Inequality and Institutions in the US

It is well known that inequality didn’t become a major problem in the US until around the mid to late 1970s. In fact, during the so-called “Golden Age” of 1947-1973, labor productivity and median family income roughly kept pace with each other:

Productivity_and_Real_Median_Family_Income_Growth_1947-2009Productivity and median family income started to diverge in the mid 70s and this was mostly due to stagflation. In fact, all incomes groups were affected by stagflation, which is why very high incomes also lagged productivity growth during the 1970s. But while stagflation explains the split between productivity and compensation in the 1970s, it doesn’t explain the persistent rise in inequality we have seen the past few decades.

It wasn’t until 1986 that very high income began to increase rapidly and outstrip productivity (See the classic study by Piketty and Saez). Most economist will probably talk about skill-biased technology change, no doubt an important factor. But we can also look at the history of institutional change, specifically political change, in American.

In Peter Temin’s and Frank Levy’s paper, Inequality and Institutions in 20th Century America, they look at the various events that established the “Golden Age” of 1947-1973, starting with Franklin D. Roosevelt and the New Deal era. Roosevelt was one of the first to fight high levels of inequality by using legislation. The rise of unions and organized labor (through the Wagner Act) raised wages significantly. Taxes rose sharply on the rich, from 25% to 63%, on the eve of Roosevelt’s presidency. These pieces of legislation reflected the times during which they were passed (i.e. the Great Depression), but in the long run, they fit into Roosevelt’s goal to compress income distribution.

Many of these policies extended into the post-Depression and post-war era. The Treaty of Detroit further established the power of unions, causing wages in many heavy industries (car manufacturing, steel, etc..) to rise at a stable rate. Kennedy’s policy of wage-price guideposts* also contributed to the steady rise in wages in the 1960s.

The “Golden Age” wasn’t without its problems. There were labor strikes, wage reductions, and periods of rising inflation. But economic life benefited in three important ways, an expanding middle class, mass upward mobility, and a public safety net. The policies that created these benefits are a reflection of the institutions and norms that developed during the Great Depression, specifically a greater emphasis on redistribution and equality of opportunity.

All of this changed during the period of stagflation of the 1970s. And as with the Depression, there was little that economic analysis could do to explain this problem:

Policy makers faced stagflation with little relevant history to serve as a guide. Economic theory had followed Keynes in focusing on demand shifts, and there was no theory of the supply side that related to economic policy. Only in the mid-1970s was the concept of aggregate supply developed to extend the standard IS-LM model. And as with the Great Depression, the resulting policy agenda was heavily microeconomic. To combat slow productivity growth, some economists began to argue for economic restructuring including removing what they saw as the rigidities of New Deal institutions: unions imposing work rules; a regulatory regime covering most of the nation’s utilities, telecommunications and interstate transportation; and high marginal tax rates that they assumed reduced work effort

This gave rise to the “Washington Consensus“, which in turn put more emphasis on economic efficiency and deregulation.

It wasn’t until 1980, the year Ronald Reagan was elected, when radical institutional change started to take shape. Reagan’s support of Volcker’s anti inflation policy (which helped cripple export sales, destroying many old line manufacturing jobs), supply side tax cuts, and anti-union stance effectively dismantled the New Deal era policies and institutions that dominated for three decades.

While the US industrial sector was weakening, the financial sector was growing:

Between 1980 and 1990, the Dow Jones Industrial Index rose from 875 to 2,785, a boom to the brokerage industry. Simultaneously, the high interest rates and big federal deficits of the early 1980s stimulated government securities trading and the market for corporate takeovers, creating demand for financial traders, investment bankers and corporate legal services.

20130225-graph-how-the-financial-sector-consumed-americas-economic-growth

The growth of the US financial sector is highly correlated with the rising income share of the top 1 percent.

The main point is that stagflation caused a shift in institutions and norms, specifically a shift of focus from equality to efficiency. This change was reflected during the Reagan era of the 1980s and rise of the Washington Consensus. The effects of these policies, amplified by skill biased technical change, have contributed heavily to the rise of inequality since the 1980s.

At first glance, all of this seems obvious. It’s fairly easy to pinpoint periods of political change and see how that has affected economic conditions, in this case inequality. That’s the primary focus of Temin’s and Levy’s paper and they do a good job of looking how political institutional change has affected inequality. But their use of the word “norm” is a bit flaky and they never really explain how and why norms have changed since the “Golden Age” of 1947-1973. While they do look at stagflation, they also explicitly say that economic shocks affect countries differently:

Economic shocks do not determine institutions. The Vietnam War and the oil shocks deranged the international economy. Yet countries responded to these shocks in idiosyncratic ways. The contrast between the US and Japan in the 1970s is only one example of 40 the great diversity. Economic shocks can affect policy, and the shocks of the 1970s may have accelerated institutional change, but there is no indication that it forced counties to adopt homogenous labor-market institutions. It did, however, create opportunities for political choices to change institutions, and we chronicle the results in the US.

It’s fair to say that stagflation changed the set of problems that the public cared about. While the Great Depression and the subsequent three decades put more emphasis on equality and wages, stagflation put more emphasis on productivity and economic efficiency (the public emphasized economic problems as the nation’s biggest problem for the first time since 1946). This shift in public priorities was then reflected during the Reagan era. These policies dramatically shaped wage determination and the economic structure in this country, which in turn lead to rising inequality.

Notes:

*Walter Heller explains the policy here:

One cannot say exactly how much of the moderation in wages and prices in 1961-65 should be attributed to the guideposts. But one can say that their educational impact has been impressive. They have significantly advanced the rationality of the wage-price dialogue.

In business, the guideposts have contributed, first, to a growing recognition that rising wages are not synonymous with rising costs per unit of output. As long as the pay for an hour’s work does not rise faster than the product of an hour’s work, rising wages are consistent with stable or falling unit-labor costs. Second, they are helping lay to rest the old fallacy that “if productivity rises 3 percent and wages rise 3 percent, labor is harvesting all the fruits of productivity” Guideposts thinking makes it clear that a 3-percent rise in labor’s total compensation, which is about  three fifths of private GNP, still leaves a 3-percent gain on the remaining two fifths  – enough to provide ample rewards to capital, as is vividly demonstrated by the  double of corporate profits after taxes in the five years between the first quarters of  1961 and 1966.

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15 Comments

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15 responses to “Inequality and Institutions in the US

  1. Suvy

    How much of this is due to the inflation tax? If we have 2% inflation every year, that’s a 2% reduction in real wages. I find it difficult to see how real wages can go up without the economy having a deflationary bias.

    • Considering that real wages kept up with productivity during the “Golden Age”, I don’t think an inflation tax contributed much to the rise in inequality during the 1980s. I think it had more to do with government policy and the change in economic structure.

      • Suvy

        Well, 2% inflation vs 0-1% deflation is a yearly drop of 3% in terms of real wages; over time, that really does add up. Also remember that during the period before the 70s, William McChesney Martin was Fed Chairman and we were also working off a fixed exchange rate. The inflation during Martin’s time as Fed Chairman was consistently <2% until LBJ became president and forced Martin to monetize his deficits. If you exclude the Korean War and the Vietnam War, Martin's time as Fed Chairman had extremely low inflation and monetary policy was extremely tight vs Greenspan's time as Fed Chairman. We can't ignore the role of monetary policy in determining the role of real wages.

        I do agree that we need higher wages. We need much higher wages. However, I don't think the way to do that is the way we did that in the 40s and 50s. If we take labor unions as an example, they do allow wages to be higher in the short run, but there are longer term costs. In the case of labor unions, they can put a lot of pressure on very good companies. Unionized workers force companies to give benefits that they can't financially sustain and it does create problems. I actually think teachers unions are one of the largest impediments to creating a better school system here (I strongly support school vouchers btw).

      • I think it’s important to keep in mind that inflation affects all income groups. While lower classes are certainly hurt more, higher income groups also see an inflation tax. It’s also important to keep in mind that generally speaking, real wages kept in line with productivity during the “Golden Age” despite the 2% inflation target that the FED pursued. A 2% inflation rate doesn’t explain the sudden divergence of real wages and productivity seen in the 1970s.

        The inflation during Martin’s time as Fed Chairman was consistently <2%

        But inflation has also been steady since the 1980s, yet we’ve seen a dramatic rise in inequality, so I’m not sure this matters as much as you think it does. Also, I’m not saying that we should ignore monetary policy as a factor that effects inequality, I just think it’s less important when compared to things like government policy (specifically tax policy), institutions, and economic structure.

        With regards to Unions, I don’t want to comment as I haven’t read the relevant empirical research.

  2. Suvy

    By the way, the US had the world’s highest wages in the 1870s. High wages were actually a critical part of economic policy since Alexander Hamilton. They were also a key part of Abraham Lincoln’s economic policy. The strong middle class in the US didn’t start after the Great Depression; it started well before the Great Depression.

    • But inequality was still growing during the 19th century. I also think your statement that “the strong middle class in the US didn’t start after the Great Depression; it started well before the Great Depression” is somewhat misleading. If by strong middle class you mean high skilled labor, then I can agree with this statement. But low to mid skilled workers (people manufacturing, farmers, and other manual laborers) didn’t benefit as much from US economic growth. This is why many studies on inequality pre World War I show that there was a high education premium during this period. This is in much contrast from the “Golden Age”, where many low skilled workers benefited more from economic growth and rising productivity relative to their pre World War I counterparts.

      • Suvy

        I’d disagree on the cause of high inequality in the US. The US, since the very beginning, has had a very entrepreneurial economy. Any time you have an entrepreneurial economy, you’ve got winner take all effects which push up inequality. I also think a huge driver of the inequality has been the Fed, which has pushed up asset prices. Assets are overwhelmingly owned by rich, which means that pushing up asset prices transfers wealth from the middle class to the rich. I also think that the role of government should be to “raise the floor”, not to “mind the gap”.

        If what you’re saying is true, it then means that we just need more highly skilled labor and that starts with a better education system.

      • The US, since the very beginning, has had a very entrepreneurial economy. Any time you have an entrepreneurial economy, you’ve got winner take all effects which push up inequality.

        Which is why you saw a rise in inequality during the 19th century. It wasn’t until the New Deal era and Roosevelt’s income compression policy that you really saw a drop in inequality.

        I also think a huge driver of the inequality has been the Fed, which has pushed up asset prices.

        I do agree that the rise asset prices and other financial assets is a major contributor the recent rise in inequality. This is why I referenced the US financial sector in the post. But is this the result of the FED, deregulation, speculation, or financial instability? It’s probably a mix of all of these factors. Either way, I’m not sure it’s entirely fair to point to the FED as the sole source.

        I also think that the role of government should be to “raise the floor”, not to “mind the gap”.

        This to me is a false dichotomy. Separating inequality and economic growth as if they are two separate issues is nonsense. I don’t want to delve to much into this, but if you haven’t already read Stiglitz’s The Price of Inequality, I highly recommend you do so.

        If what you’re saying is true, it then means that we just need more highly skilled labor and that starts with a better education system.

        I wasn’t clear on this. Education is certainly important, but it’s not the only factor. You must also look at things like the income tax (which wasn’t introduced until the 20th century), labour unions, and the change in institution structure in the US. These factors (among others), combined with the education, all effect the level of inequality.

        Anyway, the importance of education all depends on the economic and institution structure of the US economy. For example, during the “Golden Age”, you could get a good paying blue collar job without a college education. This is in large part had to do with government policy and labor unions. However, post “Golden Age”, a college education is practically necessary if you want a good paying job. Now, I don’t know much about labor conditions and government policy during the late 19th century, but I would bet that it looked a lot different when compared to the New Deal era.

      • Suvy

        For the record, I’m with Michael Pettis in saying that it wasn’t deregulation and speculation that caused the financial crisis. Every single financial system responds to excess liquidity the exact same way: by taking way too much risk. The problem is a financial system that’s too elastic and central planners that think every problem can be solved by flooding the market with liquidity (ex. Greenspan). I’m also not a huge fan of Joseph Stiglitz either. The criticism that Taleb has of Stiglitz in Antifragile is spot on and you should see the video I’ve posted below. The guy who Stiglitz is arguing with is a hedge fund manager by the name of Hugh Hendry. The video was in 2010 by the way, so it’s pretty clear to see whose line of thinking was correct. Also notice how Stiglitz attacks Hendry for being a speculator, even though Hendry’s logic and reasoning is much superior to Stiglitz. Of course, everything in hindsight is 20/20, but still.

        As for the income tax, it was supposed to be only levied on the top 1% when it was brought in. Then it was expanded again and again. We also have the payroll tax which is just a tax on the middle class. I think we need much lower taxes and a much smaller federal government. The fundamental problems we have had over the past 60-80 years is that there are a few people who have too much power. It works great when those people make good decisions (like Eisenhower), but when they make bad decisions, we’re all screwed. It’s like getting stuck on a highway with no exits for a 300 mile journey, if something goes wrong, you’re absolutely screwed.

      • For the record, I’m with Michael Pettis in saying that it wasn’t deregulation and speculation that caused the financial crisis. Every single financial system responds to excess liquidity the exact same way: by taking way too much risk.

        I’m not saying that deregulation and speculation are the sole causes of the 2008 financial crisis, the role of the FED is important too. But I also think that we can take some insight from the work of Minsky and Steve Keen. The role of private debt and financial instability are also important to look at.

        I’m also not a huge fan of Joseph Stiglitz either. The criticism that Taleb has of Stiglitz in Antifragile is spot on

        I think we are getting a little off topic here. Anyway, I haven’t read Taleb criticisms of Stilglitz in Antifragile, but I have of what Taleb calls the “Stiglitz Syndrome”, and I don’t find it very convincing. Taleb’s criticisms of “public intellectuals” comes across as very bad, especially when he makes the same mistakes that “public intellectuals” do.

        The guy who Stiglitz is arguing with is a hedge fund manager by the name of Hugh Hendry.

        That video was interesting, but I think Stiglitz still touches on the fundamental point about currency sovereignty and Greece, which many have made before. But I will say that at 7:00, Hendry does make a very important point about private debt.

        As for the income tax, I think that it’s an important government tool for reducing inequality. It was generally used effectively during the “Golden Age”, so I don’t see why it can’t be effective again.

      • Suvy

        Alex, what do you think about the impact of free trade on real wages here in the US. It’s a lot harder to stay competitive.

      • I haven’t read much of the relevant research on this, so I won’t comment. I would suspect that real wages would falls as a result of free trade, but I can’t be sure. However, this paper by Krugman is interesting and relevant to this topic.

      • Suvy

        Governments that have debts denominated in their own currency still can have major debt issues. We have to remember that debt always involves a transfer of real resources. If the transfer isn’t productive, it will drag on growth. Also, the stresses of the system don’t show up in the bond market; they show up in the currency market. Just take a look at Japan today. Also, anyone that says QE isn’t inflationary needs a reality check. Japan has had deflation for almost 25 years and in less than 12 months after they started their QE, the Yen has depreciated almost 30% while prices are taking off and Japan has ended deflation. QE is just a way to debase the currency.

        The problem I have with Stiglitz is that he doesn’t recognize the underlying problem which is way too much debt. He thinks that the way to solve a Greek default is by lending them more money. You don’t fix a debt problem with more debt. Stiglitz’s solution is to turn the damn thing into a Ponzi scheme. The only reason Greek debt hasn’t been completely written down to what it’s worth is because that debt shows up on the asset side of the German banking system. Stiglitz attacks Hendry for being a speculator and saying that he’s got a conflict of interest being on the program when Stiglitz was being paid by the Greek government to advise them. Stiglitz (and Falkenstein) don’t seem to understand Taleb’s arguments well. Taleb’s math is 100% spot on. Also, there’s a lot of reasons why Fannie Mae went down, not the least of which was its very high leverage. I’m also absolutely sure that Taleb didn’t just buy every single OTM put option like a lot of people think he did. I’m willing to bet that he had a strategy for finding convexity in the puts he was using and I’m pretty sure he used an algorithm to do it. Also, Taleb points out how OTM options have become very expensive in Antifragile and I’m sure there’s way more to his strategy than just that. Also, Taleb doesn’t say that it’s a good idea to buy VIX like Falkenstein claims and I remember him saying the opposite (I think it was on his facebook page). Buying VIX is a sucker’s bet and I’m sure Taleb knows that. Taleb works as an adviser to a firm called Universa, which is run by Mark Spitznagel. You may want to look at some of their work. Spitznagel knows his stuff; he’s a sharp guy.
        http://www.universa.net/research.html

        My main issue with trying to regulate our financial system to prevent bad decisions is that regulators tend to be more pro-cyclical than counter-cyclical. I’d much rather have a system that just crashes after hitting debt capacity constraints. We need a financial system with much less elasticity. Letting politicians and bureaucrats try to fine tune the economy with monetary policy is a recipe for disaster. The only reason why we need a central bank at all is because we need some sort of a lender (dealer) of last resort. There must be some sort of a liquidity backstop; that’s the only reason for a central bank. A central bank puts way too much power in the hands of a few people and if they screw up, we’re all completely screwed.

        The reason I don’t like the income tax and why I hate the payroll tax is because they tax productivity. Some sort of a LVT and increased capital gains would be nice to see, but we need much lower payroll taxes and I wouldn’t even mind a repeal of the 16th Amendment.

  3. Blue Aurora

    I like this discussion going on between Suvy and Rousseau1214. It’s great to know that despite different perspectives, we can have civil discussions on the econoblogosphere. It also seems to me that both perspectives contain a kernel of truth, and the truth is to be found somewhere in-between.

  4. Pingback: The Critics of Income Equality | Economics and Society

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