The last major section of Heather Boushey’s Unbound discusses how inequality distorts the economy. Here the author discusses how the shift of income and wealth toward the top of the distribution has affected macroeconomic processes. The first chapter in this section focuses on the economic cycle—the circular flow from production to income and back again by way of saving and investment in more production. The second chapter concentrates on investment in particular, and how growing inequality has affected the level and nature of investment.
The economic cycle
If a country wants to sustain a high level of economic activity—lots of production and consumption of goods and services—does it matter how income and wealth are distributed?
In the economically depressed 1930s, John Maynard Keynes emphasized how much the economy needs consumers as well as savers and investors. Thrift is a good thing up to a point, but too much thrift undermines the aggregate demand that firms need to justify high levels of production. The distribution of income and wealth has a bearing on this because of the “marginal propensity to consume.” The poor have to spend more of their income, while the rich can afford to save more. Milton Friedman questioned how much the propensity to consume depends on current income. People with variable incomes may smooth out their spending over time, drawing on their past income or borrowing against future income at times when their current income is lower.
Nevertheless, recent research does confirm that the rich do save more, while others have to spend the bulk of their income or even overspend and run up debt. A substantial shift of income and wealth toward the top of the distribution makes it harder for ordinary households to consume without incurring more debt.
Boushey regards the financial crisis of 2007 and the resulting Great Recession as the “perfect case study” for examining that proposition. Alan Krueger’s research found that “between 1979 and 2007, about $1.1 trillion (in 2007 dollars) was annually shifted toward the very rich.” Consumption by the rest of the population held up pretty well, not because incomes were rising for them, but because households took on more debt. Household debt rose from less than 60 percent of GDP before 1979 to 100 percent by 2007. (After the crisis it fell back somewhat, but is still around 80 percent now.)
The federal government responded to the Great Recession with expansionary fiscal and monetary policies that lowered interest rates and stimulated aggregate demand. Economic recovery was very slow, however. Some economists believe that the government was too quick to turn back toward austerity and phase out programs aimed at low-income households.
The lesson from this experience seems to be that the economy can sustain a high level of economic activity for a time despite growing economic inequality. But eventually, the economy is dragged down by either too little consumption or too much debt. Economic inequality is associated with financial instability, as Mark Zaindi concluded:
In a recent essay, Moody’s Analytics’ Zandi—who oversees one of the most well-respected forecasting models—integrated inequality into his model for the United States. Adding inequality to the traditional models did not change the short-term forecasts very much, but he concluded that higher inequality increases the likelihood of instability in the financial system when looking at the long-term picture or considering the potential for the system to spin out of control.
Since the rich are able to save more than the poor, “the shift in income from the bottom to the top of the income distribution accounts for an increase…in the global savings rate.” As Boushey puts it, “more savings are sloshing around in the economy.” Productive investment of all those savings is another matter, however. If incomes are not growing in the middle and bottom of the distribution, businesses may be reluctant to expand production or launch new products.
One thing that personal savers and businesses can do with their money is lend it, especially when household debt is growing. Finance is one industry that can have a boom even when other areas of investment are weak. The deregulation of finance in the 1980s and 90s facilitated such a boom, but at the risk of more financial instability. Commercial banks were allowed to own banks in multiple states, charge higher interest rates, and engage in investment banking. New financial instruments like credit default swaps got exemptions from traditional forms of regulation. One result was a boom and bust in home mortgages, as complicated loans that borrowers couldn’t understand or really afford were packaged into more complex securities, which were then overrated by rating companies and insured by unregulated credit default swaps. When mortgage defaults began to rise, the financial system collapsed. “The rise in credit supply—made possible both by the additional savings flooding the economy and the deregulation of finance—was the leading cause of the Great Recession.”
In this era of greater inequality, corporate profits have boomed, and a larger portion of the profits have been distributed to shareholders through dividends and stock buybacks. That leaves a smaller portion for companies to reinvest in actual expansions of goods and services. “Economic inequality means lots of savings but too few attractive opportunities for profitable investments, which creates a long-term trajectory of slow growth… The term economists use to describe this combination of trends is secular stagnation.”
This view is in sharp contrast to the politically popular idea that tax cuts for the rich and greater wealth at the top will support more investment and more rapid economic growth. That was the thinking behind the Reagan, Bush and Trump tax cuts, as well as Governor Brownback’s failed experiment in Kansas. To the extent that such tax cuts discourage government spending on human capital development and other economic needs not addressed by private firms, they further weaken the economy.
Between the need for investments in the development and deployment of green energy, the need to mitigate the effects on our food supplies, and the need to assist communities upended by the rising prevalence of climate change-induced natural disasters, there’s a comprehensive agenda to be enacted. At the same time, there’s an unmet need for investments in health care, education, and the diverse needs of the elderly and families caring for young children or disabled family members that would lead to improvements in quality of life and sustain economic growth.
A Paradigm Shift
To some, Heather Boushey’s critique of economic inequality may sound radical, even “socialist”. I do not think of it that way. Nowhere does she recommend abolishing capitalist competition or ending unequal rewards tied to real differences in contribution. On the contrary, what is troubling is the spectacle of large corporations and their executives wielding so much power that they can grab the lion’s share of the rewards whether they deserve them or not. Society has to balance the need to motivate people through higher pay with the need to give everyone access to the means of economic participation. Workers need the human capital to be productive; consumers need the buying power to demand investment in useful goods and services; and citizens need the voting power to make government work for the benefit of the many, not just the few.
If Boushey’s desire for a more egalitarian society were very radical, the changes she would like to see would have little chance of happening, since the United States is not a radical country. As it is, she detects a change in thinking in economics that may portend changes in policy as well. Certainly the Biden administration is more in touch with the new thinking than previous administrations.
In 1962, when Kuhn laid out how scientific revolutions happen, he argued that a paradigm changes when the consensus shifts. This is happening right now in economics. Behind the scenes, in academic conferences and journals across the nation, a new framework is emerging, one that seeks to explain how economic power translates into social and political power and, in turn, affects economic outcomes.
The country may be ready to move on from its forty-year experiment with more extreme inequality and “trickle-down economics” It has not generated the economic growth promised—the rising tide that was supposed to lift all the boats. In many ways, the country may be going back to something reminiscent of an earlier age, a passionate concern for the common good.