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.   


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)

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

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