Inequality Made Easy: The Basics of Redistribution

In my last post, I set forth what I called “the Quantity Theory of Inequality.” Looking it over, I see that it may seem too technical for many people to focus on, so I decided to summarize how inequality works, and in effect how the economy works, in one post that everyone can understand. I’ll also put this in the historical contest of the development of economic ideas.

This is hard-won information – I did a lot of work to get to this point. Later this year, the book I am writing with all of the necessary proof will be published, one way or another! Meanwhile, here is a straightforward summary of the inequality problem, without citations. It’s a bleak prospect, but all is not lost — yet. The U.S. can correct its economic backslide, but if we keep favoring the rich and corporations, the economy will eventually collapse, and perhaps not too far in the future.

I. Mainstream economics, which subscribes to Paul Samuelson’s “neoclassical synthesis,” has basically everything wrong. Its idea of macroeconomics is an aggregation of microeconomic ideas, fashioned around the goal of maximizing personal gain and satisfaction. It imagines — an idea that came from the creators of the neoclassical tradition, especially Alfred Marshall (1842-1924), A.C. Pigou (1877-1959), and the American J.B. Clark (1847-1938) — that economies are self-correcting and will always return to “full employment” equilibrium. The idea of a naturally stable, efficient economy, popularized by Arthur Okun (1928-1980) and by Milton Friedman (1912-2006) is no more than wishful thinking. Okun expressly and incorrectly attributed the idea to the “invisible hand” metaphor used in 1776 by Adam Smith (1723-1790), and Friedman simply likened the market economy to a lottery in which government regulation and taxation defeats the whole purpose of economic “freedom.” Neoclassicism has never been more than a house of cards.

II. Classical economics were effectively rejected, not enhanced, by neoclassical theory. The best of the early classical philosopher-economists – Adam Smith, T.R. Malthus (1766-1834), David Ricardo (1772-1823) – began their “principles of political economy” texts with discussions of “economic rent” or the charges landowners added to the cost of production without themselves contributing to output. They developed principles of value, and of supply and demand, but they had no illusions about efficiency. Except for Ricardo, who was a wealthy man, they were avowed socialists; and they all regarded the objective of “political economy” to be maximizing the welfare of the entire society. The Ricardian School was perfected by J.S. Mill (1806-1873), who was, with the possible exception of Smith, the most passionately outspoken socialist of the group.

III. Basic classical ideas were extended by three economists – the German Karl Marx (1818-1883), the American Henry George (1839-1897), and the Englishman J.M. Keynes (1883-1946). Marx believed (correctly, it turns out) that inequality would grow in capitalist economies as profits accumulated, and George believed (correctly, it turns out) that the problem of poverty amidst plenty was largely due to rent-taking by landlords. Each had identified a piece of the puzzle. Keynes, however, attributed poverty to unemployment, and developed a full employment model. He had brilliant insights respecting interest and investment, but perhaps his greatest contribution was “the theory of effective demand,” which was a direct refutation of Marshall’s neoclassical ideology. Like the neoclassical economists, however, Keynes failed to account for the distribution of wealth and income, which he considered “arbitrary.”

IV. Another American economist, Irving Fisher (1867-1947), was a contemporary of Keynes who went off in another fruitful direction. He perfected the old concept known as the “Quantity Theory of Money” (QTM). The QTM was expressed in his “equation of exchange”: PY = MV. This is a definitional equality, a tautology, reflecting two sides of the same coin: Over a year, the total of goods and services sold (Y) times the average price level (P) equals the total money supply times the velocity of money. E.g., if M = 50, and PY = 100, then V=2. All money is spent twice in the year. Fisher may be better known for his “Debt-Deflation Theory of Great Depressions.” His debt-deflation model is dubious, at least in current circumstances. As the American economy gradually becomes more stagnant today, it is not proving out: There’s been plenty of debt, and a major housing debt bubble burst in 2009, but where is the deflation? Regardless, just as the neoclassical model and Keynes’s full employment model failed to do, Fishers’s formulation of the QTM failed to take into account distribution, and the growth or decline of inequality. 

V. The QTM holds the key, I suggest, that ties all of these loose ends together. As I attempted to explain in my last post, the average annual amount of money in circulation is exactly correlated with the average price level, as both are reflections of total income (GDP). If we hold everything else equal, hypothetically, it is clear that doubling the money supply simply doubles prices. But it is the corollary of that fact that is critical to understanding how the economy works: If we, hypothetically, hold prices and the money supply constant, and let everything else change, what changes in the QTM is the velocity of money, and what changes in the real economy is the distribution of money. Hence, massive inequality growth, both logically and mathematically, reduces the velocity of money. This means that our perception that inequality depresses growth, which is borne out by the income statistics of the 20th and 21st Centuries, is not merely a statistical observation: It is the direct consequence of the mathematical relationships reflected in the QTM. It is necessarily true.

VI. It can be quickly and easily verified that Friedman’s depression theory, which says that a more aggressive Fed policy could have prevented the Great Depression, was based on the presumption of a constant velocity of money. But that is not true when income inequality is growing rapidly, and wealth is concentrating high on the distribution ladder. Similarly, as I attempted to show in the last post, “monetarism,” or the idea that pumping more money into the money supply can revive a sagging economy, fails if the slowing velocity of the money shuts down the ability of monetary infusions to stimulate recovery or growth. It’s like trying to inflate a leaking balloon.

So here’s the upshot: The wealthiest Americans are making too much money – taking in way too much rent and excess profits – and paying too little in taxes. In fact, this whole thing started in the Reagan Administration when taxes on top incomes were cut, and today they are far too low. Corporations are paying fewer and fewer taxes each year. The interest on the exponentially rising national debt is, in the words of J-B Say (1767-1832) “a perpetual annuity” that in a few years will overrun the federal budget. Because of Reaganomics, we have over $18 trillion of un-repayable debt.

As we approach the next fiscal crisis, America is oblivious to this reality because it does not understand the economics of inequality and the consequences of redistribution dictated by the QTM. It’s not just a matter of “fairness” for the rich to pay more taxes: It’s a matter of payback, and more importantly, a matter of survival. We need to tell Bill Gates and Jeffrey Immelt and other billionaires who want government to pay the common costs without impacting their profiteering that they are on the wrong side of history, along with all of the other mega-billionaires, the GOP, and all of those Representatives and Senators, on both sides of the aisle, who believe the “trickle-down” fantasy that making the rich richer benefits everyone. It is a mathematical certainty that it does not.

My message to anyone who believes the economy can grow back on its own, without a complete reversal of the government policies (especially regressive taxation) that got us in this mess, is this: Don’t believe it.

JMH – 4/2/2015

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