The Price of Inequality: How Today's Divided Society Endangers Our Future (37 page)

The administration did make several mistakes. First, it underestimated the depth and duration of the downturn. It thought that without the stimulus unemployment would peak at around 10 percent. Administration economists, some of whom had been connected with the creation of the bubble, underestimated its size. They simply couldn’t believe that real estate prices were
that
overinflated; so they believed that the fall in prices would be only temporary, and with the recovery of housing prices consumption would be restored. As businesses saw a quick recovery, they would be reluctant to let their good employees go. The reality was otherwise: there had been an enormous bubble, and with prices still 30 percent below precrisis levels going on five years after the bubble broke—in some places more than 50 percent below precrisis levels—it has become increasingly clear that the real estate sector will be depressed for years to come, even if the financial sector were perfectly back to health.
46
That’s a problem, because before the crisis some 40 percent of all investment was in real estate.

A second mistake was that the administration believed that the primary problem was the financial crisis—not recognizing the underlying need for structural transformation. The enormous increases in productivity in manufacturing, outpacing the increase in demand, inevitably meant that labor would have to move out of that sector—just as the enormous increases in agricultural productivity in the years before the Great Depression meant that labor had to move out of agriculture into manufacturing. Moreover, with globalization an increasingly large fraction of the jobs in manufacturing would reside in developing countries and emerging markets, compounding the need for structural transformation.

The administration failed, too, to grasp another fundamental problem, the growing inequality and its impact on what had happened before the crisis, and what was likely to happen subsequently. Before the crisis, the average household savings rate was near zero, and that meant that many Americans were dissaving—had negative savings. With the upper 20 percent of the population holding approximately 40 percent of the national income and saving approximately 15 percent of that income (for a total of approximately 6 percent of national income being saved), it meant that the bottom 80 percent, with the remaining 60 percent of the national income, had to be
dissaving
at a rate of 10 percent of their income. Again, even if the banks were perfectly restored to health and even if the deleveraging of the household sector (that is, paying down their excessive indebtedness) was complete, these households shouldn’t return to their wayward ways of consuming persistently beyond their income, and banks shouldn’t lend to them. That’s why it’s unrealistic to think that the consumption excesses of the precrisis level will resume.

And, of course, the declining share of wages—the increasing inequality—will make the recovery all the more difficult, without government assistance.

These mistakes in economic analysis had consequences. The belief that the economy would recover quickly on its own—once the banks had been brought back to health with government assistance—led to a stimulus package that was too small and too short-lived. Because the administration thought the downturn would be short, it thought firms would hold on to their workers; but businesses knew otherwise, and hence the layoff of workers was greater than the administration anticipated. Moreover, the stimulus was not as well designed as it could have been; there could have been more stimulus per dollar of spending. But the belief that only a short-term palliative was needed, while the financial sector recovered, may have made the administration more relaxed about these weaknesses.
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The administration’s misjudgments in this area were compounded by one more: the thought that if its spokesmen could talk up the economy and “restore confidence,” the almighty American consumer would somehow return. In March of 2009 they started talking about green shoots; but by summer these shoots had turned brown. In the years that followed, glimmers of hope would occasionally appear, but these attempts to repeatedly exude confidence may actually have undermined confidence (and especially in both the administration and the Fed): clearly, the country’s leaders hadn’t grasped what was going on.
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Why government spending can be very effective

The logic of why government spending can be—and has been—effective in stimulating the economy is compelling. If government, say, increases spending, GDP increases by a multiple of that amount. The relationship between the increase in GDP and the increase in government spending is called the multiplier. Not surprisingly, those on the right say that the multiplier is small—and maybe even near zero. Of course, when the economy is at full employment, more government spending won’t increase GDP. It
has
to crowd out other spending. If the Fed increases interest rates or reduces credit availability, as it works to ensure that the increased government spending is not inflationary, investment will be crowded out. But these experiences are irrelevant for the question of assessing the impact of government spending when unemployment is high (and it’s likely to be high for years to come) and when the Fed has committed itself to not increasing interest rates in response. In these circumstances—the conditions of the Great Recession—multipliers are likely to be large, far in excess of one.
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The government spending can, of course, be even more effective if it goes to high productivity investments, including those that facilitate the restructuring of the economy. Beyond the high direct returns to such investments, there are other benefits—returns to private investments are increased, so that private investments are “crowded in”; the deficit is reduced in the medium term, and not only should that instill confidence but consumers, realizing that their future tax burdens will be lower than they might otherwise be, may consume more today.
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Even private consumption is “crowded in.”

Government money spent on structural reform—helping move resources from old, less competitive sectors to new sectors—stimulates the economy, and the higher incomes give individuals and firms the resources to adapt to the changed economy.

In many of the European countries facing austerity, there is simultaneously a demand for faster structural reforms. The structural reforms that they often focus upon do not entail government assistance in moving the economy into new sectors. Rather, what is referred to is a mixture of counterproductive measures (lowering minimum wages) and rent-reducing measures (like more effective enforcement of competition laws and reducing licensing restrictions), with measures of ambiguous effect—rushed privatizations that have, in many countries, actually increased rents and impaired efficiency. These reforms are topped off with aspirational messages—to be more competitive. Even were these reforms to occur at historically unprecedented paces, it would be years before the full benefits were realized. But these reforms at best (when they are well designed, and many are not) improve the supply side of the economy; as we have repeatedly noted, however, the weaknesses in the economy today stem from the demand side, and a cutback in workers’ income, either as a result of firing workers or lower wages, simply lowers total demand, lowering GDP and weakening the capacities of those who have to make the structural transformations to do so. Adjustment is likely to be impaired. In fact, unless something is done about demand and growth
now
(and most of the European programs seem to be doing little or nothing), structural reforms that increase efficiency imply that fewer workers will be required to produce whatever output the economy generates. Desirable as the structural reforms are for the long run, they run the risk of increasing unemployment and lowering output in the short run.

C
ONCLUDING
C
OMMENTS

The views of the bankers and others of the 1 percent on how to respond to the crisis—cut wages and cut budgets—won’t restore our economies to prosperity. It’s not even clear that the policies they advocate will be very successful in reducing the deficit in the current conditions of economic weakness: lower GDP and higher unemployment will mean lower tax revenues and higher expenditures. Nor is it even clear that they’re in the interests of the 1 percent, though it’s easy to see why they might think that. Lowering wages (“more labor market flexibility”) would increase profits, if only sales held up. The bankers, moreover, are always focused on getting paid back. They think of a household that owes them money. If the household cuts back on spending on itself, it has more money to give the bank. But the analogy between the household and the economy is false: cutting back on government spending destroys demand and destroys jobs. The household won’t have the money to repay the banker if its income falls concomitantly with cutbacks in expenditure. And repayment will be even more difficult if income falls by a multiple of the cutback in expenditures—which is precisely what economics has shown to be the case.

What’s striking is how many people—pundits and ordinary citizens alike, those in government and those outside—have been seduced by the myth of austerity and the myth that the government budget is like a household’s budget. Many people have been captured by a subtle, parallel argument that the Right makes about macroeconomics: There was a stimulus. The economy didn’t get better. It even got worse. Ergo, the stimulus didn’t work. But the stimulus did work; it prevented the unemployment rate from being even higher.

The 1 percent has captured and distorted the budget debate—using an understandable concern about overspending to provide cover for a program aimed at downsizing the government, an action that would weaken the economy today, lower growth in the future, and, most importantly for the focus of this book, increase inequality. It has even used the occasion of the budget battle to argue for reduced progressivity in our tax system and a cutback in the country’s already limited programs of social protection.

Given the weaknesses in the economy (both the lack of demand today and the lack of investment in our future), deficit fetishism focuses on the wrong problem, at least for now. But even if one gave in to deficit fetishism, we’ve shown that there are alternative tax and expenditure policies that can simultaneously increase economic efficiency, increase the nation’s output and lower its unemployment rate, and address one of the country’s most troublesome problems, its growing inequality.

A major source of inequality, at the bottom, is unemployment. Those without jobs suffer, and so do those with jobs, as high unemployment puts strong downward pressure on wages. Since America’s political gridlock is constraining the use of fiscal policy (taxes and expenditures) to restore the economy to full employment, hope has shifted to monetary policy. As this chapter has pointed out, matters may get even worse: deficit fetishism could lead to austerity, which will weaken the economy further and put an even greater burden on monetary policy. But is monetary policy up to the task? The next chapter explains why monetary policy hasn’t really served our nation as well as it should: to too large an extent, it’s been designed to serve the financial sector and other interests of those at the top.

C
HAPTER
N
INE

A MACROECONOMIC POLICY AND A CENTRAL BANK
BY AND FOR THE
1 PERCENT

S
OME READERS MIGHT BE SURPRISED TO SEE A CHAPTER
on macroeconomics—the branch of economics that deals with the overall level of economic activity, with output (GDP) and employment, with interest rates and inflation—in a book on inequality. Nothing affects the well-being of most citizens more than the state of the macroeconomy—whether there is full employment and growth. And when macroeconomic policies fail, and unemployment soars, those at the bottom are among those that suffer the most. More broadly, macroeconomic policy greatly affects the distribution of income. Policymakers should be aware of this, but they often act as if they aren’t. Indeed, the distribution of income is seldom mentioned in macroeconomics, and that’s exactly the point.

The most important responsibility of policy makers is to maintain the overall stability of the economy. The Great Recession offers evidence of a colossal failure. And this failure has imposed an enormous burden on ordinary Americans—as workers, as homeowners, as taxpayers, as we described in Chapter 1. We explained how the failure of macroeconomics finally brought to the fore the problems with our economic system. When things were going well, most people were prospering and could persuade themselves that those who weren’t had only themselves to blame. But with the recession of 2008, the story stopped making sense. Too many people who “played by the rules, studied hard, worked hard” were just getting by, or not even getting by.
The system wasn’t working.

This book has argued that, in many ways, our economic system has benefited those at the top, at the expense of the rest, and that this system is far removed from what has been called “the achievement model of income determination,” in which incomes reflect contributions to society. In this chapter we focus on the contribution of our macroeconomic policy to this outcome—before, during, and after the crisis.

Policy entails choices. There are distributive consequences of all policies. A central theme of this book is that some of the policy choices have simultaneously increased inequality—benefiting those at the top—and hurt the economy.

But many choices are more complicated and involve trade-offs. If there is a trade-off between inflation and unemployment, pursuing lower inflation means higher unemployment and workers suffer; lower unemployment means higher inflation, and bondholders see the value of their assets erode. A focus on inflation puts the bondholders’ interests at center stage. Imagine how different monetary policy might have been if the focus had been on keeping unemployment below 5 percent, rather than on keeping the inflation rate below 2 percent.

Different policies also impose different risks on different segments of society. If things go wrong, who will bear the consequences? If things go right, who reaps the benefits? The Fed gambled, in trusting that banks on their own could manage risk—a gamble that paid off handsomely for the banks, and especially for the bankers, but in which the rest paid the price. The Fed could have curbed the reckless and predatory lending, the abusive credit card practices, but chose not to do so. Again, the banks were the winners; the rest the losers.

Monetary and macroeconomic policy and Fed action thus contributed to the country’s growing problem of inequality in several ways. At the bottom and in the middle, higher unemployment than was necessary at times (implying lower wages) meant lower incomes for workers. Less protection from the abusive practices of the banks hurt their standards of living. We’ll even see how current macroeconomic policies may even be contributing to creating a jobless recovery—when the recovery actually gets really under way. Hidden subsidies to banks and support for deregulation that contributed so much to the financialization of the economy contributed to the increasing inequality at the top, and aggressive policies fighting inflation meant that rich bondholders didn’t have to worry that inflation would erode their value.

These failures are not an accident. The institutional arrangements by which monetary policy is set are designed to give disproportionate voice to the bankers and their allies. This was even reflected in the models that became part of the standard tool kit of central banks. While they focused on inflation (something bondholders cared a great deal about), they ignored distribution (something bankers wouldn’t want central bankers to think too much about)—even though, as we have argued, growing inequality was critical in creating the economy’s instability.

Just as the Great Recession drew attention to America’s growing inequality—destroying the myth that all were benefiting from the growth that had occurred in the preceding quarter century—it destroyed two other myths: that a focus on inflation was the cornerstone to economic prosperity, and that the best way of ensuring economic stability was to have an independent central bank. This chapter will explain how the monetary policies that were pursued simultaneously weakened overall economic performance and increased inequality.

There is an alternative set of policies and institutional arrangements that holds out the promise of not only better and more stable growth but also of a more equitable sharing of the benefits of that growth.

H
OW
M
ODERN
M
ACROECONOMICS AND
M
ONETARY
P
OLITICES
H
AVE
H
URT THE
99 P
ERCENT

The central focus of much of modern macroeconomics and monetary policy is on inflation—keeping inflation low and stable allegedly provides the macroeconomic conditions under which a market economy can flourish. Inflation—especially very high and erratic levels of inflation—can be a problem, but the United States and Western Europe have not faced a serious problem of inflation in more than a third of a century.
1
Focusing on yesterday’s problems can distract one from the more pressing issues of today. In the years before the Great Recession, of far more concern than a possible slight loss of efficiency from a slight increase in inflation should have been the very big loss from the collapse of the financial system.
2
In the years after the onset of the Great Recession, of far more concern than a possible slight loss of efficiency from a slight increase in inflation should have been the very big losses from the waste of resources as a result of the economy’s not living up to its potential.

As we noted in chapter 4, those who suffer the most in crises are workers and small businesses, and that’s been especially true in this crisis, where corporate profits remain high in many sectors
3
and banks and bankers are doing well. High unemployment hurts those who depend on working for their living; most of those with jobs face shorter hours and lower incomes. But it particularly hurts those at the bottom. The more skilled workers displace the less skilled, and the less skilled displace the unskilled. While each of these groups suffers with lower incomes, those that are displaced from their jobs are hurt the most.
4

A high level of joblessness doesn’t just affect those who lose their jobs or have their working hours cut: it hurts the bottom 99 percent by forcing down wages as workers compete for jobs. And the way most central banks conduct monetary policy creates a ratchet effect that has been working ruthlessly for the past several decades. As soon as wages start to recover, the central bankers, with their single-minded focus on inflation, raise the specter of price increases. They raise interest rates and tighten credit,
to maintain unemployment at an unnecessarily high level.
Too often they succeed in choking off wage increases—with the result that productivity has been growing
six times
faster than wages.
5
(At the time of the 2008 crisis, workers had not yet recovered what they had lost in the last recession.)
6

Central bankers have a hard time limiting their opinions to monetary and bank regulatory policy. (If they had stuck to their knitting, and gotten monetary and regulatory policy right, the economy would be in far better shape.) A central theme of these bankers is that there should be more “labor market flexibility,” which typically means lowering wages, and especially minimum wages and job protections. But the weakening of systems of social protection has amplified the adverse effects on the 99 percent of mistaken macropolicies. Minimum wages have not kept up with inflation (so that the
real
federal minimum wage in the United States in 2011 is 15 percent
lower
than it was almost a third of a century ago, in 1980); and this has obviously made lowering wages easier, especially at the bottom.
7
Unemployment insurance also has not kept up with the times, so those who lose their jobs and are lucky enough to have unemployment insurance receive a fraction of their previous pay.
8
And, as we saw in chapter 1, the number of unemployed who are not receiving benefits has risen to staggering levels.

But the weakening of the system of social protection and the push for more flexible labor markets may itself have amplified the macroeconomic consequences of flawed monetary policies. The central economic problem in the Great Recession, as we have noted, is lack of total (or aggregate) demand. With good systems of social protection, workers’ income and consumption are sustained, even in the face of a downward “shock” to the economy. Economists refer to these shock absorbers as automatic stabilizers. On the other hand, wage declines in response to an adverse shock to the economy amplify its effects. The central bankers who were simultaneously calling for more “wage flexibility,” focusing on inflation, and ignoring the risks of financial fragility were simultaneously pursuing a policy that exposed the economy to a risk of a major shock and advocating policies that would ensure that the shock, when it occurred, would have deep and serious consequences.

Oblivious to the distributional consequences of monetary policy

As I noted, the standard macroeconomic models don’t even recognize that the distribution of income matters, and so it’s not surprising that the Fed in its policies has often seemed oblivious to the distributional implications of its decisions. Even when it does focus on employment, its failure to take into account the distributional consequences of its actions lead it to adopt policies that may be counterproductive.

For instance, the Fed focuses on interest rates in the mistaken belief that changes in the interest rates are a simple “lever” by which it can control the economy—lower the interest rate and the economy expands; raise the interest rate and it slows down. And though there are times and circumstances in which the interest rate may have those effects, at other times the links are at best weak and other instruments might have been more effective. For instance, in response to the real estate bubble, it would have made more sense to raise the down payment requirements for mortgages than to raise interest rates; one didn’t want to slow down productive investments, just to dampen the bubble. Such regulations were anathema to the Fed, with its religious devotion to the price system and the wonders of the market.

When the economy went into a tailspin, the lowering of interest rates may have saved the banks, but it clearly didn’t reignite the economy. Even if the lower rates that banks paid for funds had been passed on to borrowers, in most sectors there wouldn’t have been much increased investment, given the low level of capacity utilization—the economy already had more than enough capacity to produce whatever was demanded. So, besides cheap money for the banks—a hidden subsidy—there really wasn’t much benefit to lowering the interest rate. When the Fed lowered interest rates in response to the collapse of the tech bubble, it didn’t lead to much business investment, but it did lead to the real estate bubble. But with real estate prices down as much as they were, it was almost inconceivable that lower interest rates would have much effect there.

There was a cost, however: all those retired individuals who had invested prudently in government bonds suddenly saw their incomes disappear. In this way, there was a large transfer of wealth from the elderly to the government, and from the government to the bankers. But little mention of the harm to the elderly was made, and little was done to offset it.
9

The lower interest rates might have dampened spending in other ways. Persons nearing retirement, seeing that they would have to put away that much more in safe government bonds to get the retirement income they desired, would have to save more. As would parents saving to put their kids through school. Even cursory attention to the distributional consequences of such policies would have raised doubt about the effectiveness of the low interest rate policy.
10

The Fed, with its focus ever on the 1 percent, did however suggest that lower interest rates would increase stock market prices—helping those at the top, who, as we have seen, own a disproportionate share of the stock market—and higher stock market prices would lead to more consumption, because people would feel wealthier. But interest rates would not remain at such a low level forever, which meant the gain in stock prices was not likely to be permanent. It was unlikely that any temporary increases in stock prices caused by a temporary lowering of interest rates, of benefit particularly to the rich, would translate into substantial increases in consumption.
11