Growth and Inequality: Thinking About the Middle-Out Hypothesis

July 26th, 2013 at 12:36 pm

I’ve got a new commentary up at the NYT about a theme that was central to the President’s speech the other day: linkages between income inequality and economic growth.

One thing I didn’t have space to get into in the piece was the evidence for this theory, some of which was helpfully discussed by Jim “Tank” Tankersley (I’ve played basketball with him) in the WaPo.

Tank’s first group of studies emphasizes the basic point, one you hear repeated a lot, that a strong middle class boosts growth.  In my link above, I support a nuanced version of this in the US case: I think it holds at times like the present, when growth is a spectator sport for the middle; at other times, I think it works more through the economic shampoo cycle (bubble, bust, repeat).

But I’m not sure the citations he provides work for advanced democracies.  The IMF study gets its explanatory juice out of correlations between the growth of inequality and that of real per capita income.  But if you look at their first figure, for the US and the UK, the growth rate is quite stable since the 1950s, especially relative to a) developing countries (see their figure 1b) and b) the actual rise in US inequality, which is largely a post-1979 phenomenon.

Similarly, the Easterly hypothesis is driven by correlations between political stability and more national income going to the middle class.  But while we certainly have dysfunctional politics, itself related to the toxic mix of high wealth concentration and all the money that drives US politics, we decidedly don’t see the rioting by the poor that Tankersley mentions.  (This observation reminded me that the US actually fared well in the book “Why Nations Fail” that also gets at this instability dynamic).

Tank also cites studies on entrepreneurs coming from the middle class.  Sure, but here again, not sure there’s much correlation with inequality’s growth.  Eyeballing charts like these give one the sense that entrepreneurship grew apace in the 1990s and less so in the 2000s (particularly if you look at the important data in chart 2 re jobs created).  But inequality grew strongly in both periods.

That’s an “N” of two (i.e., two business cycles), so it’s of course an extremely weak test.  But that’s part of the challenge with these inequality/growth connections.  Both processes—inequality and growth—involve a lot of moving parts, and it’s tricky to find reliable connections.  As I point out in my post—and this gets to another of Jim’s points—even the basic propensity to consume arguments don’t always hold up.  Once you include housing and wealth effects, middle-class spending was strong in the 2000s.  Moreover, as I argue, and Jim agrees, this too looks like a dangerous side effect of inequality in terms of bubbly asset inflation.

As we economists say at the end of every conference, there’s a lot of great work here, but more research is needed.

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8 comments in reply to "Growth and Inequality: Thinking About the Middle-Out Hypothesis"

  1. Peter K. says:

    If William Safire were around I’d bet he’d do column on the word “juice.” “Explanatory juice” is a good thing as in the “juice” from a fruit or vegetable. One squeezes an orange in order to get the juice. Obama’s used the term in his Galesberg speech: “Towards the end of those three decades, a housing bubble, credit cards, and a churning financial sector kept the economy artificially juiced up. It’s slightly pejorative in that it means the bubble was unsustainable and “artificial.” In sports it refers to steroids. It can refer to electricity as in “give it some juice.”

  2. Colin says:


    Something about your column I do not understand: you note that real middle-class incomes were up 13 percent from 2000-7, but then state that inequality is squeezing middle class paychecks. How can paychecks be getting squeezed if they increased? That seems a contradiction, no? What am I missing?

    • Jared Bernstein says:

      Good ?. CBO shows market income for middle fifth up only 6%, 2000-07, so less than 1% per year. Transfers up 30% (!) taxes down 6%. EPI shows median wages flat in those years, so there’s your squeezed paychecks. So, middle income gains largely due to more hours of work, lower taxes, and higher transfers. These #’s all contrast sharply with top 1%, eg, market inc up 23%.

      • Colin says:

        Re: flat wages, isn’t this to a large extent a product of more and more of worker compensation going to pay for health care, thus leaving less money for wages? If so, doesn’t this reflect more a health care problem than an inequality one? (stagnating wages strikes me as a real problem, but the fact that some people aren’t seeing their income grow as fast as others far less so, since that is a relative measurement of welfare while it seems to me we should only be concerned with absolute welfare)

  3. urban legend says:

    Saying inequality grew strongly in both the 2000s and 1990s is tricky. Between 1994 and 2000, the real income necessary to enter the second quintile grew 16%, while the growth rates for the fifth quintile and top 5% entry points were 13% and 15% respectively. Those numbers in the 2000-2008 period were declines of almost 8% for the second quintile, compared to only a 2% decline for the fifth, and less than 1% for the top 5%. (Using 2007 as a cut-off works out about the same.)

    There are other ways of looking at it, but those figures suggest that in the late 1990s lower income people were experiencing rapidly-improving incomes comparable to those at higher (albeit, still probably middle class) income levels. I would contend that this data is superior in reflecting real-world experience than, say, income share by quintile. If the pattern of the 1990s had continued into the 2000s, with real second quintile entry income at $5500 higher in 2008 than they actually were, and even if the top 1% or top 0.1% incomes were growing much faster than all the others, poverty would have been declining rapidly, we would barely be discussing inequality, and there would have been no “Occupy” movement. It seems to me it’s seriously misleading to lump the two periods together.

  4. Dave says:

    And, one other major issue to mention:

    If our main method of demand stimulation is through investment (monetary easing), it is much better to let the investors take the hit than the borrowers, because you cannot stimulate the demand of the borrowers by decreasing the cost of investment.

    So Fed action should really depend upon the cause: if the cause of lowered demand is a loss of investment funds, the fed should stimulate by easing the cost of investment funds as it does now. However, if the borrowers are the source of the lowered demand, the Fed has to work the other side of the balance sheet to fix the problem.

    So if no structural changes are in store for the federal reserve, then the moral of the story is that next time you have to let the investors absorb the loss of the asset bubble. By forcing borrowers to absorb the loss, you eliminate the Fed’s ability to resolve the problem.

  5. Dave says:

    Of course, I gave you kind of a binary explanation without any magnitudes or equations. The reality is that this effect can play out in different magnitudes depending upon the size of the consumer class, the investor class, the level of debt lost, etc…

    So the structure of the economy (for instance, China’s investor-centric economy vs. our consumer-centric economy) strongly affects the magnitudes of the effect the Fed can have through simple investment-inducing easing.

  6. Lance Brofman says:
    “… In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.
    The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment. As one banker described the events leading up to 2008 – First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies all of which reduce the value of investments.
    If the economy was suffering from accumulated chronic underinvestment, shifting income from the non-rich to the rich would make sense. Underinvestment would mean there was a shortage of shopping centers, hotels, housing and factories were operating at 100% of capacity but still not able to produce as many cars and other goods as people needed. It might not seem fair, but the quickest way to build up capital is to take income away from the middle class who have a high propensity to consume and give to the rich who have a propensity to save (and invest). Except for periods in the 1950s and 1960s and possibly the 1990s when tax rates on the rich just happened to be high enough to prevent overinvestment, the economy has generally suffered from periodic overinvestment cycles.
    It is not just a coincidence that tax cuts for the rich have preceded both the 1929 and 2007 depressions. The Revenue acts of 1926 and 1928 worked exactly as the Republican Congresses that pushed them through promised. The dramatic reductions in taxes on the upper income brackets and estates of the wealthy did indeed result in increased savings and investment. However, overinvestment (by 1929 there were over 600 automobile manufacturing companies in the USA) caused the depression that made the rich, and most everyone else, ultimately much poorer…”