Income Inequality Tells a Story…and Don’t Let Anyone Tell You Otherwise

University of Arizona social scientist Lane Kenworthy is one of the country’s best researchers in poverty and inequality, as well as a regular reader of this blog. So when I saw that he would be joining this month’s Cato Unbound debate on income inequality, I couldn’t wait to read it. But when I read the lead essay by Will Wilkinson, I knew Kenworthy’s essay would leave me disappointed. I was right.

Kenworthy shouldn’t feel responsible for my disappointment. He did his usual superlative job. The reason it didn’t meet my expectations was because Wilkinson’s essay led Kenworthy to bat down a frustratingly common misconception, and he could only spend a few paragraphs on more interesting matters, like policies and solutions. Kenworthy did the right thing. Wilkinson based the bulk of his argument on a rather obtuse assumption. I almost expected him to do this before I even read the essay–it’s a common libertarian criticism–but I was hoping he wouldn’t back Kenworthy into that corner. He did, and Kenworthy couldn’t let readers walk away believing Wilkinson’s naive story.

What did Wilkinson say that strikes me as so misguided?  Income inequality doesn’t matter. Or more precisely, it’s a poor measure of differences in living standards. Wilkinson prefers consumption inequality. After all, he reasons, it doesn’t matter how much money you have lying around; what really matters is what you do with it. If Bill Gates has billions and billions but he basically buys the same stuff as someone with far less, then there really isn’t much difference between their lifestyles. And sure enough, consumption inequality numbers are lower than those for income inequality.

Kenworthy starts by pointing out that consumption data actually understates inequality. But there’s a more important, subtle point to this opening salvo: Everyone knows this. Everyone who studies inequality, that is. So either Wilkinson just ignored this problem–which is intellectually dishonest–or he honestly had no idea–which means he shouldn’t be in this debate in the first place. Either way, this rookie blunder portends just how deeply naive his argument is.

You should read Kenworthy’s essay to get the rest. He goes on to show how many important elements consumption leaves out of the equation. I have to give you this paragraph so you’ll be tempted to read the whole thing:

The point is that income adds value even if it is not spent right away. Consider, as a potentially helpful analogy, political freedom. On virtually every scoring or classification of political liberties, the United States receives the highest possible score. Yet many Americans make little use of these liberties. Only about half of those eligible actually vote in presidential elections, and the share is much smaller for off-year national elections and smaller still for local elections. Many who do vote have limited knowledge of key issues, and they tend to be heavily myopic in their thinking. Few Americans participate in politics in other ways, such as active involvement in a party or other political organization, campaigning for a candidate, engaging in organized political discussions, or giving money to a political party or candidate. Only a small portion of Americans, in other words, make much use of the political freedoms they enjoy. If we care about political liberty only insofar as people make use of it, perhaps we should judge our country to have far less political freedom than is commonly thought.

I’ll leave Kenworthy to rebut Wilkinson’s premise that consumption is a better measure of living standards than income. And I should add that Wilkinson mentions Paul Krugman’s The Conscience of a Liberal several times for its emphasis on income inequality. Then he trumpets a claim that Krugman specifically dispelled in Chapter 12 of the book, which leads one to wonder if Wilkinson is criticizing something he’s never read. So if after reading Kenworthy, you still think Wilkinson is onto something, read Krugman.

Meanwhile, I want to make two more fundamental points, which I hope will show that the very idea that we should ignore income inequality is grounded in a profound misunderstanding of political economy and economic history. To think this issue is only about redistribution or economic opportunity is to miss the big picture entirely.

The first point, which Kenworthy briefly mentions, is that income inequality is one of the fundamental imbalances that led to the recent financial crisis. I traced the logic behind that claim in this column, published in the Hazleton Standard-Speaker in December 2008:

Here’s how economists explain the crisis in their lingo:

Three forces interacted to leave the country vulnerable to external shocks: a burgeoning availability of private capital, especially short-term capital, that was in search of higher returns; macroeconomic policies that permitted capital inflows to fuel a credit boom; and newly liberalized, but insufficiently regulated financial markets that were growing rapidly. The scenario played out as follows: The push from global capital markets, often without due diligence and beyond prudent limits, interacted with poorly regulated domestic financial systems to fuel a domestic credit expansion. This manifested itself as an asset price bubble and added to the excessive debt of already over-leveraged firms, which exposed the region to the shocks of changing investor expectations.

But why am I telling you what happened to Thailand over ten years ago?

That’s right: This financial crisis may be new to most Americans, but it is quite familiar to economists around the world. Despite being a perfect description of our current recession, the above analysis is actually the World Bank’s word-for-word explanation of the East Asian crisis that took place in the late 1990s (with a few minor adjustments to conceal the countries’ names). In the last couple decades, the same type of crisis has occurred, in various forms, in Thailand, Korea, Indonesia, Argentina, Mexico, Russia, Brazil, and Turkey, just to name a few.

Sure, each crisis was unique in its scope and guilty parties, but they all had the same hallmarks: Too much debt, too little regulation of financial markets, usually a trade deficit, and in some cases, a low saving rate. (Crises in developing nations usually involve a fixed or pegged exchange rate, too; thankfully, we don’t have that complication.) While many economists didn’t predict everything that has played out thus far, almost all of them (including this column) warned about the underlying imbalances.

Booms and busts are, as the legendary economist John Kenneth Galbraith wrote in his later years, part and parcel of human nature. A lifelong student of euphoria and crashes, Galbraith explained it with that uncanny clarity that he always had with a pen, “The cyclical tendency of the basic economic system must be assumed. There are diverse causes, but the evident and reliably persistent one is speculative excess in good times… The speculative episode in one form or another—in securities, real estate, junk bonds, the mergers-and-acquisitions mania of the 1980s with its depressive debt accumulation, all in descent from the frenzy for tulips in Holland in the seventeenth century and the great South Sea Bubble in the eighteenth—is…an inescapable feature of the system. It has been experienced in the United States since the earliest days of the Union. Recession or depression and unemployment inevitably follow. Better understanding, appropriate regulation, greater common sense, can perhaps help to control the boom, but, as a practical matter, attention must be concentrated on mitigating the distress and hardship and especially the unemployment that result from this basic cyclical instability in economic life.”

While we can debate whether this particular bubble could have been prevented or moderated, the fact remains that the glaring imbalances that magnified the bubble into the biggest financial crisis since the Great Depression have been obvious for many years to anyone who was paying attention.

Economists call it “Bretton Woods II,” after the meeting place where the world superpowers brokered an international financial arrangement after World War II. The “II” came about when Richard Nixon broke that deal by taking us off the gold standard.

In the 1980s, Paul Volcker needed to bring high inflation under control, so he jacked up interest rates and paid the price with a deep (but necessary) recession. High interest rates usually mean the dollar appreciates, which means our money is worth more. In other words, we can buy more stuff from abroad, but it also means the stuff we make is more expensive to foreigners. Imports rose, exports sank, and the trade deficit ballooned.

Ronald Reagan wanted tax cuts and more military spending, which meant a higher budget deficit. How do you pay for a budget deficit? Borrow abroad, which means a bigger trade deficit. To borrow that much money, though, you need some awfully steep interest rates (which is the return the foreign lenders would get on their loan to us), and as Volcker had just proved, high interest rates put quite a damper on the economy.

Thankfully, foreign countries, first Japan and later China and its neighbors, wanted to create export booms to fuel their economy, which meant they were more than happy to pump money and goods into our economy despite our low interest rates. This continued all the way until the Bush administration, which, like Reagan, wanted big tax cuts and military spending without high interest rates. Our Asian trading partners were only too happy to oblige.

That’s where you and I come in. Real earnings plummeted from 1973 to roughly 1995, then rose until 2002, at which point they stagnated. There were, of course, especially precipitous declines during recessions, but they are supposed to be followed by expansions that bring the standard of living back to normal and then some. Not this time. Economic historian Brad DeLong finds the period from 2000 to 2007 to be “the first business cycle during which median household income in America falls from peak to peak.” [Incidentally, Larry Summers recently made the same point.]

Low interest rates mean cheap debt. Since wages didn’t keep up with inflation, people dove headfirst into debt (read: mortgages) to maintain their standard of living. Americans bought and bought, and prices rose and rose. And that, my friends, is called a bubble.

To be clear, the cause of the current recession is the housing bubble—not Fannie Mae, Freddie Mac, Ronald Reagan, or even investment bankers—but their mistakes have evolved from the imbalances that economists warned us about, turning a routine recession into a financial crisis of epic proportions.

If the financial crises abroad taught us anything, it was (1) economies can suffer for a long time without government intervention, and (2) countries that do not correct the underlying imbalances are destined to repeat the same catastrophe. Next week, we will look at some immediate steps that President Obama can take to get our nation back on track, as well as a few long-term issues that he should dedicate some intense manpower and brainpower to resolving.

And the next time economists complain about seemingly boring, amorphous concepts like saving rates and structural imbalances, pay attention because the nightmare unfolding before your eyes is exactly what happens when a generation of economic advice falls on deaf ears.

I go into much more depth in my forthcoming book, but the basic point is clear: Incomes stagnated, or even fell, and consumption remained the same, or even rose. (The economics profession made a tacit admission of guilt for not giving this phenomenon enough credence by awarding this year’s prestigious John Bates Clark Medal to inequality expert Emmanuel Saez.) You wouldn’t know this from looking only at consumption inequality. In fact, the stability of consumption inequality over the past few decades should have been a warning. How can income inequality rise so drastically without consumption inequality changing? Wilkinson assigns the entire divergence to better, cheaper goods for lower-income folks to buy, but the numbers don’t add up, and his willful disregard of income inequality (as if any economist should ignore any major economic metric just because they don’t like what it has to say) is symptomatic of the very attitude that led us into the crisis. Even if you firmly believe that income inequality doesn’t represent what everyone says it represents, it is part of the story–a part you can’t get by looking at consumption inequality–and ignoring any part of the story is just asking to be fooled.

After giving Wilkinson such a hard time, I should point out that the second half of his essay is good. He says that inequality is only a symptom and we have to correct the causes of economic injustice. Indeed, but let us not say this symptom doesn’t matter. It mattered enough to warn us that Americans were overborrowing themselves into a housing bubble and financial crisis, and it has mattered throughout history to warn us when the political scales have been tipped in a very dangerous way. This is my second point.

One example of this phenomenon is documented in a 2000 Journal of Economic Perspectives article by Kenneth L. Sokoloff and Stanley L. Engerman that explores one of the fundamental causes of the divergence in economic growth between different nations in the past few centuries:

Although many explanations have been proposed, the substantial differences in the degree of inequality in wealth, human capital, and political power, which were initially rooted in the factor endowments of the respective colonies but persisted over time, seem highly relevant.

Those early differences in the extent of inequality across New World economies may have been preserved by the types of economic institutions that evolved and by the effects of those institutions on how broadly access to economic opportunities was shared. This path of institutional development may in turn have affected growth. Where there was extreme inequality, and institutions advantaged elites and limited the access of much of the population to economic opportunities, members of elites were better able to maintain their elite status over time, but at the cost of society not realizing the full economic potential of disadvantaged groups.

The bottom line, then, is what political economists have argued since the days of Aristotle: Income inequality is not only a symptom that the economy is misallocating resources but a warning that the political structure is shifting toward a dangerous balance that favors centralized power, immoral expropriation of wealth, and less economic growth. One famous explanation of the recent financial crisis posits exactly that shift. A similarly respected analysis cites growing income inequality for the polarization of our political system.

I’m going to be honest: When I first started out in economics, for the life of me, I could not see why income inequality mattered. I thought, Clearly, a proper economy shouldn’t create a caste system, but how does the difference in wealth actually affect the economy? Sokoloff and Engerman point out one way, and there is an entire literature of similar studies where that came from. Wealth is power, as one of my high school history teachers used to say, and the story of history is, to a large extent, one of the wealthy controlling history–creating reality, to use the infamous Bush terminology. The difference in wealth has been one of the fundamental struggles that shaped wars, political structures, and daily life since the beginning of civilization. The saddest part is, I know Wilkinson knows all this because one of the things I most admire about his punditry is his commitment to individual rights, based on his deep revulsion against the long history of monarchs who held all the power and expropriated all the money. Not only was it a morally repugnant system, but it was an economically inefficient one. Of course we are in no danger of returning to that extreme, but the slide toward income inequality always affects the balance of political power, which in turn shapes the economy and the social structure.

You can’t glean any of that from consumption inequality. Wilkinson is a keen student of political economy. He understands this institutional story. Which is why it’s a shame that he had to relearn it from Lane Kenworthy and me.