Did Income Inequality Cause the Financial Crisis?
Policymakers and academics have identified income inequality as a proximate cause for a number of society’s ills, from deteriorating social cohesion and unhappiness to high mortality rates. But could America’s widening income gap also be responsible for the 2008 financial crisis?
That’s the controversial conclusion reached by economists Michael Kunhof and Romain Rancière, whose 2011 report for the IMF explains how rising inequality incentivizes poorer households to over-leverage, eventually leading to financial crises. In their model, households are broken down into two groups—the richest 5 percent, representing capital; and the bottom 95 percent, representing labor. As in the real world, Kunhof and Rancière assume the capital group experiences large and persistent income gains over time, while wages for labor grow slowly or stagnate. But the top 5 percent cannot consume all of their disposable income (you can only buy so many cars), so they create financial wealth through loans to the bottom 95 percent, who need credit to maintain their accustomed level of consumption. As inequality grows, credit supply from the top and credit demand from the bottom expand simultaneously, increasing the probability of systemic default as risk and debt build.
If Kunhof and Rancière’s model sounds familiar, that’s because it is. In the United States, real average annual earnings for production and other non-supervisory workers peaked in 1972 at $40,884, while total consumer credit amounted to just $2,804 per person. By 2008, average annual earnings had fallen by $6,408 to $34,476, and households were making up the gap with an extra $4,940 in credit per person—more than triple the ratio of credit to earnings as in 1972.
As in Kunhof and Rancière’s model, U.S. politicians responded to growing income inequality and stagnating median wages in the years leading up to the financial crisis by promoting policies to prop up the living standards of the indebted lower and middle class. But instead of addressing the root causes of inequality (such as regressive tax policy and declining collective bargaining power), they cut the cost of borrowing even more, pouring gasoline on the already fiery housing market. Low income families were incentivized to take on second and third mortgages they could not afford, and the financial class pounced—diverting capital into financial gimmicks like mortgage-backed securities to obfuscate and distribute the underlying risk.
There is some disagreement within the economic community as to whether the relationship between higher levels of inequality and financial crises are causal or correlational. But consider this: when someone making $20,000 a year gets a raise, they spend it. When someone making $2,000,000 a year gets a raise, they invest it. And as an ever greater share of national income accumulates at the top (and discretionary income for the bottom 95 percent stagnates), the greater the demand for high-yield financial innovation independent of the faltering demand-side consumer economy. Until real median wages rise and the income gap begins to narrow, debtor nations such as ours will continue this disastrous boom-bust cycle.
The One Percent’s Jobless Recovery
Something strange has happened in the U.S. economy. Nearly three years after the Great Recession officially ended in June 2009, unemployment remains stubbornly high at 8.1 percent and real wage growth is nonexistent, but corporate profits and GDP have never been higher. Six million workers have dropped out of the labor force in the last two years—twice the number of people who have found new jobs—but the Dow Jones and NASDAQ are trading above pre-recession levels as if nothing had ever happened. Economists like to call this incongruity a “jobless recovery,” but you might as well call it a recovery for the 1 percent: according to recent data, that small fraction of the nation’s wealthiest captured a stunning 93 percent of a income gains from 2009–10. Income growth for the bottom 99 percent was just 0.2 percent.
This unequal pattern of growth is highly unusual in recent history. For most of the post-war years, periods of economic recovery were defined by a rapid return to high employment and GDP growth. But for the past two decades, there has been an increasing disconnect between the strength of the economy and the health of the labor market. When the economy crashed in 2008, businesses aggressively laid off employees while demanding greater productivity from their remaining workforce. Without a union or effective labor laws to protect them—and with fierce competition for their jobs—many workers resigned themselves to more work for the same salary.
That’s not how it used to be. Research shows that until the mid-1980s, labor productivity tended to slow during recessions, as it was difficult for businesses to downsize effectively. But with the sharp decline of unions during the Reagan years, the correlation between productivity and employment turned negative. “These days,” writes economist Brad DeLong, “U.S. labor productivity looks to be countercyclical: firms take advantage of downturns in demand to rationalize operations and increase labor productivity, pleading business necessity in the face of the downturn to their workers.” Which explains why business sector productivity soared 5.3 percent in the depths of the Great Recession, driving corporate profits up 116 percent to a record $1.4 trillion. Although the stock market boom did little for the 70 percent of Americans who received less than 2 percent of their income from capital gains, the returns to the 1 percent were enormous.
The divergence between productivity and labor (including wage compensation and employment) is the key to understanding rising income inequality, the stagnation of average wages, and the current state of our jobless, 1-percent-oriented recovery. “Productivity and the compensation of the typical worker grew in tandem over the early postwar period until the 1970s,” writes Lawrence Mishel, president of the Economic Policy Institute. “However, the experience of the vast majority of workers in recent decades has been that productivity growth actually provides only the potential for rising living standards.” In reality, average wage growth has stagnated, while the gap between productivity and compensation has accelerated.
According to Mishel’s research, this divergence can be explained primarily by growing income inequality and a recent shift in the allocation of compensation from labor to capital. Part of this story is the rise of the 1 percent, whose earnings grew 156 percent from 1979 to 2007. But Mishel differentiates between this divergence at the top—attributable to the extraordinary growth of executives’ compensation (especially in the financial sector)—and the wage stagnation of the middle class, who have suffered disproportionately from ”laissez-faire policies … including globalization, deregulation, privatization, eroded unionization, and weakened labor standards.” Wage inequality at the bottom is similarly a unique phenomenon, the result of continual high unemployment and the eroding value of the minimum wage.
Mishel’s research strongly suggests that improving labor standards—including a higher, inflation-indexed minimum wage and stronger protections for collective bargaining—must be central to any effort to reestablish the historical link between productivity growth and rising median wages. Here the experience of Europe, with its longstanding support for labor and milder income inequality, should be instructive. Another way to increase workers’ leverage would be to return to full employment, putting upwards pressure on wages. But most economists expect that could take years at current trend growth: businesses will continue to squeeze productivity gains from ever-smaller workforces until an increase in consumer demand requires them to begin hiring again. And consumer demand will not return to pre-recession levels until the jobs crisis is resolved.
It sounds like a catch-22. (That is, until you remember the role of the U.S. government, which can borrow cheaply to stimulate the economy, creating outsize returns on investment.) Of course, in the long-term, the market will find equilibrium on its own—it just may not be the equilibrium we want or expect.
The Right Wing Radicalism of Paul Ryan
Representative Paul Ryan (R-Wis.), current chairman of the House Budget Committee and the eponymous author of the Republican’s 2013 budget proposal, wants to lower taxes on the rich, eliminate assistance for the poor, uninsure millions of Americans and increase military spending. His plan would cost $4.6 trillion in lost tax revenue over the next decade (not including the $5.4 trillion loss from the Bush tax cuts) and save $5.3 trillion in nondefense budget cuts. Two-thirds of those tax breaks would go to households earning over $200,000, and two-thirds of the “savings” would come from gutting programs that benefit the poor—a radical redistribution of wealth from the bottom to the top. So how has Ryan become “the most popular guy in Washington,” asks Jonathan Chait, “revered as much by the mainstream media as by the tea party”?
The answer, according to Chait, has everything to do with the moderate image that Ryan has cultivated over the years—as a humble, self-sacrificing policy wonk and courageous fiscal austerian. “The Paul Ryan that has been introduced to America is a figure of cinematic rectitude—a Jimmy Stewart character, but brainier,” Chait writes. “He is America’s neighborhood accountant, a man devoted to the task of restoring our fiscal health, whatever slings and arrows may come his way.” As a result, the right wing radicalism of Ryan’s budget proposal has gotten an unusual pass from media figures like the New York Times‘ James Stewart, who insist that Ryan “seems very genuine.” This despite the fact that the Ryan Plan “would likely produce the largest redistribution of income from the bottom to the top in modern U.S. history,” according to CBPP president Robert Greenstein, “and likely increase poverty and inequality more than any other budget in recent times.”
Conservative commentators like former Bush advisor Michael Gerson are presently trying very hard to advance the notion that Ryan’s approach—which Gerson brands “Reform Conservatism” in a recentWashington Post column—is a ”modern, market-oriented way” to fix a broken system. This is preferable, he suggests, to the Tea Party’s “Rejectionist” strain of conservatism, which seeks to “fundamentally reorder the role of the federal government.” It’s a straw man argument that allows Gerson and other Establishment conservatives to distance themselves from their party’s fringe element while praising the “disproportionate creativity and influence” of Republicans like Ryan.
Yet one glance at Ryan’s actual proposals reveals a startlingly radical agenda. According to TCF budget analyst Andrew Fieldhouse, the Ryan Plan consists of four component parts:
1. New tax cuts (49.7% of benefits go to households making over $500,000 a year)
- Individual income tax rates consolidated to 25 percent and 10 percent brackets
- Alternative minimum tax (AMT) repealed
- Taxes included in the Affordable Care Act repealed
- Corporate tax rate cut to 25 percent
- Corporations no longer taxed on foreign income
Total cost: $4.6 trillion in lost revenue
2. The extension of the Bush tax cuts
Total cost: $5.4 trillion in lost revenue
Which would be funded by
3. Non-defense spending cuts (62% of cuts come from programs that assist low-income households, like Medicaid and food stamps)
Total savings: $5.3 trillion
4. Trillions of dollars in unspecified offsets
Total savings: ???
Altogether, that amounts to an additional $4.7 trillion deficit over the next decade, which Ryan suggests will be offset by reductions in tax expenditures in the future. Republicans like Gerson want to sell this budget as an honest effort at reform, the brainchild of a moderate policy wonk reaching across the aisle in good faith. But it only takes one look at the numbers to grasp how radical such a “reform” would be. Without specifying which loopholes and deductions he would eliminate, the Ryan plan is revealed for what it is: the end of the social safety net as we know it and a trillion dollar windfall for the rich.
Graph of the Day: “The Great Divergence”
Yesterday morning, The Century Foundation hosted New Republic senior editor Timothy Noah for the first public discussion of his new book, The Great Divergence: America’s Growing Inequality Crisis and What We Can Do About It, which examines the economic and political policies that have widened the income gap between the richest and poorest citizens in our society over the last thirty years. (Click here for video of the event, featuring panelists Dan Alpert, Robert Hockett and Dorian Warren.)
According to Noah, the “Great Divergence”—a term originally introduced by Paul Krugman—describes the dramatic reemergence of income inequality after 1979, following several decades of wage compression and increasing equality that economists sometimes call the “Great Compression.” Before the stock market crashed in 1929, the richest 1% received nearly a quarter of all wage and capital income—until today, the most unequal time in American history. But thanks to New Deal-era policies like progressive taxation, strong labor laws and the GI Bill, the poor and working class were able to share in the benefits of America’s incredible postwar boom in productivity. Wages rose throughout the mid-2oth century, creating a large and dynamic middle class. By 1970, the income share for the top 1% had shrunk to just 9 percent.
The Great Divergence, Noah writes, “has coincided with a dramatic decline in the power of organized labor;” the result of conservative policies that have weakened unions and allowed wealth from productivity gains to be diverted from labor to capital. Congressional support for labor faltered in the late 1970s, and the Reagan administration was notoriously hostile towards the movement. After peaking in 1954 at about 40 percent of the private sector workforce, union density today stands around 7 percent—the same level as in 1933. “It’s as if the New Deal never happened.”
By 2007, the income share for the top 1% had returned to its 1928 peak of 24 percent—a figure thatresearch suggests may be even higher now, despite the 2007-2009 recession. And the decline of organized labor is just one piece of the puzzle. In his book, Noah explores a whole range of reasons for inequality’s rise, taking time to refute the supposed impact of race, gender (women entering the workforce) and immigration. Better explanations include a rising college wage premium, an increase in corporate lobbying in Washington, regressive tax policies and competition from low-wage labor markets in China and the developing world (Noah estimates trade with low-wage nations is responsible for 12 to 13 percent of the Great Divergence, “and perhaps more”).
As a result, the United States has one of the highest levels of income inequality in the developed world, and is now one of the least socially mobile as well. Such a society, Noah concludes, is less reflective of our democratic ideals with each passing day. We can, and should, do better.
Video: Timothy Noah on America’s Growing Inequality Crisis
This morning I had the pleasure of helping host New Republic senior editor Timothy Noah for the first discussion of his newly released book, “The Great Divergence: America’s Growing Inequality Crisis and What We Can Do About It,” at The Century Foundation in New York City.
Joining Tim were four excellent panelists (from left to right in the photo above): Greg Anrig, vice president for policy at The Century Foundation; Timothy Noah; Daniel Alpert, Century Foundation fellow and founding managing partner of Westwood Capital; Robert Hockett, Century Foundation fellow and professor at Cornell Law School; and Dorian Warren, assistant professor of International and Public Affairs at Columbia University.
I’ll be posting more about Tim’s presentation and his new book later this afternoon, but in the meantime, check out the video recording of the event below.
Balancing the Budget on the Backs of the Poor
In recent weeks, Rep. Paul Ryan (R-Wis.) has suggested severe cuts to safety net programs like food stamps and housing assistance, in the spirit of the 1996 welfare reform that moved millions of struggling families off the dole and into poverty. Comparing the safety net to “a hammock that lulls able-bodied people to lives of dependency and complacency,” Ryan has proposed ”welfare reform round two,” which would similarly replace federal funding with fixed grants to states, allowing local politicians to slash poverty assistance programs when the budget is tight and spend the funds elsewhere. “Yes, we divert [welfare funds],” State Representative John Kavanagh, a Republican, told the New York Times, in a recent article about welfare reform in Arizona. ”Divert’s a bad word. It helps the state.” It’s certainly easier than raising taxes.
The practice of diverting welfare funds, and the human tragedy that invariably results, is hardly unique to Arizona. The percentage of families with children living in poverty who received cash assistance declined sharply throughout the United States after the 1996 welfare reform law, which transformed the New Deal-era Aid to Families with Dependent Children (AFDC) into the Temporary Assistance for Needy Families program. TANF, unlike AFDC, was designed to be a transitional program, relying on block grants and lifetime caps on aid to push recipients quickly out of the program. For a few years, the reform seemed to work. The late-1990s economic boom and an unemployment rate below 4 percent helped to reduce welfare caseloads while allowing states to use their TANF funding to plug unrelated holes in the state budget, guilt-free. But when the economy slowed down in 2001, and crashed in 2007, states were unwilling or unable to redirect TANF benefits back to families in need.
“Reformed” welfare—unlike the Supplemental Nutrition Assistance Program (SNAP), or food stamps—had lost its critical counter-cyclical function. From 1995 to 2010, the number of families with children living in poverty rose by 17 percent, from 6.2 million to 7.3 million. But instead of expanding to meet the increased need, as SNAP did, TANF continued to shrink. While food stamps reduced the depth of child poverty by an average 15.5% and its severity by 21.3% from 2000 to 2009, the percentage of families with children living in poverty who received welfare actually declined, from 68% in 1996 to just 27% today. Inflation has further eroded the value of TANF block grants by nearly 30 percent.
Researchers Luke Shaefer of the University of Michigan and Kathryn Edin of Harvard report similar findings: at the same time that the average number of welfare recipients declined from 12.3 million per month in 1996 to 4.4 million today (of whom just 1.1 million are adults), the number of households with children living on less than $2 per day per person has more than doubled, from 600,000 to over 1.4 million.
But for state legislators like the above-quoted Mr. Kavanagh of Arizona, cutting safety net funding has been a no-brainer. “We have reduced our caseload, and we don’t have people dying in the street. There were an awful lot of people who didn’t need it.” Republicans like Paul Ryan and Mitt Romney are likewise on the record in favor of extending the block grant structure for means-tested programs like Medicaid, housing subsidies, job training and food stamps. “Welfare reform showed us how well a state-led approach can work,” Romney told a crowd in Detroit. “Let’s extend that conservative, small-government philosophy across the entire social safety net.”
We already know how that story ends. For the millions of Americans who struggle every day with hunger and poverty, Romney’s “small-government philosophy” is just another way of saying “you are on your own.”
What Slowing Productivity Growth Means for Tomorrow’s Jobs Report
The U.S. economy went on something of a crash diet during the Great Recession, cutting millions of Americans from the workforce and squeezing dramatic productivity gains from those who remained. Unit labor costs dropped and output per hour rose as busiensses became leaner and meaner. But slimming down can only increase efficiency to a point, and as the economy has recovered, the pendulum has appeared to swing back in favor of workers. Revised estimates released yesterday by the Labor Department show that productivity growth slowed to 0.9 percent annualized at the end of last year, down from 1.8 percent in the previous quarter. And unit labor costs rose 2.8 percent, more than doubling earlier estimates.
That bodes well for tomorrow’s jobs report, which is expected to show modest gains throughout the economy. If productivity is slowing, than the only way businesses can expand output is to hire more people. Hopefully that will put sufficient pressure on wages, which have plenty of room to rise against price markup without any inflationary effect.
But let’s not miss the forest for the trees—or in this case, the historic trend for the market correction. The graph below—which plots productivity growth against labor costs since 1990—shows that the divergence between efficiency gains and wage compensation is a long-term trend that is not likely to be altered by the recovering labor market. The underlying problem remains intensifiying income inequality, here expressed as workers’ decreasing share of corporate profits. Although tomorrow’s job numbers are likely to be another piece of good news for the economy—joining high consumer confidence and declining unemployment insurance applications on a growing list of positive indicators—it is critical that we do not allow the conversation about systemic inequality to fade into the shadows. The graph below illustrates a tectonic, not cyclical, shift. We’ll need more than a band-aid to correct our course.
A Recovery for the One Percent
The top 1% captured 93% of the income gains in the first year of recovery.
That is the shocking new statistic from income inequality expert Emmanuel Saez, whose latest data for the World Top Incomes Database shows that America’s richest 1 percent survived the Great Recession just fine. Back in 2011, some commentators,Megan McArdle among them, suggested that the financial crisis might have affected the trend toward greater inequality. No data was yet available to substantiate a claim either way, although a slew of dramatic trend pieces from the New York Times seemed to suggest the party was over for the 1 percent. Saez’s new data should put that claim to rest. Income inequality is indeed back, and rising as fast as ever.
Graph of the Day: Mitt’s Reverse Robin Hood Tax Plan
Hoping to revive a struggling campaign and shore up his Republican bona fides, Mitt Romney last week released a new version of his tax plan that would dramatically lower taxes for America’s wealthy while raising rates on the poor. The Tax Policy Center got to work examining the details, and the results aren’t pretty: Romney’s proposal would save the top 1 percent of earners nearly $150,000 per year on average, and the top 0.1 percent over $725,000. Amazingly, that massive cash transfusion would be paid for, in part, by higher taxes on the poorest fifth of Americans, who would see their taxes rise by an average $143.
Compare that to Obama’s tax proposal, which would lower taxes for the middle class while only raising rates on families making over $250,000 per year. Deficit reduction would be helped by the top 1 percent, who would pay about $87,000 more per year on average.
Romney has offered few details about how he would pay would pay for his own plan, which TPC estimates would add nearly $500 billion to the budget deficit when fully implemented, and $900 billion if the Bush tax cuts are allowed to expire. History has shown that tax cuts for millionaires do not pay for themselves (witness the incredible un-miracle of the “Bush Boom”). And while Romney claims he can make up for lost revenue by eliminating deductions and loopholes in the tax code, he has yet to offer any details that would allow TPC to analyze their effect.
Graph of the Day: Putting the Squeeze on Labor, Part II
Yesterday I commented on what Mark Thoma and Karl Smith both identified as one of the most significant graphs in the White House’s Economic Report of the President. That graph showed how the historical post-war relationship between wages and prices—or more fundamentally, between labor and capital—has broken down over the last thirty years. You can probably guess who has gotten the short end of the stick. Traditionally it has been the case that a competitive market prohibits businesses from raising prices too high or pushing labor costs too low, as both consumers and labor will look elsewhere for a better price. And historically, that dynamic has held: from 1947 until the mid-1980s, American wage earners accrued a proportionate share of economic output as productivity rose. But since the Reagan Revolution, corporate profits have surged while wages have flatlined, breaking the post-war trend that essentially created the American middle class. As I argued in my previous post, the present imblanace between capital and labor is unlike anything we have experienced in two generations. A global oversupply of labor and skill-biased technological change account for much of this inequality. But we cannot ignore that “laissez-faire” policies have encouraged this unprecedented redistribution of wealth to the richest 0.1%, while diminishing social mobility for the poor. Regressive tax policies that privilege capital gainsand loopholes like the carried-interest deduction have created the conditions that allow the Forbes 400 to control as much wealth as 150 million Americans while paying an average tax rate of just 18 percent. We cannot accept that disparity as the new normal.
Graph of the Day: Putting the Squeeze on Labor
The White House’s new Economic Report of the President—broadly, an annual overview of how the president and his Council of Economic Advisors (CEA) view the state of the economy—is generally optimistic for 2012, noting better-than-expected job growth and economic expansion for ten straight quarters. It also underscores just how severe the financial crisis was that the president faced, with revised estimates showing that the economy contracted at an 8.9 percent annualized rate in the last quarter of 2008, not the 3.8 percent initially claimed.
The outlook on wages, productivity, and prices is less rosy. The CEA notes ominously that for the first time since World War II, the historical link between wages and prices has broken. For the last ten years, inflation has been driven by rising price markup, while unit labor costs have fallen behind productivity gains. In other words, prices are increasing and corporate profits are soaring—but workers are being left behind, with labor share of output (the inverse of price markup over labor unit costs) at its lowest level in seventy years.
On the one hand, that means there is now considerable slack in the labor market, so the CEA can predict that the economy has plenty of room to expand without creating inflationary pressures. But it also indicates a tectonic shift, since the Reagan Revolution, in the relationship between unskilled labor and capital. If this new trend holds, then we are looking at an economic environment that is unlike anything we have experienced in the post-war era. Karl Smith is more blunt: “At its heart the issue is that Industrialization Really Was Different, and there is no reason to think it will come again. The reality of this new world is that you cannot simply work hard and make a good living.”
In a way, he’s right. The post-war era really was a unique time in American and economic history, with wage compensation tied to productivity growth—a rising tide that lifted all boats mostly equally. The past several decades have seen that relationship erode, as manufacturing and union jobs disappeared overseas, and corporations sought massive gains in competitiveness and profit at the expense of labor. Globalization and technology share much of the blame, but it is also instructive to look at the experience of other industrialized countries, many of which have been able to mitigate soaring income inequality with education and industrial policies designed to equalize opportunity and share the benefits of economic growth. Once, around the turn of the twentieth century, enterprising young progressives headed to Europe to study policy, returning to America with the seeds of what would become the New Deal, and later, the Great Society. Perhaps it is time, once again, to look abroad for answers.
Graph of the Day: The Growing Education Gap Between Rich and Poor (Continued)
New research on the state of U.S. education shows that income inequality has surpassed racial inequality as the single most significant predictor of education outcomes. According to the Russell Sage Foundation, the achievement gap between rich and poor students is now larger than the gap between white and black students—perhaps a watershed moment in the changing discourse on inequality.
Century Foundation Senior Fellow Rick Kahlenberg weighs in on the debate, describing a few of the myriad strategies that TCF and other organizations have proposed to close the socioeconomic achievement gap in education. But I wanted to highlight a few of Rick’s own graphs, from Rewarding Strivers: Helping Low-Income Students Succeed in College, which illustrate a few of the ways in which income inequality critically disadvantages students at the bottom of the income distribution.
Much of the funding for public schools typically comes from local property taxes, leaving poorer districts with significantly lower-quality staff and facilities than wealthier districts. The table above shows how teacher quality drops at high-poverty schools, while the number of students who will grow up to live in poverty skyrockets from 4 percent to one in seven—even when controlling for individual ability and family home environment.
But the disadvantages don’t stop there. Rick’s research for The Century Foundation also indicates that students from the bottom income quartile received zero or negative advantage in the college admissions process, while recruited athletes, minority groups, and legacies enjoyed a significant boost. Leaving aside the issue of athlete and legacy preference, which Rick has argued against forcefully in the past, it is disturbing, in light of this new research, why few schools have adopted programs to encourage economic diversity.
