American Inequality

A Case for Economic Equity and Long-Term Growth (Draft)

Abstract

Macroeconomic policy issues, as well as the theoretical assumptions underpinning their conclusions, must be considered within a political Liberalism framework that ensures and upholds the democratic values of freedom and equality inherent to the constitution. The complexity of economic development requires a holistic empirical approach that accounts for the historical, political, sociological, and business factors contributing to the makeup of society when crafting and recommending economic policy.

For this paper we will assume that economic growth is the aim for society. Inequality is a product of increased bargaining power resulting from increasingly powerful institutions in the business, financial, and governmental sectors (Kumhof 2011; Barnhizer 2004; Argyres 1999). Research has repeatedly confirmed growing inequality globally and domestically (Hisnanick 2011). Inequality, manifested as widening income and wealth disparity, contributes to domestic and global account imbalances, consumer debt, and economic stagflation, i.e. inflation and unemployment (Kumhof 2012; Rajan 2012). In addition, inequality is linked to key social variables such as political stability, civil unrest, democratization, education attainment, health and longevity, and crime rates (Thorbecke 2002). Greater economic equality always results in greater long run economic prosperity for the whole. (Wilkinson 2009)

The thesis explored in this paper is that bargaining power inequalities causally contribute to economic and socioeconomic inequality due to path dependency, organizational inertia, and habit formation. Bargaining power inequalities increase proportionally with capital accumulation, concentration, and centralization. This paper will show that the restoration of equal bargaining power will rectify financial and labor market imperfections and spur economic growth. In addition, this paper argues that US economic growth over the past several decades has been vastly overestimated due to increases in financialization.

Executive Summary

In order to determine the best policy for rectifying inequality and spurring economic growth, this essay provides an overview of current economic and socioeconomic conditions within the US and abroad, identifies problems within those conditions, and details the contributing historical economic policies that shaped them. It then examines the systemic causal mechanisms contributing to current US economic conditions, present potential policy solutions that seek to address these underlying causal mechanisms, and lastly interpret and rank their theoretical effectiveness. This paper addresses the following areas:

The Problem

  1. Increasing debt, unequal capital accumulation, stagnating wages, and increasing inflation are responsible for the steadily rising economic inequalities experienced the past several decades. The habit formation of conspicuous consumption has compounded the impacts of income inequality.
  2. Inequality has deleterious effects on social well being and long term economic growth, and is the source of a host of cultural ills, affecting education, healthcare, political corruption, etc. It also affects entrepreneurship, creativity, and technological innovation in the long run.

The Cause

  1. Historical monetary policy, financialization, and financial liberalization (deregulation) have directly contributed to exacerbating economic inequality by negatively affecting business cycles through the misdirection of short term economic incentives and failing to consider the long-horizon. In addition, credit market imperfections, due to asymmetrical preferences and institutional constraints, causally contribute to inequality, in both physical and human capital accumulation.
  2. Bargaining power increases with capital accumulation both domestically and globally, establishes organizational inertia in business and legal exchanges, and further compounds the effects of inequality. Avoiding full employment decreases labor demand, in turn decreasing wage bargaining power, leading to wage stagflation.

The Solution

  1. Increasing economic equity yields the highest long term economic growth, improves social well-being, spurs creativity and innovation, and empowers society to resolve its cultural ills.
  2. Economic equity can be achieved by reevaluating the role of monetary policy, restoring bargaining power, regulating financial investment activities, incentivizing real-asset investment, and implementing a single structured tax policy on the wealthiest.

Introduction

Economic inequality comprises disparities in the distribution of economic assets (wealth) and income. While the term is typically used when discussing the inequalities among individuals or groups, it can also be used to describe the inequalities among nations. Closely related to the concept of economic inequality is equity, or the equality of outcomes and the equality of opportunities.

Despite a steady increase in aggregate output (GDP) over the past several decades income inequality has risen exponentially. From the 1970′s to present, earnings of the top 5% of citizens have risen steeply while earnings of the bottom 95% have stagnated, with adjusted minimum wages is lowest in history (Hisinack 2011). As it stands a small fraction of citizens own the vast majority of capital assets, liquid or illiquid, while the other 80% of the US population owns 7% of the wealth.

Compounding multiple decades of real wage stagnation has been a continual rise in the adjusted consumer price index. Due to stagnating wages and rising prices, the savings rate for citizens– specifically the low and middle class– have seen a chronic decline and historical lows. As a result of these financial pressures the US population has accrued massive consumer debt to maintain consumption, of which 33% is revolving credit, such as credit cards, and 67% is comprised of loans, such as mortgage, car, student, etc, (Kumhof 2012).

Due to the dollar’s position as the world’s reserve currency, the past several decades have seen rising global account imbalance as foreign investment in the US steadily increases. Most of this foreign investment wealth originated from gains in the emerging Asian markets and increases in commodity, energy, and oil prices. With the US leading the world in developed financial markets, foreign investors are attracted to the financial liquidity of US markets. In addition, they perceive US assets as safe investing due to its reliable historical growth and stable government.

In the years following the tech bubble collapse, many believed that the low interest rates post 2001 would cause a run on the dollar. Instead foreigner investors looked for other American safe-assets. This high demand, combined with competitive greed and lack of regulation, led to the development of debt markets and their financial instruments and securities such as CDO’s and CDS’s. This lead to financial institutions placing additional pressure on mortgage lenders to find borrowers to meet demand. With rising real estate prices, this wasn’t difficult. These debt markets had exceptional yields and were thought to be reliable and safe assets.

Due to bargaining power imbalances and habit persistence over income1, lower class wage inequality has risen with increases in productivity and aggregate output. As a result of borrowing and taking on debt, the rise in income inequality has been much greater than the rise in consumption inequality; that is, despite low and middle class income or wage stagnation, borrowing has allowed their consumption to increase, fueling domestic demand. However, because the lower class does not have access to international financial markets, they must borrow from wealthy domestic lenders. From 1998-2008 private credit from other financial institutions, i.e. credit cards, loans, etc., rose from 37% to 150% of GDP, whereas private credit from deposit money banks rose marginally from 55% to 65% (Kumhof 2012). The sustained increase in consumption from borrowing has kept domestic demand high and increased aggregate output. It also created a deficit as domestic lenders acted as intermediaries for foreign investors who sought financial safety in the dollar in the form of liquid financial assets. Over the years economic policies have continued to exacerbate inequality as lower class consumption and income decreased to the benefit of the wealthy as their consumption and investment assets increased.

After the recent recession there was a collapse in debt markets, specifically involving the housing market, and households experienced a massive shock to their balance sheets when the value of their net assets, like tied up in their homes, essentially dried up overnight. The hardest hit were those with large debt balances, specifically middle income households. Many people were forced to cut back consumption to pay off the massive debt they accrued for a house that’s significantly less valued than when they bought it. In order to get their finances in order and repair their impaired balance sheets households had to cut back consumption. This resulted in the drop in consumer demand we’re experiencing today (Brown 2010).

The following paper will provide an overview of the various channels that have contributed to the rise in inequality in order to identify key causal mechanisms. It will then recommend appropriate policies that facilitate equality and optimal economic growth.

Overview of Economic and Socioeconomic Conditions

In the wake of the recent Great Recession it is important to take a step back and evaluate economic conditions and policies from a broad scale. The source of the crisis originated in debt markets which have expanded rapidly in the past several decades. Consumer savings was at a historical low preceding the crisis, with debt levels at an all time high. Real wages have stagnated since the late 1970’s, just following the Coinage act of 1972 and the introduction of fiat currency. Despite a steady rise in productivity and consistent growth in GDP, an equal share of labor profits across the income distribution have not experienced a proportional increase (Hisnanick 2011). Data shows that over the period from 1979-present, the top one percent have received a gains in wealth while the middle and low class have experienced dramatic declines.

Research shows that the Fed’s use of monetary policy has promoted this inequality by using the federal funds rate to maintain a target inflation rate (Galbraith 1998; Mouhammed 2008). Monetary policy shocks due to contractionary monetary policy actions are directly linked to increased inequalities in labor earnings, total income, consumption, and total expenditures (Silvia 2012; Galbraith 2009, 2007; Christiano 1996).

Using the Taylor Rule under the Phillips Curve’s assumption of the inverse relationship between inflation and unemployment, the Fed has avoided full employment in order to justify low inflation. The consequence of monetary policy has undermined wage bargaining power which has resulted in stagnating wages. In addition, the Fed has maintained a target inflation rate to maintain high consumption, stabilize prices, avoid deflation, and promote economic growth. This has contributed to steadily rising inflation and decreased bargaining power for low and middle income households despite stagnating real wages. Lower incomes and habit forming consumption patterns have lead to an increased demand for credit which has facilitated increased financialization and liberalization. According to the Annual Industry Accounts published by the Bureau of Economic Analysis (BEA) for 2010, the finance, insurance, real estate, rental, and leasing industries accounted for 21.1% of the total value added to GDP, with finance and insurance constituting 8.4%. The evidence shows that, at a national level, inequality is in effect a curvilinear function of income level and thus a macroeconomic problem.

Consumption

Psychology and sociology have contributed much to understanding the choices and values within an economy. Thorstein Veblen first coined the term “conspicuous consumption” in his book The Theory of the Leisure Class to denote the tendency for people to spend money on goods to indicate or show off their wealth and social status. Patterns of conspicuous consumption are dictated by the desire to emulate those of greater wealth and higher social status, or “keepin’ up with the Jones’s”. How a person demonstrates this emulation evolves according to the values of society. Conspicuous consumption is a key feature in a capitalist society where material goods provide the measure of a person’s wealth and social status.

The tendency to emulate those in higher socioeconomic standing causes individuals to spend more surplus income and savings, and the result is habit forming. Research shows that consumption patterns are path dependent, and that increases in consumption are much more readily adopted when income rises than decreases in consumption when income falls (Secki 2000).

Betrand and Morse (2012) confirm this phenomenon in their working paper titled Trickle-down Consumption. Evidence showed that, holding income constant, poor and middle income households that were exposed to higher concentrations of top income households spent a greater portion of their income, experienced a drop in savings, and a rise in debt directly preceding the Great Recession. These areas of inequality also experienced a greater number of bankruptcy filings than in more equal areas.

Because rising inflation increases consumption and decreases saving, habit forming consumption patterns explain the growing increase in debt levels as households face wage stagnation and income shocks. Peñaloza (2011) has showed how debt and credit normalization in US households occurs through the process of cultural reproduction in which economic behaviors are spread due to emulation and imitatation. Individuals seek to sustain consumption levels through debt to maintain their lifestyles. As real wages stagnate and inflation rises, surplus income falls and people have less surplus income and less savings, and therefore less money to spend that doesn’t detract from subsistence or necessary consumption.

In order to maintain consumption individuals borrow money in the form of revolving credit (credit cards) and loans (home, auto, student). Consumer credit and household debt has been facilitated by monetary policies that keep interest rates low. Debelle (2004) has shown that low interests rates and easing liquidity constraints have led to a tremendous rise in household debt. An increased debt burden has resulted in an increased sensitivity to fluctuations in interest rates, income, and asset prices. This is especially the case in households that have variable interest rates rather than fixed. Additionally, Credit Card stickiness makes investing in consumer credit attractive. Studies revealed that despite a drop in prime rates and a decrease of interest rates in large denominated CD’s, credit card rates barely moved. According to Calem (1995), “the shifting spread between card rates and banks’ costs of funds suggests that card issuers have exercised market power.”

The increases of consumer and household debt are a significant reason for our GDP growth. The increased availability of credit through financial liberalization2 has sustained domestic demand the past several decades. Kumhof, Lebarz, Ranciere, et. al (2012) examined how income inequality is exacerbated by domestic lending of the rich. As rising aggregate output (GDP) is coupled with rising income inequality and stagnating wages, poor and middle class consumption is less than their drop in income due to domestic lending of the rich. That is, as prices increase, consumers seek more credit (debt) to sustain consumption which fuels the domestic demand that increases aggregate output and widens current account deficits.

Aguiar (2011) found that the increase in consumption inequality closely mirrored income inequality between the period of 1980-2007. That is, the “increase in consumption inequality has been large and of a similar magnitude as the observed change in income inequality.”

Politics

Political influence has shaped economic policy decisions and contributed to trends in financial development. It is important to understand what role politicians and policy makers have played in exacerbating income inequalities.

Linking inequality with pre-crisis economic policy, Betrand and Morse (2012) found that Republicans from high income districts were more likely to vote for an expansion of housing credit to the poor. Spending patterns of the rich exerted a greater influence on spending patterns of the poor in areas where home prices experienced fluctuations, suggesting that housing credit and the ability to borrow against rising home equity may have contributed to overconsumption by the poor.

Rajan (2012) and Ramcharan studied the historical policies surrounding the Great Depression to draw comparisons with the recent crisis. One such policy was the McFadden Act of 1927 which sought to boost competition of lending. They observed a motivation of legislators in certain districts to vote against the expansion and competition of lending as a way of leveraging inequality to the benefit of wealthy private lenders who comprised the bulk of their constituency. This consequently increased profits of wealthy lenders in the short term but fueled a financial frenzy similar to that of 2008.

Alesina and Rodrik (1994) and Persson and Guido (1994) estimate a negative, reduced form effect of income inequality on investment and growth rates through the political process. Alesina and Rodrik (1996), used a Gini coefficient of income and land distribute to measure income and wealth distribution, endogenous economic and political variables in a two-equation system and test it on a sample of 71 countries. Their results suggest “a negative effect of inequality on political stability, as well as a negative effect of political stability on investment.”

In addition, due to political influence and lobbying power, taxes on the rich have consistently decreased since the 1950’s from 94% to the current 35% for the top income bracket (Klein 2012). In addition, reduced estate taxes and capital gains taxes have provided additional income to the wealthy.

Capital Accumulation

A key feature for understanding the mechanisms that promote inequality is capital accumulation, or the increase in wealth through concentration and centralization, or creation. I argue that financialization functions as the primary mechanisms responsible for capital accumulation, concentration and centralization, rather than capital creation.

In contrast prior economic literature on capital accumulation that viewed variations in investment shares as unrelated to variation in long-run growth rates, Bond (2010) found that capital accumulation plays a major role in economic growth. Using a sample of 75 countries in the period of 1960-2000, his central finding was that “investment as a share of GDP has a large and statistically significant effect, not only on the level of output per worker, but more importantly on long-run growth rates.” This has important implications for understanding economic growth and issuing policies that increase investment. However, Bond did not examine the forms of investment that stimulated growth; that is, he did not differentiate between financial and real investment. This reaffirms the importance of capital accumulation and savings as a means of increasing investment and economic growth. However, it is necessary to distinguish which forms of investment activities are responsible for this growth.

Inequality and Growth

Classical economic theory argued that initial inequality was correlated with long term growth and a decrease in inequality. Kuznets (1955) proposed the “inverted-U” hypothesis that economic growth would lead to an initial rise but eventual fall in inequality. Work by Deininger and Squire (1996) found no evidence for Kuznets “inverted-U” curve but instead found a strong relationship between initial income inequality and long term growth. The idea that inequality was correlated with economic growth has since been the conventional wisdom of mainstream economic theory. Recent data research and modeling show that initial income inequality is indeed negatively correlated.

The classical view that prevailed until recently was that the rich have a higher marginal propensity to save than the poor which in turn implied a higher degree of of initial income inequality will yield to higher aggregate savings, capital accumulation and growth.3 Conversely, recent research found contrasting mechanisms and channels that link higher initial income inequality with lower growth. These channels show that high initial income inequality of income leading to lower economic growth can result from (1) high rent seeking activities lead to less secure property rights4, (2) Social tension and political instability lead to increased uncertainty and thus lower investment5, (3) Poor median voters with greater demand for redistribution which lead to higher taxation and thus greater distortion6.

Galor (2000) attempted to reconcile these approaches with a “unified model” that accounted for earlier stages of economic development where physical capital accumulation was a prime engine for growth. His analysis showed lower economic growth at later stages as human capital accumulation becomes a prime engine for growth. This is due to the capital-skill complementarity which leads to lower human capital accumulation due to the under investment in human capital accumulation due to credit market imperfections. Chui (1998) confirmed the mechanisms of human capital accumulation when he modeled the effects of income inequality on education. He found that both income and talent played a role human capital accumulation, but that more individuals receive education in higher income groups and that the threshold for talent is much lower.

Financialization and Liberalization

While financial liberalization leads to more efficient and liquid financial intermediation, Fitzgerald (2006) found little evidence that financial liberalization resulted in higher savings rates, which is supposed to be the main contributor of investment and growth. Two reasons were offered for explanation. First, financial reform causes a shift of saving from real assets to financial assets, which creates depth without raising interest rates. Secondly, financial liberalization leads to the expansion of consumer credit, which in turn reduces aggregate household savings due to the difference between household financial assets and financial liabilities.

Fitzgerald (2006) examined whether financial liberalization aids in industrial sector development and found that much of corporate investment is largely self-financed out of retained profits. He asserts that “we should not expect, therefore, to find a large effect on aggregate investment levels from financial liberalization.” The analysis concluded that financial liberalization (of private assets) and financial development (as moving from banks to capital markets) were not associated with higher rates of economic growth. According to Fitzgerald (2006), the deregulation of interest rates lead to banks taking greater risks for higher profits by lending to booming markets. The result is an asset price boom which leads to speculative investing, higher interest rates, greater macroeconomic instability, and fluctuations on a borrower’s return on investment.

Over the past several decades there was an increase in financial investment while the accumulation of capital goods declined. Stockhammer (2000) shows that financialization has a negative effect on capital accumulation by shifting firm management priorities in order to create shareholder value reflective of absentee ownership or shareholder interests.

Orhangazi (2010) also examined the impact of financialization on real capital accumulation in the US using data from a sample of non-financial corporations from 1973 to 2003. His findings confirm a negative relationship between real investment and financialization. He offers up two channels that explain the negative relationship: “First, increased financial investment and increased financial profit opportunities may have crowded out real investment by changing the incentives of firm managers and directing funds away from real investment.

Second, increased payments to the financial markets may have impeded real investment by decreasing available internal funds, shortening the planning horizons of the firm management and increasing uncertainty.”

Das (2003) examined data from 1993-2003 and found that large-scale equity market liberalizations that resulted in higher equity prices, lower cost of capital, investment booms, greater capital flows, and higher growth shifted the distribution of incomes in the reformed countries. Specifically, data supported a “positive coefficient between liberalization and the highest income quintile’s share of mean income, and a negative coefficient between the liberalization and the middle class income share,” which represented the sum of three middle quntiles. There was no relationship between liberalization and the lowest income quintile. He found that while inequality deepens, aggregate income levels rise universally after liberalization, with the rich gaining a disproportionate shift in wealth as the middle class shrinks.

Montgomerie (2012) examined unsecured, non-mortgage, debt trends in middle income households within the US to determine the effects of financialization. After analyzing household survey data, Montgomerie found that financialization increased participation in the credit boom of middle income households which has lead to unsustainable spending and greater financial insecurity among the middle class.

As financialization and financial liberalization have continued to grow in the US the use of leveraging has become more commonplace as a means of increasing returns. Kumhof (2011) modeled empirical data from 1920-1929 and 1983-2008 and discovered a pattern between high leveraging, inequality, and crisis. The conclusions show that rapid financialization, coupled with higher incomes for the high income households and high debt leveraging from the poor and middle class, was responsible for the proceeding crisis in both the Great Depression and the Great Recession. Kumhof shows that increased incomes in high income households was recycled back into the financial market which provided loans needed by low and middle class households sustain consumption. This eventually lead to the burst of the debt markets. Kumhof attributes this increased financialization to the increased bargaining power of the high income households.

Lin (2011) examined non-finance industries in the US between the period of 1970 and 2008 and found a host of negative impacts associated with increased reliance on financial channels for income. In the long run they found that increased reliance on financial income “decreased labor’s share of income, increased top executive’s share of compensations, and increased earnings dispersion among workers at the industry level.” While many argue that globalization, technology change, declining unionization, and changes in capital investment are responsible for these trends, Lin’s evidence shows that financialization contributes significantly to inequality, accounting for more than half of labor’s income decreases, ten percent of officers increases in compensation, and fifteen percent of earnings dispersion and redistribution. They find that financialization is a “system of redistribution that privileges a limited set of actors” by restructuring social relations relating to bargaining power that influence income dynamics which facilitate unequal distribution of earnings.

Globalization

In addition to the inequalities created domestically due to financialization and financial liberalization, global account imbalances have widened as international investors seek investment in US financial markets. Kumhof (2011) presented findings that increasing domestic inequality in developed countries is associated with greater current account imbalances both domestically and internationally. The United States’ historical stability and well developed financial markets offer depth and liquidity which has positioned the dollar as the world’s reserve currency and a safe haven for foreign investors. This has contributed to the US trade deficit and foreign investment in debt markets which has facilitated US financialization and increased borrowing domestic borrowing.

Contrary to popular belief, inequality within China has risen just as quickly as other developed nations. The explanation for their lack of indebtedness is due to their inefficient financial markets, in contrast to the US hyper efficient financial markets, which creates liquidity constraints that increase savings. Chinese citizens save more, despite making less and less, because of the poorly developed financial markets that provide banking services and financial intermediation. This excess surplus travels to the US and fuels the debt investment which drives our current consumption and domestic demand. These behaviors are responsible for driving global current account imbalances.

Monetary Policy

Many economists have become more critical of Federal monetary policy when looking to explain US business cycles and growing inequality. Research has shown that monetary policy shocks have detrimental economic impacts, with specific regards to inequality and welfare.

The Fed’s typical short-term political fix for spurring economic growth is to target policies that allow for cheaper borrowing, i.e. increased financial liberation. Hence the Fed keeps rates at 0% to increase borrowing. (Kumhof, Lebarz, Ranciere, et. al 2012) But long-term financial liberalization only leads to higher domestic debt levels, higher debt services, and lower worker consumption: it generates increases in workers’ consumption, yet slows down capital accumulation as investors prefer financial investment over real asset investments, i.e. less value-added investing and more speculative investing in financial security and real estate markets. These activities eventually lead to economic stagflation.

The Fed justifies lowering interest rates by claiming that lower interest rates spur investment. This argument has been used to increase financial liberalization (deregulation) to make borrowing easier, leading to increased financialization of US markets. Financialization increases liquidity, and therefore decreased liquidity constraints. Empirical research shows that increased financialization is inversely correlated with increased savings and, even more importantly, real investment (Japelli 1994).

Using the Flow of Funds7 account to assess the impact of these contractionary monetary policy shocks on the financial industry, Christiano (1996) found that: “(i) they are associated with a fall in nonborrowed reserves, total reserves, M1, the Federal Reserves’ holdings of government securities and a rise in the federal funds rate, (ii) they lead to persistent declines in real GNP, employment, retail sales and nonfinancial corporate profits as well as increases in unemployment and manufacturing inventories, (iii) they generate sharp, persistent declines in commodity prices and (iv) the GDP price deflator does not respond to them for roughly a year.”

Using consumer expenditure surveys, Silvia (2012) found long run impacts from contractionary monetary policy shocks that increased “income, labor earnings, consumption, and total expenditures inequality across all households”. Two channels were deemed key to explaining the policy responses: The first was the effects of labor earnings across income distributions, where the upper end incomes rose and the lower end incomes fell. The second channel was the unequal change in consumption of the high income households relative to the low income households, suggesting “significant wealth transfers via unexpected changes in the interest rates and inflations”. According to Silvia, zero bound nominal interest rates are conceptually similar to contractionary monetary policy shocks, which he shows increase income and consumption inequality. He concludes that zero-bound episodes in the the standard representative agent models significantly understate welfare costs.

The Federal reserve is notorious for its concern with inflation and price stability, but under legal mandate the Fed’s function is to maintain stable growth with full employment. Interested in how the Federal Reserve actually responds to economic conditions, Galbraith (2007) gathered data from the American economy from 1984 to 2003 that captured the yield curve of short term and long term interest rates and performed vector autoregression modeling (VAR). The Fed’s claims it has control of short term interest rates and reacts to short inflation, under the Taylor Rule, rather than the long term when inflation expectations differ.

Because the short term rates are implied in the yield curve, Galbraith hypothesized that the yield curve should flatten if inflation increases in the short run. Accounting for the state of demand and the rate of employment, the VAR analysis showed evidence contrary to the Fed’s claims of fighting inflation, neglecting unemployment, and fighting recessions. Instead, the model revealed that: after 1983 the term structure does not respond to inflation levels or the inflation rate; the Fed reacts to low employment; after 1983 the Fed “systematically tightens when unemployment is low”, rather than when unemployment is high.

Galbraith’s results also undermine the prevailing notion that low unemployment is an inflation risk, citing the 1990’s as an example when unemployment was low and inflation did not rise. Between the period of 1984- 2003 the CPI maintained a stable, stationary, mean. He asserts that a trended variable like unemployment cannot imply a statistical relationship with a variable that has a stable mean.

Galbraith concludes that, contrary to conventional wisdom, monetary policy does in fact play a role in inequality, that the income inequalities react to term structure and are therefore influenced by the Fed’s rate setting decisions. This is corroborated with Atkeson’s (2001) findings that the Non-accelerating inflation rate of unemployment (NAIRU) based on the Phillips curve model is not useful for forecasting inflation, that NAIRU was no more accurate in predicting a change in the inflation rate than a “naive” forecast. Similarly, Orphanides (2002) explored whether activist monetary policies during the 1960’s and 1970’s would have averted the Great Inflation and found that they would have resulted in worse macroeconomic conditions.

Mouhammed (2008) utilized a Veblen-approach to conduct a comprehensive analysis of the Federal Reserve based on empirical evidence by examining the institutional interests that influence policy decisions. The analysis summarized the aforementioned findings confirming that the Fed reacts reacts to full unemployment by increasing the federal funds rate and cutting off the money supply which causes the economy to produce below full productive capacity. This was evidenced in the 1990’s when the US was experiencing its greatest economic expansion but due to an increased Federal funds rate low income laborers could not acquire jobs or bargain for higher wages. His conclusion reveals that the Fed reflects the interest of absentee ownership8 by facilitating the process of capital accumulation, decreasing the capacity of labor utilization, and weakening the low income and middle income labor force. Stockhammer (2000), Palley (2007), and Dore (2008) also discuss the negative economic impacts of economic policies that favor shareholders and absentee ownership. The effect is a shift in income distribution that reflects the growing trend of inequality since the early 1980’s that has long term negative consequences for economic growth and stability.

Bargaining Power

The result of financialization, deregulation, and monetary policy have significant impacts on power bargaining distributions between high income households and lower income households, reflecting the lenders and borrowers respectively. As such, bargaining power plays a significant role in explaining business and legal exchange outcomes, as well as establishing organizational inertia9 trajectory. Bargaining power can be defined as the ability to exert influence over a party in a given situation. The inequality of bargaining power is when one party has more or better alternatives in a given “bargain” agreement or contract than the other contracting party. These alternatives arise from exogenous variables and externalities that are not immediately apparent in negotiations.

Rajan (2011) studies the agreement process of very unequally endowed parties. He models two parties, one rich the other poor. Relevant to Galor’s (2000) findings on capital accumulation and inequality, Rajan finds that introductions of credit markets typically reduce total welfare of all parties involved. The opening of credit markets are worst overall when endowments are small and one party is poor. They are best when endowments are high and both parties are well endowed. While one would think that credit markets are needed by the poor more, their introduction in fact causes them greater damage.

Dubbed the credit constrained human capital accumulation hypothesis by Galor (2000), credit market imperfections prevent the poor from gaining access to much needed capital due to their inability to provide collateral. The consequence is that the poor cannot finance human capital accumulation due to asymmetric information which creates a moral hazard between the borrower, who knows more about the investment, and the lender. As a result of unequal wealth and the lack of capital for collateral, the poor cannot acquire additional human capital, leading to a poverty trap and lower economic growth. However, the presence of a larger middle class increases the number of potential investors and alleviates the moral hazard problem by increasing the amount of loanable funds available to creditors. By decreasing credit constraints in this way, lending to the poor can take place and economic inequality can be reduced. Perotti (1996) confirms that a greater income share of the middle class has a strong negative effect on fertility, and this, inturn, has a significant and positive impact on growth.

Bargaining power inequality has been shown by Bental (2008) to decrease labor shares and wages per effective units. An analysis of OECD countries showed that unequal bargaining power has resulted in increased productivity and a decrease in ratio between effective labor and capital. Noting the growing inequality literature, Frederiksen (2010) studied Danish income distributions between 1992 and 2003 to study the effects of alternative mechanisms like power bargaining on inequality. Accounting for the effects of skill upgrading, the model predicted higher wages for all employees, specifically that highly educated workers should experience a six percentage point increase, but empirical evidence showed an 8 percentage point decrease for non-management positions. Thus, any increases in organizational income lead to a decrease in employment share. Frederiksen concluded that between productivity and bargaining power shocks, a reduction in bargaining power of highly educated non-management employees was the most likely candidate for skill-upgrading. Considering the US is experiencing high unemployment of educated and uneducated alike and a shifting income distribution, these finds are relevant. Many economists cite structural unemployment for the cause, but bargaining power inequalities may provide a more lucid explanation.

Intimately connected with bargaining power is unionization which equalize bargaining power inequalities through the use of collective bargaining. Fitchenbaum (2011) shows that unions have a direct positive impact on labor’s share of income, with the decline in unions responsible for about 29% of decreased wages. Western and Rosenfeld (2007) show that decreases in unionization are responsible for a third to a fifth of all increases in inequality. Schmitt and Mitukiewicz (2011) researched changes in unionization and found that, rather than the effects of globalization and technology change, the role of politics and lobbying were the greatest cause of decreased unionization and increased inequality.

Causal Analysis

There are many factors contributing to inequality. Based on the collected research, monetary stands out as the most salient mechanism that has facilitated the changes in unequal bargaining power which has lead to income and wealth inequalities through the channels of financialization and liberalization. In this way it is important that we examine the assumptions built into the justification of monetary policy.

The Fed utilizes the Non-accelerating Inflation Rate of Unemployment (NAIRU) analysis for the natural rate of unemployment and the actual accuracy of the Phillips curve, which states  , where: π and πe are the inflation and expected inflation, respectively; b is a positive constant; U is unemployment, and Uis the natural rate of unemployment, or NAIRU; is unexpected exogenous shocks to the world supply.

There are two crucial assumptions built into the concept of NAIRU: first, that inflation is self-perpetuating; second, that unemployment is inversely related to inflation (Phillip’s Curve), so that as unemployment goes down, inflation goes up, and vice versa.

The basic NAIRU analysis assumes that when inflation increases workers and employers account for expectations of higher inflation and create contracts that matches the expected level of price inflation to maintain constant real wages. That is, they expect high inflation and counter up their wages to maintain a constant level of real wages. Thus, to prevent ever increasing wages through contract bargaining due to higher labor demand, the analysis requires accelerating inflation to maintain a targeted unemployment level (hence the central bank target inflation rate).

The implicit assumption is that workers and employers cannot contract to incorporate accelerating inflation into wage expectations. However, there is no explicit justification for assuming that expectations or contract structures are limited in this way, aside from the fact that these wage arrangements are not commonly observed. Given a scenario with low unemployment, i.e. a higher demand for labor, why wouldn’t they adjust their wage expectations to reflect accelerating inflation? Why must the wage contracts lead to runaway wage increases and thus self-perpetuating inflation? No research has supplied an answer for the possibility of contracting to accommodate inflation expectations. This leaves the economic effectiveness of the Phillip Curve and its assumptions tentative. King, Stock, et. al, (1995) showed that while the unemployment-inflation correlation was stable short term between the period of 1954 to 1994, the long term correlation was unstable.

The main contention is this: monetary policy is detrimental to long term economic outcomes and social welfare. The federal reserve is operating on behalf of institutional interests rather than in terms of the well being of the citizens at large. What is the consequences of a target inflation rate of 2-3% in order to keep unemployment at 4-5%? The higher the unemployment, the lower demand for labor, and the lower the wage bargaining power. People can’t demand higher wages if there’s a surplus of workers desperately pandering for the same job: High supply means low demand. If we never allow for low unemployment, never experience a high demand for labor, wages will not increase because workers possess no wage bargaining power; that is, there’s no demand for hiring additional workers, especially at the wages they request to live on. The result? Wage stagnation.

Policy Recommendations

As resources become monetized and increasingly scarce through the process of capital accumulation, concentration, and centralization, there will be an inevitable rise in exploitation and inequality. Economic data  from the USA points to this trend. Throughout history there is an overriding tendency for exploitation driven by shareholder economic profits.

Contrary to much of the current political rhetoric, unions are actually a good thing for democracy, equality, and economic progress. While they don’t aid in making US wages competitive abroad, it is important to note that the US is a major importer, not a major exporter. Ensuring that our labor force is receiving equal and fair distributions of income and wealth maintains consumption, drives domestic demand, and fuels economic progress. Income inequality and disparate levels of capital accumulation increases financialization, decreases real asset investment, and hampers long term economic growth, and could potentially lead to economic stagflation, which many argue we are seeing the beginnings of.

Many are ideologically opposed to unions, but evidence shows that unions have been instrumental in improving our economic development and our standard of living as a nation and are important for our long term economic growth (Madland 2009).

One of the most important roles of unions is ensuring fair wages through collective bargaining by restoring and equalizing bargaining power. There is no arguing there have been massive changes within the labor markets from industrial to technology, but that doesn’t explain why wage inequalities have risen, and evidence points to decreases in unions (decreases in collective bargaining power) and increases in corporate/ management bargaining power as being a driving factor behind that rise.

Why are individuals leaving unions? As mentioned before, economic institutions make it incredibly difficult to join a union; they will import labor from somewhere else in the country before they’ll accede to union demands. It’s simply not advantageous to join a union when you could risk losing your job. This is especially the case when unemployment is high and there is a labor surplus; they can simply hire someone else.

Federal monetary policy is a major reason for contributing to this bargaining power inequality. By establishing an “naive” target inflation rate and avoiding full employment, they create a surplus of labor which in turn decreases employee wage contract bargaining power that would otherwise increase their wage compensation to fair levels (and eliminate wage stagflation).

Monetary policy should be curtailed except for extreme measures. As per the evidence accumulated in research, the Taylor rule should be abandoned along with NAIRU. Since there is no empirical evidence that low employment leads to runaway inflation, full employment should be sought in order to restore wage bargaining power, increase incomes, and enlarge the middle class. Perotti (1996) showed that greater income equity resulted in a greater income share to the middle class leading to a strong negative effect on fertility and thus positive economic growth.

Over the past several decades the US financial industry has ballooned out of control, fueling our reliance on debt. Unfortunately, while shrinking the financial industry is the best long term solution, it currently fuels domestic demand as well as our output by supplying credit to middle and low income households to maintain consumption. Kumhof, Lebarz, Ranciere, et. al 2012; Kumhof 2011). The traditional response for low GDP has been low interest rates in order to free up capital which has been facilitated via financial liberalization or making to cheaper and easier to borrow. This is not sustainable and many economist predict stagflation on the horizon. The US needs to systematically reign in financialization and increase national savings rates to reduce debt and maintain strong consumption.

A fiscal policy needs to be instituted that specifically targets the wealth. A massive wealth tax on the top income earners will help us pay off our deficit. Raising taxes for the upper incomes will reduce the widening income inequalities. In the 1950’s taxes on the wealthy were 94%, and economic output was at an all time time. Post war fiscal policies see a continual downward trend toward current tax levels on top earners at 35%. Since 1950 the declining tax rates have see a proportional decline in GDP (Klein 2010).

In a recent Washington Post interview, economist and high top income earner David Levine argues that increased taxes have historically been associated with a prosperous economy (Klein 2010). When you have to work harder for your money, productivity increases. The article discusses ways to achieve an optimal tax policy using the Laffer Curve and argues that taxes should focus on hitting maximum in the range of 50 to 70 percent.

Conclusion

It is vitally important that economists and policymakers reach a consensus for combating against income inequality. In the long term greater equality will lead to greater economic stability and growth. Sociologist Richard Florida (2011) examined what role inequality played on innovation and entrepreneurship within societies. He found that equality is linked to greater levels of creativity and innovation, as well being increased levels of well being. Great equality will also increase the middle class which reduces credit market imperfections, increases available credit for low income households by providing a capital bridge otherwise unavailable by large lending institutions due to asymmetric information, and increases real value-added investment which translates to market expansion and economic growth.

Currently the US works more than any other country and possesses the least vacation days of any other industrialized/ OECD nation as well as the least paid vacation days. Many would contend that the $7.25 minimum wage isn’t too bad when looking at other countries, but $7.25 is meaningless without a context. The cost of living, i.e. CPI/ inflation, has continued rising despite stagnating wages making it increasingly difficult to save and live comfortably, especially for those in the lowest income brackets. Poverty levels are artificially low due to the credit boom; which, since its bust, has led to increasing poverty levels. The Gini coefficient has risen consistently since the 70’s, which can be attributed to the coinage act of 1972 and introduction of fiat currency which instituted federal monetary policy which has been shown to contribute to rising inequality.

The vast majority of worker representation throughout US economic history has been the direct result of union organization and many should appreciate the value of unions as vital to our progress. Some of the benefits derived from the collective bargaining power leveraged by unions include the 40-hour work week, overtime pay, vacation pay, sick days, workers compensation and a living wage. And the decline of unions is mostly do to corporations becoming increasingly ideologically opposed to them: It’s all about shareholder profits (Levy & Temin 2007).

It is important to recognize bargaining power inequalities that naturally arise due to misaligned motives. With the decline in unions that correlates with the decline in wages, policy makers need to be cognizant of the impacts of this on social welfare and institute a policy that guarantees labor bargaining power, either through a collective group of individuals.

We need to discard models that are not up to date, specifically those that posit fixed static variables like rational expectations, consumption patterns, and others. While this may sound a bit abstract and may not translate as anything immediately meaningful at first glance, the consequences of adopting a theoretical approach as opposed to a historical empirical approach are very real. Specifically, theoretical economics embodied by mainstream neoclassical theory is not only a very poor framework for analyzing long term policy decisions, despite however great it is great for short term modeling and analysis, and it breeds an attitude lacking conscientiousness, one of instant gratification for the now irregardless of long term consequences. This attitude is embodied in the quote by economist John Keynes who said “The long run is a misleading guide to current affairs. In the long run we are all dead.” Interestingly, conscientiousness is the single most important personality measure for predicting the long term success of individuals. And why wouldn’t this hold for institutions? Studies show that conscientiousness dictates the long term success of a host of social and economic outcomes, including education achievement and longevity (Busato, V., Prins, F., Elshout, J., et. al. 1998; Chowdhury, M., Amin, M. 2006; Kern, M., Friedman, H. 2008). If we want to achieve economic prosperity and reinstate the US as an economic powerhouse, policy makers need to think of long term outcomes and address inequality issues will full force.

Footnotes 

1 Habit formation is the process in which behaviors become automatic. Habit persistence over income implies that consumption habits persist despite changes to income.

2 Financial liberalization refers to the process in financial activities are deregulated to make borrowing cheaper and easier.

3 Kaldor (1966) proposed that high initial income inequality lead to higher aggregate savings which in turn lead to higher capital accumulation and high economic growth. Modern approaches have tried reconciling discrepancies.

4 Benhabib and Russticini (1991)

5 Alessina and Perotti (1993)

6 Alesina & Rodrik (1994); Bertola (1993); Persson & Tabellini (1991)

7 Flow of funds accounts are a system of interrelated balance sheets for a nation which are calculated periodically.

8 Absentee ownership refers to persons who owns and rents out a profit-earning property, but does not live within the property’s local economic region.

9 Organizational inertia is when a mature organization maintains a dynamic moving trajectory due to path dependence established by a precedent; or the habit of an organization to continue on its current path.

Image Appendix

 

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