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Full Analysis: The Instability of Inequality

The following piece of analysis was summarized in a recent OpEd on Project Syndicate.

This year has been characterized by social and political turmoil and instability throughout the world, with masses of people in the real and virtual streets protesting: The Arab uprising and revolts; the recent riots in England as well as the earlier protests there against pension cuts and higher tuition fees; the Israeli middle class protesting high housing prices and the squeeze from high inflation; Chilean students concerned about education and jobs; the vandalism of the expensive cars of “fat cats” in Germany; Greeks demonstrating against fiscal austerity; India’s movement against corruption; the deadly riots in China’s globally integrated eastern provinces in reaction to corruption, inequality and illegal land seizures as well as similar complaints in the Chinese blogosphere where the Chinese can more freely express their dissatisfaction with government policies; and now the “Occupy Wall Street” movement in New York and across the U.S. While these protests don’t have a single unified theme, they express—in different ways—the concerns of the working and middle classes about their economic future, challenges in accessing economic opportunity and the concentration of power among economic, financial and political elites.

Some of the common causes of these protests are:

  • Serious economic and financial insecurity and malaise among blue and white collar workers with the recent global financial crisis leading to a very weak recovery in advanced economies;
  • High rates of unemployment and underemployment in advanced and emerging economies;
  • A lack of skills and a skills-mismatch preventing young people and workers from competing in a more globalized world economy;
  • Resentment against corruption, including “legalized forms” such as interest groups using the financial power of lobbying to pursue their narrow interests;
  • Poverty, insecurity, anger and hopelessness about the future and a desire for greater social justice; and
  • A sharp rise in income and wealth inequality (Figure 1) in advanced economies and even fast-growing emerging markets (EMs), as well as across economies.

The squeezed and sinking 99% and the thriving top 1% (as the Occupy Wall Street protestors have it) may be a simplification of a highly complex situation. But it resonates with a deeper truth that unfettered free markets, deregulation and globalization have not benefitted all and that some of their pernicious consequences are associated with massive job losses, mediocre income growth and rising inequality. To save globalization and its power to increase productivity and economic growth, we need to start seriously addressing its consequences, including the rise in inequality and the stagnating real incomes of most households and workers.

Figure 1: Including Capital Gains, Income Inequality Worsens in U.S. (% share of total income)
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Source: Paris School of Economics

Inequality and its Causes

Of course, the causes of this social, economic and financial malaise are complex and cannot be attributed to one single factor. For example, the rise in inequality—a source of much of the recent resentment (the “99% of the population against the richest top 1%,” as the New York street protestors put it) is the result of many complex factors (see “Some Factors Behind the Recent Rise in Inequality and Economic Pressure on the Working and Middle Classes” in the Appendix below, for further details), such as:

  • The addition of 2.5 billion Chindians (and another billion of other EM populations) to the global labor force is reducing the jobs and wages of unskilled blue collar and of off-shorable white collar workers in advanced economies;
  • Skill-biased technological change;
  • Winner-take-all effects;
  • The nascent rise of inequality in rapidly growing, previously low-income economies (the Kuznets Curve or inverted U inequality-income relationship);
  • The growth of less competitive and margin-increasing oligopolies;
  • Some effects from economic and financial globalization; and
  • Less progressive taxation.

In the U.S., for example, by 2010, income inequality was back to levels not seen since 1928 in the first Gilded Age, right before the onset of the Great Depression (Figure 2). By last year, the share of income of the top 1% by income was 23%, having risen from 10% two decades earlier. The top 5% control about 75% of the financial wealth.

Figure 2: Top 1% Share of U.S. Total Income at Highest Since Gilded Age
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Source: Paris School of Economics

The Gini coefficient (Figure 3) for the U.S.—which measures formally inequality—shows a sharp rise to over 0.45, close to or worse than that of highly unequal economies in poorer EMs. At the same time, real median incomes for U.S. households are now back to 1999 levels. Thus, the working and middle classes are now both seriously squeezed, income-wise and wealth-wise (as stock prices have moved sideways for over a decade now and home prices have fallen by over one-third from their peak in 2006).

Figure 3: Income Gini Coefficient (most recent data—2006-08)
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Source: CIA, World Bank

The Knock-On Effects of Inequality

The rise in inequality and the related weak growth of working and middle class incomes has many and complex causes; equally, it is also problematic for many reasons, even if one ignores the issue of the “fairness” of inequality.

First, the increase in private and public leverage and the related asset and credit bubbles are partly consequences of inequality: The mediocre growth in incomes of the past few decades (driven by the factors increasing inequality discussed above) created a gap between incomes and spending aspirations (“keeping up with the Joneses”). In Anglo-Saxon countries (not just the U.S. and UK, but also others that followed the Anglo-Saxon economic model such as Iceland, Ireland, Spain and Australia in recent years), the response was a democratization of credit—via financial liberalization—that allowed struggling households to borrow to make up the difference between spending and income, leading to a rise in private debt. In the social welfare state economies of continental Europe, the gap was filled by the provision of public services (free education, health care, etc.), although not fully paid for with taxes, thus leading to the rise of public deficits and debt.

In both cases, such growing private and public debts eventually became unsustainable, leading to financial crisis. So, while originally there was a surge of private debt in the laissez-faire Anglo-Saxon economies and of public debt in the continental European social welfare state economies, both ended up with massive—and at times unsustainable—levels of public debt. When the private debt bubbles burst as asset prices collapsed, public deficits and debts surged even in the Anglo-Saxon economies as private losses were socialized, automatic stabilizers kicked in and counter-cyclical fiscal policies were implemented to prevent the Great Recession of 2007-09 turning into the Great Depression 2.0.

Second, corporate firms in advanced economies are now cutting jobs because they say that there is uncertainty, excess capacity and not enough final demand. But cutting jobs reduces labor income, increases inequality and reduces final demand. Thus, what is individually rational (firms need to survive and thrive, be profitable and achieve Wall Street’s or the City’s earnings targets), is destructive in the macro aggregate as a firm’s labor costs are an individual’s labor income and demand. So, we get a Catch 22 situation in which free markets don’t create enough final demand as firms shed jobs as there is not enough demand, while those actions further reduce labor income and demand. The sharp worsening in the distribution of income that comes from this labor-cost slashing (note that the share of labor income in GDP is sharply down and falling in the U.S.)—from labor to capital, from wages to profits, from poor to rich, from households to corporate firms—then reduces aggregate demand as the marginal propensity to spend (save) of households/workers/the poor is higher (lower) than of firms/capital owners/the rich.

In a previous era, Henry Ford was willing to increase the wages of his own workers as he realized that higher spending, including spending to purchase the cars that he produced, was dependent on higher wages. But Ford Motor Company was large enough in the early part of the 20th century to internalize the effect that its own wage policy would have on the overall economy. In the U.S. instead, the belief that markets always work if unfettered by regulation has now led to a destructive decrease in jobs as the past few recessions have been followed by job-loss recoveries, then job-less recoveries and then weak job-creating recoveries. Even labor markets don’t work properly if countries don’t invest enough in the skills and human capital of their labor force. In this regard, the labor market policies of some continental European economies—such as Germany—have proven better at maintaining and restoring job growth. In Germany, during the recent financial crisis, we saw labor-hoarding—unlike the massive unfettered labor shedding by U.S. corporations—as working hours were reduced, but a massive outright slashing of jobs was avoided; as a result, labor income did not fall as much, workers skills were not damaged as much by a long spell of unemployment and, once the economic recovery started in earnest, the unemployment rate decreased rapidly in Germany, while it has been stagnating at high chronic levels in the U.S.

So, Karl Marx was partly right in arguing that globalization, unfettered financial capitalism and the redistribution of income and wealth from labor to capital could lead capitalism to self-destruct (even if many of his views were wrong and his view that socialism would be a better system has proven totally mistaken). As he argued, unregulated capitalism could lead to a regular excess of capacity and production, to under-consumption and to repeated and destructive financial crises, fueled by booms and busts of asset prices and credit bubbles.

Moving Back to a Balance Between the Market and the State

These excesses of laissez-faire capitalism were clear even before the Great Depression as workers began to organize to ensure their wages and benefits increased with productivity growth. And enlightened “bourgeois” classes in liberal democracies in Europe realized that, to avoid socialist revolutions, workers’ rights needed to be protected, wage and labor conditions improved and a welfare state created to redistribute wealth and to provide the financing of public goods—education, health care, a social safety net—for the working masses. That push toward a modern welfare state accelerated after the Great Depression when the state took on the role of macro-stabilization, the development of more advanced welfare state institutions such as social safety nets and the provision of opportunity to all via public education, health care, old-age pensions and progressive income and wealth taxation. Thus, the rise of the social welfare state was a response of market-oriented liberal democracies to the threat of popular revolutions, socialism and communism as the frequency and severity of economic and financial crises increased. Three decades of relative social and economic stability then ensued from the 1940s until the early 1970s during which period inequality sharply fell, median incomes grew rapidly and the working and middle classes experienced a sharp rise in their living standards.

While classical economists—from Malthus to Ricardo and Marx—believed (based on hundreds of years of economic history) that the working classes would always be stuck at close to subsistence wages as an unlimited supply of labor would prevent real wages from rising above such a level, real wages and economic conditions sharply improved in the second half of the 19th century as the technological innovations of the Industrial Revolution led to an increase in productivity growth that was shared by both labor and capital. Indeed, the major intellectual revolution of thinkers such as Marshall—compared with classical economists—was that wages could grow over time alongside the increase in labor productivity growth, driven by technological innovation and the rise in the capital-to-labor ratio, spurred by investment in physical capital. The massive rise in incomes of many societies in the past 150 years that has vastly improved the living conditions of a large fraction of humanity has been driven by market-oriented economic regimes and the progressive application of technological progress—whether embodied or disembodied in new capital—to the production of goods and services, thus leading to a huge increase in the productivity of labor.

But that relationship between rising productivity and increasing working and middle class incomes was never mechanical: It required workers to obtain the opportunity and skills—via education, training, proper health care—to increase their own productivity and thus partake of the increase in income deriving from the productivity growth that new technologies provided. It also required the existence of a welfare state that provided such public goods as well as a social safety net and old-age income security. All those government policies were key to preventing an increase in inequality that in laissez-faire markets is often the result of the excessive concentration of economic, financial and political power within small elites.

While purely redistributive policies that redistribute income from capital to labor and from rich to poor do not work if the economic pie is small and not growing quickly enough, proper taxation policies (effectively progressive) to fund the provision of public goods that increase the skills, productivity and economic opportunities of lower-income and lower-skill individuals in turn allow the economic pie to grow faster so that its benefits are shared by both labor and capital. The ability of workers to organize themselves into unions and thus demand better wages, benefits and working conditions also helped to sustain the share of labor income in GDP and prevent a sharper rise in inequality.

The rise of the middle class and the increasing living standards of the working class was thus not a mechanical result of economic growth, but the active outcome of many economic policies—such as universal publicly provided education financed by progressive taxation, to give just one example—that increased the skills, knowledge and human capital and the economic opportunities even of individuals born in disadvantaged economic circumstances. Social mobility in any society was never the result of market forces, but the outcome of progressive economic, fiscal, taxation and other social policies.

Some of the lessons about the need for prudential regulation of the financial system, limiting the excesses of unregulated laissez-faire markets and the inequality effects of unfettered competition were lost in the cycle of deregulation that accelerated in the Reagan-Thatcher era of unfettered market capitalism—the Anglo-Saxon model. The drive to massive deregulation was also fed by the extremes of the “social welfare model” (like that prevailing in continental Europe), the deficits of which were illustrated in fiscal crises, excesses of regulation and a lack of economic dynamism, leading first to “euro-sclerosis” and then to the current eurozone crises. But now, that laissez-faire Anglo-Saxon model has also miserably failed, as the current economic and financial crisis has shown.

Thus, to enable market-oriented economies to operate in more stable and balanced ways, we need to return to the right balance between markets and the provision of public goods. That means moving away from both the Anglo-Saxon model of unregulated laissez-faire capitalism and voodoo economics and the continental European model of deficit-driven welfare states. Even an alternative “Asian growth” model—if there really is one—has not prevented a rise in inequality in China, India and many other parts of the continent. EMs—from Asia to Latin America—need to further develop some of the key institutions of a modern social welfare state to prevent socio-political instability and to promote the growth of consumption-based economies.

For example, China will not become a consumer society until wages start to grow more quickly than productivity to reverse the opposite trend of the past few decades and until other policies are implemented to shift income from capital/corporates/state-owned enterprises to labor/households. In Latin America, a continent cursed for decades by political instability driven by massive inequality (repeated cycles of authoritarian regimes followed by radical populist regimes and back to dictatorships), this vicious cycle was broken when, in the last two decades, market-oriented reforms were combined with economic policies—introduced both by moderate center-left and center-right governments—aimed at reducing inequality and providing economic opportunities to the working class.

Conclusion

In conclusion, any economic model that doesn’t properly address inequality by providing public goods and economic opportunity to all will eventually face a crisis of legitimacy. Many academic research studies, including a recent IMF study, show that widening inequality leads to lower economic growth. So, even aside from the issue of “fairness,” inequality is also bad on traditional economic “efficiency” criteria. And the recent frequency and severity and consequences of economic and financial crises, themselves partly caused by rising inequality and income insecurity, is damaging and risks a backlash against globalization and market-oriented reforms. Thus, a third way that balances the role of markets and states in the economy needs to be found. Otherwise, the protests of 2011 will become more severe and cause disruptive social and political instability that eventually harms long-term economic growth and welfare by leading to a backlash against globalization and against market-oriented economies in advanced economies and EMs alike.

APPENDIX: Some Factors in the Recent Rise in Inequality and Economic Pressure on the Working and Middle Classes

  • First, technological change is always initially labor-shedding (as it saves on the use of the labor input), but over time it leads to income increases and rising demand that in turn increases labor demand. Thus, “luddites” in every generation (from the Industrial Revolution when the original luddites destroyed machines that in their view reduced the demand for labor) have been wrong in arguing that technological progress destroys jobs: It actually creates greater per-capita income and more jobs over time. Still, the nature of technological change in recent decades has been more labor-saving than labor-increasing and biased toward skilled labor and against un/low-skilled labor. Thus, workers with fewer skills have lost jobs and incomes, while skilled workers have done much better in terms of the growth of their real wages and job opportunities.
  • Second, a basic principle of international trade theory is that greater trade with a labor-abundant economy will reduce the wages of workers in a capital-abundant economy. Thus, the fact that workers in EMs are joining the global economy reduces, over time, the wages of unskilled workers in advanced economies. But adding billions of people to the global labor supply—workers from Chindia and other EMs—is a much more disruptive factor (in a long transition) than the rise of Germany in the 1960s or Japan in the 1970s. In the latter episodes, worries were expressed that Germany first and Japan next would monopolize jobs, but over time the rise in their wages and policy mistakes assuaged worries that either country would “take over” the world economy. Similarly, present-day concerns that China will take over all manufacturing jobs and the global economy are misplaced (some of the increased costs of moving to China are now, in fact, prompting “reshoring” and the production of the lower-value-added labor-intensive goods produced by China is now moving to some poorer countries in Asia, such as Bangladesh and Vietnam). Still, adding billions of Chinese and other EM populations to the global economy is a problem that is several orders of magnitude larger than the integration of Germany or Japan into the global economy.  The production of cheaper goods and services by billions of workers in such EMs now joining the global labor supply increases the incomes of consumers all over the world, including those in advanced economies, but it hurts the real wages and jobs of workers—unskilled blue collar and now white collar—in advanced economies. So, there are winners and losers from international trade and globalization. For globalization to be Pareto-efficient—i.e. beneficial to all—policy needs to redistribute income to losers or, better, to retrain them for other jobs/skills to allow them to compete and regain their lost jobs and incomes.  But it takes much longer and consumes more fiscal resources to provide greater skills to such workers than the displacement of such jobs because the rise of EMs is a much larger phenomenon—size-wise—than the reintegration of Germany, Western Europe and Japan into the global economy.
  • Third, because of the IT revolution, services—which were, traditionally, internationally non-traded goods—have now increasingly become international tradable products. Thus, while the rise of China and other low-income EMs has been threatening the jobs of low skilled blue collar workers in advanced economies, the tradability of services (see Indian call centers and software developers, etc.) implies that now even the jobs of low-skilled (and even some higher-skilled) white collar workers are subject to international competition. A study by Alan Blinder suggests that up to 2% of U.S. jobs could be—in principle—offshorable. In the 1980s and even part of the 1990s, most jobs in manufacturing and traded sectors lost to foreign competition could be substituted with the growth of jobs in non-traded sectors such as services (professional services, health care, education, government, etc.). But now that a larger number of previously non-traded sectors are tradable, given the new information technologies, jobs can now be offshored even in the services sector, leaving even fewer opportunities for income and job creation for workers so displaced.
  • Fourth, as recently documented in a study by Nobel Prize winner Michael Spence, globalization may be associated with the increase in inequality: Globalization does not benefit all, but leads to winners and losers both within countries and across countries as a combination of skills-biased technological change and rising competition in traded labor-intensive low-value-added sectors from labor-abundant EMs has squeezed the jobs and real wages of such workers. So, little job creation has occurred in the traded sectors of advanced economies, while most of the benefits of the sharp increase in the productivity of sectors able to adapt and thrive in international competition has gone to capital and to skilled labor, not to unskilled workers At the same time, job creation in services sectors sheltered by trade competition—education, health care, government, etc.—has been stronger than in traded sectors, but real wage growth in such non-traded sectors has stagnated as productivity growth there has been mediocre. So, in recent decades, competitive traded sectors have created few jobs, while non-traded sectors have created more jobs, but very little wage growth. Thus, according to Spence, we need to find new and better policy tradeoffs that achieve a balance between the efficiency and economic growth that globalization provides and the inequality of incomes, wealth and job opportunities that globalization causes.

14 Responses to “Full Analysis: The Instability of Inequality”

MortgageAdviceOctober 18th, 2011 at 4:32 am

You can certainly feel the "quit resentment" here in Australia especially in the 30-45 year old age bracket. The standard of living has in my opinion decreased over the last 20 years. Big mortgages and the costs of living have out stripped wages growth for all but bankers and partners in big accounting and law firms. http://mortgageexpertsonline.com.au/_blog/Mortgag…

andrewlaintonOctober 19th, 2011 at 2:54 pm

Good article – needs some firm modelling to confirm the relationship between Debt Growth, Inequality and changes in effective demand

Foster and Catchings 1930s mathematical models (oddly similar to Marx and Edward West reproduction schemas) did postulate such a relationship – but have been forgotten since Keynes, perhaps they need to be dusted off and updated. Have been trying to persuade Steve Keen to do it.

Tokina lensesOctober 19th, 2011 at 9:01 pm

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dedinsNovember 1st, 2011 at 1:44 am

Since world's population has entered 7 billion+, inequality issue should obtain highest priority agenda in every country.

grinchyprinterNovember 1st, 2011 at 1:13 pm

I've followed you for years Mr. Roubini; a sane, insightful voice in a wilderness of wild and weird information. I recall how Friedman, Reagan a la Greenspan's supply side theory (thank you for giving it it's appropriate name: voodoo) sounded great to a young college graduate in '81—and wow, the 80's — 90's boom (minus the first warning shot banking crisis in the 80's) was a great boost to the beginnings of my career . But gee, now at 48, questioning what our domestic political situation looks like, I'm not convinced this time our typical ingenuity will be there for us to "fix" things. Analyzing the actual results of the supply side experiment — is a downright head shaking, "what were we thinking?" moment. It will take more than prayer and morality plays to fix this mess. But will we?

jacklettNovember 1st, 2011 at 1:38 pm

Chapter 1 of "Decline and Fall of the American Programmer" by Ed Yourdon is a good example, which dates back to the 1990s, of point three of the
APPENDIX: Some Factors in the Recent Rise in Inequality and Economic Pressure on the Working and Middle Classes.

patnewmanNovember 4th, 2011 at 1:56 pm

Welcome radical challenge to the text book theory of international trade. Globalisation does not conform to that now out of date model. Juxtaposition of Anglo Saxon and Euro economies is one of degree rather than mutual exclusive categories. Is 'social democracy' always sovereign debt driven – recent problems consequence of increasingly regressive taxation? Link between private debt and inequality and stagnant (at best ) wages explains well. Public sector (in UK) embracing off shoring for many support jobs. What is the third way (surely not a Frankenstein revival of Blairism!) Thank for this excellent and readable blog.

Denbo68November 8th, 2011 at 2:42 am

Jacklett…don't forget to mention Yourdon's follow up book "The Rise & Resurrection of the American Programmer" pubished only 4-5 years later. He backtracked a bit if i remember correctly.

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