Conservatives and libertarians argue for “rugged individualism,” ironically, by evoking collectivism. Unfettered markets, they say, make a bigger pie for everyone. But data show they’re wrong. (More)

Inequality and ‘The Greater Good’ Part II: “A Bigger Pie”

This week Morning Feature considers the conservative argument that rising inequality serves the greater good by fostering work, innovation, and growth. Yesterday we saw how the right have twisted President John Kennedy’s phrase “a rising tide lifts all boats.” Today we see how models predict that even a growing economy can leave most people behind, and evidence that rising inequality both caused the Great Recession and undermined the recovery. Tomorrow we’ll conclude with proposals to enable more innovators and broaden the benefits of growth.

“Getting right prices”

Today’s dominant economic theory, neoliberalism, champions private economies as the solution to all problems, including inequality. Enable free markets to find Pareto optimal prices, and the economic pie will grow for everyone, including the poor. In their 2009 working paper for the University of California-Riverside, economists Ali Dini and Victor Lippit offered this flowchart to illustrate the theory:

Neoliberal photo Neoliberal.jpg

They explain:

The solution for poverty goes through implementing “adjustment and stabilization” policies which aim to increase the efficiency through “getting right prices,” privatization, liberalization, and deregulation. It is assumed these kinds of policies could lead to higher economic growth (bigger pie). […] Price liberalization will increase the profit margin which enables the firms to accumulate more and increase their productive capacity. As profit margin increases, firms invest more which leads to more demand for labor. New investments increase the productivity of factors and also wages which increase the primary income of the poor. The increase in income, on the other hand, reduces the poverty and increases the demand for produced goods. Therefore, a cumulative cycle is generated which can regenerate itself and lead to low poverty without any intervention in markets.

Or, as Heritage Foundation writer Matthew Spalding wrote in a 2012 screed against the social safety net:

The United States thrives because of a culture of opportunity that encourages work and disdains relying on handouts.

“The net effect is to reward effort and enterprise, generating a vibrant, prosperous economy”

But as Dini and Lippit explained, neoliberalism did not work for the poor:

[I]t should be noted that cash subsidies did not initially exist in [neoliberal] adjustment policies. It was supposed that if the cycle above would work well, the share of poor goes up so poverty goes down in the long-run. Within a decade of implementing this policy in the 1990s, however, the negative results, particularly in African countries, were so great that the International Monetary Fund (IMF) and the World Bank were forced to pose the idea of the social safety net.

Not to worry, the right might argue. Just keep that pie growing and, sooner or later, everyone will be better off. Steve Randy Waldman explored this further in an insightful article at Interfluidity:

Suppose, as I think many people on the right would argue, this ideology or worldview has contributed to power and prosperity of the United States. Sharp distinctions between winners and losers encourage individuals to work hard rather than slack off. Some succeed, some don’t, but the net effect is to reward effort and enterprise, generating a vibrant, prosperous economy. The punishment of losers is a price that must be paid to create a nation that is collectively a winner. And the burden of that price falls on those who most deserve it, those who lose – in part due to misfortune sure, but largely because they simply failed to work as hard or as well as their competitors.

Waldman is not defending neoliberalism. Rather, he highlights an irony in the conservative/libertarian argument. While they talk about “rugged individualism,” their argument is communitarian. Sure, neoliberalism hurts some individuals … but the economy as a whole will be better … and sooner or later that will help everyone.

“It’s time … for government to get out of the way”

Indeed Charles Koch made that exact argument last week in USAToday. After railing against public spending, regulation, the Affordable Care Act, and the social safety net, he concludes:

Our government’s decades-long, top-down approach to job creation has failed. Its policies have made our problems worse, leaving tens of millions chronically un- or underemployed, millions of whom have given up ever finding meaningful work. In doing so, our government has not only thwarted real job creation, it also has reduced the supply and quality of goods and services that make people’s lives better and undermined the culture required to sustain a free society.

When it comes to creating opportunities for all, we can do much better. It’s time to let people seek opportunities that best suit their talents, for businesses to forsake cronyism and for government to get out of the way.

“The current level of income inequality in the U.S. is dampening GDP growth”

That approach would work very well for the wealthy, at least temporarily. But it would be disastrous for the rest of us. And as Standard & Poors concluded last week, it doesn’t even make the pie grow faster:

Higher levels of income inequality increase political pressures, discouraging trade, investment, and hiring. Keynes first showed that income inequality can lead affluent households (Americans included) to increase savings and decrease consumption, while those with less means increase consumer borrowing to sustain consumption…until those options run out. When these imbalances can no longer be sustained, we see a boom/bust cycle such as the one that culminated in the Great Recession.

Aside from the extreme economic swings, such income imbalances tend to dampen social mobility and produce a less-educated workforce that can’t compete in a changing global economy. This diminishes future income prospects and potential long-term growth, becoming entrenched as political repercussions extend the problems.

Alternatively, if we added another year of education to the American workforce from 2014 to 2019, in line with education levels increasing at the rate of educational achievement seen from 1960 to 1965, U.S. potential GDP would likely be $525 billion, or 2.4% higher in five years, than in the baseline. If education levels were increasing at the rate they were 15 years ago, the level of potential GDP would be 1%, or $185 billion higher in five years.

Our review of the data, as well as a wealth of research on this matter, leads us to conclude that the current level of income inequality in the U.S. is dampening GDP growth, at a time when the world’s biggest economy is struggling to recover from the Great Recession and the government is in need of funds to support an aging population.

“Playing such a game appears highly unattractive”

London Mathematical Laboratory fellow Ole Peters constructed a formal model to examine the causes and effects of inequality. His model is a very simple economy: you choose some portion of your income to put at risk on a coin-flip, winning 50% of your wager if you guess right and losing 40% of your wager if you guess wrong. Overall, the wins pay more than the losses cost, so the net expected value is positive and the total economy will grow. But as the (anonymous) author of Direct Economic Democracy explains, most people will lose money:

Clearly winning gains more than losing loses BUT a subsequent win does not make up for a preceding loss and a subsequent loss loses more than was gained by a preceding win (1.5×0.6=0.9<1); that is the “magic” of compounding. This simple set up means that a large enough population of players will, in aggregate, steadily gain from playing the game but all of the winnings will randomly accrue to an ever smaller minority of players whilst almost everyone loses almost everything. Ole Peters points out that from an individual’s perspective playing such a game appears highly unattractive. A critical point to emphasize is that it is just as unattractive for a winner to continue with the game as it is for anyone else. A winning or losing streak does not influence the future. A rational winner would choose to stop and keep the winnings.

“Inequality and unsustainable growth may be two sides of the same coin”

This, far more than right wing complaints about regulations and the safety net, may explain why fewer people are taking the risk to start new businesses. When the wealthiest 1% have taken 95% of the net economic growth since the start of the Great Recession … there isn’t much ‘bigger pie’ left for anyone else.

And even worse for neoliberals, IMF researchers Jonathan Ostry and Andrew Berg found that rising inequality stifles economic growth:

First, we continue to find that inequality is a robust and powerful determinant both of the pace of medium-term growth and of the duration of growth spells, even controlling for the size of redistributive transfers. Thus, it would still be a mistake to focus on growth and let inequality take care of itself, if only because the resulting growth may be low and unsustainable. Inequality and unsustainable growth may be two sides of the same coin.

And second, there is remarkably little evidence in the historical data used in our paper of adverse effects of fiscal redistribution on growth. The average redistribution, and the associated reduction in inequality, seem to be robustly associated with higher and more durable growth. We find some mixed signs that very large redistributions may have direct negative effects on growth duration, such that the overall effect – including the positive effect on growth through lower inequality – is roughly growth-neutral.

And as economists Barry Cynamon and Steven Fazzari revealed in their January study, rising inequality both created the Great Recession and stagnated the recovery:

Rising inequality reduced income growth for the bottom 95 percent of the income distribution beginning about 1980, but that group’s consumption growth did not fall proportionally. Instead, lower saving led to increasing balance sheet fragility for the bottom 95 percent, eventually triggering the Great Recession. We decompose consumption and saving across income groups. The consumption – income ratio of the bottom 95 percent fell sharply in the recession, consistent with tighter borrowing constraints. The top 5 percent ratio rose, consistent with consumption smoothing. The inability of the bottom 95 percent to generate adequate demand helps explain the slow recovery.

Michael Fletcher summarized their findings for the Washington Post:

Traditional economic theory holds that during lean times, people draw down on savings or increase debt to sustain their lifestyles. But in the case of the last recession, people in the bottom 95 percent were already tapped out from years of debt-fueled consumption, leaving them with next to nothing to draw on or borrow.

And now, nearly five years into the recovery, the top 5 percent are back to normal, consuming as they did before the downturn. But everyone else is still hurting, and their consumption levels are far below what they had maintained for nearly two decades before the downturn, the paper says.

That is a big problem for the larger economy. Those tapped-out consumers represent about half of the nation’s overall economic activity. With them financially shackled, slow overall growth is all that can be expected, the paper argues.

“This isn’t just unfair, it’s expensive”

The evidence is clear, and it fits what used to be standard macroeconomic theory, as Paul Krugman explains:

But how is that possible? Doesn’t taxing the rich and helping the poor reduce the incentive to make money? Well, yes, but incentives aren’t the only thing that matters for economic growth. Opportunity is also crucial. And extreme inequality deprives many people of the opportunity to fulfill their potential.

Think about it. Do talented children in low-income American families have the same chance to make use of their talent – to get the right education, to pursue the right career path – as those born higher up the ladder? Of course not. Moreover, this isn’t just unfair, it’s expensive. Extreme inequality means a waste of human resources.

And government programs that reduce inequality can make the nation as a whole richer, by reducing that waste.
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Will the new view of inequality change our political debate? It should. Being nice to the wealthy and cruel to the poor is not, it turns out, the key to economic growth. On the contrary, making our economy fairer would also make it richer. Goodbye, trickle-down; hello, trickle-up.

Neoliberalism doesn’t help the poor. It doesn’t even make a bigger pie. It just makes the rich richer. Tomorrow we’ll explore better ideas.

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Happy Friday!