Inequality and Growth: Two Sides of the Same Coin

[Note – This article was originally published on 3/29/2014.]  

Two-sides-of-the-Same-Coin

In a cogent and extremely relevant article posted on January 16, 2014 (here), Neil Buchanan asked: Where Have the Academic Experts Been Hiding? Here’s the part I want to talk about:

The Role of Scholars in Economics in Downplaying Inequality

What is surprising is that, especially among economists (even nominally liberal economists), there has long been a tendency to treat inequality as an unworthy subject of discussion. This is not a matter of the conversation simply being hijacked by academic conservatives.  There are plenty of conservative economists in top-tier economics departments.  (Harvard’s Economics Department alone is the home to four of the most high-profile conservative economists in the world.)  The interesting dynamic has been the complicity of mainstream economists in taking inequality off of the agenda of “respectable” research.

Why would they do this?  The innocent (and, I think, mostly accurate) explanation is that economists, after the 1970’s, wanted to focus on how to get the economy as a whole to grow.  At that point, distribution of wealth and income was not much of an issue, as described above, because it seemed that the fruits of growth would automatically be spread widely. The analytical move by academic economists was to say that growth and equality were simply different issues, and that the issue driving the conversation should be how to maximize growth.  That did not require that the conversation would never return to the question of inequality, but that is the way it turned out.

I certainly observed many situations, among both economists and legal scholars whose research is modeled on mainstream economic reasoning, in which anyone who even raised the question of equality was all but laughed out of the room.  The mockery was not always (or even most of the time) an attack on someone for caring about inequality; rather, it was instead a condescending statement that the offending party “just doesn’t get it.” In other words, the ideologically neutral form of the conversation was, “Let’s talk about growth, and set inequality aside to discuss later, in a different conversation.”  Unfortunately, that quickly became “You’re talking about the wrong thing if you try to talk about inequality,” and then, “Talking about inequality is not allowed.”

In short, even the non-conservative parts of academia have helped to feed the “centrist” obsession with repressing any discussion about inequality and redistribution.  Happily, that has started to change over the last few years, with more and more economists and legal scholars noting that the growth/distribution divide never made all that much sense, and that the social problems that are associated with gross inequality have reached crisis proportions.  (Emphasis added)

The ideological problems are far deeper than Buchanan’s discussion reveals. The issue of whether and how inequality is related to growth is itself deeply steeped in ideology (let’s call it “level 1” or “L1” mythology), and our difficulty understanding the full extent of the problem, or even with understanding how the economy works, is almost entirely due to our failure to understand that fundamental point. If you are conservative, as opposed to “non-conservative,” you extend your ideology to a more extreme, and more obviously faulty level (which I’ll call “level 2” or “L2” mythology). This post will explain the difference between these two levels of ideology.   

Level 1 Mythology

I have been saying ever since I began to focus extensively on inequality, about three years ago, that growth and inequality are “two sides of the same coin.” For most of the that time, it seemed like only Robert Reich, among the few economists who were speaking up about inequality, shared that perspective. Then, in July of 2012, Joseph Stiglitz published his book The Price of Inequality, and I had another ally. Highly unequal societies are highly unstable, he has been saying, and that is exactly what “unstable” means: Inequality depresses growth. 

Most economists, among them notably Paul Krugman, didn’t agree. This disparity of views is explained by a difference in perspective: Today’s mainstream economists are raised in the “neoclassical” school of economics, and those in the mainstream like Krugman who consider themselves Keynesians are actually to a large extent “neo-Keynesians,” which is considerably different from the true Keynesian perspective. The neo-Keynesian perspective emphasizes Keynesian theory in connection with policy matters, but is locked into the neoclassical perspective of how the economy works, a very awkward position to be in. Together, the neoclassical and neo-Keynesian schools of economics constitute the vast bulk of what Buchanan refers to as “mainstream economics” today, and that includes nearly all of the economics taught since I learned economic theory in the early 1960s.

Both of these schools are based on solely on an ideology — the L1 mythology — which is fundamentally wrong (by 180 degrees) about how market economies work. Put simply, it is bottomed on a “supply-side” vantage point in its conception of growth: Make it, this point of view insists, and people will buy it. But this perspective turns out to depend on a whole host of assumptions (e.g., perfect competition, perfect knowledge, perfect efficiency, full employment equilibrium) that are not, and have never been, true. Thus, the argument that growth results from expanding investment is like the argument that you can push a piece of string in a straight line across a table. It confuses cause and effect.

Consequently, forecasts or retrospective analyses of growth designed to reflect supply-side assumptions, as frequently discussed on this blog, are fraught with confusion and contradiction. I have reviewed reports on studies involving growth or inequality as I learn about them, and I have routinely found timidity and candid admissions of confusion from the analysts that the studies did not produce the results they expected.   

John Maynard Keynes taught us that investment responds to demand. Keynes’ “demand-side” perspective, put simply, reminds us that people need money (from income, wealth, or debt) before they can buy anything. A piece of string must be pulled across the table. Conceptually, this understanding was the basis of his General Theory of Employment, Interest and Money (1935). It was all but abandoned by mainstream economics after the 1960s, however, because it implied that instability and decline were natural developments in market economies, and therefore that central governments would have to step in and stimulate demand throughout the economy. The L1 myth developed around a rejection of Keynes’s General Theory.

The Keynesian Logic

The General Theory focused on how much demand would be generated by a given (initial) level of “income” (GDP), defined essentially as the total of all transactions, including all payments for labor, capital or consumption. Keynes specified three independent variables in his model: The interest rate, the propensity to consume, and the marginal efficiency of capital. These three factors, acting independently, Keynes argued, determine income and growth. The cyclical level of economic activity revolves initially around the propensity to consume; i.e., as people decide to reduce current spending and increase deferred spending (saving) current economic activity declines, resulting in an initial decline of GDP, compounded (as money circulates) by a bounded multiplier effect.    

This was Keynes’s major contribution to theory. Classical (hence neoclassical) theory ignored the demand function, and therefore had no way to explain growth or decline. The neoclassical model (as developed via Ricardo, Walrus, Marshall and eventually Paul Samuelson, among others) erred by assuming that “supply creates its own demand,” essentially treating the economy as a static aggregation of transactions. Because the interest rate is independent of the other two variables and is not an equilibrium of the supply and demand for money, and because a decline in current consumption does not automatically imply an increase in future consumption, Keynes famously reasoned, an increase in saving, instead of resulting in more investment, results in increased unemployment. No, this was not intuitively obvious to many, though Keynes said it was, which is why it was such a major theoretical development. The upshot, however, is that a market economy is inherently unstable, and that because investment depends on expectations of future demand, an economy’s current level of demand must be stabilized as it rumbles along by infusions of government spending.

The point is that the entire basis for neoclassical economics is itself a myth: As James Galbraith has pointed out, most economists take it as a matter of faith that economies will return on their own to full employment after brief down periods, that is without the stimulation Keynes demonstrated was necessary; but when an economy is always declining, that cannot happen, and eventual collapse into deep depression is inevitable. That is the ultimate reality revealed by Keynesian demand-side economics.

Mainstream academic economics was destined to be controlled, however, not by science but by philosophy; in particular, the philosophy of Milton Friedman, who wanted to keep government from interfering with the “free” economy. So he argued that economies will grow and prosper even while wealthy people are making and keeping as much money as a “free” market will allow. Ignoring considerations of social utility, Friedman made it clear that he opposed interference with the natural distribution of wealth and income established by the free market, which he analogized to the operation of a lottery:

Consider a group of individuals who initially have equal endowments and who all agree voluntarily to enter a lottery with very unequal prizes. The resultant inequality of income is surely required to permit the individuals in question to make the most of their initial equality. Redistribution of the income after the event is equivalent to denying them the opportunity to enter the lottery. (Capitalism and Freedom, U. Chicago Press, 1962, 2002 ed. p. 162)

Note that, from the outset, the underlying issue was distribution, and a separate elaborate line of argument was subsequently constructed by the “conservative” economic community to the effect that income and wealth distribution has no macroeconomic significance, and should be ignored. That line of argument forms the basis of L2 mythology.

Level 2 Mythology

The best example of that argument, “Reducing poverty, not inequality” (here) was offered in 1999 (here) by the former chairman of Ronald Reagan’s Counsel of Economic advisers, Harvard professor Martin Feldstein, who asked us to imagine that a “magic bird” made a small award that would not affect anyone else’s “material well-being.” The truth, however, is that many trillions of dollars of wealth have transferred to the top 1% over the last 30-40 years, both from the bottom 99% and the proceeds of America’s escalating national debt. So the “material well-being” of the bottom 99% has been drastically reduced by redistribution:

productivity veresus inflation-adjusted-wagesThis chart, published by Gus Lubin (November 12, 2013, here), shows that since the advent of the Reagan Revolution presided over by Martin Feldstein and other ideologues, America’s productivity continued to grow, but the gains have remained with the producers while median wages have fallen.   

By now, nearly all informed Americans should be clear on the bankruptcy of the “magic bird” myth. Paul Krugman is getting more serious recently in attacking this issue (“That Old-time Whistle,” New York Times, March 17, 2014, here):

But over the past 40 years good jobs for ordinary workers have disappeared, not just from inner cities but everywhere: adjusted for inflation, wages have fallen for 60 percent of working American men. And as economic opportunity has shriveled for half the population, many behaviors that used to be held up as demonstrations of black cultural breakdown — the breakdown of marriage, drug abuse, and so on — have spread among working-class whites too.  

Meanwhile, media reports continue to amaze us. Detroit is in bankruptcy, its residents wallowing in third-world poverty. Syracuse, NY and many other cities face intractable fiscal problems. Just yesterday, I heard a PBS radio news report that a hospital in northern Massachusetts actually shut its doors because it cannot afford to stay open; sufficient funding could not even be found to keep the ER open. It is becoming increasingly evident that America’s economic woes are attributable to a fundamental shortage of money in the active money supply available to the bottom 99%. This is the stuff of stagnation, of depression.

The “Invisible Hand”

The sum and substance of the L1 mythology, finding no support in scientific economics, was eventually propped up by “the doctrine of the invisible hand,” a mythical and wholly false attribution of Friedman’s alleged “free market” philosophy to Adam Smith. (See my post “The Cult of the Invisible Hand,” December 22, 2013, here.)

Hang on to your hats: The fallacies behind the L2 myth (that distribution is macroeconomically insignificant) and the L1 myth (that an economy will always return to full employment “equilibrium” on its own) are virtually identical. L1 is like believing in the tooth fairy: the money needed for growth will magically appear under our pillow, as needed. L2 is the converse: growing income and wealth concentration does not have a negative impact on the active money supply, or put another way, the lottery winners can gather in money without restraint without hurting anyone else, without violating the so-called “Pareto Principle.” The latter idea has been stretched into the “trickle-down” argument, an idea that may have even pre-dated Adam Smith: This is the claim that the more money concentrates at the top, the better off those below will be; growth at the top causes growth at the bottom. 

In all these instances, when money is needed, it’s simply assumed to be there. That’s a fraud – the money supply is finite, so people really are hurt by inequality growth. Joseph Stiglitz recently weighed in on this point in his excellent discussion of the globalization of inequality (“On the Wrong Side of Globalization,” Opinionator, March 15, 2014, here):

In this series, I have repeatedly made two points: The first is that the high level of inequality in the United States today, and its enormous increase during the past 30 years, is the cumulative result of an array of policies, programs and laws. Given that the president himself has emphasized that inequality should be the country’s top priority, every new policy, program or law should be examined from the perspective of its impact on inequality. * * * And this brings me to the second point that I have repeatedly emphasized: Trickle-down economics is a myth. 

Here’s the real kicker: The impacts of redistribution on growth are vastly more significant than changes in Keynes’s propensity to save, the relatively minor trade-off between current and future consumption. Distribution of wealth and income  encompasses the entire money supply. We now know that since the Reagan Revolution began, the rate of growth was depressed in all five income quintiles, so growing inequality, while it was demolishing the bottom 80%, on a net basis even reduced the rate of growth of the top 20%. Worse, there has been no income growth, Thomas Piketty and Emmanuel Saez have demonstrated, outside of the top 5%. The problem has been consistently getting worse for decades, and now 95% of all income growth is going to the top 1%. The middle class and small businesses are evaporating. 

Needless to say, the “invisible hand” has been called into service to justify, and lend an appearance of inevitability to, the perpetuation of inequality. In fact, it was so used almost from the start, I have been surprised to learn, dooming Adam Smith to eternal misinterpretation just because he chose to use a religious metaphor once in Wealth of Nations, and once in The Theory of Moral Sentiments. 

Okun’s “Efficiency” Argument 

Here’s an important case in point: Back when Friedman and Feldstein were in their heyday forty years ago, another highly respected economist, Arthur Okun, who was Chairman of Lyndon Johnson’s CEA, floated the proposition that trying to correct inequality would likely reduce growth, not increase it, because it would decrease economic “efficiency,” or the ability of the economy to produce (Equality and Efficiency: The Big Tradeoff, The Brookings Institution, 1975). That could be rephrased: Trying to increase incomes of working people is likely to reduce total work. If that sounds absurd, don’t be alarmed: it is a real beauty. (In fact, the idea is apparently inconsistent, in a demand-side universe anyway, with his own more sensible “Okun’s Law,” the assertion he reportedly made of “a clear relationship between unemployment and national output, in which lowered unemployment results in higher national output.”)

According to Paul Krugman (“Liberty, Equality, Efficiency,” The New York Times, March 9, 2014, here) most economists have believed in “the big tradeoff” ever since:

Almost 40 years ago Arthur Okun, chief economic adviser to President Lyndon Johnson, published a classic book titled “Equality and Efficiency: The Big Tradeoff,” arguing that redistributing income from the rich to the poor takes a toll on economic growth. Okun’s book set the terms for almost all the debate that followed: liberals might argue that the efficiency costs of redistribution were small, while conservatives argued that they were large, but everybody knew that doing anything to reduce inequality would have at least some negative impact on G.D.P.

But it appears that what everyone knew isn’t true. Taking action to reduce the extreme inequality of 21st-century America would probably increase, not reduce, economic growth.

There’s no “probably” about it. We’re in a bottom 99% depression, not just a post-recession depression-like period as described by Krugman in his last book. 

Two Sides of the Same Coin

The relationship between inequality and growth is gradually sinking in with the economics profession, but understanding it requires jettisoning the supply-side world view that dominates the discipline. Both growth and inequality are statistics representing measures of income. The annual rate of growth is reflected in the amount of reported income accumulating over a year. Inequality is a measure of the distribution of that income. The factors that increase income and wealth concentration also reduce growth. So growth and distribution are literally two sides of the same coin.

It’s a bit more complicated than this, but here are the two main factors:

1. The demand-side factor: This one is easy for Keynesians, and both Reich and Stiglitz have emphasized it.  People with top incomes have a lower propensity to consume (percentage of income spent on consumption) than middle class people, or poorer people, who can save little or nothing and, at or near the bottom, are running up debt. So, as wages and jobs decline and income shifts to the top, the aggregate consumption (spending, GDP) is by definition declining. Two sides of the same coin by definition;

2. The supply-side factor: All profit is a form of economic rent, payment above and beyond the cost of production. As a career regulator of utility rates, I am intimately familiar with this one. The task of rate-setting is to prohibit the taking of monopoly rents by big corporations providing essential services. Most prices in the economy, even for essential products and services like health care, vehicle fuel, food, shelter, and clothing, are set under conditions of monopolistic control by huge corporations. Thus, these prices not only gradually reduce real incomes through inflation, they also attempt to maximize profit, which entails limiting supply below the point where the price would clear market demand. This too simultaneously compresses growth and increases inequality, compared to the result under competition.   

These two factors alone, together with the clear history of substantially reduced growth since the Reagan Revolution began, really should be dispositive of this issue.  Still, supply-siders don’t get it. Krugman’s article reported two recent studies by IMF economists trying by statistical correlation to test the relationship between growth and income inequality, both as against other social factors and across countries. (“Inequality and Unsustainable Growth: Two Sides of the Same Coin?,” by Andrew G. Berg and Jonathan D. Ostry, International Monetary Fund, IMF Staff Discussion Note, April 8, 2011 (here), and “Redistribution, Inequality, and Growth,” by Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides, IMF Staff Discussion Note, February, 2014 (here).) 

Note that these researchers had an inkling of the true nature of their variables, as they revealed in the subtitle for their initial 2011 study. Nonetheless, their supply-side perspective cautioned timidity and restraint. In their first study, although they found inequality to be “one of the most robust and important factors associated with growth duration,” (pp. 13-14)  they timidly concluded: “The main contribution of this note may be to push slightly the balance of considerations towards the view that attention to inequality may serve both equity and growth at the same time.” (p. 18) The report on the second study led them to acknowledge a significant connection between inequality and growth. Still, they showed continued supply-side influence in a report that revealed more surprise than timidity:

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

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

These two studies turned out to provide substantial corroboration of the fact that income inequality and growth are two sides of the same coin, despite a relatively poor potential correlation among the variables actually tested, yet the surprise these analysts professed was only that their results did not validate Okun’s big tradeoff.  

I checked to see what Okun himself had said: After extolling the virtues of capitalism as compared to state socialism (communism), he presented the source of his efficiency argument:

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)  

That was it: His “authority” was the falsely alleged viewpont of Adam Smith. Of course now we know for sure that trickle-down is a myth: Greed is not harnessed to serve social purposes; greed avoids social responsibility. In fact, greed has successfully avoided progressive taxation, which by definition is taxation that stops the further concentration of income and wealth.  The basic point of trickle-down, of course, is to avoid paying taxes. I’ll include again the Piketty/Saez graph charting the top 1% income share, along with capital gains, together with the top income tax and capital gains rates.

DP8675a

The wealthy classes today steadfastly avoid discussing the issue of increasing their taxes, occasionally advancing the Laffer curve argument that even attempting to increase taxes on top incomes would be counter-productive (disproved by Piketty/Saez/Stantcheva’s 2010 study of the income elasticity of the top income tax rate), while their spear-carriers in Congress continue to propose further reducing their already wholly inadequate tax contributions.  

We must now add Arthur Okun to the list of those who, like Milton Friedman and Martin Feldstein, wanted an economy that served only the rich. He was opposed to progressive taxation, but in 1975 he freely admitted, having no reason to try to deny it, that “[t]he progressive income tax is the center ring in the redistributive arena, as it has been for generations.” (p. 101) 

Coincidentally, in his latest Op-ed (“America’s Taxation Tradition,” New York Times, March, March 27, 2014, here), Paul Krugman has begun to develop this point, quoting Teddy Roosevelt’s famous 1910 “New Nationalism” speech, where Roosevelt argued that “[t]he absence of effective State, and, especially, national, restraint upon unfair money-getting has tended to create a small class of enormously wealthy and economically powerful men, whose chief object is to hold and increase their power” and called for “a graduated inheritance tax on big fortunes … increasing rapidly in amount with the size of the estate.” Krugman added:

The truth is that, in the early 20th century, many leading Americans warned about the dangers of extreme wealth concentration, and urged that tax policy be used to limit the growth of great fortunes.

Of course, estate taxation and income taxation are both crucially involved, because great wealth accumulates from excessive incomes. However, the larger point is that there is really no mystery here anymore: We’re facing the same old class warfare, and the entire “science” of “neoclassical” economics has sunk ever more deeply into an age-old mythology tailored only to serve the interests of wealth. 

The American economy will require much reform to survive, but first and foremost progressive taxation of incomes and wealth must be reinstated. Will that happen? I worry that corporations, because they are not really people, probably lack a survival instinct. Mankind has painted itself into a seriously dangerous corner.

JMH – 3/29/2014 (ed. 3/30/2014)   Reposted 12/18/2014

  

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