As the Rich Get Richer – Part II

(Return to the Contents Topics page.)

Part II – The Economics of Inequality 

The underlying factor in inequality growth is expressed in the old adage, “the rich get richer and the poor get poorer,” and it is ancient knowledge.  The Greek historian Plutarch, who died in 102 A.D., reportedly said: “An imbalance between rich and poor is the oldest and most fatal ailment of all republics.”  It’s not hard to understand why this is true.  People who possess wealth can more easily produce additional wealth than those who do not, beyond the limitations of time and effort imposed on their own work product.  Their financial capital produces real returns when it is employed in the production of more value, perpetuating the concentration of wealth.

Causes of Income Inequality

Most of the attention in the last two years has been focused on the direct causes of income inequality, such as factors that reduce the return to labor (including technological advance, the decline of American manufacturing, labor market globalization, and the decline of unionism), and sociological and institutional factors that enable corporate CEOs to get away with rewarding themselves with much higher salaries.  As Stiglitz argues, however, things have gotten so bad that this discussion is now largely beside the point.  As Henry George and John Maynard Keynes and numerous others have understood, indeed taken for granted, the remedy if too much wealth is being siphoned up is to tax it back down.

Economic rents

Perhaps the biggest factor in the growth of income and wealth inequality is that “excess profits,” that is profits businesses make above and beyond the returns on investment required to compensate them for the risk associated that investing in their enterprises, increase the concentration of wealth at the top and the level of income inequality over time.  In Henry George’s day, landowners (primarily) had the ability to exact “economic rent” from the use of their assets, that is making money without involving their assets as physical elements of actual work products.  Stiglitz emphasizes the role of “rent seeking” in the rapid growth of income inequality today.  By “rent,” he is referring not just to the economic rent associated with land, but to the unearned income associated with all “excess” profit, that is, earnings above the cost of capital required to produce real economic value.

Such profits are zero under the assumption of “perfect competition,” as firms facing competition theoretically strive to satisfy demand at lower cost and customers, armed with “perfect knowledge,” theoretically strive to seek them out.  But competition and knowledge are always imperfect, at best, and the transfers of wealth through economic rent have been enormous.

Under economic regulation, rates have traditionally been set for natural monopolies so as to permit companies enough revenues to cover their costs of doing business, including the “cost of capital” as determined in capital markets.  The approach is intended to permit a company to provide high quality service without collecting excess profit, or economic rent. Such an approach effectively minimizes the accumulation of economic rent and the consequent growth of income inequality and the concentration of wealth at the top.

The “Reagan Revolution” intentionally expanded the opportunities of capitalists to extract economic rents, most notably by reducing effectiveness of anti-monopoly laws (designed to ensure natural competition) and economic regulation (designed to compensate for competition in the case of natural monopolies).  Here are two examples: (1) As detailed by Barry Lynn (Cornered: the New Monopoly Capitalism) the Walton family became collectively the richest people in the world by using market power to control production and supply of products, not by actually out competing viable competitors; (2) As discussed by Paul Krugman (End this Depression Now!), hedge fund managers on Wall Street bring in annual earnings in the billions of dollars via large-scale gambling with other peoples’ money.  Both are examples of economic rent that, effectively, is wealth transferred from the bottom 99% to recipients high up in the top 1%.

In my career in utility regulation at the New York Public Service Commission, I witnessed the effects of both trends, particularly during the GW Bush administration.  Private sector corporate emphasis had, by then, generally changed from satisfying customer demand to maximizing financial profits.  This shift of emphasis was felt even within the public utility industry, which had been regulated throughout the country for more than a century as an essential industry with predominantly natural monopoly characteristics.

For example, Wall Street tied one New York utility through merger to a parent company that owned a circus.  Another company’s CEO testified in one of my hearings that millions of dollars of essential distribution maintenance expenditures had been deferred for a year (to be paid for presumably with future rate increases) because the company’s management was “not sure” whether it would “still be in the business” of providing electricity service in New York the following year.  These kinds of occurrences were previously unheard of in utility regulation in New York, and can only be explained as examples of financial venture capitalism.

The widespread triumph of such financial “equity” capitalism, and of market power over competition, has been thoroughly documented by Barry Lynn among others.  It is no wonder Lynn argues that the “science” of economics “has become a form of madness, a dream of human imagination we mistake for a pattern of the world.”

Keynes’s General Theory

When the English economist John Maynard Keynes set out to explain how entire economies could grind to a virtual standstill for years in the Great Depression, the science of economics was still in its formative stages, and needed revamping.  In his major work (The General Theory of Employment, Interest, and Money), he revolutionized economics as a science.  He determined that classical economic theory could not have predicted, much less explained, the Great Depression; In fact, he argued, it had no predictive value at all, because it was merely a description of an economy at full employment, a “special case” in his general theory that does not describe “the economic society in which we actually live.” His two main points of disagreement were with the classical theory’s failure to appreciate the role of aggregate demand in determining economic activity, and its misperception of the function of the interest rate.

As to the former, he explained that society’s aggregate “propensity to consume” (the percentage of income spent on current consumption) was crucial in determining aggregate demand.  Importantly, wealthy people tend to spend a lower percentage of their income than the less well-to-do, so lowering overall employment leads to lower overall aggregate demand.  The propensity to consume was one of three independent variables in his model.

Regarding the second point, the classical model had assumed that the interest rate was determined by the point at which the demand for capital equaled its supply.  Instead, he argued, the interest rate is the price equilibrating the supply of money with the demand for liquidity, and in no way is determined by savings and investment.  It affects and helps determine the level of investment and saving; it is a determinant, not a determinate  in the system.  Hence, the interest rate is the second of Keynes’s independent variables;

Next, Keynes reasoned, the willingness to invest is determined not by the interest rate, but by the expectation of the future yield on an investment; investment will take place when that expectation is equal to or greater than the required return of the investor, the investor’s “cost of capital” or technically speaking “the marginal efficiency of capital,” a return which itself exceeds the rate of interest sufficiently to reflect the riskiness associated with the investment’s expected return.

Thus, Keynes’s three independent variables were (1) the propensity to consume, (2) the interest rate, and (3) the marginal efficiency of capital.  What this all boiled down to in practical terms is this:  Given that all current output is either for current consumption or for investment in the means to provide for future consumption, if spending declines in an economy, the residual level of increased saving does not translate into a corresponding increase in investment (as presumed by the classical theory) but instead translates into reduced expectations of future returns and, therefore, lower investment and employment.

Equilibrium Theory

The full implications of The General Theory are enormous, and usually overlooked.  Students of economics are taught about the importance of aggregate demand and fiscal policy, but encouraged to think along classical lines in terms of a hypothetical full-employment “equilibrium.”  Keynes himself reasoned in terms of equilibrium theory, using the term almost ninety times in his book.  There’s a problem here, however: In some microeconomic contexts where there is viable competition it may make sense to think at least hypothetically of achieving an “equilibrium” at a price that equilibrates the supply and demand for a product, but it does not make sense to think of an economy-wide equilibrium level of employment.  This is a key difference between microeconomic ideas and correct macroeconomic thinking, but it is mostly overlooked by economists.

Look at it this way:  Keynes had refuted (indeed rejected as “nonsense”) the one idea that led to the idea that an entire economy would tend to equilibrate at full employment, and that was the flawed notion that investment would always equal savings.  Thus, crucially, Keynes himself had established that employment (and output, and growth) are inherently in a state of disequilibrium.

There simply is no countervailing force that would automatically spur more demand and investment, absent government intervention to increase demand.  Investor confidence, a psychological factor, is crucial, and declining demand does nothing to incent investor confidence.  This is the factor that famously influenced banker and industrialist Marriner Eccles (discussed by Robert Reich in Aftershock) as Franklin Roosevelt’s Secretary of the Treasury to advocate government spending to lift the United States economy out of the Great Depression.  There is no automatic incentive to investment and growth.

But the need to understand the inherent instability of a market economy is only part of our problem.  Inequality growth, as discussed above, is a separate factor involving the effective use of market power to generate excess profits and collect economic rent, transferring excessive wealth and incomes to the top.  There is certainly no “equilibrium” here.  Either we let that happen or we don’t.

The first step, though, is to recognize that it is happening.  Analysts routinely make a false “assumption of normalcy” during a downturn, expecting that when full employment is restored, the economy will return to an earlier “equilibrium” point.  But that doesn’t happen, and in fact it hasn’t happened over the last thirty years.  As inequality grows, each recession has grown progressively longer and deeper, and now we’re in a depression:

No economist, to my knowledge, has publicly associated this downward spiral with the growth of income and wealth inequality, but that is, I submit, what is causing it.  As wealth and income inequality grows, it causes reductions in income and aggregate demand, resulting in more inequality which causes even more reductions in demand, investment, and employment, in an unstable vicious cycle.   There is no countervailing force in a laissez-faire economy that would cause income inequality or the concentration of wealth to tend toward some sort of “equilibrium.”  Only government intervention can stop the descent into depression.

Trickle-down Reaganomics

American economics remains, as noted in Part I, enthralled by the notion that lower taxes on the incomes of the rich will bring about employment, growth, and economic recovery.  Of course, it has done exactly the opposite over thirty years, leading to lower growth, the decimation of prosperity, and another depression.  Still, that does not stop wealthy ideologues from pressing this self-serving argument, knowing that untruths can stick in a sound-bite world where reality and fantasy are indistinguishable.

The supply-side mythology, it is important to note, is a perverse variation of the classical theory’s argument, properly rejected by Keynes as nonsense, that if saving increases investment will automatically take place to make use of the money.  The new variation is that if you cut their taxes, the “job providers” at the top will have an increased incentive to invest in the means of production and create jobs.  Note Obama’s understated refutation: “We tried that, and it didn’t work.”

The answer, of course, is to raise taxes on top incomes, capital gains, and corporate profits back up to where they belong, that is, where they were before the advent of Reaganomics in 1980 and the long decline that followed. A Paul Krugman protégé, Timothy Noah (The Great Divergence), has recently recommended that we “soak the rich,” despite Krugman’s reluctance as yet to do the same.  Noah provides a sensible set of taxation proposals that includes adding more graduated tax brackets for top incomes.  Raising the marginal income tax rate is a remedy Reich has advocated for some time, as does Stiglitz (who emphasizes, however, first reversing the direct causes of inequality growth).

     The top tax rate in effect in the 1970s before the Reagan administration was 70%. Although as Piketty and Saez point out it is the effective rate on top incomes that matters, somehow there must be a return to the net effectiveness of taxation that was in effect then. Certainly there is no excuse for letting billionaires pay taxes on capital gains at the same 15% marginal rate that applies to the ordinary incomes of people in poverty.

     It may be that the relaxation of financial and anti-trust regulation that took place beginning in 1980 opened the wealth transfer siphon so much that substantial income inequality growth would have occurred even without a reduction in the taxation of the rich. If that is true, then even higher levels of taxation may be needed to stop the incredibly confiscatory income and wealth redistribution that is taking place today.  Regardless, tax changes can be introduced more quickly and effectively than any of the corrections to regulatory policy needed to shut the siphon down.  And substantially more progressive taxation will be needed in any event.  Taxation has to be a big part of the answer.

The thing we have to remember is that there is no equilibrium in sight.  As long as America allows it to, the situation will just keep deteriorating until the economy collapses.

JMH – 8/28/12

(Return to the Contents Topics page.)

This entry was posted in - FEATURED POSTS -, - MOST RECENT POSTS -, Wealth and Income Inequality. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s