How to Unblock the Economy - by Reducing Inequality

8/2/2019 How to Unblock the Economy - by Reducing Inequality

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How to Unblock the EconomyHow to Unblock the EconomyHow to Unblock the EconomyHow to Unblock the Economy

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by Neil Talbot and Sam Talbot

Table of Contents

Summary: The 1% Economy ...... p. 1

The State of Inequality ............... p. 3

Why is there Insufficient Demand? ...... p. 5

Unblocking the Circular Flow of Income .... p. 7

Searching for Policy Solutions in 6 Major Areas .... p. 11

Reconciling Short-Term and Long-Term Measures .. p. 15

Conclusions ..... p. 16

Summary: The 1% Economy

The American economy is suffering from a fundamental imbalance. This imbalance,

simply stated, results from the inadequacy of the current level of wages and the current levelof employment to support economic activity and investment.

Like any market economy, the American economy depends on consumption to support

economic activity directly, and to support it indirectly by buying the output of goods and

services that makes investments profitable.

The economy is not paying ordinary working Americans enough for them to be able to

support consumption, in other words to buy the goods and services they produce. A resort has


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been made to borrowing by means of consumer borrowing through mortgages and other

loans, and government deficits to sustain spending.

Meanwhile, wealthy individuals the 1%, as Occupy Wall Street calls them and

corporations are awash in cash, with not enough places to invest it. In a desperate attempt to

maintain the profitability of their investments, investors and corporations are searching for

and in the process creating one financial bubble after another. When the bubbles burst,

recessions will result.

In this paper, we argue for the necessity of a large shift of earning from wealthy

individuals and corporations to ordinary working people. The simplest way to achieve this is by

reversing some of the tax changes that have favored corporations and the rich.

Would this redistribution be a Robin Hood kind of theft from the rich? Is it morally right?

The simple answer is:

The economy should be answerable to the people, rather than the

other way round we must reject the myth that the economy

belongs in any absolute sense to the rich.

If the economy is not the property of the rich, to be manipulated for their benefit, what

is it good for?

The economy should provide a framework within which people

have the opportunity to fulfill their potential.

With this objective in mind, what are people entitled to expect of the economy? Surely, at

least, it should pass the following four tests:

(1)Does the economy achieve reasonably full employment with wages at or abovethe living wage level for those people who are able to work?

(2)Does it provide support for those people who are unable to work because theyare too young, too old, too sick, or are in school?

(3)Does it create a framework of financial stability within which people are able toplan their working lives, housing, retirement, etc.?

(4)Does it encourage individuals to be inventive, creative and entrepreneurial?In 2011, as highlighted by the emergence of Occupy Wall Street, it is clear that the

economy must be given a failing grade on at least the first three of these tests. Why has it been

underperforming so badly, and what can be done to rectify matters?

The increasingly unequal distribution of income that has emerged in the United States in

the past three decades constitutes an imbalance in the economy that has become pervasiveand fundamental. This booklet makes the case that an extremely unequal distribution of

income is incompatible with a stable full-employment economy.

While a degree of inequality may be conducive to the fourth test providing scope for the

entrepreneurial spirit extreme inequality has the opposite effect of undermining economic

growth and stability, as discussed below.


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The State of Inequality

The facts regarding the increasingly unequal distribution of income have been widely

publicized, but they have not lost their ability to shock. Or to bring out deniers. Fortunately, the

bipartisan Congressional Budget Office (CBO), has issued a major study, Trends in the

Distribution of Household Income Between 1979 and 2007, October 2011, which makes theraw data indisputable.

The data compiled by the Congressional Budget Office are striking. Between 1979 and

2007, the incomes of the top 1 percent increased by 275 percent, for the rest of the top 20

percent they increased by 65 percent, for the middle 60 percent the increase was 40 percent

and for the bottom 20 percent only 18 percent. The result of these three rich get (much)

richer decades is that the share of income received by the top 1 percent of the population

more than doubled from 8 percent to 17 percent, while the share of income received by the

bottom 20 percent actually declined from 7 to 5 percent. The incomes received by the top 1

percent in 2007 were more than three times the total incomes of the bottom fifth of the

population. And the income of the top 20 percent exceeded that of the remaining 80 percent ofthe population.

The data can be presented in various ways. In Chart one, average household income is

shown for the top 1 percent of the U.S. population, and for each fifth ranked from the highest

income to the lowest, for the period 1979-2007.

Chart 1. Chart 2.


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What is striking is that the lions share of the increases in income has been garnered by

the top 1 percent. Taking the top 20 percent as a whole, the chart shows significant gains, but

for the remaining 80 percent of the population the gains have been very small. Chart Two

shows how this growth of incomes at the top of the income distribution has changed the shares

of each group in the total. The top 1 percent have dramatically increased their share of total

income, and the top 20 percent as a whole have also succeeded in achieving a modest increase,but all the remaining fifths, constituting 80 percent of the population, have suffered diminishing

shares.

Judging by all the talk of hardship and the need to tighten belts, you would think that

the cause of this decline in income shares of the vast majority of Americans must be related to

the impoverishment of the country as a whole, but this is not the case. Chart Three shows that

the value added per worker has continued to rise steadily in each decade, especially since 1980.

What has lagged is not productivity but pay. Workers are producing more but not earning

more. Since the mid-1970s, average pay per worker has basically gone nowhere, i.e., it has kept

up with inflation but no more than that.

Chart 3.


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Why is there Insufficient Demand?

Most economists agree that the immediate problem facing the economy is a lack of

demand for goods and services, primarily consumer demand which accounts for over two thirdsof the total. However, this is wrongly framed as merely a short-term problem, that there isnt

enough consumer demand to grow the economy out of the recent economic slump of 2008-

2009. But why arent consumers stepping up to the plate? The Wall Street Journals lead

headline of June 26, 2011 points out that Debt Hamstrings Recovery. Correct: indebted

consumers (and indebted governments) are reluctant to spend money as freely as they

otherwise might. The Journal cites the work of Carmen Reinhart of the Peterson Institute for

International Economics who, with Harvard economist Kenneth Rogoff, has thoroughly

documented the depressing effect of heavy indebtedness on consumers and government

following severe financial crises. But from a more fundamental standpoint, debt, like the

weakness of demand, is more a symptom than a cause.

Most of the proposed cures for our current malaise, such as most of those proposed by

Paul Krugman in the New York Times, involve spending more government money to prop up

the consumer. While this may be the most effective way to get consumers to spend more

money, it does so, as noted above, by adding to the government deficit. A more fundamental

solution must also entail paying off old debt so that consumers and government can spend

more freely and grow the economy without starting a new cycle of indebtedness.

In a provocative article in the New York Times of October 26, 2011, entitled Its

Consumer Spending, Stupid, Prof. James Livingston argues that consumer debt and

government spending enhance economic growth, and he proposes a redistribution of income

away from profits toward wages, enabled by tax policy and enforced by government spending.

Prof. Livingston is clearly on the right track, although we believe he needs to address

more fully the problem of debt. The simple broad solution to our current economic imbalance is

to increase the take-home pay of working people. As the economy emerges from recession,

growth should be sustained by higher wages and tax revenues withoutresorting to continual

increases in debt, and in fact, with a gradual reduction of both consumer and government debt

over time. Meanwhile, Prof. Livingston correctly addresses the bubble side of the coin of

inequality when he says that corporate profitsare just restless sums of surplus capital, ready

to flood speculative markets at home and abroad.

Nicholas Kristof (Americas Primal Scream, New York Times, October 15, 2011) draws

the right conclusion:

Economists used to believe that we had to hold our noses and put up with high inequality as

the price of robust growth. But more recent research suggests the opposite: inequality not only

stinks, but also damages economies.

What is so powerful about Kristofs article is that it is based on evidence that countries

with more unequal economies grow more slowly, and are more prone to bankruptcies and


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financial panics. In other words, a highly unequal economy is less likely not more likely than

a more equal economy to pass the performance tests proposed at the outset, including the

fourth test, i.e., that it favors creativity, innovation and entrepreneurship, which would tend to

be associated with financial stability and steady increases of demand.

This paper provides, in effect, a why and how narrative to accompany the evidence

cited by Kristof. We can now develop a cogent account of why in the 2000s consumers were

induced to take on too much debt mortgages in particular and then defaulted and nearly

brought down the financial sector and the economy in the process. A moralistic account of the

wickedness of lenders and the foolishness of householders is inadequate, although clearly

many players in the financial markets leapt at the opportunity to participate in Wall Streets

bonanza of credit extension with little concern about the potential risks for either borrowers or

investors.

The obvious fact, the elephant in the room, is that, on the one hand, ordinary

consumers were (and are) getting too small a slice of the economic pie, period, and could not

sustain a middle class lifestyle without taking on debt. Similarly, the government sector has

found itself with pressing needs for education, health care, infrastructure and so forth, but too

little revenue; hence the resort to debt to cover massive deficits.

The unifying explanation proposed here that under-consumption and over-

indebtedness are the unavoidable results of the extremely unequal distribution of income is

not new in American economic theory, but it has fallen into disuse, perhaps because it did not

fit economic conditions during the middle decades of the last century, when income was more

evenly distributed. In Chart Four we can see the long historical picture.

(credit: Bill Marsh/New York Times, November 4, 2011)


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As depicted in the chart, the share of the top 1 percent reached 23.5 percent in 2007,

the highest that it had been since 1928, just before the Great Crash, when the 1 percent

received 23.9 percent. From 1929, it fell at first dramatically and then slowly until it reached a

low of 8.9 percent in 1976. Then, especially in the Reagan and Bush years, owing in part to taxcuts and stagnant wages, it rose again to nearly its previous high level.

The issue of an extremely unequal distribution of income has, clearly, become more and

more relevant as the distribution of income has become more and more unequal since the

1980s, and by the 2000s the shoe fits well, better than it has at any time since 1929. Meanwhile

most of the current generation of macro-economists seem to have forgotten about it.

Unblocking the Circular Flow of Income

The blockage of the circular flow of income provides a unified explanation of the way inwhich extreme inequality has contributed to both the underlying economic weakness that is

characterized by slow growth and stubbornly high unemployment on the one hand, and the

financial crises of 2000 (the bursting of the dot-com bubble) and 2008 (the bursting of the

housing bubble) on the other.

There are, in other words, two sides to the coin of extreme inequality. On the one side,

low wages (and high unemployment) are unable to support adequate consumer demand for

the products of sound investments. The other side of the coin is high corporate profits and

bloated high-end incomes that result in a build-up of unused cash, literally trillions of dollars

that cannot be put to use, given the absence of demand for the products and services of further

investments. In these circumstances, excess profits and high-end incomes feed speculativeexcesses such as the dot-com and housing bubbles, which sooner or later are bound to burst.

To understand the concept of the circular flow of income that underlies this analysis,

imagine the closed economy of a town in which everybody works for one company, which is

owned by one local owner, and which provides full employment and produces all their

consumption needs.

The townspeople including the owner spend all their income on the goods and services

sold to them by the company, which pays out all its revenue in wages and profits.

Diagram 1 on the following page is a simplified depiction of the circular flow of money

from households to companies (in the form of purchases of goods and services) and back tohouseholds (in the form of wages and profits). In other words, what goes around comes around

in a good sense and the town economy can continue to function indefinitely with full

employment.

A simple economy of this type will not have unemployment or slack in the use of

resources, assuming that other features of the town economy are also in balance. These

features would include any spending on imports from other towns, which we assume would


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be equal to receipts from any exports to other towns. Likewise, savings (which reduce

demand) would be equal to investment (which increases demand).

In the diagram we introduce some notional numbers. Assume the townspeople are paid

$9 million a month in wages and salaries by the company, and the owner makes $1 million

profit which he uses for his own consumption. In this example, the company will continue to

have revenues of $10 million to disburse on wages and profits each month, which will enable it

to continue to hire all the workers.

Now consider what happens if the owner the 1% decides to cut costs by reducing

wages to the townspeople the 99% from $9 million to only $8 million a month,

maintaining the level of prices and trying to double his profit to $2 million, although he does

not or cannot spend more than $1 million on his own monthly consumption. This is the

situation depicted in Diagram 2, which roughly reflects the bubble period leading up to 2008.


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Note that demand for the goods and services produced by the company would be short

$1 million a month, if it were not for the fact that we introduce a bank, in which the owner

deposits his additional $1 million savings and which in turn lends that $1 million to the

townspeople. Focusing on the center-left part of the diagram, we see that the 99% maintain

their standard of living of $9 million by borrowing an additional $1 million each month from the

bank in the form of cash-out refinancing of their homes, home equity lines of credit, etc.

In this case the 99% not only maintain their spending at $9 million, the 1% can make a

profit of $2 million, spend $1 billion from revenues and deposit $1 million in the bank, from

which the bank can lend money to the other 99%. Together the 99% and the 1% can continue

to buy 100 percent of the output of the company, which can continue to operate at full

employment. Welcome to the bubble economy!

The bank, however, is accumulating additional deposits from the 1% and making

additional loans to the 99% every month, with no prospect of the loans being paid off. So long

as the 1% are willing to finance the debt from the bank, and the bank is willing to turn a blind

eye to the financial situation of the 99%, this imbalance can continue indefinitely. But of courseat some point the 1% and/or the bank will have second thoughts about the creditworthiness of

the 99%, who are likely to be defaulting on their mortgages at an increasing rate. A financial

crisis must ensue. Welcome to the subprime mortgage crisis of 2008!

As the crisis unfolds, bad debts and unemployment emerge as huge problems and

everybody looks to government to bail them out. This is the situation depicted in Diagram 3, in


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which the government underwrites consumer spending by the 99%, directly or indirectly, to the

tune of $1 million per month.

What the government is doing is replacing the bank as the lender of last resort. It does

so in this case, however, by borrowing from the 1% without increasing taxes to pay for the $1

million consumer spending each month. The situation is sustainable to the extent that the

government deficit is sustainable. We believe that this deficit spending is necessary to avoid a

double-dip recession, although it is not a permanent solution to the problem of inadequate

demand, since it kicks the deficit can down the road for future governments to pick up.

Of course, in reality we know that despite the boost to demand provided by government

deficit spending, the situation deteriorated in 2008-2009 to the point where demand has

remained far short of the level needed to create full employment. For the sake of simplicity,

this is not shown in the chart. What has happened is that, as argued by critics such as Paul

Krugman, the federal government simply is not spending enough, state and local governments

are being constrained to tighten their belts, and other sources of demand such as investments

are falling short.

A broad solution is reflected in Diagram 4, in which the government increases the tax bill

of the 1% by $1 million, and returns the economy to sustainability. Full employment is feasible

in this situation, provided other sources of demand such as investments and exports (not

shown in the diagram) contribute to the economic recovery, even if there is no stimulus from

government deficit spending.


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Is this a full account of the current economic blockage and a solution? Clearly not. For

instance, the saving necessary to finance investment for the future would need to come from

the 1% and hopefully a larger contribution from the now better-paid 99%. But the central fact

remains that a tax regime that shifts a significant amount of the tax burden from working

households to corporations and the wealthy is perhaps the largest single element of a solution.

Other elements would include additional measures to favor investment and enterprise, which

not only add to demand in the short term, but increase productivity over time.

Searching for Policy Solutions in Six Major Areas

In order to restore balance to the economy, we submit that there are six critical and

related areas that have to be addressed, adding up to a necessary shift of income from wealthy

individuals, banks and other corporations (who have more money than they are able to spend)

to working people and to government (who have less money than they need). We will discuss

these areas after describing how this shift would unblock the circular flow of income in theeconomy by releasing funds to spending and thereby increasing final demand, especially

consumer demand. This would stimulate employment and investment, which in turn would

further increase demand.

In the current situation of pervasive unemployment, and with this great imbalance in

mind, policy proposals should be subjected to this litmus test: do they increase the flow of

income in the near term? Second, however, are they compatible with a balanced federal


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back into sufficient purchases of U.S. goods and services.) There are two broad ways to enhance

the labor-competitiveness of U.S. manufacturers and other companies. One is to remove heavy

cost burdens that are placed on employers and employees in the U.S. economic system. In

particular, there are the burdens of payroll taxes and health care costs currently imposed on

employers and employees as part of the labor cost package. (This is discussed below.)

The other broad solution is to allow the U.S. dollar to decline in an orderly fashion

against other currencies through the workings of the currency market, to the extent that wages

in the U.S. are higher than those of competitive countries such as China.

2. Excessively high upper-end incomes. Secondly, in contrast to the low-wage policies

for ordinary workers, the corporate sector in recent decades has increasingly been awarding

astronomical salaries, bonuses, stock options and fees to top corporate officers and outside

consultants such as financial advisers, advertising agents, and accountants.

Professional salaries also evidence extreme inequality. While it would be hard to

address this issue, perhaps a process for the selective review of price-setting may be in order in

certain professions like medicine and law. To the extent that professions operate like guildswith restrictive membership, barriers to entry could be considered. In any event, it is hard to

believe that salaries and fees running into the millions of dollars a year can be justified, while

average wages languish.

The other factor at work here is that profits as a share of national income are at a high

level. Again, this is good for the individual firm, but to the extent that in aggregate those profits

lie unused in the coffers of corporations and the wealthy, they are being blocked from

performing a useful function.

As is clear from the Congressional Budget Office study discussed above, almost all the

growth in incomes in recent decades has accrued to the top few percent of income earners.

Inequality is, in other words, a growing problem, which implies that the political economyunderlying income-setting has changed at the upper level in the opposite direction to that in

the basic wage-setting process for the mass of workers. The present system at the upper level

is a kind of crony capitalism in which corporate committees and consultants pat each other on

the back by awarding each other ever higher salaries and fees.

But its our money, the corporate insiders and advisers might object. Its ours to do

with what we will. Not so. If you look out across the whole country, across all Americans, it is

clear that we are all stakeholders in the private sector and are all contributing to it as

consumers, ordinary workers, shareholders, taxpayers and the rewards as between different

stakeholder groups must be assessed, and modified if necessary, by all of us through the

political process as well as the marketplace. The relatively unregulated marketplace of the2000s has let us down.

Various political and corporate measures could be introduced to reduce the excesses of

insider earnings. For instance, greater transparency of salary- and fee-setting could be

supplemented by greater rights for investors to challenge the way in which corporations are

spending their money.


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A complementary and simpler way of getting the top end of the income distribution

back into balance is by reversing some of the tax changes that have favored corporations and

the rich. Higher effective high-end income taxes and corporate tax rates are undoubtedly

justified

The current implicitsolution to the economic imbalance caused by the excess earnings

of corporations and the rich is for the rich to increase their personal consumption, in the form

of additional and larger dwellings, automobiles, yachts, airplanes, corporate perks, whatever.

And it is no doubt true that in technical economic terms, if the rich were to succeed in

consuming a larger share of their income, while investing less, a macro-economic balance

between spending and investment could be reached, consistent with full employment, without

addressing the distribution of income. To the wealthy and their pundits and politicians that

might seem to be a satisfactory solution.

However, the entrenchment of a small class of people literally and metaphorically in

gated communities, with the rest of the population restricted to a low-wage environment

providing goods and services to the wealthy directly or indirectly, is not consistent with

democracy. Nor does it address the legitimate concerns of Occupy Wall Street.

3. Burdens on employment costs. There is no logic in treating social security and health

care costs as part of the costs of employment. I repeat: there is no logic in treating social

security and health care costs as part of the costs of employment. But for historical reasons

both types of costs are currently recovered from employers and employees and at this point

have become a crushing burden. It is no wonder that employers are reluctant to take on more

workers, and it is not surprising that the wages left over after these costs have been paid are

squeezed by employers. Consider the calculations made by automobile manufacturers about

the costs per car of assembling cars in this country and the resulting competitive handicap.

As hard as it is to imagine the American economy without the burdens of social securityand health care costs on private sector employers, it seems necessary if we are to achieve and

sustain full-employment to make this break and to recover these costs out of general tax

revenues. At one stroke, manufacturing in this country even with higher cash wages would

become more competitive than it currently is.

4. Changes in Taxation. The pair of changes discussed above the elimination of payroll

taxes and the removal of health costs from employers and employees would significantly shift

the burden of taxes. Additional or enhanced sources of tax revenues would be required to

recover the additional costs. These would include the increases in income and corporate taxes

mentioned above.

What is necessary is not only to return nominal tax rates closer to levels that prevailedbefore the Reagan-Bush tax cuts, but to reduce tax breaks so that effective tax rates are

returned to more reasonable levels. The point, again, is to unblock the flow of expenditure in

the economy by, in effect, recycling additional income from the groups that can easily afford it

to the government and consumers, who desperately need it.

These sources might prove to be adequate, but if not, some additional form of taxation

would be needed. (A general carbon tax would be a good candidate, because it would at the


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same time help address global climate change issues.) Obviously, any major changes of this

nature would be highly contentious and hotly debated, but the justification for them would be

a huge reduction in the cost of employing labor.

5. High health-care costs. A solution must be found to the problem of high health care

costs. While the focus of this paper is macroeconomic, one or two sectors are so large and so

burdensome on the economy as a whole that it is worth singling them out for special mention.

Health care is such a sector. Not only does it absorb approximately one out of every six

dollars spent in the economy, it also is directly implicated in the budget problems of the federal

government because of the large and rising costs of Medicare and Medicaid. Other things being

equal, these costs will continue to rise as health care inflation continues and the population

ages. In the framework of a single-payer health care system or public option, however, there

would be many opportunities to reduce the level of costs per capita, as is clear from

comparison with all the other countries that have universal health care systems in place.

6. The problem of the bloated financial sector. Finally, the financial sector absorbs

about 8 percent of the GDP, and although this is somewhat less than half the share of healthcare, the sector is directly implicated in the episodes of repeated bubbles and busts that have

destabilized the economy.

Adult supervision of the financial sector is required. Finance has doubled its share of

GDP in recent decades, while the countrys economic performance has deteriorated. It is fair to

label it as dysfunctional and to require fundamental financial reform if the country is to get

back onto an even keel.

Reconciling Short-Term and Long-Term MeasuresIn the short term, as emphasized by Paul Krugman and others, the most important

priority is to increase spending to create jobs, even if it means increasing the federal

government deficit. But debts have to be paid back in the long run, and it is essential that the

government should have a sound plan for restoring fiscal prudence to the country after the

Bush years of tax breaks and profligate war spending.

Higher effective corporate tax rates and higher effective taxation of the wealthy are

clearly necessary in the near term if fiscal prudence is to be restored without jeopardizing the

economic recovery. The overall effect would be to increase somewhat the share of taxes and

government in the economy, although the increase should be well within the historical range.

As the economy recovers, attention should shift to longer-run concerns like increasing

basic wages. The reduction of health care costs and cutting the financial sector back to size

would reduce the unacceptable economic burden of those sectors on consumers, lighten the

burden of medical costs on government, and make it less likely that government would be

called on once again to rescue ailing financial institutions.


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Conclusions

To sum up, if the grossly unequal distribution of income in the U.S. is not addressed

through a set of measures such as those discussed above, the economy will be condemned to

continue its recent pattern of financial instability and sluggish performance. While the

measures proposed here are far-reaching, they are essentially conservative in the sense thatthey are designed to modify the current economic system in order to make it work better, not

to replace it with a fundamentally new system.

Meanwhile, this analysis provides a framework for reviewing alternative policy

proposals, a kind of litmus test. For example, if we look at some of the budget proposals being

put forward in Congress and the states in 2011, we can see that they go in the wrong direction.

In particular, they are having the effect of reducing government spending at all levels and

further inhibiting the already-weak economic recovery.

Neil Talbot and Sam Talbot, November 2011

Tel: (212) 334-5809. Email: [email protected]

Neil Talbot lives in New York and is an economic consultant to state governments in the U.S. He

has degrees in economics and finance from Cambridge University and Boston College

respectively. Sam Talbot is a food service worker and labor union organizer in New York.

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How to Unblock the Economy - by Reducing Inequality