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 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.
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.
*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.