Capitalism in Crisis: Income Inequality in the US

Capitalism in Crisis: Income Inequality in the US

ESSA Writers
Market ConfidenceHousehold Income
March 25, 2014

It is now 5 years into the US recovery after the severe recession of 2008-9,  unemployment has fallen to 6.7% and quarterly GDP growth remains between 1-2%. At first glance the recovery finally appears to be picking up momentum, with stronger then expected growth in the last half of 2013.

Looking at the longer term trends however, any optimism is quickly expunged as it appears the US is performing far below its potential. The IMF outlook for 2013 shows actual GDP to be more than 4% below potential GDP. This is known as the output gap, which is the difference between actual output and the maximum amount of goods and services the economy can produce when all inputs are fully utilised.

A darker shadow is cast by the Bureau of Labor Statistics, as the participation rate is now at a 30 year low, falling below 63%. Some have attributed this poor performance to the prodigious levels of income inequality in the US , shedding light on the precariousness of the recovery.

The scary truth

Two tennents of the US have distinguished it from most other countries during the 20th century. These are its relatively pluralistic society and also the vast amount of wealth and income generated from the majority of its population, especially during the great moderation between 1950 to 1970. Unfortunately it is becoming widely apparent that the egalitarian manner by which income is shared in the US is reversing back to the conditions just prior to the Great Depression.

A famous graph by economists Picketty and Saez of pre tax income in the US from 1913 till present shows income concentration rising back to the levels in the late 1920’s.

Alarmingly, the annual median household income has barely risen since the 1970’s and is now hovering around $50,000.00. This is a strong indicator suggesting that the living standards of the majority of the population have barely changed over the past 40 years.

So what are the implications of this?

There is an enduring perception around the world, especially within the US, that an overly generous redistribution of income from the rich to the poor perverts incentives to work hard, stifling economic growth. This is largely based upon the famous work by economist Arthur Okun, emphasising the trade-off between growth and income equality.

The trade-off is an overly simplistic insight into the implications of redistribution. Assuming the sole purpose of progressive taxes is to finance a transfer system for the poor, the argument may have potency. Rather, the purpose of taxation is to finance a government’s expenditure, which may include investing in a range of things, such as education or infrastructure. This type of spending has huge social benefits for both the rich and poor which could in fact outweigh the costs associated with progressively taxing the rich.

Arthur Okun’s trade-off is now becoming less apparent than ever. Extreme income inequality is being directly attributed to slow economic growth in the US. This argument has been described as the secular stagnation hypothesis, popularised by economist Larry Summers. The idea is simple. Wealthier people have a higher propensity to save. As a growing share of income is flowing into the hands of a few, consumption is falling whilst saving is rising. Therefore, economic activity is slowing as a growing savings-investment gap is forming in the US.

The debate now focuses on how to plug this gap. Some advocate increased public investment rather than private, in order to avoid risky investments including those in mortgage backed securities prior to the GFC.

Wealth and income

Former MIT economist Thomas Piketty has taken a different approach in explaining the causes of income inequality. He focuses on the growing gap between the return generated by wealth, rent, dividends and profit, as opposed to labour. A free exchange blog post of Piketty’s work explains wealth’s share of total income may be measured as the savings rate as a ratio of the growth rate over time. Wealth can then be estimated as 400% of annual output, and possibly rise to 800%.

Although not advocated by Piketty, the growing share of income generated by wealth as opposed to labour may also be attributed to technology. Daron Acemoglu argues technological developments and globalisation following the 80’s and onwards has largely made middle-skilled jobs redundant. This means the demand for middle skilled jobs has fallen, eroding the wages and size of the middle class. In contrast, corporate profits are rising as labour-saving capital becomes more productive, increasing the income flowing to wealth.

Speculative capital

An important aspect of both Piketty’s argument and the secular stagnation hypothesis is the savings rate. The danger of higher savings largely reflecting income of the wealthiest portion of society is that it is being used to make speculative investments, such as MBS’s during the GFC. Stockhammer believes wealthier people have a higher propensity to make risky investments. He therefore partly attributes growing income concentration to the rise of risky derivatives and the collapse of financial markets in 2008. This may also serve to explain the severe financial volatility in emerging markets as global capital is moving away from the US in search of a greater yield.

Yet ultimately, the undoubted consensus is that income inequality is bad, and addressing it should be high on the US government’s agenda.