in the same way as consumer prices. (Id.)

The over-simplification embodied in the long-run equilibrium concept necessarily leads to over-optimistic expectations. For example, the aggregate saving rate (s) increases when income becomes more concentrated, because wealthy people have a much lower “marginal propensity to spend” than people at lower income levels, who spend all or nearly all of their incomes and reduce any savings they may have when their incomes fall. Statistically, the model will pick up the consequent long-run changes in the capital/income ratio, but it provides no way to evaluate short-run effects, which in the United States have been extreme over the last three decades. 

For many readers this is conceptually difficult material. But the untutored mind is an asset here: I urge readers to stay with me, because after reviewing Piketty’s account of the genesis of his model, and Gardner Ackley’s 1963 analysis of the development of production function-based growth models, we reach some surprising conclusions. If you wish, go now to the “Summary and Conclusions” at the end for a broad overview of all of this.  

PRODUCTION FUNCTION-BASED GROWTH MODELS

Piketty’s Discussion of “Harrod-Domar” and Other Growth Models

It was not until p. 230 that Piketty identified the source of the main ideas for his book, which is the theory that has become known as the “Harrod-Domar” growth model:

When the formula β = s/g was explicitly introduced for the first time by the economists Roy Harrod and Evsey Domar in the late 1930s, it was common to invert it as   g = s/β. Harrod, in particular, argued in 1939, that β was fixed by the available technology (as in the case of a production function with fixed coefficients and no possible substitution between labor and capital), so that the growth rate was entirely determined by the saving rate. (p. 230)

It was also at this stage of the book when Piketty mentioned the term “production function” for the first time. It is important to know what that is:

In economics, a production function relates physical output of a production process to physical inputs or factors of production. The production function is one of the key concepts of mainstream neoclassical theories, used to define marginal product and to distinguish allocative efficiency, the defining focus of economics. * * * 

In macroeconomics, aggregate production functions are estimated to create a framework in which to distinguish how much of economic growth to attribute to changes in factor allocation (e.g. the accumulation of capital) and how much to attribute to advancing technology. Some non-mainstream economists, however, reject the very concept of an aggregate production function. (Wikipedia, here)

The aggregate production function is a purely “supply-side” perspective, which assumes that consumer and investor markets will always clear (at least, as discussed above, in the long run).  

Piketty mentions several early “production functions” and stances on the “capital-labor split,” e.g.: 

Marx: “For Marx, the central mechanism by which ‘the bourgeoisie digs its own grave’ corresponded to what I referred to in the Introduction as ‘the principle of infinite accumulation': capitalists accumulate ever increasing quantities of capital, which ultimately leads to a falling rate of profit (i.e., return on capital) and eventually to their own downfall.” (pp. 227-228)

Cobb-Douglas: This “production function,” first proposed in 1928, “became very popular after World War II (after being popularized by Paul Samuelson)” (p. 218). This function specifies that “no matter what happens, and in particular what quantities of capital and labor are available, the capital share of income is always equal to the fixed coefficient α, which can be taken as a purely technological parameter.” Thus, “if α = 30 percent, then no matter what the capital/income ratio is, income from capital will account for 30 percent of national income (and income from labor for 70 percent).” (p. 218). [In other words, income from capital is unrelated to the value of capital assets in the C/I numerator.] * * * “[H]istorical reality is more complex than the idea of a completely stable capital-labor split suggests. The Cobb-Douglas hypothesis” is a “useful point of departure for further reflection.” (p. 218) 

Bowley-Keynes: The capital-labor split in Britain remained relatively stable in the period 1880-1913 (Bowley); in 1939, “Keynes took the side of the bourgeois economists, calling the stability of the capital-labor split ‘one of the best-established regularities in all of economic science’.” (p. 220)   

Piketty says little about Harrod’s and Domar’s ideas except to suggest:

Harrod: “If the savings rate is 10 percent and technology imposed a capital/income ratio of 5 (so that it takes exactly 5 units of capital, neither more nor less, to produce one unit of output) then the growth rate of the economy’s productive capacity is 2 percent per year. But since the growth rate must also be equal to the growth rate of the population (and of productivity, which at the time was still ill-defined) it follows that growth is an intrinsically unstable process, balanced ‘on a razor’s edge.’ There is always either too much or too little capital.”

* * * Harrod’s intuition was not entirely wrong, and he was writing in the middle of the Great Depression, an obvious sign of great macroeconomic instability. Indeed, the mechanism he described surely helps to explain why the growth process is highly volatile: to bring savings in line with investment at the national level, when savings and investment decisions are generally made by different individuals for different reasons, is a structurally complex and chaotic phenomenon, especially since it is often difficult in the short run to alter the capital intensity and organization of production.  

Domar: “In 1948, Domar developed a more optimistic and flexible version of the law g = s/β than Harrod’s. Domar stressed the fact that the savings rate and capital/income ratio can to a certain extent adjust to each other.” (p. 231)

(Robert) Solow:  “Even more important was Solow’s introduction in 1956 of a production function with substitutable factors, which made it possible to invert the formula and write β = s/g. In the long run, the capital/income ratio adjusts to the savings rate and structural growth rate of the economy rather than the other way around. Controversy continued, however, in the 1950s and 1960s between economists based primarily in Cambridge, Massachusetts (including Solow and Samuelson, who defended the production function with substitutable factors) and economists working in Cambridge, England (including Joan Robinson, Nicholas Kaldor, and Luigi Passinetti), who (not without a certain confusion at times) saw in Solow’s model a claim that growth is always perfectly balanced. thus negating the importance Keynes had attributed to short-term fluctuations. It was not until the 1970s that Solow’s so-called neoclassical growth model definitively carried the day.” (p. 231)

This selective and limited set of ideas and partial theories is inherently confusing. But I urge everyone, especially economists, to step back and take a moment to reflect on the upshot of all this, and ask some basic questions such as these:

1. How can an idea, especially a mere kernel of an idea, that was so extensively debated more than fifty years ago, suddenly emerge now in the 21st Century as “the Second Fundamental Law of Capitalism?”

2. How can such a simple formula have different “versions”? 

3. Why has Piketty presented a simple Harrod-Domar model as the basis for his discussion of production functions, when he apparently favors a different model proposed by Robert Solow?

4. Wasn’t Keynes’ General Theory mainly concerned with short-term fluctuations in aggregate demand, and if so why did his views on short-term fluctuations come up in discussions about the long-run production function?

Ackley’s Evaluation of the Harrod-Domar and Other Growth Models

Ackley’s text was divided into four parts: (1) Concepts and Measurements, (2) The Classical Macroeconomics, (3) The Keynesian Macroeconomics, and (4) Some Extensions. In parts 2 and 3, he provided basic, functional models of classical and Keynesian systems, which showed how they accounted for growth and change of major variables, as augmented by Keynes’s introduction of the concept of effective demand and the “consumption function.” Part 4 contained four chapters which, we might say, dealt with gaps in the coverage of the basic theories: XVII, The Theory of Investment; XVIII, Economic Growth, the Problem of Capital Accumulation; XIX, Selected Problems of Nonproportional Growth; and XX Macroeconomics and Microeconomics. Other than to note that the topic of income and wealth distribution was nascent in the U.S. at that time, given low levels of inequality and high and growing middle-class prosperity, Ackley had nothing to say on that score. However, he did provide a systematic overview of the various growth models that had been proposed and debated over the previous few decades. His discussion was limited to economies “already employing productive techniques and highly-developed economic institutions,” employing a “free-enterprise system of organization.”  (p. 505)

Baumol’s “Magnificent Dynamics”: Ackley discussed William Baumol’s summary (Economic Dynamics, 1951) of the “magnificent dynamics” of the early classical school’s growth model in which “per capita income is just sufficient to permit the population to reproduce itself at the physical (or cultural) minimum level of subsistence,” and should per capita income exceed subsistence, there would be “a margin which would be divided between (a) payment of wages in excess of subsistence, thus encouraging population growth, and (b) profits in excess of the capitalists’ living expenses, a difference that can (and will) be invested to equip the growing population with the necessary tools (or at least to provide the enlarged investment . . . associated with a larger working force.” (p. 507) This model “is too simplistic, not very relevant to Western society.” (p. 509)

Keynes and the stagnationists: Because of the highly inelastic marginal productivity of capital in highly developed countries, “the growth of capital through investment must ultimately lead toward capital ‘saturation,’ a deficiency of investment opportunities relative to full-employment saving, and a necessary decline in income and employment necessary to eliminate the excess of saving.” (p. 509) * * * “Keynes’ view recognizes what the simple ‘magnificent dynamics’ model just reviewed had missed. Namely, it recognizes that capital is more than a means of employing labor. It is itself productive, and an increase in capital even with no increase in labor (or… greater than the increase in labor) can yield a positive, although diminishing return. (p. 510)

“[T]he basic error in this Keynesian position” is “a failure to realize that a growth of income — a growth which the very act of investment permits — can prevent capital saturation.” (p. 511) * * * “However, the causal link from population growth to investment, clear enough for public investment and perhaps even for housing and basic utilities, is far from obvious with respect to private investment in facilities to produce ordinary consumer goods. An increase in population increases potential consumption, and thus the potential size of the economy and the capital stock which it can use without reducing rate of return. But perhaps only if the investment first occurs and incomes rise as a result can the potential consumption, be translated into actual demand and thus provide a justification for the investment.” (p. 512)

“To the extent that the stagnationist position rested on Keynes’s failure to see that the size of the capital stock can only be considered ‘large’ or ‘small’ in relation to the size of the national income, and that it is possible for the two to grow together, the position embodied an analytical error.” * * * “If [the stagnationist position] argued merely that stagnation is a possible state for a wealthy economy, it was arguing little more than Keynes had already demonstrated, quite without reference to long run capital accumulation.” (p. 512)

Domar: “An understanding of one fundamental relationship between capital accumulation and growth stems perhaps most clearly from the work of Every Domar. Domar starts from Keynes’ recognition that today’s investment competes, at least initially, not only with yesterday’s but with tomorrow’s investment. It provides new productive capacity, which, if it is not adequately used, will discourage further investment tomorrow. This will increase the surplus of idle capital. But unlike Keynes Domar saw that there was nothing inevitable about this outcome. If total demand tomorrow should be sufficiently greater than today’s demand, the newly added productive capacity could be fully employed, and there would be room for new investment again tomorrow.” * * * Domar asked at what rate demand would have to grow – and how might this growth come about – in order to make full use of the rising productive capacity provided by capital accumulation.” (p. 513)

Domar’s formula was not the same as Piketty’s (American Economic Review, 37, March 1947). As Ackley explained, Domar was concerned with the degree of utilization of new capacity: The amount of investment (i) times the amount of added capacity per $ of investment (µ) =  the amount of added capacity in a period (µi).  The math for his formula is set forth at pp. 513-514. Here is Ackley’s intriguing observation:

 “Thus, if investment grows at a constant percentage rate, αµ, productive capacity, although continually growing, will be fully used.” Should investment grow “at a lesser rate, added productive capacity would not be fully utilized; instead an increasing margin of idle capacity would accumulate. Thus we have the paradox that if only productive capacity grows fast enough, no idle capacity will develop. But too small a growth of capacity will produce a surplus of capacity.”

This bizarre result, which is due to the fact that actual output from additional capacity is growing even more slowly than capacity, is illustrated and confirmed with a numerical example (p. 516). Here is Ackley’s overview of Domar: 

“Domar did not pretend to provide a theory of growth, but only to indicate one significant aspect of the problem of growth, and to compute, on simplified assumptions, what the necessary rate of growth would have to be in order to avoid the accumulation of excess capacity which would inhibit growth. That is, Domar described an equilibrium growth path, but indicated little about what might cause the economy to follow or to depart from that path. This equilibrium growth path is defined by the condition that all of the capital provided by previous investment is utilized, yet neither is there any capital shortage.” (p. 517)

Harrod: “Harrod had a more ambitious aim. Not only did he recognize the problem of growth but also he tried to provide a theory which explained how steady growth occurred in an economy (“An Essay in Dynamic Theory,” Economic Journal XLIX , March 1939); and also how, if this growth were interrupted — if growth once diverged from its equilibrium path — the economy might either ‘explode’ into too rapid growth, producing inflation, or cease to grow altogethre, producing depression. * * * Harrod’s own presentation leaves certain points quite unclear; consequently, in summarizing his argument, we are necessarily going somewhat beyond his own formulation. * * * Whereas Domar had no theory of what investment would be (but only what it must be for growth to be sustainable), Harrod adopts the acceleration principle as a theory of investment.” (p. 518)

(The acceleration principle rests on the idea, “[a]bstracting from all other influences,” that “the necessary stock of capital (in physical terms) depends on the rate (in physical terms) of demand for final output. * * * [I]f income changes, by a positive or negative amount, investment (or disinvestment) will occur” at a rate  depending on the degree of change in income (p. 486).)

“The equilibrium growth rate is a constant. * * * If the rate of growth happens to diverge even once from its equilibrium path, it will thereafter diverge increasingly.” (p. 520) 

“[L]et  us see if we can express in words what this is all about. Harrod’s vision is of a growing, expanding economy, in which businessmen are always, in effect, “betting” on growth, but not always sure how much growth to count on. Since they must produce in advance of sale, they have no choice but to make a ‘bet.’ Having made their production decisions, the carrying out of these decisions (a) generates consumer incomes and, through consumer spending, a market for part of the output they have decided to produce; and (b) requires additions to productive capacity in the form of capital goods and extra inventories, the magnitude of which additions depends  on the growth of output they have decided (collectively) to provide.” 522 

“There is one . . . rate of growth of output, but only one, which is correct, in the sense that it will generate just enough demand to permit them to sell all that they have produced. This is the “equilibrium” or “warranted” rate. If the collective bets of sellers happen to hit this rate, all is well.” (The correct rate will perpetuate itself.) “But if the collective ‘bets’ should involve an output increase which exceeds this warranted rate, demand will be generated which is even greater, so that shortages appear, etc.* * * But if they are insufficiently optimistic, and make production plans involving insufficient growth, their pessimism will be more than confirmed.” 522  

Two “aspects of all of this” are “particularly implausible”:

1. All of this rests on an “empirical generalization that producers behave in the manner described in the equation”;  i.e., they will repeat last period’s growth when they find it just right;

2. “Second, the notion that production plans come first, and that these, then, through the accelerator, determine investment, quite reverses the more usual (and a priori more plausible?) sequence.” (p. 523)

“In summary, Harrod tried to do considerably more than Domar. Domar defined a sustainable growth path in which all of the capital provided by previous investment is utilized, yet without any deficiency of capital. Harrod’s warranted growth rate also embodies this concept of equilibrium. His use of the accelerator … necessarily precludes either deficient or surplus capital. Rather his warranted growth rate is additionally concerned with another kind of equilibrium: that between demand and supply for current output. Harrod assumes, with little apparent foundation, that producers always expect sales to grow by the same percent as they have been growing. * * * An equilibrium between demand and supply of current output is the crucial element of his growth theory.” (525-526)

“[I]t should be stressed that either [formulation of the Harrod] model does extreme violence to reality. Either model, in strict form, implies a greatly oversimplified theory of expectations.” (p. 529)

Solow: “[E]ven without any technological change the accumulation of capital at a faster rate than the growth of labor would tend to raise the K/y [capital/income] ratio, and, of course, the average productivity of labor. That is, the data we observe are the result of a number of simultaneous changes, and we must attempt to sort out that part which is due to technological change. Among others, an interesting contribution to this task has recently been made by Robert Solow, “Technical Change and the Aggregate Production Function,”Review of Economics and Statistics XXXIX (August 1957), 312-320. 

Domar Revisited: Ackley noted in his summary (pp. 534-535 that all of the growth models he discussed (Keynes, Harrod, and Duesneberry) relate to the “demand approach to economic growth.” These models were concerned with the issue of generating sufficient aggregate demand to permit continued growth. He returned to Domar, because he had tried to determine what the necessary rate of growth would have to be in order to avoid the accumulation of excess capacity which would inhibit a sustainable level of growth. Then he proposed a new approach:

“In the first section of the next chapter, we return, in effect, to the simpler problem posed by Domar: what kind of a rate of growth of demand (if it did occur) would fully utilize an economy’s growing productive facilities? We do not worry about demand. Either we assume that it is naturally buoyant, or that government can make it so. The important question, then, is how fast does capacity grow? But now, for the first time, we are prepared to recognize that an economy’s productive capacity depends on something more than just the size of its capital stock.” (p. 535)

This is a curious reformulation of the issue of growth. Although he had concluded that the size of an economy’s productive capacity depends on “something more than just the size of its capital stock,” by inviting brainstorming that simply assumes needed demand will be there (which was, I must note, the original stance of classical theory, one that Keynes worked tirelessly to overcome with his insistence on the introduction of the demand function in his General Theory) Ackley appeared to be opening an inquiry as to whether any sensible “supply-side” model could be developed. After thirty pages of miscellaneous brainstorming, though, he pretty much gave up the effort:

“Now all of this is by way of framework or background for a theory of growth, and, in itself, provides little insight. Only as we develop further empirical hypotheses can we hope to contribute to growth economics. Some hypotheses are possible and plausible. A very simple one relates to the demand for money in a growing economy.”

Some Observations:

Much thanks to anyone still here after wading through this difficult section. Just now, with all of this in front of us, some clarifying observations emerge: Notice that Ackley’s more detailed discussion of these production capacity-based growth models reveals that they were all short-run models, and that they all attempted to reconcile growth of capital stock with aggregate demand, a singularly Keynesian perspective. Ackley saw, in the development of these models, a consistent recognition “that an economy’s productive capacity depends on something more than just the size of its capital stock.” But he also found all of these models wanting, either unable to live up to expectations that the development of capital stock would provide stable growth, or reflecting unwarranted assumptions about human expectations and behavior.

Piketty’s discussion of consumption function-based growth models avoids reference to these issues.  Instead, Piketty mentions model development in passing, while reducing the issue to the simple Domar question Ackley identified:

“We do not worry about demand. Either we assume that it is naturally buoyant, or that government can make it so. The important question, then, is how fast does capacity grow?”

Piketty proceeds carefully, however, realizing that abandoning “the demand approach to economic growth” requires limiting the question of growth to one of identifying a long-run “equilibrium.” This leads to a conclusion that Piketty does not deny, but appears loathe to frankly acknowledge: His model is incapable of predicting growth.

SUMMARY AND CONCLUSIONS

Here is a brief “executive summary” of the points I find significant with respect to Piketty’s two alleged “fundamental laws of capitalism”:

About What’s Important

1. The point I will be emphasizing in my next post is that, from the standpoint of concerns about inequality, Piketty has raised the wrong issue. Inequality growth is directly related to the concentration of wealth and income, factors that directly destroy prosperity and create poverty, but Piketty’s two laws address a different topic;

2. More precisely, Piketty’s two “fundamental laws of capital” relate to the concentration of capital stock invested in the means of production. “Capital intensity” has almost nothing to do with the distribution of wealth and income (inequality);

3. Although he earnestly seeks to find implications from his “laws” for inequality, Piketty concedes that capital intensity does not determine how wealth is distributed in an economy, and that the two variables move independently;     

4. Because his treatment of the capital accumulation problem relies on dubious neoclassical “equilibrium” assumptions that incorrectly assume productive capacity and wealth are equivalent in the “long run,” Piketty raises the specter of a conclusion he knows is wrong, that there is a long-run equilibrium level of inequality;     

About Production Function Growth Theory

5. On his premier topic, capital accumulation, Piketty has resolved an old theoretical dispute about the growth of productive capital by converting a “short-run” model into its long-run counterpart, thus (a) over-simplifying the question of capital growth, and (b) stripping the model of explanatory power; 

6. From Domar on down, attempts to develop a short-run growth model based on productive capacity did not go well. Theoreticians could not agree on what simplifying assumptions would best represent reality, and data limitations would make it difficult to adequately test these theories;

7. By 1963, although demand-side theories in macroeconomics were making some progress (thanks to Keynes), Ackley’s review of supply-side aggregate growth theories showed that area to still be in a rudimentary stage of development and badly in need of fresh hypotheses;

8. Production function models, however useful they may be in microeconomics, were never developed sufficiently to provide a realistic explanation of  aggregate economic growth;

9. Piketty has presented a system of “tautologies,” or “accounting identities” that by itself has no explanatory power;

10. Although his growth model intends to describe a long-run rate of capital accumulation, it merely describes a long-run trend of capital accumulation, described as a path toward an eventual “equilibrium” state; and as Piketty freely admits, the model tells us nothing about how or when (if ever) such a state might be achieved;

11. Nonetheless, Piketty assumes, without supporting evidence, that an economy is always trending toward the equilibrium level of capital intensity established by its long history of capital accumulation; instead, the trend of capital intensity keeps moving up or down with a host of factors (like technological change);   

About “Model-Dependent Realism”

12. Piketty refers to the two components of his model as “fundamental laws” when they are not functional laws at all. Together, they merely use accounting identities to describe a theoretical equilibrium condition that cannot ever be perceived in “reality;”

13. To the extent Piketty believes his “fundamental laws of capitalism” explain that “reality” consists of persistent growth toward an equilibrium state of capital accumulation, he has reached a faulty conclusion by virtue of a neoclassical perspective that is not supported by experience. Thus, his model fails the test of “model-dependent realism” elucidated by Hawking and Mladinow;

JMH – 6/27/2014 (“Summary” ed., 6/28/2014)

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Picking Piketty Apart – Part I: His Contribution

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

The distribution of wealth and incomes had been ignored by mainstream economists, not regarded a material factor in the functioning of market economies, for decades before and after Kuznets published this statement.  Now we are learning how prophetic it was. When Kuznets was working on distribution issues in the 1950s, at a time when income inequality was declining in the United States (and Europe), he complained vociferously about the lack of relevant data. Now the needed data is available, thanks in no small measure to the work of French economists Thomas Piketty and Emmanuel Saez, who compiled a comprehensive database of the incomes of many countries taken directly from income tax returns. 

The database was first published in 2003, but public awareness of its significance did not materialize until after the Crash of 2008. Now, at last, Piketty has published a nearly 700-page book, Capital in the Twenty-First Century (Belknap, Harvard, 2014). The book instantly became a best-seller, and now the reactions are coming in. Having studied the inequality problem in the United States closely for nearly four years, and having now read the Piketty book effectively twice, I am prepared to offer a critical “digest” of it, from the perspective of those like myself primarily interested in the future of the U.S. economy.

It is important to get a sense of what Piketty intended to accomplish with this book, and of the degree of his success. In his introduction, he reveals the broad conceptual framework of his presentation: Data sources like income tax returns and estate tax returns provide information on the degree of inequality among income earners and among wealth holders. This information concerns “flows” of money. Other data sources reveal “the total stock of national wealth (including land, other real estate, and industrial and financial capital) over a very long period of time” (pp18-19); “We can measure this wealth for each country in terms of the number of years of national income required to amass it.” (p. 19) This “capital/income approach,” a ratio of a “stock” (net worth, wealth, or “capital”) to a “flow” (national income) Piketty argues, “can give us an overview of the importance of capital to the society as a whole.” 

Initially, he “takes the inequality of income from labor and capital as given,” in order to focus (in Parts One and Two) on the “global division of national income between capital and labor” (p. 40). Thus, he isolates and defers for later discussion the topics of income and wealth concentration and distribution that have dominated the discussion in the United States. These include the rapid rise of U.S. income inequality since 1980, and the much greater degree to which wealth (and the income derived from wealth) is unequal than is the income from labor.

In a second post, I will present a detailed review of the growth model Piketty employs in connection with the global division of national income between capital and labor, i.e., the capital-labor split. This is a much more difficult topic, and most readers will find this new to the inequality debate; but it is based on decades-old growth models, one of which Piketty now offers as “The Second Fundamental Law of Capitalism.” The reliability of this model is crucial to the impression he conveys of the future stability of the U.S. economy.

In a third post, I will review Piketty’s impressions about the future of U.S. inequality, and suggest how inadequacies of his neoclassical framework support the need for the new “distributional macroeconomics.” I will argue in that regard that the mechanics of distribution and growth are dominated by: (1) The prevalence in U.S. society of unearned income (economic rent); (2) the principle Piketty refers to as “The law of Cumulated Growth” (p. 76); and (3) Keynes’ principle of effective demand, which I have referred to as “The Law of Effective Demand.” These are three complementary, and cumulative, aspects of what Piketty calls “divergence,” that is, progressive decline. As I have argued for several years, the problem is far worse, and far less “long-run,” than Piketty envisages, and now Piketty’s own analysis helps me clarify why.

This post is devoted to some general reflections on the impact Piketty’s work is having. What has been his effective contribution thus far?   

Attention

Just getting attention focused on the inequality issues is a big deal, especially for Americans. A lot of people here haven’t been thinking about it, and because of Piketty’s book, hopefully, many more people will become aware that U.S. inequality is far worse than Europe’s. In these comparisons, he’s mostly talking about the income inequality that has developed since the 1970s, which is what we’ve been talking and thinking about in America for several years. It has been no secret that the U.S. has the highest income inequality among wealthy nations – the Piketty/Saez reports in 2011 showed this. But the comparative data in Piketty’s book shows how much worse the U.S. experience is than that of France, Great Britain, or Germany, and other more egalitarian wealthy nations:

In my view, there is absolutely no doubt that the increase in inequality in the United States contributed to the Nation’s financial instability. [I]t is important to note the considerable transfer of US national income – on the order of 15 points – from the poorest 90 percent to the richest 10 percent since 1980. * * *

[I]n the thirty years prior to the crisis, that is from 1977-2007, we find that the richest 10 percent appropriated three-quarters of the growth. The richest 1 percent alone absorbed nearly 60 percent of the total increase of the US national income in this period. Hence, for the bottom 90 percent, the rate of income growth was less than 0.5% per year. [fn] These figures are incontestable, and they are striking: Whatever one thinks about the fundamental legitimacy of income inequality, the numbers deserve close scrutiny. [fn] It is hard to imagine an economy and society that can continue functioning indefinitely with such extreme divergence between social groups. (p. 297)  

Here, he’s clearly implying that either the United States will no longer politically tolerate this continuing deterioration, or it will continue to slide ever deeper into its depression. That the inequality growth is leading potentially to Great Depression II is an argument I have been making for several years. Piketty still couches the discussion in the context of “social” divergence with which he is most comfortable, but note his recognition of the undeniable fact, firmly established in reports from his colleague Emmanuel Saez, that the growth of income has been increasingly appropriated by wealthy people in income’s top 1% since 1980, to the point where now that group is receiving over 95% of all growth.

Affirmation

It is important that a mainstream, “neoclassical” economist, has at last come out and begun to discuss the truth about what these data mean. Although he overlooks factors that a Joseph Stiglitz or Robert Reich would emphasize, this is, importantly, the first time to my knowledge that a neoclassical economist has acknowledged that income inequality in the U.S. is a dire macroeconomic problem, not just a trivial matter like the difference between the pay of young adults who have college degrees and those who don’t, and not just a “political problem” as asserted by one of Piketty’s main cheerleaders, Paul Krugman. It was only two years ago that Krugman, in his latest book, characterized income inequality as a political problem, an impression he found supported by the views of Piketty and Saez:

Recently, Piketty and Saez have added a further argument: sharp cuts in taxes on high incomes, they suggest, have actually encouraged executives to push the envelope further, to engage in “rent-seeking” at the expense of the rest of the workforce. Why? Because the personal payoff to a higher pre-tax income has risen, making executives more willing to risk condemnation and/or hurt morale by pursuing personal gain. As Piketty and Saez note, there is a fairly close negative correlation between the top tax rates and the top 1 percent’s share of income, both over time and across countries. 

What I take from all of this is that we should probably think of rising incomes at the top as reflecting the same political and social factors that promoted lax financial regulation.” (End this Depression Now! Norton, 2012, p. 82)

Krugman’s position was untenable: It not only implied that rising income inequality had no macroeconomic significance, but it misconceived human nature: Rising incomes at the top reflected declining federal income taxes, as he noted, and the U.S. Chamber of Commerce and other business groups had lobbied hard for the tax rate reductions that made higher after-tax incomes at the top possible. There is no reason to doubt that all or nearly all of the wealthiest Americans had zero qualms about keeping their income gains. Piketty, although he says he is striving for a softer, gentler economics more sensitive to the other social sciences, makes no contrary claim now. He clearly acknowledges that these gains were in fact at the expense of lower income groups; and that the income inequality in America, which has gradually grown since 1980, has now reached an intolerable level.    

Wealth

For many readers, no doubt, Piketty effectively introduces the crucial role of wealth concentration, and the division of income from wealth in the labor-capital split of income, into the inequality discussion. The role of growing wealth concentration has been mostly lacking from inequality discussions. Piketty’s main contribution, in my view, is the comparison he presents of wealth concentration among wealthy countries. He presents three tables at pp. 247-249:

Table 7.1: Inequality of Labor Income across time and space.

Table 7.2: Inequality of capital ownership across time and space.

Table 7.3 Inequality of total income (labor and capital) across time and space

In all three tables, he shows the percentage distribution among the “upper class,” the top 10% (broken down as well into the top 1% and the next 9%); the “middle class,” the next 40%; and the “lower class” (the bottom 50%):  

            1. For labor income, he characterizes as “low inequality” Scandinavia in the 1970s-1980s: The top 10% got 20% (the top 1% getting 5%) and the bottom 90% getting 80% of income. Medium inequality is Europe in 2010. High inequality is the U.S. in 2010, where: The top 10% got 35% (the top 1% getting 12%) and the bottom 90% getting only 65%. Very high inequality, he suggests, might be the U.S. in 2030? This is a speculative projection (his growth models do not permit projections of either growth or inequality): The top 10% gets 45% (the top 1% getting 17%), and the bottom 90% gets only 55%.

But note Piketty’s curious suggestion that it is possible for income inequality to continue to grow for another 15 years to such an extent, after he found it “hard to imagine an economy and society that can continue functioning indefinitely” at the high level of income inequality of the U.S. in 2010. I’ll return to this point in the third post in this series.  

            2. Low inequality in capital ownership, according to Piketty, exists only in an ideal society that has never been observed. The top 10% owns 30% of capital (with the top 1% owning 10%) and the bottom 90% owning 70% (only 25% for the bottom 50%). Medium inequality, again is perceived in Scandinavia in the 1970s and 1980s, High inequality is the U.S. in 2010, where the top 10% owns 70% of wealth (with the top 1% holding 35% of capital) and the bottom 90% owns 30% (with the bottom 50% owning only 5%). Very high inequality of wealth ownership he assigns to Europe in 1910, where the top 10% held 90% of wealth.

It is immediately apparent that wealth everywhere is far more concentrated than income. (The reason is that wealth is a stock, which accumulates from income). I’ll discuss in the third post Piketty’s prevalent perspective that “inheritable” wealth is the main problem, so that our concern evidently should be mainly with estate taxes. This overlooks the major accumulation of “new” wealth in the United States through excess earnings, a factor I had felt Piketty had overlooked altogether, until I got to p. 377:

In order to understand the cumulative logic (of wealth concentration) better, we must now take a closer look at the long-term evolution of the relative roles of inheritance and saving in capital formation. This is a crucial issue.  * * * It may be that the global level of capital has remained the same but that its deep structure has changed dramatically, in the sense that capital was once largely inherited but is now accumulated over the course of a lifetime by savings from earned income.   

To miss that point in connection with U.S. inequality growth, in my view, is to miss the essence of the U.S. inequality experience, and to sorely underestimate the danger the U.S. economy is in. Household wealth accumulates far more rapidly than just “in the course of a lifetime by savings from earned income”: e.g., Bill Gates (not atypically) had become a multi-billionaire while still a young man, and his wealth came from unearned income (corporate distributions), not the product of his own labor. Piketty, who has lived in France for years, appears to be out of touch with the American experience; but as will be discussed later in this series, the problem is more fundamental than that.

3. With respect to Table 7.3, “inequality of total income (labor and capital) across time and space,” Piketty’s categories are the same as for Table 7.1: Low inequality is Scandinavia (1970s-1980s), where the top 10% gets 25% (with 7% going to the top 1%) and the bottom 90% gets 70%. Medium inequality is Europe 2010, and high inequality is represented by the U.S. in 2010, as well as Europe in 1910, where the top 10% got 50% of total income (20% going to the top 1%) and the bottom 90% got 50%. Very high, is again speculatively presented as the U.S. in 2030, where the top 10% obtain 60% of total income, with 25% going to the top 1%.

This identifies the major impact in the U.S. since 1980 of the growth of income from wealth. My concern here is that Piketty has understated the intensity of income inequality growth in the U.S. in his projection for 2030, assuming we could get there at all. The top 1% share, according to the Piketty/Saez data, had already grown to over 22% before the Crash, in 2007, and has been growing again, robustly, since 2010. More on this later.    

Support for Piketty’s Book

Regardless of any shortcomings in the theoretical prism used to focus on the U.S. data, and the consequent underestimation of the scope of the inequality problem here, the Piketty book provides a huge service to Americans by revealing the marked contrast between what is happening here and what is happening in most of the rest of the wealthy countries. Notably, this situation is alarming even from Piketty’s neoclassical perspective, and the main questions facing us are: How much worse can things get before the U.S. economy collapses? And how soon might that happen? 

But the U.S. political situation is intransigent. Public opinion is mired in a “trickle-down” mentality, with the mainstream media persistently suggesting that the verdict is still out on whether “austerity” government, financed by still more tax breaks for the wealthy, can result in investment and income growth. The information in Piketty’s book constitutes a full refutation of the plainly erroneous trickle-down idea, which of course has been repeatedly disproved by all aggregate income data in the U.S. over the years. Senator Elizabeth Warren, who is proposing to alleviate the dangerous $1.3 trillion student debt bubble that is crippling our society with increased taxes on the wealthy, points to Piketty’s book in support, maintaining that American wealth has been relentlessly sucked to the top and has not trickled down. (See her joint appearance with Piketty in a conversation moderated by the Huffington Post’s Ryan Grimm on June 2, 2014 (here).

The noteworthy fact is that American public attention has been diverted from the incredible increase in concentration of wealth at at the top since 1980. The American public’s awareness of this entire issue is in sore need of a jolt, and it perhaps is getting that jolt from the publicity attending Piketty’s book. See, e.g., the A.P. account of April 23, 2014 (here).

            The fact that inequality of income and wealth is growing in the United States at an alarmingly rapid pace has given rise to vapid denials from the political right; for example, the argument presented by Chris Giles (“Data Problems with Capital in the 21st Century,” Money Supply, May 23, 2014, here):

Two of [the book’s] central findings – that wealth has begun to rise over the past 30 years and that the U.S. obviously has a more unequal distribution of wealth than Europe – no longer seem to hold.

Without these results, it would be impossible to claim, as Piketty does in his conclusion, that “the central contradiction of capitalism” is the tendency for wealth to become more concentrated in the hands of the already rich.

Paul Krugman recently took Giles to task (here):

Giles finds a few clear errors, although they don’t seem to matter much; more important, he questions some of the assumptions and imputations Piketty uses to deal with gaps in the data and the way he switches sources. * * * Piketty will have to answer these questions in detail, and we’ll see how well he does it.

But is it possible that Piketty’s whole thesis of rising inequality is wrong? Giles argues that it is:

* * * [U]nlike what Piketty claims, wealth concentration among the richest people has been pretty stable for 50 years in both Europe and the US.

There is no obvious upward trend. The conclusions of Capital in the 21st century do not appear to be backed by the book’s own sources.

OK, that can’t be right — and the fact that Giles reaches that conclusion is a strong indicator that he himself is doing something wrong.

Krugman cites the CBO study on the distribution of income (Congressional Budget Office, Trends in the distribution of household income Between 1979 and 2007. October 26, 2011, here, p. 11) which provides Lorenz curves showing the concentration of business income over the years.

Concentration of Business Income

“It’ just not plausible,” he argues, “that this increase in the concentration of income from capital doesn’t reflect a more or less comparable increase in the concentration of capital itself.” Thus, Piketty’s fact-based presentation has led Krugman himself to emphasize the connection between income and wealth concentration, something to my knowledge he had not previously done. 

Beyond that, there is simply an obvious, undeniable truism that wealth compounding is a natural process: If existing wealth is growing at all, it is growing for those who already possess wealth, and the more they already have, the greater their future natural accumulation will be. Wealth, therefore, is necessarily becoming more concentrated.

Conclusions

Attacks from the right are to be expected, as the self-interest perceived by wealthy people clearly requires opposing increases in their taxes. But this kind of reaction is a form of denialism similar to the attacks made by corporate interests on scientific evidence of climate change: Perceived self-interest easily trumps facts and logic.

Piketty has taken a rare stand, on behalf of mainstream, supply-side theory, for the conclusions that income and wealth inequality have major macroeconomic consequences, and that levels of income and wealth concentration must therefore be controlled. We have already heard Keynesian analysis from Stiglitz and Reich: The major contribution this book makes is to clarify that “mainstream” arguments denying the macroeconomic significance of inequality are unsupportable.

My perception is that there would be no winners in a major collapse into Great Depression II. Multi-billionaires may feel immune today, but their wealth and power will evaporate in a collapsing economy. Hopefully, Piketty’s book will significantly encourage the political right and all extremely wealthy people to realistically reappraise the policies of political denial, and reconsider the weakness of their perceived self-interest. That unfettered inequality growth ultimately entails deep depression, and likely the end of their success along with the end of overall human welfare and prosperity, is a prospect that presumably will concern them. The important question now is how long the current trend can last.

We cannot accept Piketty’s two “fundamental laws of capitalism” at face value. I will in the next two posts (after an approximately one-week delay) thoroughly review the underpinnings of the growth models Piketty has used, and discuss how they lead to unduly optimistic growth expectations.

JMH – 6/14/1014  (ed. 6/20)

 

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Walmart’s Game Plan and Capitalism’s Endgame

walmart_casestudy_design_logo-1_959_487_90_c1

On tax day, when millions of American taxpayers and small businesses pay their fair
share to support critical public services and the economy, they will also get stuck with a multi-billion dollar tax bill to cover the massive subsidies and tax breaks that benefit the country’s largest employer and richest family.

[T]he American public is providing enormous tax breaks and tax subsidies to Walmart and the Walton family, further boosting corporate profits and the family’s already massive wealth at everyone else’s expense. – Americans for Tax Fairness (ATF), “Walmart on Tax Day,” April 2014, p. 3 (here).

As I have been demonstrating on this blog, capitalism is a self-destructive economic system and the vehicle of self-destruction is excessive wealth concentration occurring when regressive taxation allows rapid inequality growth.  Walmart provides what may be the best available demonstration of the mechanics of this process. Here is ATF’s description of the company and the Walton owners:

Walmart is the largest private employer in the United States, with 1.4 million employees. The company, which is number one on the Fortune 500 in 2013 and number two on the Global 500, had $16 billion in profits last year on revenues of $473 billion. The Walton family, which owns more than 50 percent of Walmart shares, reaps billions in annual dividends from the company. The six Walton heirs are the wealthiest family in America, with a net worth of $148.8 billion. Collectively, these six Waltons have more wealth than 49 million American families combined. (p. 3, footnotes omitted)  

Compare that with Walmart’s similar description of itself on its website’s “Corporate & Financial Facts” page in its “News & Views” section (here):

Walmart serves customers more than 200 million times per week at more than 11,000 retail units in 27 countries. We employ 2.2 million associates globally, including approximately 1.3 million in the United States. Walmart is one of the largest private employers in the U.S. and Canada. For the fiscal year ended January 2013, Walmart increased net sales by 5% to $466.1 billion and returned $13 billion to shareholders through dividends and share repurchases. Walmart ranked second on the 2012  FORTUNE 500 list of the world’s largest companies by revenue.

The Walmart slogan, on its “Our Story” page, is: “Saving people money so they can live better.” It is true that Walmart strives mightily to charge the lowest prices on most of the things it sells. That is the cornerstone of its game plan. But Walmart’s contribution, ironically, is to incrementally worsen the lives others live, not improve them, while the Walton family prospers astronomically at the expense of the markets and societies it dominates. In broad terms, Barry Lynn explains why:

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 know as A&P, with violations of anti-trust 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&T was at the very height of its power. Indeed, Wal-Mart exercises a de facto complete monopoly in many smaller cities, and it sells as much as half of all the groceries in many big metropolitan markets. Wal-Mart delivers at least 30 percent and sometimes more than 50 percent of the entire U.S. consumption of products ranging from soaps and detergents to compact discs and pet food. (Barry Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, Wiley, 2010, p. 6.)

Monopolies impose uncompensated costs on societies, which is why they were illegal for so many years in America. Providing products and services at the lowest prices is only beneficial if those prices are established through effective competition, so consumers can be assured of getting real value and high quality for their dollars. Competition, under any version of conventional economic theory, reduces profits — and perfect competition reduces profits to zero. How, therefore, if Walmart customers were actually getting their money’s worth, has the Walton family managed to accumulate a net worth of $150 billion? 

The Walmart game plan, which ranges from control of suppliers to tax avoidance to the suppression of employee wages, is well documented. From a broad perspective, we know that tax breaks for large corporations, like General Electric, have generally reduced corporate contributions to the common (social) costs of society while enhancing their profits. Consider these recent comments from J. David Cox Sr., National President, American Federation of Government Employees, AFL-CIO:

There are two main reasons why Congress should let the tax extenders package stay dead. The first is, we simply can’t afford to let tens of billions of dollars in otherwise taxable revenue go uncollected each year. Just one year of this tax revenue would fund the creation of three quarters of a million public sector jobs, including teachers, first responders, highway crews and librarians. Creating these jobs would pay dividends for the employees, their families and the communities that tax breaks for big corporations simply don’t.

And that takes me to the second reason for keeping the tax extenders package dead and buried. By far, the main beneficiaries of these tax write-offs are mega corporations and wealthy individuals — folks who do just fine without any financial assistance from the government.

Most everyone has heard of General Electric. They “bring good things to life,” or so their commercials used to say. Nowadays, the only thing GE is interested in bringing to life is the tax loophole that enables the company to avoid paying its fair share in federal income taxes. The so-called active financing tax loophole, one of the 55 tax breaks that expired at the end of 2013, enables GE and other large corporations to make it appear that profits earned in the U.S. were generated in offshore tax havens like the Cayman Islands. 

The GE tax loophole alone costs taxpayers about $63 billion over 10 years. (“Congress Should Keep Lights Off on Tax Package That Nets GE Billions in Tax Breaks,” The Blog, Huff Post, April 2, 2014, here.)

The point is that tax avoidance by big corporations and their wealthy owners either robs society of public benefits (services and infrastructure) enjoyed by everyone or imposes the costs of those things more heavily on everyone else. In popular parlance these days, that amounts to the wealthy and the corporations not paying their “fair share.” Over time, this leads to depression. 

Here, our primary interest is in the narrower claim that Walmart enhances its profits still more by by imposing some of its operating (labor) costs on taxpayers and society when it pays wages that fall below the poverty level.

Walmart and taxation

ATF estimated that Walmart and the Waltons receive taxpayer subsidies and tax breaks estimated at more than $7.8 billion per year, enough to hire 105,000 new public school teachers:

  • $6.2 billion in federal taxpayer subsidies: “Walmart pays its employees so little that many of them rely on food stamps, health care and other taxpayer-funded programs” (p. 3);
  • $1 billion in federal tax avoidance through tax breaks and loopholes, including accelerated depreciation;
  • $607 million in personal FIT avoided by the Waltons through distribution of Walmart dividends.

The second and third elements point to ubiquitous aspects of the inequality problem: The low tax rates on corporate dividends and capital gains are at the heart of the income tax regressivity that is causing inequality and decline throughout the economy. Accelerated depreciation is a more subtle problem: When I was regulating utility rates, I would occasionally get an argument for lower rates through “economic depreciation,” a form of decelerated depreciation. The longer it takes to depreciate large capital items, however, the more interest and equity costs are accrued, adding to total cost reflected in rates, so we depreciated plant as quickly as feasible to keep costs and rates down. Walmart, however, presumably does not reduce its prices to reflect the tax savings from using accelerated depreciation. 

The recently controversial point here is the first one, that Walmart through wage suppression has paid so little that many of its employees are living in poverty and are forced to rely on public assistance to survive. This point has become a national scandal: Yesterday (5/21/14) ED Schultz reported (here) on the City of Portland, Oregon’s decision to divest all its Walmart investments because of the company’s perceived anti-social policies, including especially its refusal to pay its employees a living wage.

Schultz covered several points, including job losses in the U.S. from exportation of Walmart jobs to China, but focused mainly on Walmart’s low wages. According to Schultz, Walmart’s low wages cost taxpayers $5,815 annually per Walmart employee. Using Walmart’s figure for its total U.S. employment, that works out to about $7.6 billion of total subsidies, higher than the ATF estimate of $6.2 billion.  Schultz pointed out, as did Barry Lynn in his book, that this abuse of its monopoly market power enables Walmart to effectively undermine small businesses, destroying their potential competition.

In 2007, a grass roots public interest group “Good Jobs First” published a “Wal-Mart Subsidy Watch” on the internet (here) providing state-by-state estimates of Walmart’s “use of public money”:

This includes more than $1.2 billion in tax breaks, free land, infrastructure assistance, low-cost financing and outright grants from state and local governments around the country. In addition, taxpayers indirectly subsidize the company by paying the healthcare costs of Wal-Mart employees who don’t receive coverage on the job and instead turn to public programs such as Medicaid.         

The issue has blossomed in the last five years, as Walmart employee reliance on public assistance has grown. Good Jobs First promised to continue its efforts, but apparently has not done so. (My call to its Washington, D.C. number accessed an answering machine, but no one was available to take my call.) Thus, it appears, Portland, Oregon’s stand has been the first major development in a few years to attract attention to Walmart’s game plan.

Rebuttal

In a recent Forbes Op-ed (“Fantastical Nonsense About WalMart, The Waltons And $7.8 Billion In Tax Breaks,” April 14, 2014, here), contributor Tim Worstall offered the following responsive arguments:

  • The ATF report is “full of the most fantastical nonsense”;
  • The writers of the report misunderstand “how taxes and benefits work” and came up with a nonsensical ($7.8 billion) total;
  • Americans for Tax Fairness “appear to me to be rebels without a clue”;
  • With respect to the argument that “Walmart pays its employees so little that many of them rely on food stamps, health care and other taxpayer-funded programs,” Worstall argues that “much of that $6.2 billion is actually a cost to WalMart, not a benefit;”  
  • With respect to the other two points about tax-avoidance, Walmart and the Waltons are simply obeying the law.

I’ll give Worstall a pass for his name-calling and posturing; it’s par for the course in political Op-ed writing. When it comes to trying to figure out the truth, however, we need to look past appearances and authoritative posturing. For example, the argument that Walmart is simply obeying the “law” is far too facile:

(1) That claim overlooks the fact that corporations like GE, Mobil/Exxon, and Walmart (created in 1963) were part of the political movement that created tax laws favorable to them after 1980;  

(2) The ATF report does not argue that Walmart has violated the these tax laws. Beyond receiving inherently favorable tax treatment, moreover, Walmart, like most big corporations, has tried to take advantage of any available loophole to minimize its taxes. In some cases, it has arguably ignored the spirit and intent of the law — for example, by deducting rent it pays to itself on state level tax returns (Wall Street Journal, February 1, 2007, here). Unlike ordinary households, big corporations can and do typically litigate unfavorable tax rulings aggressively in the courts, even in support of unsound positions.

Still, I’ll give Worstall a pass on this one too – ATF can properly be characterized as arguing that Walmart and the Waltons are getting unfair, not illegal, tax treatment.

With respect to the $6.2 billion estimate, the core point, Worstell relied on obfuscation: He first explained how ATF estimated the nationwide cost to taxpayers of Walmart employees use of public assistance programs, then pointed out that programs included in this estimate “include the National School Lunch Program, School Breakfast Program, Section 8 Housing Program, Earned Income Tax Credit, Medicaid, Low Income Home Energy Assistance Program, and the Supplemental Nutrition Assistance Program (SNAP, commonly known as food stamps).” Then he argued:

The problem with this is that only one of those programs is a subsidy to WalMart: all of the others are subsidies to the workers and thus are, in fact, costs to WalMart.  * * * Benefits that you get out of work are not benefits to potential employers. They are costs to them, for they raise your reservation wage.

Worstell’s arguments, however, are insensible. The argument is not that Walmart is receiving subsidies, but that its failure to pay a living wage forces taxpayers to provide assistance to Walmart employees, by an estimated $6.2 billion annually. The argument that these programs impose additional costs on Walmart is the actual “fantastical nonsense”: The “reservation wage” — which is the theoretically lowest wage rate at which a worker would be willing to accept a particular type of job (here) — does not go up just because the wage already accepted by Walmart workers is supplemented through public assistance. There isn’t even a hint from Worstell that Walmart might somehow be forced to pay more because its workers are receiving public benefits.

This was quickly followed by two even more ridiculous arguments:

  • First, imagine Walmart didn’t even exist – its employees would still be getting these payments, so they cannot be construed as subsidies to Walmart. (Or, they might not be unemployed – they might be working for employers that are actually paying a living wage);
  • Second, they would actually be receiving more taxpayer money without their Walmart jobs. (So what’s the point? That Walmart is actually saving taxpayer dollars by existing and hiring people who would otherwise be unemployed?)

Worstell presumes, then rationalizes, his own conclusion — that Walmart benefits society. His arguments, however, reveal a cynical contempt for the very idea that American workers should make enough money to live on. He apparently won’t accept that big corporations could have a responsibility to pay American workers a living wage, but he does appear to believe he can disguise that antisocial view behind rhetoric suggesting that Walmart’s policies can somehow be seen in a socially favorable light.       

The Capitalist Endgame

Walmart’s game plan for maximizing its profits shows how heartless capitalism can be in practice. Ed Schultz pointed out that Walmart could pay all of its employees a living wage by raising its prices less than 2%. But that might reduce somewhat Walmart’s stranglehold on retail markets. There seems to be no room in Walmart’s game plan for manufacturing or even for retail staff at American wage scales.  

To me, like the minimum wage issue discussed in my last post, understanding the Walmart game plan is crucial to understanding what kind of a society we have become. But the economic consequences of Walmart’s profiteering go way beyond these details. It was Tim Worstall who made the now-famous observation in December of 2011 that six Waltons had more wealth than the bottom 30% of Americans (here) . In itself, however, that is not a particularly useful piece of information. What we need to know is how much the Walton wealth is increasing each year, together with all of the wealth held by the rest of the top 1%, top 0.1% and top 0.01% of wealth-holding households. With that information we can compute how quickly the wealth of the bottom 99% is being sucked out of the active economy.

Walmart had a profit of $16 billion in 2013, money that is not trickling back down.  For the entire U.S. economy, however, total U.S. corporate profits had continued to rise sharply, reaching a record high of $1.7 trillion in 2013.  At the same time, workers’ share of national income had fallen to the lowest level since WW II (here).  These figures reflect the ever-widening income inequality that directly results in the accelerating concentration of wealth. About 25-30% of that, evidently, results in more wealth for the top 1% — its net worth is increasing, I estimate, by $400-700 billion per year — with devastating consequences for the bottom 99% economy. Much of that is extracted ultimately from new money borrowed by the federal government each year, but much of it still comes from the increasingly impoverished middle class.

Walmart provides a useful object lesson, a useful template for the many levels of corporate malfeasance that in more prosperous times were against the law.  Sadly, “saving people money so they can live better” is not the contribution Walmart is making to America. But to better understand how, and how much, big corporations collectively are hurting the economy we must shift our attention to the big picture. The inequality growth spiral has gone on way too long and, I fear, we have now reached capitalism’s endgame.   

JMH – 5/22/2014 (ed. 5/23/2014)

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Why Economics Failed: The Parable of the Minimum Wage

economist mod econ theory

(Illustration by John Berkerly for The Economist, July 16, 2009)

“Macroeconomics” is, of course, to be distinguished from “microeconomics.” Macro-economics deals with economic affairs “in the large.” It concerns the overall dimensions of economic life. It looks at the total size and shape and functioning of the “elephant” of economic experience, rather than the working or articulation or dimensions of the individual parts. To alter the metaphor, it studies the character of the forest, independently of the trees that compose it.  — Gardner Ackley, Macroeconomic Theory,  Macmillon, 1961, 1963,  (p. 4)

An eminent member of the University of Michigan faculty, Gardner Ackley was an important and influential economist. He was appointed by President Kennedy to the Council of Economic Advisors, and promoted to Chairman of the CEA by Lyndon Johnson. Fifty years ago, however, he may have been even better known in academic circles for his legendary and groundbreaking textbook on macroeconomics. 

It was my intense interest in macroeconomics that propelled me into the PhD program at the University of Michigan following graduation, with honors in economics, from Oberlin College in 1966. At Oberlin, I had learned about macroeconomics from Ackley’s text, and his approach to economics — his incisive logic and unpretentious objectivity — had intensified my interest in the field. Ackley had convinced me that, although there may never have been a “bright line” between microeconomic and macroeconomic theory, there are crucial differences that must be understood and respected between the way an aggregate economy behaves and the behavior of individuals and firms. 

When I was in graduate school at Michigan, Gardner Ackley was away, but I did have one memorable encounter with him, and it was the highlight of my academic experience. In 1970, my senior year of law school, I wrote a paper for a labor seminar discussing the incompatibility of full employment and price stability — stagflation. The paper is gone now, and I don’t remember exactly what I wrote, but I do remember emphasizing structural unemployment and the impacts of the Vietnam War; and I remember that it earned an “A” from Gardner Ackley, the guest reviewer my professor had asked to read it.

Recently returned from his assignment as Ambassador to Italy, Ackley had completed his years of public service. It did not come to light until many years later that in 1966 he had recommended to President Johnson that he raise taxes to pay for the Vietnam War (here). For the delay until 1968 in passing the recommended tax increase, Paul Samuelson later said, “we paid dearly in the inflation of the 1970s” (here).

Rereading his textbook today reveals that Ackley’s influence on me and the way I understand economics is incalculable. I am forced to wonder whether my own frequent use of the forest metaphor for macroeconomics, a full half-century later, might be traceable to an embedded memory of the quoted passage. In truth, his use of the metaphor was not entirely apt: He not only showed that the line between macroeconomic and microeconomic theory was hazy and occasionally non-existent, but he also adeptly traversed the ground between the “trees” — the mathematical and graphical representations of complex macroeconomic models and theories — and the “forest” — the broad high-altitude perspectives and implications of ground-level analyses. Ackley clarified what economic theory tells us will happen under specific assumptions, and he carefully described the limitations imposed on the use of a model by its underlying assumptions and by the limitations of data. 

The Descent into Confusion

Today, mainstream macroeconomics is in a meltdown. It has no satisfactory explanation for the steady rise of income and wealth inequality over the last 30-35 years in the United States or the consequences of that long trend, and in the last few years it has been struggling even to make reliable “short-run” forecasts. Long-run growth forecasts remain inherently unreliable, little more than extensions of recent trends in unemployment or GDP. I have for several years been reviewing the history of economic theories to help pinpoint what has gone wrong with economics, and it turns out that Ackley’s insights, fifty years after he published them, can make a huge difference in explaining and justifying a new framework for a “distributional macroeconomics” and reconciling it with Keynesian macroeconomics. 

That progress in “scientific” macroeconomics had already stalled somewhere along the way from Adam Smith to John Maynard Keynes, and never recovered, is now becoming indisputable. Consider the recent frank concessions of Raj Chetty, a Harvard economist who in 2013 was awarded the biennial John Bates Clark medal, an honor bestowed on the the American economist under the age of 40 who has made the most significant contribution to scholarship in the field. In defending the “science” of economics (“Yes, Economics is a Science,” The New York Times, October 20, 2013, here), Chetty conceded that mainstream economics is still struggling to answer the basic questions of macroeconomics, namely, the causes of growth and decline, and that the profession does not yet adequately understand the mechanics of how market economies work:

It is true that the answers to many “big picture” macroeconomic questions – like the causes of recessions or the determinants of growth – remain elusive.

I have been emphasizing this concession ever since (e.g., see my December 2013 post “Economics: The Lost Science,” here), in light of the persistent decline of mainstream, popular economics into ideology:

That this should still be so is amazing, when the basic features of a market economy’s functional mechanisms had occurred, untested, to Adam Smith 237 years ago (Wealth of Nations, Book II, Ch 3). Yet we see today a discipline almost entirely dominated by ideological fantasies like “trickle-down,” an upside-down notion which unabashedly proclaims “less is more” and, somehow, enlists support from the victims of the extreme inequality it engineers.

The continuing confusion surrounding “big picture” issues that I so superciliously dismissed as “amazing” is actually understandable (though not excusable) for several subtle reasons that are revealed in Ackley’s analysis. After rereading his book, I immediately began writing a post for this blog to explain how Ackley’s legacy can help us find the “elusive” answers to Chetty’s “big picture” questions, a post that quickly turned into a two-part series. Two days ago, however, a strange parable on the minimum wage began to develop in my daily routine, suggesting that this post on the minimum wage would serve as an ideal introduction to the other two posts, which will follow soon.

Credit Chetty for distinguishing between “the causes of recession,” which have routinely been addressed since John Maynard Keynes as short-run, cyclical phenomena, and the determinants of long-term growth. Economic phenomena are complex and messy, and any economic model is necessarily an oversimplification. Economic models employ simplifying assumptions to focus on the most important variables, but these assumptions often conflict so much with what actually happens in real life experience as to call into question the validity of the models themselves. That is exactly what was going on when Keynes developed his General Theory of Employment, Interest and Money. Keynes put it this way: 

The celebrated optimism of traditional economic theory, which has led to economists . . . . [teaching] 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 so is to assume our difficulties away. (Ch. 3, “The Principle of Effective Demand”)

Gardner Ackley’s analysis showed how both the classical and Keynesian models depended on demand (spending) to achieve short-run full employment “equilibrium.” His book covered the field as he found it in the early 1960s, and it revealed that the profession’s understanding of long-term growth was still immature and unsettled, and that little was as yet understood about the determinants of overall prosperity and growth. That this was still true in 2013 has been confirmed by Raj Chetty. Indeed, mainstream economics is even incapable today of properly assessing the effects of the minimum wage on employment and growth.

Growth, and the Minimum Wage

My parable begins early Thursday morning, just after 7:00 a.m. I had been up well past midnight working on my discussion of the Ackley legacy, and diminishing returns had set in. I arose at 6:00 however, because I had a 7:00 a.m. appointment for a tooth extraction. When I arrived, my dentist went right to work, giving me a series of shots. He then left me alone for a while to let the numbing process take effect. His assistant handed me the TV controller, and I switched through the channels until landing on C-Span, which was broadcasting “The Washington Journal.”  

Greta Brawner was hosting this broadcast of the The Washington Journal (Thursday, May 1, 2014, here).  Reviewing her program later, I noted that she had headlined the broadcast with a story of declining growth in the first quarter of 2014, in which growth had slowed to an annualized 0.1 %, attributable according to her source to an especially cold winter. While waiting for the anesthetics to kick in, I had switched to C-Span somewhere around 7:15, finding Ms. Brawner’s call-in show in progress, and she was asking viewers for their opinions on how to stimulate economic growth. 

This ought to be good, I thought. I did not yet know her name, but it seemed remarkable to me for the host of a major news program to be asking for views on the causes of growth from the general public, which on average has virtually no knowledge of economics, and no notion whatsoever of the mechanics of growth. It seemed especially ironic to be soliciting such uninformed views at a time when the mainstream economics itself had admitted to finding an understanding of the mechanics of growth “elusive.”  

Ms. Brawner had a stack of news story enlargements in front of her, and when someone called in with a point she wanted to pursue she read quotes from these articles, and people who wanted to emphasize private sector freedom over government intervention, it appeared, were getting more of her time and attention. Before long a caller identifying himself as a political independent offered an unusually comprehensive response. He said he would raise the minimum wage, close tax loopholes for billionaires and corporations, hold corporations responsible for environmental damage, and invest in infrastructure and education.

Well prepared for such a call, Ms. Brawner turned immediately to the issue of the minimum wage, citing a recent Congressional Budget Office (CBO) report concluding that increasing the minimum wage to $10.10 would actually reduce employment by somewhere between zero to one million jobs. Shortly thereafter, the dentist returned and began to extract my tooth.  Later that morning, I retrieved the February, 2014 CBO report “The Effects of a Minimum-Wage Increase on Employment and Family Income” (here), scanned it, and saved it for further review. I replayed the Brawner show, discovering that she had also run a lengthy clip of Mitch McConnell, in an address at the Senate, firmly berating Democrats for hurting the people they claim to be trying to help: We all know, McConnell insisted, that the proposed increase in the minimum wage would cause the loss of one million jobs. 

Why Economics Fails

Fortuitously, the next morning’s New York Times arrived with Paul Krugman’s Op-ed entitled “Why Economics Failed” (here). Krugman had been teaching a class on “The Great Depression: Causes and Consequences.” It was fun, he reported, but:

I found myself turning at the end to an agonizing question: Why, at the moment it was most needed and could have done the most good, did economics fail?

He focused on topics he frequently addresses, including budget deficits, interest rates, and inflation, but his core message was about decline, the opposite of growth:

The financial crisis and the housing bust created an environment in which everyone was trying to spend less, but my spending is your income and your spending is my income, so when everyone tried to cut spending at the same time the result is an overall decline in incomes and a depressed economy. And we know (or should know) that depressed economies behave quite differently from economies that are at or near full employment.  

Coincidentally, Krugman’s explanation of the core problem of insufficient demand was given in terms of the failure of “Say’s Law,” as (I have recently discovered) it had been reframed by Garner Ackley 50 years ago. Supply does not automatically create its own demand, and therefore the failure of economics to which Krugman refers is its failure to recognize Keynes’s “principle of effective demand”: Just as reduced demand causes decline, increasing demand is needed to stimulate growth, as the caller on whom Brawner had unleashed McConnell’s tirade the previous morning appeared to understand. Krugman continued:

And the diagnosis of our troubles as stemming from inadequate demand had clear policy implications: as long as lack of demand was the problem, we would be living in a world in which the usual rules didn’t apply. In particular, this was no time to worry about budget deficits and cut spending, which would only deepen the depression. When John Boehner, then the House minority leader, declared in early 2009 that since American families were having to tighten their belts, the government should tighten its belt, too, people like me cringed; his remarks betrayed his economic ignorance. We needed more government spending, not less, to fill the hole left by inadequate private demand.

Given that government programs consistently redistributing money to people who will quickly spend most or all of it (like unemployment insurance and food stamps) stimulates growth, it would seem to follow that similar private sector wage increases, and a higher minimum wage, would do the same.     

Reflections on the “Law of Effective Demand”

I call Keynes’s principle of effective demand the law of effective demand because it is as close to an inviolable “law” as economics has got. People must have money in order to buy things.

I finished my coffee, put down the New York Times, and headed off to a an appointment I had with my podiatrist that morning. He asked me about my work in economics, which we had discussed on an earlier visit, and I told him that I had learned about the February 2014 CBO conclusion that increasing the minimum wage would substantially reduce employment, and that I needed to study that report closely:

“When you think about it,” he replied, “that makes sense.”

“Why?” I asked.

“If their wage costs are going up, employers will have to cut back on production and jobs in order to stay profitable.”

“Perhaps,” I responded, “but it’s not that simple: Employer responses to short-run cost increases are only a part of the issue. There is also an economy-wide stimulation from all of the additional money circulating in the economy as a result of paying the minimum wage, creating more jobs .”    

His eyebrows rose. He smiled and rubbed his chin, and told me he wanted to see what I was writing about economics.   

The CBO Report

Pages from CBO effect of Minimum Wage on employment feb 2014

In its first figure (p. 5) CBO calls our attention to the scale of the two proposals it reviewed, increasing the minimum wage to  $10.10 and to $9.00. The latter would raise the minimum wage to the level of bottom 10th percentile of “workers wages” (in $2013 dollars) and the former to the a level midway between the bottom 1oth percentile and the bottom 25th percentile wage levels. 

The chart also reveals that real wages at and near the bottom have remained stagnant since the 1970s, and have fallen significantly since the start of the Great Recession in 2009. And it shows that the minimum wage has remained below the 10th percentile median wage, barely staying at roughly the same inflation-adjusted level for about 25 years.  

This says nothing, however, about overall growth, to which aggregate employment is closely tied. On that score, CBO forecasting is inherently problematic. Note that CBO projects that real hourly wages at the bottom will grow from here on out. But we know that cannot happen with inequality continuing to rise, without (a) a significant increase in unemployment and/or a significant reduction in per capita hours worked, or (b) a major increase in aggregate growth. Aggregate growth is not increasing, which is ostensibly why Greta Brawner devoted here show to discussing growth: Indeed, she reported a significant decline of first quarter growth to an annual rate of 0.1%, which was shrugged off as the result of a cold winter.

These are broad implications of CBO forecasting that are unrelated to any changes in the minimum wage. CBO has never, so far as I know, considered the impacts of income and wealth redistribution on growth, and failure to consider those impacts seriously compromises CBO forecasting. We now know that income growth after WW II, a period of declining inequality, was far more robust than since since 1979. This graph, for example, compares growth rates for per capita national income, average bottom 90% household income, and top 1% income, between two consecutive 30-year periods, 1946-1976 and 1976-2006.  

3-27-08tax2-f2b

It is important to note that overall national income growth (the yellow bar) was about one-third lower when income inequality was growing. Income inequality has continued to grow, and its growth has accelerated, since the Crash of 2008. These facts make the CBO projection of rising wage rates at the very bottom of the bottom 90% (the blue bar) wildly unrealistic. Realistically expected aggregate growth cannot sustain such averages at the bottom without, as I indicated, a major reduction in hours worked by the bottom 10% and bottom 25%, and that implies greatly increasing unemployment.

Since there is unrecognized unemployment growth built into CBO modeling, it is difficult to see how much credibility we can give to the CBO claim that increasing the minimum wage all by itself will cause a major reduction in employment. The best we can do is to try to understand CBO’s reasoning process.

The CBO Reasoning 

The report opened with a discussion of the isolated effects the CBO expects the minimum wage to have on the incomes of low-wage workers:

Increasing the minimum wage would have two principal effects on low-wage workers. Most of them would receive higher pay that would increase their family’s income, and some of those families would see their income rise above the federal poverty threshold. But some jobs for low-wage workers would probably be eliminated, the income of most workers who became jobless would fall substantially, and the share of low-wage workers who were employed would probably fall slightly (p. 1).

CBO then estimated that the proposed $10.10 minimum wage would increase the earnings of low-wage workers by $31 billion. (p. 2)

Beyond that, however, CBO merely listed a series of apparently subjectively evaluated factors, then jumped directly to its findings, without revealing its approach to forecasting or explaining how it reached its conclusions. CBO began its lengthy discussion (pp. 6-8) of how increases in the minimum wage affect employment and family income with this:

According to conventional economic analysis, increasing the minimum wage reduces employment in two ways. First, higher wages increase the cost to employers of producing goods and services. The employers pass some of those increased costs on to consumers in the form of higher prices, and those higher prices, in turn, lead the consumers to purchase fewer of the goods and services. The employers consequently produce fewer goods and services, so they hire fewer workers. That is known as a scale effect, and it reduces employment among both low-wage workers and higher-wage workers.

Second, a minimum-wage increase raises the cost of low wage workers relative to other inputs that employers use to produce goods and services, such as machines, technology, and more productive higher-wage workers. Some employers respond by reducing their use of low-wage workers and shifting toward those other inputs. That is
known as a substitution effect, and it reduces employment among low-wage workers but increases it among higher-wage workers. (p. 6)

Beyond the potential for scale and substitution effects to reduce output and employment, CBO mentioned that employers’ costs could be aggravated, following a minimum wage increase, by attempts to preserve wage differentials above the minimum wage, and that higher wage rates can be implicated by collective bargaining agreements that tie wage increases to the federal minimum wage.

CBO did not entirely dismiss the increased demand generated by $31 billion of additional income, but its conclusions were guarded:  

An increase in the minimum wage also affects the employment of low-wage workers in the short term through changes in the economy-wide demand for goods and services. A higher minimum wage shifts income from higher-wage consumers and business owners to low-wage workers. Because those low-wage workers tend to spend a larger fraction of their earnings, some firms see increased demand for their goods and services, boosting the employment of low-wage workers and higher-wage workers alike. That effect is larger when the economy is weaker, and it is larger in regions of the country where the economy is weaker. (p. 7)

Discussion

All of the factors CBO mentioned are relevant, but there is no coherent evaluation of their importance, and CBO left the impression that it was rationalizing subjective conclusions that lack firm support. The report conceded that its conclusions were controversial: “There is a wide range of views among economists about the merits of the conventional analysis.” (p. 6) Here are some problems I see with CBO’s reasoning:

1. One would expect some economy-wide reduction purchases of goods and services whose prices have been raised in response to a minimum wage increase. However, there are reasons to doubt the significance of any “scale” effect on employment:

a. The demand for many goods and services is price-inelastic, and increasing prices in these instances do not cause much or any decline in output and employment;

b. Many firms enjoying profitable sales of goods and services the demand for which is more price-elastic, may elect not to increase their prices at all, in the interest of maintaining or expanding their successful share or control of markets. Such firms would absorb a reduction in profits, expecting profit margins to fall anyway following a decline in sales if they did raise their prices.

2. That substitution effects in the “production function” might cause significant unemployment is a more speculative proposition. There are many factors involved in the feasibility of substitutions, and it does not seem likely that in many instances an increase in the cost of a firm’s cheapest labor would suddenly make substitution profitable or feasible:

a. The marginal cost and productivity of all factors of production are relevant, and it seems unlikely that the functions performed by the lowest-paid employees can often be more cheaply performed by making them more capital-intensive and less labor-intensive;

b. Any such cost-saving innovations would likely have already been introduced, and would not need to await the provocation of a minimum wage increase;

3. There is insufficient discussion of the demand-increasing effect of the wage increases:

a. The $30 billion of increased demand produced by a higher minimum wage would be immediate and significant;

b. The assumption that a minimum wage increase is offset by reductions in higher-level wages is speculative and unjustified. As already discussed, a minimum wage increase is more likely in most instances to simply reduce profits, preserving its stimulating effect;

c. This is a static assessment, giving no consideration to multiplier effects and the potential for additional investment and lasting improvement of long-term growth;

d. Admittedly, prospects for long-term growth are more likely from direct spending through government programs and investment (financed by progressive taxation), but there is no reason subjectively to conclude that raising the minimum wage will necessarily cause employment to decline at all, much less materially.

Conclusions

These are my main concerns in connection with CBO’s analysis and conclusions, and I’m sure that experts on the minimum wage would likely provide a deeper analysis of its implications. It is fair to say, though, that the CBO’s unexplained analysis is too speculative to be legitimately termed a “forecast,” and CBO’s forecasts are seriously compromised in any case by its use of supply-side models and its failure to account for the depressing effects of rising income inequality.

Reducing inequality will promote growth, and increasing the minimum wage seems likely to have a relatively small but potentially long-term effect of reducing inequality, or slowing its growth. The CBO report fails to demonstrate that a higher minimum wage of $10.10 will cause the loss of up to one million jobs, and it is not clear that it will reduce employment at all. People who are looking for an increase in the minimum wage to substantially reduce inequality, however, are overly optimistic.

Although about $30 billion of additional income would be added at the bottom via an increase in the minimum wage, according to CBO, some $400-700 billion of wealth is moving to the top annually through the normal channels of income and wealth redistribution, a process that affects everyone beneath the top 1% income classification, and has already wiped out most of the former middle class. Clearly, benefits from an increase in the minimum wage are dwarfed by the impact of increasing income and wealth inequality. There can be no long-term correction of inequality or its stunted growth until the problem is rooted out at its source, by reinstating progressive taxation.

I have seen no indication that CBO understands the importance of demand to economic growth. The basis for such an understanding will be more fully addressed in my future posts dealing with the legacy of Gardner Ackley.

JMH — 5/4/2014 (ed. 5/5/2014)

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The Time-Warp and the Three Milliseconds

navajo couple

(“Navajo Family Receives Electricity in Their Home for the First Time,” by Candice Naranjo, AP, April 13, 2014, here, and Sara Morrison, The Wirehere.)

Spread’s tunnel was not intended to carry passengers, or even freight; it was for a fiber-optic cable that would shave three milliseconds — three-thousandths of a second — off communication time between the futures markets of Chicago and the stock markets of New York.  * * *  Who cares about three milliseconds? The answer is, high-frequency traders, who make money by buying or selling stock a tiny fraction of a second faster than other players. * * *

[S]pending hundreds of millions of dollars to save three milliseconds looks like a huge waste. And that’s part of a much broader picture, in which society is devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return. * * * What are we getting in return for all that money? Not much, as far as anyone can tell. Defenders of modern finance like to argue that it does the economy a great service by allocating capital to its most productive uses — but that’s a hard argument to sustain after a decade in which Wall Street’s crowning achievement involved directing hundreds of billions of dollars into subprime mortgages.

In short, we’re giving huge sums to the financial industry while receiving little or nothing — maybe less than nothing — in return. [T]there is a clear correlation between the rise of modern finance and America’s return to Gilded Age levels of inequality. So never mind the debate about exactly how much damage high-frequency trading does. It’s the whole financial industry, not just that piece, that’s undermining our economy and our society. — Paul Krugman, “Three Expensive Milliseconds,” New York Times, April 14, 2014 (here).

“I always said that if I wasn’t studying psychopaths in prison, I’d do it at the stock exchange.” – Robert Hare, creator of the Hare Psychopathy Checklist and its variants, the most widely used diagnostic tools for psychopathic personalities.– Paul Rosenberg, “The Sociopathic 1 Percent: The Driving Force at the Heart of the Tea Party,” Alternet,  March 8, 2014.

The contrast is too glaring, and the stakes are too high. So as occasionally happens on a Monday morning, I must return to my blogging post. Having just completed a series of posts showing how the wealthiest Americans have used the borrowing power of the U.S. government, and a huge national debt, to amass unimaginable wealth at the expense of everyone else and of our nation’s future, I thought my work might be done for a while. But there was another issue lurking in the background, one not as straightforward as the national debt, that continued to concern me: That was the problem of private debt. Sure enough, this morning’s news provided a seemingly compelling need for an immediate comment on the conceptually more difficult private debt problem.  

Although Wall Street investment banking is just one of the vehicles seriously undermining our economy and contributing to inequality and decline, it is clearly one of the most significant, and certainly the most unscrupulous. I have been prompted to take a closer look at how Wall Street investment banking is seriously undermining our economy by today’s Op-ed from Paul Krugman.  In this article, he has reported on a Spread Networks fiber-optic cable, constructed and installed through tunnels in the Allegheny Mountains of Pennsylvania at a cost of hundreds of millions of dollars, in order to shave three-thousandths of a second off the time required to send information from the futures markets in Chicago to the stock markets in New York.        

The Time-Warp

I found today’s news filled with irony: On the same day we are told how fiber-optic cable providing such an amazingly tiny time gap will afford the crucial difference in making billions of dollars in arbitrage trading, we are also informed of a Native American community that is only now being wired, for the first time ever, for basic electricity.  Ironic it is, for sure, that pockets of American society have never received basic electric service, and it feels very much like an anachronism in the land of opportunity. But it is also truly ironic, with poverty on the rise and many Americans around the country unable to afford housing or utility services, that our society’s higher priority is to invest so heavily in the marginal ability of very wealthy people to get even wealthier.

This says a great deal about the state of American society: Surely, before pouring hundreds of millions into its project, Spread Networks concluded that the investment was worth the risk, that once in place, the expected profitability of the project would not likely be countered by legal regulation or by prohibitive taxation, either of transactions or incomes. Such is the state of Wall Street’s perception of its political power, and the power of the wealthiest among us. The only question for them, I feel certain, was whether they could do it, could procure all the necessary easements and other required permissions. When they found they could, the decision to go forward was a foregone conclusion.

Wall Street and its representatives in Congress have relentlessly shown indifference to the lives and well being of the American people, as we have seen in their positions on financial reform, health care, and all other social programs. The sociopathy of the political right gains more attention all the time. Incredibly, some Republican state governors, we are told, are intentionally hurting their own states’ citizens by declining medicaid expansion, throwing away money and jobs simply to stand in political opposition to Barack Obama.

The Three Milliseconds

This is, in my view, Paul Krugman’s most significant Op-ed in recent memory. The Krugman point emphasized in the Wall Street Journal (livemint.com, here) is this: “It’s the whole financial industry, not just high-frequency trading, that’s undermining our economy and our society.” Krugman might have argued that high-frequency trading is itself evil and harmful, that it could add to the ongoing concentration of financial wealth, or harm Wall Street trading by squeezing out marginally successful investors who lack the three millisecond advantage, but he did not. Nor did he comment on the potential addition of risk for the markets or investment firms themselves. Instead, he made a more important point, and quite strongly: Nothing the financial industry does to make money for themselves contributes anything to our real economy. All of its income consists, although he did not use the term, of what is commonly referred to as “economic rent.” 

Krugman has now taken an all-out stand against the excesses of investment banking in principle, pointedly recognizing that it is hurting our economy and creating inequality. I believe this is as far as he’s ever gone in attributing the inequality problem and economic decline to investment banking. What is more, even though he dismisses the economic significance of the three millisecond gimmick, he chose to discuss his condemnation of Wall Street in the context of relating this one quirky, hell-bent-for-glory, idea. In doing so, he has exposed the inherent, shameless evil of the Wall Street mentality. If Occupy Wall Street accomplished little else, it certainly started the conversation about Wall Street’s inherent sociopathy, and made it respectable.  I expect (and hope) that this latest Krugman post will get a great deal of attention. 

My position on the economics of inequality is slightly different, of course. I maintain that: “It’s the whole economic process, not just the financial industry, that’s undermining our economy and our society.” But a strong case can be made, and Barry Lynn does a heck of a good job of making it in his 2010 book Cornered: The New Monopoly Capitalism and the Economics of Destruction, that Wall Street strategies lie behind all or nearly all of the elements of the inequality machine that is bringing us down. 

At this point it’s hard to know which of those factors are the most crucial, but financial industry excesses are clearly in the running, and we need to continue to take them very seriously. They were, after all, the cause of the Crash of 2008, and they seem likely to provide the vehicle of our eventual downfall.

The Private Debt Concern

Money is debt, and the ability to increase or decrease the money supply lies in the system of private banks controlled by the Federal Reserve Bank. Banks create money when they extend loans, for example mortgage loans, up to multiples of their own assets, and they profit by charging interest on those loans.

In my last post, I discussed how the $17 trillion of national debt is contributing to inequality, among other things, by creating a “perpetual annuity” for the government’s creditors. It has been argued that, as much of a bind as we are in with the national debt, an even bigger problem is an out-of-control level of private debt.  That would include all business loans and home mortgage loans, all of the student debt, and the like. Consider this chart (from “It’s private debt, not public debt, that got us into this mess,” Michael Clark’s Instablog, May 7, 2012, here):

private debt 428250-13363801587809994-Michael-Clark

This chart uses the traditional approach of showing balance sheet items as a percentage of GDP. Thus, the national debt is shown as approaching 100% of GDP in 2012, the prime observation behind the Reinhart/Rogoff controversy discussed elsewhere in this blog. I disagree, however, that this chart shows a correct level of “private debt,” so I can see no basis in this chart for concluding that a high level of private debt relative to public debt is necessarily a major cause of concern. 

It is now clear that our public debt is undermining our government and society, through rapidly increasing income and wealth redistribution, and there may be a similar problem with private debt, but it’s not clear how big of a problem that might be. This graph does reflect the collapse of private debt and a simultaneous increase in public debt following the Crash of 2008: We know that the 2008 crisis was brought on by repackaging toxic debt and reselling it as subprime mortgages, resulting in defaults by unwary home owners who had refinanced their homes. The amount of private debt fell substantially with the defaults and foreclosures, and public debt rose when the Federal Government bailed out failing investment firms. The collapse of the housing bubble was a criminal “double-whammy” that drove the bottom 99% into a mild depression from which we have yet to emerge. 

Here is a graph of the finance industry’s share of GDP. This one is from the 2009 abstract, cited by Krugman, by Thomas Philippon, NYU, “Finance vs. Wal-Mart: Why are Financial Services so Expensive?” (p.3, here). Note that the shape of this graph is identical, from 1930 to 2012, to the Clark graph. If this is the same data in both cases, the Clark graph misrepresents that data showing the financial industry’s share of GDP as growing to several times total GDP:

Pages from Philippon_v3 (1)

What this graph shows is the “income share of finance,” and the designation “WN fin. NIPA” represents the data series from the Bureau of Economic Analysis that compares financial sector employee compensation to aggregate compensation, where the financial sector includes finance and insurance, but excludes real estate (here).

There is no way to directly know from this kind of information whether the entire economy is over-leveraged, but Krugman appears to be growing more concerned on that score, because of the rapid growth in financial sector income. In his post, he states: 

Specifically, the share of G.D.P. accruing to bankers, traders, and so on has nearly doubled since 1980, when we started dismantling the system of financial regulation created as a response to the Great Depression.

Krugman’s point is confirmed by the Philippon graph, which shows about a 4 percentage point increase in the financial market’s share of income since 1980, a considerable portion of the over 2o% increase in the top 1% share of income over that period identified by Piketty and Saez. This is clearly a major share of the problem.

I have noted in other posts a rising concern about the developing student loan bubble, with the balance of outstanding student loans now totaling well over $1 trillion. There may be others as well. We do not know where and when the next crisis point may arise, but Wall Street’s continuing drain on the economy is clearly a major factor driving the inequality growth cycle. Another bursting bubble would have catastrophic consequences, and an overall collapse at the top, of course, would ruin everything. 

Conclusion

The main point of connection between the bottom 99% economy and the top 1% economy is in demand and jobs. I have concluded that the top 1% has increased its net worth since 1980 by a reasonably estimated  $22-25 trillion. Our federal government is shutting down as a result, the bottom 99% is in an inexorable inequality spiral and a slowly deepening depression, and the level of the federal debt is almost beyond redemption. The United States needs a far more progressive tax structure in order to save its economy.

One of the main vehicles for top 1% wealth concentration has been the gaming of the financial markets. Remember, market economies are inherently unstable. If a small handful of traders were to increase its gains by getting a significant jump on the rest of the market in trading, that could seriously hurt the market, with unforeseen consequences. Such a trend would not bode well for growth, or for the reduction of unemployment. If stocks are trading at speculative prices now, and they may well be, the stock market would likely be a candy store for these rapid traders, who might remove a great deal more money from the active money supply as more people became mega-rich.

Importantly, Paul Krugman has reminded us that this strangely sociopathic development (my characterization, not his) is not our primary concern. The entire history of investment banking since the repeal of Glass-Steagall has had terrible consequences for our economy. Clearly, there is no upside for the bottom 99% — or, for that matter, for anyone — in an economy that could tumble out of control in a matter of milliseconds.

JMH – 4/14/2014 (ed. 4/15/2015)

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Inequality and the National Debt

national-debt-elmo-2012

(Mark McHugh, “Understanding the National Debt – Sesame St. Addition,” September 24, 2010 here) , updated April 17, 2012 (here)

Public credit affords such facilities to public prodigality, that many political writers have regarded it as fatal to national prosperity. For, say they, when governments feel themselves strong in the ability to borrow, they are too apt to inter-meddle in every political arrangement, and to conceive gigantic projects, that lead sometimes to disgrace, sometimes to glory, but always to a state of financial exhaustion; to make war themselves, and stir up others to do the like; to subsidize every mercenary agent, and deal in the blood and the consciences of mankind; making capital, which should be the fruit of industry and virtue, the prize of ambition, pride, and wickedness.

A nation, which has the power to borrow, and yet is in a state of political feebleness, will be exposed to the requisitions of neighbors. It . . . perhaps must lend, with the certain prospect of never being repaid. These are by no means hypothetical cases: but the reader is left to make the application himself. * * * 

The command of a large sum is a dangerous temptation to a national adminis-tration. Though accumulated at their expense, the people rarely, if ever profit by it: yet in point of fact, all value, and consequently, all wealth, originates with the people. – Jean-Baptiste Say, A Treatise on Political Economy, Chapter IX, Of National Debt, 1803 (here).

Two French economists, Emmanuel Saez and Thomas Piketty, have in recent years awakened us to the significance of growing income and wealth inequality, and in his much-hailed 2014 book Capital in the Twenty-First Century, Piketty has called our attention to an important aspect of the problem, the need to control the concentration of wealth. Two centuries ago, when rudimentary ideas about how economies work were just beginning to be formulated in the minds of political philosophers, another Frenchman, Jean-Baptiste Say, was among the first and the best of the new “classical” economists.   

Say, and several decades later the Englishman John Stuart Mill, each devoted a chapter in their books on economic principles to the important issues raised by the raising of national debt. Say opined, listing detriments that sound all too familiar today, that national debt in effect reallocates “value” and wealth originating with people in efforts that rarely benefit them. He regarded the activities of the state thus financed as frequently unvirtuous and, from society’s viewpoint, mostly wasteful. Mill (The Principles of Political Economy, Chapter V, “Of a National Debt ,” 1848, here) was at least equally critical of national debt:

The question must now be considered, how far it is right or expedient to raise money for the purposes of government, not by laying on taxes to the amount required, but by taking a portion  of the capital of the country in the form of a loan, and charging the public revenue with only the interest. * * *

[I]f the capital taken in loans is abstracted from funds either engaged in production, or destined to be employed in it, their diversion from that purpose is equivalent to taking the amount from the wages of the laboring-classes. Borrowing, in this case, is not a substitute for raising the supplies within the year. A government which borrows does actually take the amount within the year, and that too by a tax exclusively on the laboring-classes, than which it could have done nothing worse, if it had supplied its wants by avowed taxation; and in that case the transaction, and its evils, would have ended with the emergency; while, by the circuitous mode adopted, the value exacted from the laborers is gained, not by the state, but by the employers of labor, the state remaining charged with the debt besides, and with its interest in perpetuity. The system of public loans, in such circumstances, may be pronounced the very worst which, in the present state of civilization, is still included in the catalogue of financial expedients. 

Thus, Mill observed that in its practical effect national debt is a vehicle for redistribution of wealth to employers — a point ignored today. Beyond that, on the general question of whether to tax or borrow, he offered the common-sense test with which we are all familiar:

[T]he question really is, what it is commonly supposed to be in all cases—namely, a choice between a great sacrifice at once, and a small one indefinitely prolonged. On this matter it seems rational to think that the prudence of a nation will dictate the same conduct as the prudence of an individual; to submit to as much of the privation immediately as can easily be borne, and, only when any further burden would distress or cripple them too much, to provide for the remainder by mortgaging their future income. It is an excellent maxim to make present resources suffice for present wants; the future will have its own wants to provide for.

Among the classical economists, so far as I have discovered, there was no dissent from this “excellent maxim.” It was expected, in any event, that debts incurred were to be repaid as soon as possible after the financial emergency had passed. Say’s views also reflected Mill’s later understanding that national borrowing has the general effect of retarding private investment and employment:

There is this grand distinction between an individual borrower and a borrowing government, that, in general, the former borrows capital for the purpose of beneficial employment, the latter for the purpose of barren consumption and expenditure. A nation borrows, either to satisfy an unlooked-for demand, or to meet an extraordinary emergency; to which ends, the loan may prove effectual or ineffectual: but, in either case, the whole sum borrowed is so much value consumed and lost, and the public revenue remains burthened with the interest upon it.

That would not be entirely true, of course, if a government endeavored to invest in domestic growth; but why, other than to escape from a depression, would government borrow extensively to try to do that? And has the U.S. budget, over the last three decades, generally been a pro-growth budget?  

Say also discussed what would happen if a government ignored the maxim to borrow only when absolutely necessary, and engaged in perpetual borrowing:

When a government borrows, it either does or does not engage to repay the principal. In the latter case, it grants what is called a perpetual annuity.  * * * The governments best acquainted with the business of borrowing and lending have not, of late years at least, given any engagement to repay the principal of the loan. Thus, public creditors have no other way of altering the investment of their capital, except by selling their transferable security, which they can do with more or less advantage to themselves, according to the buyer’s opinion of the solidity of the debtor government, that has granted the perpetual annuity.

The U.S. Debt Problem

The United States has not run up more than $17 trillion of national debt to respond to any financial exigency, but rather to finance tax cuts for the wealthiest Americans and, consequently, to provide them with a vast increase in wealth (net worth). To help come to grips with this horrendous reality, let’s keep McHugh’s chart in front of us for closer inspection.

national-debt-elmo-2012The meaning of the information provided here bears closer attention:

          Per Capita Income

McHugh has, appropriately, shown the change in aggregate per capita income in the black columns in nominal dollars; adjusted for inflation, the black columns would show the median “real” per capita income declining over the past few years. Notably, these aggregate income numbers include both top 1% and bottom 99% income. The trend line for the top 1% per capita income would slope up (erratically, reflecting the Crash 0f 2008) indicating the generally increasing per capita income of the top 1%; the bottom 99% line, however, would be declining after 2007, reflecting the declining nominal median per capita income of the bottom 99%. 

There was some income growth after 1990, but as shown for example on the Piketty/Saez chart in the last post, this was an already severely reduced growth rate, as the growth of bottom 99% income had already declined sharply after 1980 when income inequality began to grow.

          Per Capita National Debt 

The exponential growth of per capita debt reflects debt interest compounding faster than the U.S. population. The U.S. debt has been a “perpetual annuity” for many years, meaning that all of the money needed to pay the interest is borrowed each year, and the principal balance keeps growing. In fact, the principal balance is growing rapidly, and as the interest burden grows relative to other government functions, the debt gets increasingly unmanageable.  The Obama Administration has been stressing that the deficit has recently been reduced. To reverse the growth of the debt, however, the government must run surpluses, and as long as lower 99% incomes continue to decline, given the regressive state of taxation, there is no prospect of surpluses ahead.  

Indeed, the Congressional Budget projects increases in budget deficits. In its latest report, “The Budget and Economic Outlook: 2014 to 2024,” February 2014 (here), and summary dated February 4, 2014 (here), the CBO projects increasing interest rates and inflation through 2014, and declining unemployment (from an estimated 7.0% in 2013 to 5.8% in 2017 and 5.5% in 2024 (p. 6). With this forecast in the background, here is the projection for the budget deficits looming ahead:

Year          Deficit ($billions)              Year          Deficit ($billions)

                        2013                -680                             2019                -752 

                        2014                -514                             2020                -836 

                        2015                -478                             2021                 -912 

                        2016                -539                             2022              -1,032

                        2017                -581                             2023               -1,047  

                        2018                -655                             2024               -1,074

This is not movement in the right direction. GDP is not predicted to double between 2014 and 2024, nor is population, so the perpetual annuity is projected to increase its stranglehold on federal government finance. The problem is not spending (see Outlays, Table 3-1). Government non-discretionary spending is, of course, projected to rise, but Social Security and Medicare expenditures are funded separately, and Social Security funding is not yet in trouble.  The expenditure that is rising the fastest, by far, is net interest expense, rising from the 2013 actual of $211 billion to $880 billion in 2024. Compare that steep rise, for example, with the expected growth in the discretionary defense budget from $625 billion in 2013 to $719 billion 2024. 

The fact that interest expense will soon exceed the entire defense budget underscores the awfully high price we pay for setting up this perpetual annuity for government creditors: Interest expense is projected to rise from 1.3% of total outlays in 2013 to 14.7% in 2024. Because interest compounds exponentially, the problem going forward is obvious.  

And every discussion of CBO projections of government tax revenues must be qualified by recognition that mainstream forecasting begins with the wildly inaccurate “supply-side” assumptions inherent in neoclassical thinking. We are not told how the CBO takes reduced consumption and incomes into effect, though we know that Fed forecasters have recently stumbled over this problem. We can, however, be reasonably certain that the bases for their growth assumptions, and for decline in unemployment to 5.5% by 2024, are no more than wishful thinking.

Here’s why: The increases in per capita national debt reflected in HcHugh’s chart, and the future debt increases reflected in the CBO projections, mirror and closely match the continuing increases in top 1% wealth. It bears repeating that the $17 trillion of national debt is the direct result of tax cuts for the rich; the national debt has done nothing but finance an increase in top 1% net worth. The rich have been allowed to retain more income as wealth, and that has caused and accentuated an inequality cycle driven by government spending. 

So far as I know, I am the only one so far to publish the estimated increase in top 1% net worth since 1980, and here is my graph:

my graph 1952-1982 c

The crucial point is that the increase in top 1% net worth has risen at about the same pace as the national debt (compare 1980 with 2012), only slightly faster. These numbers, derived from government net worth data, show top 1% net worth increasing by $17 trillion between 1980 and 2012 (in constant 2005 dollars). However, when account is taken of U.S. top 1% wealth increases from the “shadow economy” discussed in the last post, and stored in “off-shore” accounts, a reasonable estimate of the actual gain is $22-25 trillion.

Two points: First, in addition to money the federal government has borrowed ($17 trillion) to finance their growing wealth, the top 1% has gathered in an estimated $5-8 trillion from the bottom 99% over these years. The lower incomes and wealth of the bottom 99% have substantially reduced bottom 99% tax revenues. Second, and this is a critical point, this is going on right now: Between 2008 and 2012, $3 trillion transferred up. This should have been revenue provided to the federal government: instead of reversing this confiscatory trend, however, our representatives in Congress are letting it continue, and plotting to increase it.

          The budget death spiral

It cannot be over-emphasized that this destruction of our federal budget is the natural consequence of the reduced tax obligations of the rich and their corporations that have led to unimaginable inequality and depression for the bottom 99%.  Not only does a huge portion of the interest on the debt increase top 1% wealth, the proceeds of all of the government debt, including money borrowed from China or other countries, ends up profiting the top 1% as well: We are in an advanced stage of the income and wealth concentration process reflecting a systemic change in the economy; now virtually all income growth is at the top, and more inequality growth is a nearly automatic result of all government spending.  

Nor can it be over-emphasized that there was never any purpose for these tax cuts other than to make the very rich still richer. That these moguls did not anticipate the devastating consequences of their actions, looming just a few decades ahead, is no excuse. They are still denying those consequences, perpetuating a neoclassical “trickle-down” fantasy that requires total ignorance of economic reality to believe. The Paul Ryan budget calls for still more tax reductions for the wealthy (here). And the political right disingenuously and improperly argues for still more slashing of government programs in the name of “responsibility.” (E.g., “Analysis of CBO’s 2014 Budget and Economic Outlook,” Committee for a Responsible Federal Budget, here). 

Note that while CRFB correctly points out that our budget problems are not going away, on behalf of the wealthy it merely offers, like the Ryan budget plan, to make things worse, calling for a vague package of tax “reforms” which it surely must know, or at least suspect, is based solely on the no longer even marginally credible “trickle-down” myth. The economic right is either ignorant of economic realty or content to preside over the demise of the U.S. economy and society. 

Think about it  

The scope of this problem is beyond the abilities of our imaginations to comprehend, but let’s try. Mark McHugh, in “Understanding the National Debt (Sesame Street edition)” said this:

I’m tired of convoluted explanations of simple problems.  It distracts people from the truth, which is usually the intent of those doing the explaining.  The end result is large numbers of people pretending to understand things they don’t. Bernie Madoff’s “success”, ETFs, Treasury auctions, the housing market. 

The easiest way to confuse people is with numbers so mind-numbingly  big they mean nothing to the average person.  What’s 13 and a half Trillion dollars supposed to mean to Joe Sixpack?  

Thank you Mark, for that, and for translating the debt numbers into per capita figures for us. But now, let’s really think about it: McHugh’s figures show that the share of the national debt of every man, woman, and child in the U.S. grew from $32 thousand ($128 k for a family of four) in 2007 to $40,000 ($160 k for a family of four) in 2011. What could possibly have happened to our country, and in our lives, to have put each of us so deeply in (collective) debt? And perhaps more poignantly, how could each of the more than 300 million of us have picked up an additional $8,000 of national debt (federal spending for which our considerable tax dollars were somehow insufficient to pay) in just four years?

We can begin to see, I think, that such numbers are so mind-numbingly big that the answers to these questions actually become obvious. There really is no mystery here: The vast bulk of this money simply could not have been spent on us or on our country. And it does not take a lot of research to learn where the money actually went. 

Epilogue

These are the evils of which classical economics warned, but which have been rationalized and denied by neoclassical economics. Our country borrowed many trillions of dollars not because we needed to, but because the richest among us wanted to get richer, and didn’t want to pay taxes. Perhaps Martin Feldstein, the Harvard professor who helped Ronald Reagan get this debacle underway, merely didn’t understand how economies work. But then again, very few who professed to be economists back then actually did — and most still don’t. But a growing handful are learning. We are deeply indebted to Robert Reich and Joseph Stiglitz for all they are doing. Hats off as well to Mark McHugh, and to Société Générale strategist Albert Edwards who, I have recently learned, is sticking tenaciously to what appears to most analysts to be excessively bearish views about our economic future. 

The inequality problem has gotten so huge that it is sensible to worry about a backlash of denial or avoidance among reasonable people. But avoiding economic collapse is not our only serious problem. The world faces serious human population and environmental problems as well. This evening, Showtime debuts its climate change series “Years of Living Dangerously.” I watched the first episode on the internet yesterday, and one thing stands out in my mind today: A climate scientist whose work was followed by Don Cheadle showed how a devout Christian like herself could still be a scientist, and believe in the lessons of real world evidence. And she showed how other Christians could change their perspective and avoid denial: God has given us the ability to think for ourselves and make our own decisions, she explained, and in the end it is our own responsibility to help ourselves.

It does not appear that human civilization as we know it will last another century. My immediate concern is whether the U.S. economy can survive another decade. That could scare me into denial or inaction. What I fear more, however, is failing to do my best to help preserve our way of life for our children and our grandchildren.      

JMH – 4/13/2014 (ed. 4/14/2014)

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Inequality and Taxation

It’s not just Occupy Wall Street protesters that are worried about wealth and income inequality. Now people like Bill Gross, manager of the world’s largest bond fund at Pimco, are warning that the problem is making the U.S. less productive.

As noted by Société Générale strategist Albert Edwards, “you don’t have to be a communist to conclude that high levels of inequality not only adversely affects long-term growth, but also increases the economy’s vulnerability to recession.” * * * Wealth and income inequality in America is still getting worse by many measures. – Gus Lubin, Business Insider, November 12, 2013 (here).

Previous posts have established that market economies are unstable, meaning that income and wealth concentrates naturally at the top, and that growth rates decline with growing inequality. Thus, inequality growth and reduced overall growth are “two sides of the same coin.” The neoclassical notion that economies bounce along from one financial crisis to another, recovering toward optimal productivity and “full” employment between crises, is wrong. Rather, there is a gradual, inexorable decline — and the U.S. economy’s decline has been the least gradual in the world. This post and the next will explain how taxation is involved and show how it has been used to engineer the U.S. decline.

The remedy for stabilizing a market, as has long been known, is a system of “progressive” taxation, graduated taxation with the effective rates charged the highest levels of income and wealth sufficiently high to prevent increasing inequality. Progressive taxation both retards concentration and enables government to establish well-being and higher growth throughout an entire economy. This post explores the implications in the United States for growth and inequality of the abandonment of progressive taxation, and the following post explores its implications for the Federal government and the national debt.

The deterioration of the U.S. economy is the worst in the world among developed economies, by far. It isn’t just that the rich here have tended to get rich faster than the rich elsewhere: There has been a huge boost for them established by the reduction of their taxes over a 35-year period. Here is what has happened in the United States:

By 1980, wealth concentration in the U.S. was already substantial, due to the natural operation of the economy. Under the influence of wealthy interests and Milton Friedman’s “free market” philosophy, the Reagan administration began to lower the top rate of income taxation, among other things, making the tax system increasingly regressive. Inequality grew and the rate of growth slowed, both significantly. To maintain a high level of spending, the federal government began to run up the national debt as it continued to reduce taxes at the top, in several precipitous steps.

Instead of taxing rich people and corporations for its revenues, our government borrowed from them, adding still more inequality. After the crash of 2008, although an imminent depression provoked by the Bush tax cuts was narrowly avoided, declining revenues and increasing federal debt continued to hamper the federal budget. Since then, pressure from the political right developed to act “responsibly” and balance the budget, but not by raising the taxes the lowering of which had caused the problem, but by further eviscerating government programs. Such a plan is the height of irresponsibility, for it would further accelerate the already rapid decline and, in the process, eviscerate government. 

Personal Income Taxes

A series of charts will provides the clearest way to focus on the problem. This first chart, published by the Center on Budget and Policy Priorities (CBPP) in April of 2012 (here), shows a long decline in federal income tax revenue from a median-income family of four. The effective tax rate for the median family had declined from 12% in the early 1980s to 6% just before the Crash of 2008:    

Income tax rate US

We would expect federal income tax revenues to decline with a declining economy, but this trend also reflected growing income inequality within the economy, increasing the drag on federal revenues. Wages as a percent of the U.S. economy had also fallen over this same period from 49% to 44%, according to the St. Louis Fed chart presented by Gus Lubin (here):

wages-as-a-percent-of-the-economy

Thus, both wages as a percent of GDP and the average effective taxation of wages declined. Both of these trends can be traced to the growth of income inequality over this period, caused by the reduction of amount of taxation at the top, which of course meant lower revenue contributions from the wealthiest households as well. This next chart from CBPP (here) shows the trend between 1992 and the start in 2008 of the Great Recession in the average tax rate for the highest 400 households by income and the average level of their adjusted gross income:

Income tax rate plus top incomesOver a ten-year period, from 1996-2006, Average AGI of the top 400 taxpayers grew five-fold, yet their average tax rate declined from about 28% to about 18%. This shows the massive tax avoidance at the very top; this is the worst case of a much broader problem: The major decline in the progressiveness of income taxes, the principal control factor for income and wealth distribution, started much earlier (just after 1980) and it redounded to the benefit of far more than the top 400 American taxpaying households. The total impact is enormous: While inequality grew and federal revenues declined, our national debt increased from under $1 trillion in 1980 to over $17 trillion currently, replacing revenue that would have been collected from top incomes and corporations, had the effective federal taxation (of top incomes, capital gains, and corporate earnings) not been substantially reduced.

Income Inequality 

This chart, prepared by Thomas Piketty and Emmanuel Saez (here), shows the changing growth of top 1% income and bottom 99% income together with the trend in the top federal income tax rate:

DP8675b

(Note that the real income per adult of both the top 1% and the bottom 99% are indexed to 1913 = 100; the top 1% level was of course much higher than the bottom 99% level back then. Consequently, the actual difference between income levels is not shown.)

This graph shows that the reductions in the top (marginal) income tax rate immediately resulted in growing inequality, as reflected in the top 1% and bottom 99% income growth rates. This shows a remarkably close correlation between the change in the top marginal rate and change in the top 1% effective rate over the entire 1979-2008 period. Following each tax reduction, income at the top grew at a continuously faster rate thereafter because of the resulting higher concentration of wealth.

The reverse effect on the bottom 99% — the reduced rate of income growth — means that the aggregate rate of growth is somewhere in the middle; the aggregate income growth rate actually declined considerably over this period, as reported frequently on this blog.

The fact that this happened despite steadily increasing productivity explains the high degree of bottom 99% stagnation over the entire period, as shown in the previous post and in this chart (Mother Jones, July/August 2011 issue, here):

change-since-1979-300

It has been frequently observed, recently, that although productivity has steadily grown since WWII, since the start of the Reagan Revolution with the tax reductions for the very rich the top 1% has received an out-sized share of the rewards of increased productivity. We also know from other sources that only the top 10% has seen any income growth at all since 1979, and that since the Bush decline began (with the tax cuts for top incomes) in 2003, there has been no growth except within the top 5%. Since 2010, moreover, there has been no income growth outside of the top 1%. Both the increased rate of income growth at the top and the reduced rate of income growth at the bottom, accordingly, have resulted from the reduction of taxation of income and wealth at the top.

These developments were enabled by the growth of corporate power; individuals on their own could not command such a high level of income growth outside of the capitalist economic structure. Within the corporate structure, the growing spread between CEO pay and average worker compensation in the U.S. is startling. This report from August of 2011 (here) is one of several reporting a huge leap in the spread during the Clinton dot.com era, followed by a decline in the Bush years:

corp disparity-300x251 (1)The chart shows a multiple at 50x at the start of the inequality growth period in 1980, growing to 500x during the Clinton.com boom years before falling off in the Bush recession years. With the record success of the stock market in 2013-2014, these multiples are no doubt rising considerably again. This same source reported this comparison of the U.S. CEO/worker pay multiple in 2011 with that of other countries: 

corp tableThe information on CEO pay, however comprehensive it may or may not be, shows the U.S. to be in a category of its own. This is a graphic illustration of the high level of growing income inequality over the last 3-4 decades.

Corporate Taxes

Corporate CEOs and other heavily invested owners and officers have a great deal of flexibility today in deciding where to locate their operations and where to pay corporate and individual income taxes, if at all. Gone, for the most part, are the days when a company like GE was in integral part of a community (like Schenectady, NY or Pittsfield, MA) by virtue of the location of huge investments in relatively immobile industrial plant. Changes in the nature of work, the installation of massive fiber-optic communications networks, and a well-developed culture of mergers and acquisitions in investment banking, have made it easier for big companies to move around and “forum shop” taxing jurisdictions.   

Currently there is a “race to the bottom” today as states compete in attracting wealth and businesses to locate within their borders. For example, New York State continues to emphasize a program of  reducing the cost of government with strategies for attracting industry and jobs (Governor Cuomo’s “FY 2015 Executive Budget Plan,” here). The General Fund Financial Plan (p. 29), among other things: (a) combines the corporate franchise and bank taxes for “simplification and relief;” (b) reduces the tax rate on net income from 7.5% to 6.5%, “the lowest since 1968;” (c) reduces the net income tax rate on upstate manufacturers from 5.9% to zero, for 2014 and thereafter; (d) announces the elimination over three years of the temporary extension of the “18-a temporary assessment” (funding for utility company regulation) applicable to industrial customers, and acceleration of its eventual complete phaseout, and; (e) increases the exclusion threshold for the estate tax from $1 million to $5.25 million over five years.

Federal taxation of corporations has been declining since WW II, and the effective corporate tax rate has declined more sharply since 1987 (here):

corp tax corporate_profit_1950_2010

It has declined as a percent of GDP (here),

corp tax percent gdp

and very similarly as a percent of all U.S. tax revenue (here):

corp tax percent of total revs

Notably, although the effective corporate tax rate (the percent of profits) has steadily declined since the mid-1980s, corporate taxes bottomed out then as a percentage of all federal revenues, and of GDP, and have remained low.  The implication is that corporate profits have increased substantially as a percentage of GDP, while corporate tax revenues have remained at or near historic lows.

The tax loopholes built into federal laws for major oil companies, and the zero-tax returns of companies like G.E., in 2011, have become infamous. More recently, so have the tax avoidance approaches of major corporations as they “locate” their activities and profits in other countries. Consider these excerpts from a recent report by Flooyd Norris, “Switching Names to Save on Taxes,” New York Times, April 4, 2014 (here):

What was most impressive about this week’s Senate hearing into the way Caterpillar ducked billions of dollars in United States income taxes was the simple strategy involved. There was no subsidiary that somehow qualified to be taxed nowhere, as at Apple. There was no “Double Irish With a Dutch Sandwich,” a strategy made famous by Google in its quest to avoid taxes.

Instead, back in 1999, Caterpillar, helped by its audit firm, PricewaterhouseCoopers, decided that to sharply reduce the American tax on profits from the sale of parts sent from the United States to customers around the world, it had to do little more than take the name of the American parent off the invoices and put in the name of a Swiss subsidiary.

So even though the parts might have never come within a thousand miles of Switzerland, the profits accrued to the Swiss subsidiary. And Caterpillar negotiated a deal to tax those profits well below Switzerland’s norm. Senator Carl Levin, the Michigan Democrat who is chairman of the Senate Permanent Subcommittee on Investigations, put the rate at 4 to 6 percent. That cut the Caterpillar tax bill by $300 million a year. Was that legal? Opinions differ. * * *

What was most notable about the Caterpillar strategy was its sheer lack of creativeness. “This is boring as an intellectual matter,” said Edward D. Kleinbard, a tax law professor at the University of Southern California and a former chief of staff at the congressional Joint Tax Committee. If this strategy is vulnerable to legal challenge, he said, it would largely be because Caterpillar changed its corporate structure to save taxes. Had it had the foresight to adopt the structure decades earlier, the company would be on much safer ground.

Apple, he told me, set up an Irish subsidiary “as soon as it moved out of the garage.” He conceded that was an exaggeration, but not, he said, a large one. Under current corporate tax law, it is easy for multinational companies to park profits in subsidiaries based in low-tax countries. Companies that operate only in the United States find it much harder, although not always impossible, to avoid taxes.

It was interesting that Senator Levin was the only senator who appeared to be exercised over what Caterpillar and PricewaterhouseCoopers had done. “The revenue lost to those strategies increases the tax burden on working families, and it reduces our ability to make investments in education and training, research and development, trade promotion, intellectual property protection, infrastructure, national security and more — investments on which Caterpillar and other U.S. companies depend for their success,” he said. “It is long past time to stop offshore profit shifting and start ensuring that profitable U.S. multinationals meet their U.S. tax obligations.”

Not all the Republicans joined Senator Rand Paul, Republican of Kentucky, in offering an apology to Caterpillar for the existence of the hearing, but they generally agreed that it was proper for a company to do everything it could to avoid paying taxes. None of them seemed interested in the question of who should pay taxes if the companies do not. Nor was there the slightest indication of agreement with Senator Levin that corporate citizens, like individual ones, had an obligation to help pay for their government.

Instead, the preferred cure was to cut the corporate tax rate — now 35 percent, though virtually no multinational company pays anything near that amount. The country must become more competitive in attracting these companies, the senators said.

The current law of the land in America, as I understand it, is that corporations are “people” with constitutionally protected speech. “Money,” moreover, constitutes “speech,” so in spending their money corporations are exercising protected speech, and therefore they can spend their money virtually any way they want without government restraint. Resident “people” do have a legal obligation to pay taxes, but American culture appears to regard tax avoidance as a perfectly understandable, appropriate aspect of legitimate business practice; thus, corporations, whenever they can avoid or circumvent the normal rules of “residence,” legitimately have no obligation to support the operations or infrastructures of nations they inhabit, and whose people they profit from.    

The Shadow Economy

Not everyone sees it that way. The Tax Justice Network (TJN), for example, studies “tax evasion” in “shadow economies” around the world. In its 2011 report (“The Cost of Tax Abuse: a briefing paper on the cost of tax evasion worldwide” (here),  TJN argues that “tax evasion is the illegal non-payment of tax to the government of a jurisdiction to which it is owed by a person, company, trust or other organisation who should be a taxpayer in that place.” TJN estimated the absolute size of a country’s shadow economy, which is the portion of economic activity associated with tax evasion, based upon the country’s own published measure of GDP and recently reported data on the size of shadow economies published by the World Bank:

By the definition used here, economic activity in the shadow economy of a country will be tax-evading. So we next calculate an estimate of the amount of tax lost as a result of the existence of that shadow economy. We do this by looking at how much taxes are on average in the state as a share of GDP, and then apply that same tax share to the shadow economy, to reveal our estimates of lost taxes by state. (p. 2)

On this basis, TJN reported on 145 countries with a total of $61.7 trillion of reported GDP, 98.2% of the world’s total GDP, covering 61.7% of the world’s population. It estimated a world-wide shadow economy of $11.1 trillion which, at an average tax rate as a percent of GDP of 28.1%, resulted in a total tax evasion loss of $3.1 trillion. 

In its table of the ten biggest losers (p. 3) the U.S. ranks first, both in GDP and the size of the shadow economy. Total GDP is reported as $14.6 trillion, the size of the shadow economy is estimated at $1.3 trillion, a the tax revenue lost as a result of the shadow economy is estimated at $337 billion.

Inequality Growth

Corporations are the vehicles of huge incomes. Corporate executives minimize their own tax obligations by arranging corporate payments to them in ways that minimize their effective personal income tax rates. They lobby to create and take full advantage of tax shelters in federal law for the earnings of their corporations and lobby for grants, support payments, and lucrative government contracts. To the extent they can, they “locate” their domestic income in shadow economies overseas to avoid domestic taxation. They negotiate with state governments around the country in a “race to the bottom” to get the most favorable tax treatment they can for themselves and their companies in states in which it is viable for them to locate.

The end result of all of this collective activity is to greatly increase income and wealth inequality, reducing aggregate growth and causing a major decline in the economy of the bottom 99%. Because the collective tax system is regressive — that is it permits substantial transfers of wealth to a small handful of taxpayers at the very top, increasing their net worth by many billions of dollars each year — this is a continuing problem, and it is an accelerating problem with their compounding wealth.

The next post will take a close look at the implications of this trend for the federal budget and the operation of the federal government.

JMH — 4/10/2014 (ed. 4/11/2014)

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