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An imbalance between rich and poor is the oldest and most fatal ailment of all republics. – Plato
Here, in broad conceptual terms, is how growing inequality stifles the economy: The more that wealth and incomes become concentrated at the top of the economic ladder (the top 1%), the less there is to go around for everyone else (the bottom 99%). Thus, when firms decide to pay their CEOs and top management more they have less to pay other employees. Over time, this reduces consumer demand in the economy, because the bottom 99% has less money to spend. Companies that meet consumer demand then make less money, and the rate of economic growth decreases.
Similarly, when personal income tax revenues collected from wealthy people are reduced, government’s ability to stimulate the economy through public expenditures on such things as infrastructure and education declines. This too reduces consumer demand, and again economic growth declines.
Demand Drives Investment and Growth
This is the importance of inequality, and why inequality is the core factor in economic performance: Increasing the concentration of incomes and wealth within the top 1% automatically drives a suppression of demand in the bottom 99%, and suppresses economic growth. As well understood by John Maynard Keynes, and as Bruce Bartlett recently put it: “It’s the aggregate demand, stupid.”  We have learned that truth, in spades, over the entire past 80 years since the start of the Great Depression, and especially over the last 30 years. Robert Reich put it this way just last week:
Anyone who says the American economy suffers when the rich pay more in taxes doesn’t know history. We grew faster the first three decades after World War II than we have since. Trickle-down economics has been a cruel joke. 
Put simply, when you lower taxes on the wealthy and allow inequality of wealth and incomes to grow, you lower aggregate consumer demand and depress the economy. As Reich points out, that’s exactly what has happened since 1980.
This table is worth a close look, because it shows that Bartlett and Reich are right. It proves that Keynesian economics is right, and that “trickle-down economics” is a hoax. When the top 1% cut its tax responsibility beginning in 1980 and its share of incomes and wealth began to grow, its annual percentage of income growth actually declined slightly, while everyone else’s growth plummeted; the economy’s overall growth declined, to everyone’s disadvantage.
Here’s a more recent, similar graph, that shows total (rather than percentage) growth over similar periods for the top 1% and the bottom 90% (added 10/2/11):If the country had become much wealthier overall, perhaps the bottom 99% could have roughly maintained its standard of living, but that’s not what happened. As Robert Borosage relates, the bottom 99% has lost its former prosperity, and its level of poverty has grown:
The modern American dream was inspired by a growing middle class that was the triumph of democracy after World War II. Its promise was and is opportunity: that hard work can earn a good life—a good job with decent pay and security, a home in a safe neighborhood, affordable healthcare, a secure retirement, a good education for the kids. The promise always exceeded the performance—especially with regard to racial and ethnic minorities, immigrants and women—and America never did as well as Europe in lifting the poor from misery. But a broad middle class and a broadly shared prosperity at least provided the possibility of a way up.
Now that middle class is sinking, imperiled by an economy that does not work for working people. Twenty-five million Americans are in need of full-time work, wages are declining and one in six people lives in poverty, the highest level in fifty years.
Every element of the dream is imperiled. Wages for the 70 percent of Americans without a college education have declined dramatically over the past forty years, although CEO salaries and corporate profits soared. Corporations continue to ship good jobs abroad, while the few jobs created at home are disproportionately in the low-wage service sector. One in four homes is underwater, devastating what has been the largest single asset for most middle-class families. Healthcare costs are soaring, with nearly 50 million uninsured. Half of all Americans have no retirement plan at work, pensions are disappearing and even Social Security and Medicare are targeted for cuts. College debt now exceeds credit card debt, with defaults rising and more and more students priced out of higher education.
The economy works fabulously well for the few. The richest 1 percent capture nearly a quarter of the nation’s income and control about 40 percent of its wealth. They have pocketed almost all the rewards of the past decade’s economic growth. * * * [This has resulted] from policies that have weakened workers, liberated CEOs, starved social protections and savaged the middle class. 
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NEWS FLASH — I interrupt this discussion to report on Ed Schultz’ interview of Senator Rick Santorum, aired on MSNBC’s “The Ed Show” this evening (9/26/11) just as I was about to type this paragraph. Schultz questioned Santorum on this very topic. How would Santorum propose to help create jobs for the bottom 99%, he asked, in light of the 30-year growth of income inequality? Why wouldn’t he increase taxes on the rich? And Schultz asked Santorum directly and pointedly: How could reducing taxes on the “job providers” be the answer when jobs and worker incomes have declined drastically over the last 30 years, despite major tax decreases for the wealthy?
Then came the moment I knew I would see, a moment we have all seen and we will see over and over again when a Republican is asked that question: Santorum blinked, smiled, and quickly ducked the question.
Santorum said Americans have fewer jobs because jobs have been exported. (Agreed: There have been tax cuts for the rich and exportation of jobs. So, what’s the connection between taxation and domestic job creation?) He said he would bring economic growth to America by improving the “atmosphere” for business investment here, but he did not clarify that. He said he would vote to make the Bush tax cuts for the wealthy permanent.
The continuing theme of the Republican presidential candidates is that all our problems are due to government, and the taxation that supports it. Santorum implicitly endorsed trickle-down, though he attempted no theoretical support for it. Missing from the Santorum interview, as from all other Republicans’ pronouncements on economics and taxes I have heard, was any mention or understanding of the role of demand in determining the level of economic activity.
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Ending the Current Stagnation Requires Expansive Fiscal Policy
The 2007 economic crash was catastrophic, with major losses from the collapse of housing values coupled with a collapse in stock investment values. The outright loss of wealth was enormous. Earlier this year, the Fed reported that the average American family’s household net worth declined by 23% between 2007 and 2009:
The average American family’s household net worth declined 23% between 2007 and 2009, the Federal Reserve said Thursday (3/24/11). A rare survey of U.S. households, first performed in 2007 but repeated in 2009 in order to gauge the effects of the recession, reveals the median net worth of households fell from $125,000 in 2007 to $96,000 in 2009. 
That 23% represents an enormous amount of money, and the recovery has been slow:
Household net worth fell from 2007 to 2009 by a total of $17.5 trillion or 25.5%. This was the equivalent loss of one year of GDP. By the fourth quarter of 2010, the household net worth had recovered by a growth of 1.3 percent to a total of $56.8 trillion. An additional growth of 15.7 percent is needed just to bring the value to where it was before the recession hit in December 2007. 
About one-half of all financial wealth is in the hands of the top 1%, and the vast majority of the wealth of everyone else is in their homes. Thus, the Crash hurt the bottom 99% through both the stock market crash and the real estate crash, but mainly mainly through losses in the values of their homes. The value of homes declined by $9 trillion between Q2 2006 and December 2010,  and of course most of that $9 trillion loss fell upon the bottom 99%. As we know, the stock market rebounded, but housing values continue to slump in 2011. 
As this graph  shows, total U.S. net worth declined from about $66 trillion before the crash to about $58 trillion today. That $8-9 trillion of reduced wealth constitutes the decline in home values. In 2007, the top 1% held about 34% of America’s wealth. (Growth in Inequality of Wealth). The bottom 99% held about 66% of the wealth, roughly $44 trillion. The loss of $9 trillion of home values represents a 20% loss of net worth for the bottom 99%.
In short, the top 1% has recovered fully from the 2008 Crash, but the bottom 99% ended up losing 20% of its wealth. (Note the Fed’s recent report cited above that “the average American family’s household net worth declined by 23% between 2007 and 2009.”) And housing values are still in decline.
In the last post in this series, we cited Bruce Bartlett for a conclusion most economists have reached, that monetary policy (expanding the money supply and encouraging investment through lower interest rates) will not be enough to revive the U.S. economy now.  Increased spending will be needed, but government spending will not be approved by Rick Santorum and the other Republicans in the Senate and the House. Let’s take a closer look at Bruce Bartlett’s analysis on this:
That really leaves just consumers as a potential avenue for increasing spending. But that will be difficult as long as unemployment remains high, thus reducing aggregate income, and households are still saving heavily to rebuild wealth, which was decimated by the collapse in housing prices. Saving is, in a sense, negative spending.
Changes in wealth affect spending because people will spend a percentage of their increased wealth. And they are more likely to raise their spending when the wealth increase is perceived to be permanent rather than transitory. * * * A recent Federal Reserve Board working paper estimated that the long-run increase in spending from an increase in housing wealth may be as high as 9.1 percent per year. * * *
Home prices roughly doubled between 2000 and 2006, according to the Case-Shiller index, and many homeowners talked themselves into believing they would continue rising indefinitely. Thus they increased their spending and reduced their saving based not only on actual price increases, but also on expectations of future increases.
A prescient 2007 Congressional Budget Office study explained how this would affect spending and growth in the economy. It said that if people were expecting a 10 percent rise in home prices and instead they fell 10 percent, the impact on spending would be equivalent to a 20 percent fall in prices. The budget office estimated that this might reduce growth of gross domestic product by 2.2 percent per year. Since actual home prices have fallen by about a third, this suggests that G.D.P. may be $500 billion less this year than it would be if home prices had simply remained flat since 2006.
One way that the rise and fall of spending can be visualized is by looking at the velocity of money. This is the speed at which money turns over in the economy. When velocity rises, more G.D.P. is produced per dollar of the money supply. When velocity falls, the economic impact is exactly the same as if the money supply shrank by the same percentage.
The chart below comes from the Federal Reserve Bank of St. Louis and shows velocity as the ratio of the money supply (M2) to nominal G.D.P. It rose from 1.85 in 2003 to 1.96 in 2006. It has since fallen to a current level of 1.66. Thus one can say that each $1 increase in the money supply produced almost $2 of G.D.P. in 2006 and only $1.66 today.
Source: Federal Reserve Bank of St. LouisVelocity of M2 money supply, expressed as the ratio of quarterly nominal G.D.P. to the quarterly average of M2 money stock. (Shaded areas indicate United States recessions.)
This suggests that the Federal Reserve could have offset the decline in spending and velocity resulting from the fall in home prices with a sufficient increase in the money supply. And it tried. Since 2006, money supply has increased by about $2 trillion. But velocity fell faster than the money supply increased as households reduced spending and increased saving — the saving rate is now over 5 percent — and banks and businesses hoarded cash.
Non-financial businesses are now sitting on close to $2 trillion in liquid assets that could be invested immediately if there was an increase in sales, and banks have $1.5 trillion of excess reserves that could be lent as well.
Fiscal policy could raise velocity and growth by getting money moving throughout the economy. But since that is not feasible, the Fed is the only game in town. Joseph Gagnon, a former Fed economist, says that it should immediately increase the money supply by $2 trillion and promise to keep increasing it until the economy has turned around.
But the Fed is already under pressure to tighten monetary policy from its regional bank presidents, three of whom dissented from last week’s Fed decision to keep policy steady. They fear that inflation is right around the corner. But as the Harvard economist Kenneth Rogoff has argued, a short burst of inflation would do more to fix the economy’s problems than any other thing. One reason is that inflation raises spending by encouraging consumers and businesses to buy things they need immediately because prices will be higher in the future.
The right policy can be debated, but the important thing is for policy makers to stop obsessing about debt and focus instead on raising aggregate demand. As Bill Gross of the investment firm Pimco put it recently: “While our debt crisis is real and promises to grow to Frankenstein proportions in future years, debt is not the disease — it is a symptom. Lack of aggregate demand or, to put it simply, insufficient consumption and investment is the disease.” 
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Here’s my brief summary of Bartlett’s points:
(1) With housing prices rising from 2002-2006, to keep their spending levels up despite declining incomes, people tapped into their home equity, optimistically decreasing their savings rate (and their personal wealth/net worth);
(2) The Crash of 2008 cost Americans trillions of dollars. With the decline in wealth, spending and the velocity of money also declined, and the economy skittered into a deep recession. Unemployment quickly rose;
(3) The Fed tried to counter the decline, Bartlett reports, by increasing the money supply by $2 trillion since 2006;
(4) The Recession continues, and spending remains low, as people try to save to regain some of their lost wealth;
(5) According to Bartlett, banks have about $1.5 trillion that could be lent for investment, and non-financial businesses have about $2 trillion of surplus liquid assets. These funds are held inactive pending economic recovery;
(6) Fiscal policy (enabled by more tax revenues from the rich), would raise spending and demand, increasing economic activity (GDP) and reviving the velocity of money. That would spur more investment;
(7) With Congress preventing that option, all the Fed can do is increase the money supply; Bartlett offers no views on that option (which seems to have been pretty much exhausted), but he insists that no matter what, we must increase demand, consumption and investment.
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Santorum suggests that businesses need an improved “atmosphere” for investing in American jobs. The reality is that the wealth of the bottom 99% has declined by 20% since the crash, and we are now in a deep recession approaching a depression. Businesses and banks are sitting on $2.7 trillion of cash waiting for economic recovery, but for that to happen, the U.S. economy will require more demand. Meanwhile, taxes for the rich and corporations remain too low, and wealth keeps moving to the top.
To fuel recovery, America needs more government spending and job creation, and that will require higher taxes on incomes of the rich and corporations, moving towards 1970s tax rate levels. We must also avoid government spending cuts that would reduce employment and economic demand among the bottom 99% even further. The slogan “Jobs, Not Cuts” expresses this reality perfectly.
It’s the only realistic chance for recovery. Higher taxation and recovery, of course, provide continuing budget relief and work toward reducing the federal debt. Spending cuts have the opposite effect, however, causing more unemployment and poverty. If cutting deficits is the goal, spending cuts that cost jobs and reduce demand are to be avoided at all costs.
The regressive Republican policies that got us into this mess are more harmful now than ever, as we approach the edge of the cliff. They are a prescription for depression, a point I will look at more closely in my next post in this series.
JMH – 9/26/11
 It’s the Aggregate Demand, Stupid, by Bruce Bartlett, New York Times, Business Day, Economix, August 16, 2011.
 A Good Fight, by Robert Reich, Truthout, September 20, 2011.
 Can a Movement Save the American Dream? by Robert Borosage, Nation of Change, September 23, 2011.
 Household wealth down 23% in 2 years – Fed , by Charles Riley, CNNMoney, March 28, 2011
 Wealth in the United States, Wikipedia.
 Main Street has Lost $9 trillion in Home Value Since Q2 2006, Thom Hartmann, December 26, 2010. See also Marilyn Lewis’ report for MSN Money, December 10, 2010.
 Home Prices in U.S. Cities Fell 4.1% in Year Ended July, by Bob Willis, Bloomburg Businessweek, September 27, 2011.
 Total Household Net Worth As Of 2Q 2011 , EconomicGreenfield, September 23, 2011
 It’s the Aggregate Demand, Stupid, by Bruce Bartlett, New York Times, Business Day, Economix, August 16, 2011.
 Id. (Emphasis added.)
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