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.
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: Why Does the U.S. Have Lower-Wage Jobs than Europe?
The folks at the Center for Economic and Policy Research have a new report out this week that provides an interesting perspective on the now hot-button issue of income inequality. According to John Schmitt, the report’s author, nearly a quarter of American workers were in low-wage jobs in 2009, a higher percentage than in any other rich, developed country. What’s more, the number of low-wage workers—defined as those earning less than two-thirds the national median hourly wage—has been rising in the United States for “at least three decades,” from around 20 percent in 1979 to nearly 30 percent in 2010.
Of course, a high incidence of low-wage jobs does not by itself indicate income inequality. If, as Schmitt points out, “low wage jobs act as a stepping stone to higher-paying work, then even a relatively high share of low-wage work may not be a serious social problem.” But that is no longer the case, at least in the United States. Even Republican lawmakers are acknowledging that social mobility in the U.S. has fallen behind much of the rest of the developed world, with low-wage work “a persistent and recurring state for many workers.”
But, you may ask, doesn’t the United States have a higher standard of living? Aren’t our low-wage earners still better off than their counterparts in Europe? Well, not really. Low-wage workers in the United States have no legal right to paid vacation, sick days or parental leave, not to mention the lowest incidence of employer-sponsored health insurance—54 percent of workers in the bottom wage quintile have no insurance at all. And though the U.S. does enjoy a high GDP per capita, the OECD data shows no association with a reduction in the share of low-wage workers. Comparing median household income yields the same result:
Stronger labor market institutions, like those in Europe, could certainly help reduce our high proportion of low-wage jobs. Collective bargaining, a higher minimum wage, employment protection legislation, and more rigorous enforcement of national labor laws would all raise wages for the quarter of Americans struggling with low wages and ever-lower social mobility.
The Trouble with the December Jobs Report
There’s certainly good reason to cheer the latest employment figures from the Bureau of Labor Statistics—according to this morning’s jobs report, the economy added 200,000 net jobs in December, bringing the headline unemployment rate down to 8.5 percent, the lowest level in nearly three years. Still, the public sector continued to shed jobs, with budget shortfalls forcing state and local governments to layoff another 12,000 employees, for a total of 280,000 fewer government jobs in 2011.
And while employment gains were felt widely throughout the private sector, with new hires in transportation and warehousing, retail trade, manufacturing, health care and mining, among others—job security remains weak for many millions of Americans. The U6 unemployment rate—which measures formal unemployment as well as marginally attached workers and workers who are part-time but wish to be full-time—remains uncomfortably high at 15.6 percent, despite dropping nearly one and a half percent from this time last year.
And though 1.6 million new jobs were added in 2011, workers saw virtually no gains in the number of hours they could work, leading about 150,000 people to take on multiple jobs to make ends meet. The long-term unemployment rate dropped slightly but remains at historic highs, while 1.5 million Americans dropped out of the labor force entirely, bringing the participation rate to historic lows. That means that the unemployment rate is artificially depressed, and will likely increase or plateau as a broader economic recovery encourages millions of labor force drop-outs to start looking for jobs again.
Of course, there are plenty of reasons to applaud today’s jobs report—this is the sixth straight month that we have seen over 100,000 workers rejoin the work force, a statistic that is sure to help President Obama in his quest for reelection. But a healthy dose of negativity is a helpful reminder that millions of Americans remain outside our more conventional metrics of economic well-being, and despite the currently upbeat media narrative, they still need support. Extending the payroll tax-cut, for instance, will go a long way towards maintaining this momentum, as will a new round of stimulus for infrastructure investments. The optics on the economy may be shifting in favor of the President, but too many Americans are still struggling to get back on their feet to let such policy opportunities slide.
Workers’ Wages Fall, Corporate Profits Soar
By Benjamin Landy
Henry Blodget, the Editor-in-Chief of Business Insider, has compiled an excellent series of graphs this week illustrating the various ways that the distribution of wealth has grown more unequal over the last fourty years. Inspired by the Occupy Wall Street protests, Blodget highlights the ongoing economic injustice: middle class wages remain stagnant and the unemployment rate hovers near historic highs, but corporate profits and incomes for the nation’s wealthiest members are reaching levels unseen since the late 1920s.
I combined two of Blodget’s more powerful graphs and reconfigured them to compare the change in wages and corporate profits as a percentage of GDP since 1960.
The data is shocking: with the exception of a brief respite from 1967 to 1972, workers’ wages have been steadily declining as a share of the economy for over fourty years. At just 14 percent, wages have never been lower as a percentage of the economy than they are today.
Corporate profits, meanwhile, have never been better. As a percentage of the economy, today’s profits are surpassed only by a brief period in 2007, just before the stock market crashed, propelling the US economy into the Great Recession. If the current trend continues, they will soon be even higher.
And just in case you were wondering who is benefiting from those skyrocketing corporate profits, here’s a reminder:
It’s not the middle class.
