I have been arguing for nearly three years that income and wealth redistribution is the driving force behind economic stagnation and social decline, and the substantial evidence supporting that argument is becoming increasingly convincing, if not overwhelming. It has therefore become crucial that we understand the full implications of inequality growth: This isn’t just a matter of understanding economics better and revising our policies accordingly, and it isn’t even just a matter of preventing considerably more damage until we do. Wealth and income redistribution
have progressed so far, I maintain, as to threaten the ultimate survival of the American economy and of our tattered society and democracy. That may seem like an extreme view, but it is a view implicitly shared in varying degrees by a growing number of economists, including Nobel Laureate Joseph Stiglitz (The Price of Inequality, July, 2012). At this critical juncture in history, it is sobering to note, the steps that must be taken to ensure the survival for more than another century or so of human civilization itself could also be seriously compromised by the U.S. economy’s steady decline (See: Brian Merchant’s interview of Al Gore, here).
The continuing failure of the U.S. economy to recover from the Great Recession following the Crash of 2008 adds increasing legitimacy to such concerns. As I was writing Part 2 of this series Friday (11/15/13), I was surprised to see that another Nobel Prize winner, Paul Krugman, after announcing his dismay a week earlier at evidence of our “mutilated” economy presented by Federal Reserve Board economists at an IMF conference on financial crises (“the FED study,” here), seemed to have moved on to other topics. I had felt certain that he would have more to say about his stunning revelation in Friday’s Op-Ed.
He did have more to say, all right, but he waited until Monday to say it. Krugman called his New York Times column on Monday “A Permanent Slump?”(here). Yes, it means what we think it does, and it didn’t take him long to use the politically incorrect “d” word. This is noteworthy: As Krugman followers know, despite his perception of “depression-like” symptoms (e.g., a “liquidity trap”) which he spelled out in his recent books The Return of Depression Economics (1999, 2000) and End This Depression Now! (2012), Krugman has consistently taken the position that our economy is not in a depression, but is instead recovering from the Great Recession.
Not anymore. The Fed study revealed much uncertainty among mainstream economists about what is happening to our economy, uncertainty that extended even to the authors’ understanding of macroeconomic theory and the value of supply-side “potential GDP” modeling, as I discussed in Part 1 of this series (here).
As our slowly deepening depression dragged on, I had been convinced, the unfolding facts would weaken and finally erode the unflinching faith of the so-called “conservative” supply-side neoclassical economists, along with the more tenuous faith of neoclassical Keynesians like Krugman, in the recuperative power of market economies and their presumed ability to grow back to full employment (even if, like lizards that regenerate lost tails, they are never quite the same again). That appeared to happen suddenly to Paul Krugman at the IMF conference, and he did not hesitate to let us know about it.
The IMF Conference has provided a rare look at supply-side economics in action and at the concerns that mainstream economists are expressing about their inability to explain the economy’s continuing stagnation, nearly six years after the Crash of 2008. Krugman’s follow-up post on the conference provides more invaluable insights into the neoclassical perspectives on growth and stagnation. Krugman has now provided a clearer picture of what the continuing stagnation of our economy since the Crash of 2008 means to him. This post explores the limits that he perceives to the “terrifying” news that our economy has been significantly diminished by the Crash, and to the stagnation we will endure in the future. 
I have found that most people I talk to, regardless of their background in economics, understand my argument at its most basic level: “The top 1% of income earners, with greater concentration within the top 0.1% and top 0.01%, have received an increasing share of post-tax income over the last three decades, and as the top 1% accumulates vast quantities of wealth, the economy within which the rest of us live and work (the “bottom 99% economy”) has been continuously shrinking.”
That’s the first part of my argument, and here is the second part: “This decline of the bottom 99% economy has been obscured by the use of economy-wide GDP data, which includes all of the top 1% income growth. The aggregate data shows only a reduced growth of the overall economy, obscuring reality by co-mingling the decline in median income and the huge income gains at the top.”
The third part: “It has been shown that as income has continued to concentrate at the top, the rate at which income and wealth inequality is growing has accelerated, so that now, about 95% of all incremental income in the U.S. economy is going into the top 1%. Consequently, every economic problem we face, from declining education and growing poverty to declining governments and the growth of the national debt, is accelerating.”
The fourth part: “The decline of the bottom 99% relative to the growth of the top 1%, has been relatively gradual. Since 1980, top 1% wealth (net worth) has grown even more than the debt, by an estimated $22-25 trillion. Most of this was financed by an increase in the money supply, namely, the $17 trillion of national debt raised over that same period. Conventional Keynesian economics says that injecting more money into the economy this way (i.e., fiscal policy) should stimulate demand, investment and growth. Instead, however, the economy has backslid into a depression. Why? Because in addition to increasing its wealth by an amount equivalent to the entire national debt, the top 1% has also taken $5-8 trillion from the bottom 99%.”
And the fifth part: “With inequality growth accelerating, this is a very unstable situation. We can think of the national debt as a ‘top 1% wealth’ bubble. The $17 trillion of money injected into the economy mostly represents economic rent, not matched by an increase in real wealth. In these circumstances, our best economic minds should be contemplating the dire potential consequences of the next market crash.”
I maintain that, as “dismal” as the discipline of economics can be, these problems are not all that difficult to understand. Michael Moore, addressing a crowd in Madison, Wisconsin during the huge protest in 2011 against Governor Scott Walker’s attempt to unilaterally terminate collective bargaining agreements with state employees, put it plainly: “This country is not broke. There’s plenty of money; it’s just not in your hands.”
This discussion of the “neoclassical boondoggle” is about how such a straightforward explanation of what is wrong with our economy can be so 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.
The “Permanent” Slump
Here is how Krugman’s article begins:
Spend any time around monetary officials and one word you’ll hear a lot is “normalization.” Most though not all such officials accept that now is no time to be tightfisted, that for the time being credit must be easy and interest rates low. Still, the men in dark suits look forward eagerly to the day when they can go back to their usual job, snatching away the punch bowl whenever the party gets going.
But what if the world we’ve been living in for the past five years is the new normal? What if depression-like conditions are on track to persist, not for another year or two, but for decades?
This idea of “normalization” is unsettling because it reflects one of the basic flawed tenets of neoclassical ideology mentioned at the top of Part 1, the idea that an economy can magically return to full employment on its own, or will do so with a nudge. None of these economists has seen or heard of anything like the continuous failure of the current expansionary monetary policy, which is now pumping new money into the economy at the rate of about $85 billion per month. So, as Krugman reports, they are forced to consider the possibility of a “new normal” with “depression-like” conditions persisting perhaps for decades. But this “new normal” idea merely ratchets down the presumption of a tendency to move toward full-employment equilibrium, implying: “We’re behind schedule, but we’ll get there eventually.”
There is, however, another possibility: Capitalist economies are, as Keynes’s General Theory suggested, unstable, and there’s no such thing as “normal.” The monkey-wrench in that whole neoclassical line of reasoning is that the redistribution and concentration of wealth and incomes has been ignored by Keynes, Hayek, and nearly everyone else, until now. Neoclassical theories have ignored the possibility that distribution is the driving force behind demand, employment, and growth; that prolonged unemployment is mainly a symptom of increasing inequality; and that instead of recovering decades down the road, the economy will simply keep declining until it plunges straight into the depths of Great Depression II.
That is the truly frightening scenario, far worse than the $1 trillion/year decline into a “new normal” that terrifies Krugman, especially because we’re still a long way from fully appreciating the scope of the problem. Krugman continues:
You might imagine that speculations along these lines are the province of a radical fringe. And they are indeed radical; but fringe, not so much. 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.
Note that Krugman suggests that up until now it has been a “radical” notion that the economy may not automatically adjust back, with its former vigor, to full employment. As an example of such fears becoming more “respectable,” he directs our attention to Summers’s remarks, which address the same troublesome issue — the lack of a timely recovery — that troubled the authors of the Fed study that Krugman discussed on November 8. Here are the highlights of Summers’s remarks:
- The share of the adult population that is working is essentially the same as four years ago, and GDP has fallen farther behind the “potential” GDP envisioned four years ago;
- The central pillar of classical and Keynesian economics is “it’s all about fluctuations; we need less volatility”;
- The concept of “secular stagnation” has relevance today; there was something “a little bit odd” just before the crisis; despite the great bubble there was insufficient aggregate demand;
- The expectation would be once the economy “normalized” there’d be more growth and employment, not substantially less;
- Four years later there’s no evidence of growth restoring the effectiveness of monetary and fiscal policy;
- Lesson learned: “It’s not over until its over”; meanwhile we’ll have to get used to a chronic zero nominal interest rate.
These remarks all come from a “neoclassical” supply-side perspective that determines the way he analyzes and regards “fluctuations” and “stagnation.”
There are various definitions of the term “secular stagnation,” but Summers and Krugman appear to mean: “The protracted economic depression characterized by a falling population growth, low aggregate demand, and a tendency to save rather than invest.”
Last week, Krugman added two posts to his blog, “Bubbles, Regulation, and Secular Stagnation” (here) and “Monetary and Fiscal Implications of Secular Stagnation” (here), expanding on his reference to the Summers remarks. The first of these articles identifies the “basic role” of monetary policy as “stabilizing the economy,” which as represented by the IS curve looks like this:
As represented, the IS curve postulates an inverse relationship between the interest rate and income, hence employment, and hypothesizes that the “natural” interest rate is associated with “potential” output. In Keynesian theory, it would represent the interest rate constituting the highest rate beneath the “marginal efficiency of capital” (expectations of future returns) at which capital can be induced to enter into productive investment. (Krugman refers to the “Wicksellian” natural rate, a comparable idea.)
In this framework, “the tendency to save rather than to invest,” or liquidity preference, is represented as increasing as interest rates rise, and thus is reflected in lower GDP. In a second illustration, Krugman illustrates a “liquidity trap,” a time when even a zero interest rate is insufficient to coax savings back into productive investment. There being no such thing as negative interest, the implication is that output and employment will not expand because the marginal efficiency of capital is very low; even with interest-free money available, expected returns are still too low to induce investment:
This chart illustrates the “liquidity trap,” the situation in which expectations of future demand are so low that capital for investment in the means to provide sufficient production to meet that level of future demand is not forthcoming. That is the basic Keynesian mechanism of stagnation; when this condition persists for more than a few months, certainly for years, an economy is traditionally said to be in a “depression.”
When Krugman and Summers use the term “secular stagnation,” they appear to be thinking of a somewhat stable “new normal,” a lingering edge-of-depression status. None of their comments suggest they are thinking about continuing decline into deeper stagnation. Krugman’s comments in “A Permanent Slump?” continue:
He [Summers] then made a related point: Before the crisis we had a huge housing and debt bubble. Yet even with this huge bubble boosting spending, the overall economy was only so-so — the job market was O.K. but not great, and the boom was never powerful enough to produce significant inflationary pressure.
Mr. Summers went on to draw a remarkable moral: We have, he suggested, an economy whose normal condition is one of inadequate demand — of at least mild depression — and which only gets anywhere close to full employment when it is being buoyed by bubbles.
I’d weigh in with some further evidence. Look at household debt relative to income. That ratio was roughly stable from 1960 to 1985, but rose rapidly and inexorably from 1985 to 2007, when crisis struck. Yet even with households going ever deeper into debt, the economy’s performance over the period as a whole was mediocre at best, and demand showed no sign of running ahead of supply. Looking forward, we obviously can’t go back to the days of ever-rising debt. Yet that means weaker consumer demand — and without that demand, how are we supposed to return to full employment?
Again, the evidence suggests that we have become an economy whose normal state is one of mild depression, whose brief episodes of prosperity occur only thanks to bubbles and unsustainable borrowing.
This impression of a “new normal” state of continuing “mild depression” is a step in the right analytic direction; that is, a step away from denying stagnation altogether. But the first observation we must make is that such thinking is inconsistent with the dynamic economic concepts developed by Keynes, which represented a departure from such modes of thinking.
The idea of a “normal” economy is based on assumptions like full employment, full investment, optimal efficiency and optimal productivity. But if all of these could be counted upon, Keynes reasoned, there wouldn’t be stagnation and depression: “It may well be that the classical theory represents the way in which we should like our Economy to behave,” he wrote: “But to assume that it actually does so is to assume our difficulties away” (The General Theory, Ch. 3, Sec. III). And one of the fundamental flaws of classical theory, he argued, was this:
From the time of Say and Ricardo the classical economists have taught that supply creates its own demand; meaning by this in some significant, but not clearly defined sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product. The General Theory, Ch. 2, Part 6
Keynes provided an analysis of how the passage of time affected the dynamics of economic processes. Based on the principle that all human endeavor is to provide for current consumption and for the means to enable future consumption, he provided an advanced understanding of saving and investment. In that context, he disputed an idea analogous to the idea that supply creates its own demand, which we might phrase as “saving creates its own investment”:
The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished. The General Theory, Ch. 16, Sec. I
Keynes rejected the idea that saving automatically implies investment, because saving and investment have determinants independent of the interest rate. Investment depends not only on the interest rate, but on “the marginal efficiency of capital,” and saving depends not only on the interest rate but on the propensity to consume:
[T]he traditional analysis is faulty because it has failed to isolate correctly the independent variables of the system. Saving and Investment are the determinates of the system, not the determinants. They are the twin results of the system’s determinants, namely, the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest. These determinants are, indeed, themselves complex and each is capable of being affected by prospective changes in the others. But they remain independent in the sense that their values cannot be inferred from one another. (The General Theory, Ch. 14)
In classical theory, however, the interest rate was a dependent variable, determined at the equilibrium of the supply and demand for money. In Chapter 14, Keynes reviewed the classical theory of the rate of interest, and concluded the chapter with this incisive summary of his general theory:
The significant conclusion is that the output of new investment will be pushed to the point at which the marginal efficiency of capital becomes equal to the rate of interest; and what the schedule of the marginal efficiency of capital tells us, is, not what the rate of interest is, but the point to which the output of new investment will be pushed, given the rate of interest.
The reader will readily appreciate that the problem here under discussion is a matter of the most fundamental theoretical significance and of overwhelming practical importance. For the economic principle, on which the practical advice of economists has been almost invariably based, has assumed, in effect, that, cet. par., a decrease in spending will tend to lower the rate of interest and an increase in investment to raise it. But if what these two quantities determine is, not the rate of interest, but the aggregate volume of employment, then our outlook on the mechanism of the economic system will be profoundly changed. A decreased readiness to spend will be looked on in quite a different light if, instead of being regarded as a factor which will, cet. par., increase investment, it is seen as a factor which will, cet. par., diminish employment. (The General Theory, Ch. 14)
Here we find, in one beautifully concise summary, the essence of the major elements of Keynes’s General Theory. The implications are potentially far-reaching, as they imply dis-equilibrium and the possibility of prolonged unemployment in circumstances where demand is falling. However, our concern here, at least initially, is not with the potential implications, for we are examining the acknowledged confusion of Larry Summers and Paul Krugman about why the economy isn’t recovering, especially in relation to the role they perceive the rate of interest plays in decline and recovery, and how they explain the continuing decline.
The first point is that “secular stagnation” is a non-Keynesian idea. Keynes’s argument is that decreased spending (demand) results in more unemployment, not more investment, which is what we have observed in the real world. The “demand-side” system posits that reduced demand results in reduced consumption and employment, and that results in more reduced demand, consumption and employment, and so forth. This is a description of an inherently unstable system; there is no necessity for the economy to revive, and investment and job creation must be stimulated.
In contrast, the “supply-side” system, which underlies the forecasting models discussed in the Fed study and the comments of Larry Summers, posits that saving provides its own investment, and that creates more saving which provides more investment, and so forth. This is a description of an inherently stable system, that continues inexorably to grow toward full employment, interrupted only by occasional financial hiccups. But, as Keynes pointed out, the perceived stability is illusory, because supply does not create its own demand.
With these things in mind, let’s consider the IS graphs provided by Krugman: The IS curve suggests a schedule of “equilibrium” positions of the interest rate at which the supply and demand for money are equal, implying that as investment and income (GDP) grow, the supply of money tends to grow and the demand for money for investment declines. But that is exactly the classical perception of the interest rate that Keynes so carefully analysed and rejected. In fact, as discussed in this series of posts, the supply of money and the “real” interest rate are both independent, and determined by FED policy. (It seems a reasonable question whether Keynes could have profitably considered the money supply to be a fourth independent variable in his General Theory.)
Thus, Summers’s reference to an “equilibrium” interest rate, and the “Wicksellian natural rate” referred to by Krugman, give rise to theoretical concerns: The classical ideas about the interest rate have led to concepts like “normalization,” and the idea that monetary policy “stabilizes” the economy. Keynes would have rejected such ideas as painting too rosy an expectation of future demand, employment, and growth. Writing in the Great Depression, Keynes saw the consequences of the failure of these ideas, on an even greater scale than perceived by Krugman and Summers today. His basis for comparison was with the classical ideas he himself had taught for decades: For example, he pointed out that David Ricardo both assumed an economy at full employment and considered the interest rate to be the “equilibrium” price of money. And Alfred Marshall, though not assuming full employment, did appear to assert that the interest rate in equilibrium equates the supply and demand for money.
Keynesian analysis could not progress much further without considering distribution, nor did it accomplish very much. Given that the underlying economic issue remains one of allocating income between current consumption and provision for future consumption, both of which are components of “aggregate demand,” it is reasonable to suggest that the supply-side perspective would not produce conclusions markedly different from the demand-side perspective; indeed, they might reasonably be considered two sides of the same coin. This depends, however, on Keynes’s famous ceteris paribus assumption. But all other things, unfortunately, are not equal. Everyone overlooked the biggest factor affecting income, the distribution of money.
Here is what we’re up against: The established economics profession and our economic leadership are locked into their supply-side paradigm. This perspective would produce workable results, I expect, if ceteris paribus were in fact the case. However, with spending and demand in continuous decline because of the redistribution of income and wealth, the supply-side perspective is the first to fall out of touch. What becomes needed for economic analysis is a demand-side approach, and in fact a distributed demand-side approach.
The supply-siders have more mythology to divest themselves of to arrive at the “scientific” perspective that Raj Chetty professes for the economics profession. Ideas of automatic full employment and normality are convenient when things are going well, but useless when inequality is growing, and especially in its ultimate stage, depression.
To his credit, Larry Summers spotted one of the signs of redistribution, the declining demand before the Crash of 2008. He found it “a little bit odd” that demand should be falling then, despite the bubble. It did not occur to him, however, that the declining demand could be the result of the declining 99% economy (within which nearly 99% of consumer demand exists). Instead, he hypothesized that the continuing decline is due to “secular stagnation” offering no underlying change to his supply-side perception of how the economy works.
Paul Krugman added that there had been considerable growth of household debt relative to income prior to the Crash:
That ratio was roughly stable from 1960 to 1985, but rose rapidly and inexorably from 1985 to 2007, when crisis struck. Yet even with households going ever deeper into debt, the economy’s performance over the period as a whole was mediocre at best, and demand showed no sign of running ahead of supply.
It did not occur to Krugman, however, that household debt was likely rising because real household income as a percentage of total income was declining. Inequality has been growing since the beginning of the Reagan Administration. Like Summers, however, Krugman wrote off the long-term effect to secular stagnation:
Why might this be happening? One answer could be slowing population growth. A growing population creates a demand for new houses, new office buildings, and so on; when growth slows, that demand drops off. America’s working-age population rose rapidly in the 1960s and 1970s, as baby boomers grew up, and its work force rose even faster, as women moved into the labor market. That’s now all behind us. And you can see the effects: Even at the height of the housing bubble, we weren’t building nearly as many houses as in the 1970s.
Another important factor may be persistent trade deficits, which emerged in the 1980s and since then have fluctuated but never gone away.
Certainly demographics are relevant to the pace of change of working-age population, and a smaller working-age population would, of course, spend less than a larger one. If, hypothetically, the population suddenly declined by, say, 20% due to a major epidemic, the authors of the Fed report would have no difficulty whatsoever in suggesting that demand-side amendments to their supply-side models would be needed. But similarly, a steadily growing working-age population will spend less if its share of income declines; and we know that this is happening. Yet neither Krugman, Summers, nor the Fed economists acknowledged redistribution as a potential factor.
Krugman has fallen back essentially on a definition of secular stagnation similar to the one I provided earlier. What is emerging for me is a picture of mainstream economists unwilling, or unable, to surrender their neoclassical belief systems in the face of growing evidence that those systems just don’t work. For whatever reason, there is no mention whatsoever of the macroeconomic significance of income and wealth redistribution.
For John Maynard Keynes, the problem was that his classical predecessors in the study of political economy had failed to properly account for the dynamic impacts of change over time, and had developed erroneous concepts, especially of the interest rate, that described only one special case of his General Theory, namely, full employment. Stagnation exists, and the classical models couldn’t explain it, or even recognize it. His dynamic model made real progress, by introducing demand as a controlling factor in growth and acknowledging the proper functioning and role of the interest rate.
His own model, however, seems closer to the classical model than to one that recognizes the effects of redistribution. Indeed, the supply-side emphasis that grew out of neoclassical thinking likely produces results similar to demand-side models in circumstances where the ceteris paribus assumption holds. The changes in demand that operate in that system relate to changes in the propensity to consume, which varies essentially in business cycles.
Redistribution and increased concentration of income and wealth, however, introduce open-ended change. There are no limits, except for those imposed by society through its government, on the amount of decline and stagnation that can result when excessive wealth and income are permitted to accumulate at the top. This problem is huge, far greater than the problem of managing business cycles. In fact, both Krugman and Summers appear now to have recognized that neither monetary nor fiscal policy can work any more. This makes the U.S. economy, effectively, a rogue economy.
So, yes, Mr. Krugman, this is a terrifying circumstance. You yourself have fought a long, mostly losing battle against the forces of “austerity” and “trickle-down.” Just a few days ago your own New York Times, in an opinion by Lawarence R. Jacobs, reported on a “fiscal” contest between the states of Wisconsin and Minnesota, with Wisconsin slashing taxes on the rich and Minnesota increasing them (“Right vs. Left in the Midwest,” 11/23/13, here). The article asks:
Which side of the experiment — the new right or modern progressivism — has been most effective in increasing jobs and improving business opportunities, not to mention living conditions?
Obviously, firm answers will require more time and more data, but the first round of evidence gives the edge to Minnesota’s model of increased services, higher costs (mostly for the affluent) and reduced payments to entrenched interests like the insurers who cover the Medicaid population.
No: This one is an obvious no-brainer: You and I both know that money is needed in order to increase jobs and business opportunities. Everyone should know that. For this article to leave as an open question whether Wisconsin’s austerity (less money) could out-perform Minnesota’s progressive tax policies (more money) is shameful.
So where do we go from here? Until our economists start behaving like scientists, and stop confusing everybody, I don’t like our chances of overcoming and correcting the inequality problem. As I said at the top, there’s a lot at stake. It’s up to you.
JMH – 11/26/13 (ARC edits, 12/11/13)