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This post has been updated. See below.
The center-left has a Grand Unified Theory of Why the US Economy Stinks. Otherwise known as “secular stagnation”or “middle-out economics,” it holds that income inequality hurts economic growth by reducing middle-class spending power. Its chief promoter is Larry Summers, former Obama White House economist and Clinton administration Treasury Secretary.
Apparently, Standard & Poor’s is now also a believer. In a new report, “How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide,” S&P’s US Chief Economist Beth Ann Bovino digs through the data and concludes thusly:
Our review of the data, as well as a wealth of research on this matter, leads us to conclude that the current level of income inequality in the U.S. is dampening GDP growth, at a time when the world’s biggest economy is struggling to recover from the Great Recession and the government is in need of funds to support an aging population.
Now this is kind of a big deal, since S&P isn’t some progressive think tank doing the bidding of Hillary 2016. It’s a still influential bond-rating firm. And that shows, argues The New York Times’s Neil Irwin, “how a debate that has been largely confined to the academic world and left-of-center political circles is becoming more mainstream.”
But as this debate grows in importance and visibility, making sure it is data driven and research rich is critical. And there are problems with this report.
1.) S&P accepts the idea that since the 1% appear to be grabbing an ever-greater share of income gains in recent decades, rising income inequality is slowing economic growth because they rich have a higher marginal propensity to save than those lower down the income distribution. But as Paul Ashworth of Capital Economics noted in a recent report, if rising inequality were actually holding back the economy, you would expect to see the household savings rate rising over the past few decades and consumption accounting for a smaller share of overall GDP. Rather, the household savings rate has been rising for three decades, and “even allowing for the drop back over the past few years, consumption now accounts for a larger share of GDP. That suggests rising income inequality has not been a dominant macro force.”
Econ blog Ashok Rao puts it this way:
While richer people most certainly do have a lower propensity to consume, the magnitude of this effect is clearly dwarfed by forces like the Asian saving glut and potentially overvalued dollar. Luxury markets are booming: and it may not be to a good liberal’s taste, but demand for chauffeurs and butlers creates employment just like that for apparel and electronics. Indeed, to the extent richer people consume at the margin on non-tradable services, the leakage is also lower.
2.) S&P suggests rising inequality and the “imbalances” it creates can lead to “a boom/bust cycle such as the one that culminated in the Great Recession.” This comes very close to blaming inequality for downturn. I would refer Bovino to “Does Inequality Lead to a Financial Crisis?” by Michael Bordo and Christopher Meissner. The economists examined data from a panel of 14 countries for over 120 years, finding “strong evidence linking credit booms to banking crises, but no evidence that rising income concentration was a significant determinant of credit booms.” And here, again, is Ashworth:
It is true that households further down the income distribution increased their debt burdens during the housing boom years. But that debt was taken on principally to buy over-valued real estate rather than to fund everyday non-discretionary spending because incomes weren’t keeping up with inflation. The upshot is that we don’t think rising income inequality is holding back the economic recovery, at least not to any significant degree
(See here for a market monetarist explanation for the Great Recession.)
3.) S&P blames rising income inequality for reducing social mobility. Bovini: “Aside from the extreme economic swings, such income imbalances tend to dampen social mobility and produce a less-educated workforce that can’t compete in a changing global economy.
I would refer Bovini to a study from the Equality of Opportunity Project, which found US mobility has changed little in nearly half a century. Indeed, the EOP study also found that family structure, education, and geographic segregation are bigger issues than 1%-99%-style inequality, which has zero correlation with climbing the opportunity ladder. As the study put it: “upper tail inequality is uncorrelated with upward mobility … .”
4.) There is plenty of research showing no correlation between rising inequality and slower economic growth in advanced economies. Scott Winship:
Recent work by Harvard’s Christopher Jencks (with Dan Andrews and Andrew Leigh) shows that, over the course of the 20th century, within the United States and across developed countries, there was no relationship between changes in inequality and economic growth. In fact, between 1960 and 2000, rising inequality coincided with higher growth across these countries. In forthcoming work, University of Arizona sociologist Lane Kenworthy also finds that, since 1979, higher growth in the share of income held by the top 1% of earners has been associated with stronger economic growth across several countries.
5.) S&P’s discussion of potential solutions to the inequality “problem” almost entirely concern those pushed by the left: higher minimum wage, raising taxes on capital income such as through the Buffett rule, limiting executive pay, more public investment. More spending, more redistribution. As an alternative I would suggest wage subsidies to boost low-end incomes and reward work, helping startups by reducing crony capitalist regulation, lower or ending corporate taxation to boost take-home pay for middle-class America.
Again, here is social scientist Lane Kenworthy: “Faster economic growth would be a good thing (particularly if with it came a shift towards greener growth). But there is little evidence that the American economy will grow more rapidly if the US manages to reduce income inequality. … Income inequality is too high in the US. It would be good to reduce it. But it is a mistake, in my view, to put inequality reduction at the top of the agenda.”
Might income inequality be a headwind in the future? Sure. And it does make stagnant mobility more punitive. But does it explain what’s wrong with the US economy right now? I am doubtful.
Update: I should have mentioned in the original post that Bovino does spend considerable time on education as a way of reducing inequality. Certainly AEI has done lots of work on K-12 and higher ed reform. But three problems with the report on this front: First, Bovino suggests — in addition to simpler financial aid forms and more college outreach to low-income students — spending more money on college financial aid.
With evidence indicating that a well-educated U.S. workforce is not just good for today’s workers and their children but also for the economy’s potential long-term growth rate and government balance sheets, what do we need to do to get there? This will likely require some investment in the human capital of the U.S. workforce, today and tomorrow. But studies have indicated that the benefits greatly outweigh the costs. Researchers estimate that, depending on the exact program, $1,000 in college aid results in a 3- to 6-percentage-point increase in college enrollment, with the total cost in aid averaging $20,000 to $30,000 to send one student to college. Given a college graduate is expected to earn about $30,000 more per year than a high school graduate over the course of their life, the benefits outweigh the costs.
How about, instead, pushing structural reforms that would reduce costs and provide greater value? As Andrew Kelly writes in Room To Grow”:
Generous federal loan programs, particularly those available to parents, encourage enrollment at any college and at any price, providing little incentive for colleges to keep their tuition low or make sure their students are successful. Meanwhile, though advances
in technology could increase access and reduce the cost of education, federal rules governing access to student aid programs create high barriers to entry that keep low-cost competitors out of the market
Second, Bovino advocates “investment” in universal preschool, citing Brookings Institute research support . Yet another Brookings scholar, Grover Whitehurst, finds “the best available evidence raises serious doubts that a large public investment in the expansion of pre-k for four-year-olds will have the long-term effects that advocates tout.”
Third, Bovino cites evidences on education inequality that the Manhattan Institute’s Scott Winship finds to be empirically lacking:
Much of the report is dedicated to describing inequality of educational outcomes between rich and poor children—inequalities it says will lead to diminished economic growth and declining economic mobility. Like many before it, S&P cites the research of Staford University sociologist Sean Reardon, who analyzed a number of questionably comparable studies with test scores measured at different ages. Reardon’s now-famous chart connects the data points from these studies with neatly-smoothed trend lines to argue that the test score gap between rich and poor children is growing.
Set aside the obvious point that the parental income gap between children is correlated with countless other inequalities—in parental skills and values, family structures, social networks, neighborhood resources—and that any of those gaps could be driving the pattern Reardon shows. In a recurring pattern, S&P fails to note important research that directly addresses and overturns the Reardon result. University of Chicago professor Eric Nielsen carefully addresses the measurement issues in treating test scores as indicators of achievement and finds that the achievement gap between rich and poor children has narrowed over time.
Winship concludes thusly:
Overall, the S&P report on inequality lacks empirical backbone. S&P chief economist Beth Ann Bovinostated, “One of the reasons that could explain this pace of very slow growth is higher income inequality. And that also might also explain what happened that led up to the great recession.” Yes, but so could many other factors. Like many inequality spot-lighters before, S&P raises a number of important economic challenges, but with barely a thread of a connection to income inequality established. Worst of all, the inequality spot-lighters appear to have cocooned themselves to the point where they are unaware of the holes in their arguments or the countervailing evidence.
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