Inequality, the Middle Class, and Growth

January 30th, 2012 at 11:25 pm

[The following puts together a bunch of stuff I’ve been posting about here at OTE over the past few months…it’s time to start thinking about these ideas in terms of new models to replace the old, worn out ones…]

The trickle-down, deregulatory agenda—what I have called YOYO, or “you’re on your own” economics—presumes that the growth chain starts at the top of the wealth scale and “trickles down” to those at the middle and the bottom of that scale.  Problem is, that’s not worked.

Here’s a better model.  In the midst of the 1990s boom, which lifted the earnings and incomes of middle and low-wage workers much more so than the 1980s or 2000s cycles, Larry Mishel and I started talking about “wage-led demand growth.”  We meant that a much better way to generate robust, lasting, and broadly shared growth is through an economically strengthened middle class.

At the most basic level, this growth model is a function of customers interacting with employers, business owners, and producers.  A recent article by successful venture capitalist Nick Hanauer very compellingly describes this interaction:

I’ve never been a “job creator.” I can start a business based on a great idea, and initially hire dozens or hundreds of people. But if no one can afford to buy what I have to sell, my business will soon fail and all those jobs will evaporate.

That’s why I can say with confidence that rich people don’t create jobs, nor do businesses, large or small.  What does lead to more employment is the feedback loop between customers and businesses. And only consumers can set in motion a virtuous cycle that allows companies to survive and thrive and business owners to hire. An ordinary middle-class consumer is far more of a job creator than I ever have been or ever will be.

How does this dynamic interaction show up in the macroeconomy?  Economist Alan Krueger, currently serving as Chair of the President’s Council of Economic Advisers summarized these findings in a recent speech, in a section on the consequences of economic inequality.

Less robust (or debt-financed) consumption. Seventy percent of the US economy is accounted for by consumer spending, so if that part of GDP lags, economic growth slows.  It is also the case that the propensity to consume out of current income is higher among lower-income households (i.e., compared to wealthier households, they’re more likely to spend than save their income).

Based on an estimate of these relative propensities and the large shift in the share of national income that accrued to the top 1 percent over the past few decades, Krueger calculates that aggregate consumption could be 5 percent higher in the absence of such large income shifts.  Applying rules of thumb on the relationship between aggregate growth and jobs, and assuming both economic slack and that this income was not simply replacing demand elsewhere in the economy, this extra consumption growth could reduce unemployment by 1.75 percentage points, implying about 2.6 million more people with jobs.

[As consumption is 70% of GDP, and each point of GDP above trend reduces unemployment by half a point, this calculation is .7*.5*5%, or 1.75%.]

Krueger cites an important caveat about this type of calculation.  In the face of stagnant earnings in the 2000s, many in the middle class borrowed to make up—or more than make up—the difference, in which case middle-class consumption did not fall as much as it would have absent this leverage.  To point out that this method of improving middle class living standards is both unsustainable and extremely risky is an obvious understatement.

Inequality and longer term growth. Krueger also points to recent research showing that “in a society where income inequality is greater, political decisions are likely to result in policies that lead to less growth.”  Economist Mancur Olson also hypothesized about this relationship decades ago.

As more income, wealth, and power is concentrated at the top of the income scale, narrow coalitions will form to influence policy decisions in ways less likely to promote overall, or middle-class, well-being, and more likely to favor those with disproportionate power and resources.  In the current economics debate, we clearly see these dynamics in a tax code that bestows preferential treatment on those with large amounts of assets, like capital gains and stock dividends, relative to wage earners.

Trickle-down economics, inequality, and incomes.  Another piece of evidence with implications for rebuilding a strong middle class comes from new work by economists Emmanuel Saez et al.  As shown in the figures from their paper (see here), they use international evidence from a wide variety of advanced economies to examine two key links in the logic of the supply-side chain.

First, they look at the relationship between the top marginal income tax rate in these countries and the change in income inequality.  They find a strong negative correlation: in countries like ours that cut the top marginal tax rate, income is a lot more skewed (and note that this refers to pretax income, so the result is not a direct function of the tax policy changes).

But the critical question for supply-side is whether these high-end marginal tax rate reductions lead to faster income growth (we’ve already seen that they lead to more income inequality).  The bottom figure shows that they do not.  Real per capita income growth across these countries is unrelated to the changes in tax rates.


The above points emphasize an economic rationale for a growth model more favorable to the middle class.  More broadly shared growth would not only score higher on a fairness criterion; it would provide a more reliable and durable structure for overall growth itself.  It is no accident, in this regard, that the era of heightened inequality coincides with the arrival and persistence of what I’ve called “the shampoo economy:” bubble, bust, repeat.

But our emphasis on growth should not crowd out that of fairness, and in this regard, some of the most important recent work in this area has stressed the relationship between inequality and mobility, the latter being the extent to which individuals’ and families’ economic positions change over the life cycles.  Again, I will briefly summarize the relevant findings.

Economic mobility. Some policy makers, often in seeking to dismiss the inequality problem, argue that the US has enough income mobility to offset increased inequality.  We may start out further apart, they argue, but we change places enough that it doesn’t matter.  This argument fails, however, both in terms of logic and evidence.  The existence of mobility cannot offset increased inequality; for that to occur, mobility itself must be accelerating.  There is no evidence to support such acceleration and some new, high-quality work suggests a slight decline in the rate of mobility.

The US has considerably less income mobility than almost every other advanced economy.  In particular, as stressed in a recent New York Times article, parental income is a stronger predictor of the success of grown children in the U.S. relative to other advanced nations—i.e., we have less intergenerational mobility than other nations.

Putting some of these themes together, I have hypothesized that there are causal linkages between inequality and immobility.  To the extent that those who have lost income share in recent years suffer diminished access to the goods, services, and general living conditions that would enhance their mobility, we would expect to see economic results like those cited above.

Here, I’m thinking about everything from access to quality education, starting with pre-school (such early educational interventions have been shown to have lasting positive impacts), to public services, like decent libraries and parks, to health care, housing, and even the physical environment.  The new research linking mobility and inequality may well find that as society grows ever more unequal, those falling behind are losing access to the ladders that used to help them climb over the mobility barriers they faced.

Hanauer’s feedback loop is key to this model.  It’s not just that we need growth to reach the middle class.  It’s that when it does, the growth is more durable.  There’s room for a lot more research  here, but this feels like the right economic model for the present and the future.

Update: Should have noted that David Madland of the Center for American Progress wrote an excellent piece on this topic and CAP is going to be doing more work on it in the near future (Krueger’s speech was at CAP, kicking off the project).

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19 comments in reply to "Inequality, the Middle Class, and Growth"

  1. James Edwards says:

    The economy is a mechanism to get limited supply distributed as efficiently as possible to unlimited demand. I mean that’s the first line of any Econ text book right?

    Supply was perfectly capable of satisfying all the demand. There were no aliens destroying factories or sudden shortage of Lanthanoids (incorrectly and misleadingly called Rare Earth) for our electronics. There was no plague killing off vast numbers of workers.

    We ran out of money. The thing that is the tool. The thing we can print and make without even a thought. We have made money the ends rather than the means.

    Print more money and give it to consumers instead of to the rentiers who already have all the old money. Give so much money to the consumers that inflation destroys the accumulated wealth of the rich and the debt of the constrained. Then change our monetary system so that it injects money into the economy through government spending and contracts rather than as bank reserves.

    • Derryl Hermanutz says:

      Exactly! Because our money is created as bank deposits which are loaned into existence as the ‘property’ of the private for profit banking system, we face the absurdity of “running out of numbers”. Banks, and people with large holdings of money who want to live off their ‘capital’ rather than earn a living at productive work, have saddled us with a monetary system that deliberately creates an artificial scarcity of money numbers in order to preserve the value of money. Every other kind of economic good that is “saved” rather than quickly consumed, LOSES value as it rots and rusts and becomes obsolete. Gold never loses its luster, but you have to suffer costs to store and guard it or risk having it stolen. Economic goods lose value over time, but ‘capitalists’ expect their money to miraculously GAIN in value over time, which they achieve by gaining ownership of the money system and brainwashing people into believing that saving should be “rewarded” with interest payments, rather than “punished” with loss of value. Only restoration of public issuance of money will create a system where money is used to serve the needs of the real economy. With private ownership of the money issuing power, our economies serve the needs of finance, exactly the reverse of how a rational, non-tyrannical money system would be structured.

  2. Bud Meyers says:

    When “effective” corporate tax rates are higher than capital gains tax rates, it induces the company to funnel more of it’s profits into executive compensation, rather than re-investment, expansion, and hiring.

    • Tom Shire says:

      Yes. And low top tier tax rates in general inflate executive salaries at the expense of business investment, R & D, and worker compensation further down the income ladder.

    • cat says:

      The question this leads to is can we ween the C-Suite off of their gravy train after 30+ years of becoming wastefully wealthy?

      If we drive down the return on stocks by raising capital gains how do the millions of middle class workers save for retirement since pensions are ancient history?

      • Chigliakus says:

        Middle class workers are presumably going to have most of their retirement in tax-deferred 401Ks and IRAs and so messing with cap gains rates won’t affect their returns. To the extent that the higher cap gains rates discourage short term thinking, like the examples provided by Bud in the grandparent post, they further benefit the middle class. Taxing capital gains like ordinary income looks like 100% win for 99.9% of society–everyone who stands to lose from the USA becoming a banana republic.

    • Jerome Bigge says:

      If we stopped taxing business as we do, we’d have more business and more employment. Business could afford to make the investments needed instead of borrowing money. Governor Rick Snyder here in Michigan understands this and has seriously cut taxes on business. Resulting in a quite visible economic boost.

  3. Jonathan says:

    Hey Jared, I would like your take on some of the work by Rich Burkhauser who has looked at the Picketty and Saez results and has attempted to contradict them.

  4. Peter Morgan says:

    Following on from Bud Meyers’ comment, it does seem as if not much of the content of your recent posts about the consequences of the regulatory choice to tax capital gains income at relatively low rates and the associated loopholes has made it into this summary post.

  5. marcel says:

    Nobelist Mancur Olsen [sic]…

    Uhm, in what field? Not economics.

    • Jared Bernstein says:

      Whoops–it’s Olson and he wasn’t a Nobelist…my bad. But he was renowned and very much worth reading.

  6. John J says:

    I think the article is well written, but I do not know what is the call to action. I understand that the 1990s was a period of economic success; better than the 1980s or 2000s. However, people forget that this was the result ofe a once in a generation productivity boom. The proliferation of the computer and technology that occurred during the 1990s resulted in an productivity cycle boom that occurs about once every 30 to 45 years.

    I also believe that most people just do not understand economics fundamentally or historically. If you look at recession that were preceded by a credit crisis, those recoveries were more sluggish and took longer than other recoveries. The psychological shock of deeper, sharper credit recessions lasts much longer than traditional recessions.

    As far as mobility, a PEW research study looked at mobility between 1980 and 2010. Of those born into the bottom quintile, 67% moved up. Of those born into the top quintile, 61% moved down. I think this is positive.

    If you read “Outliers” by Malcolm Gladwell he discussing the achievement gap. By looking at the work ethic of Americans vs Chinese and the education system. We are falling behind, not because we have inequality of opportunity, but because we have nearly 40 days fewer school than most other developed countries. Wealthier kids have more active parents than poorer kids. The lack of activity during summer months accounts for all of the achievement gap. How are we supposed to change the attitude of parents?

    So what is the point of the article? Should we raise taxes back to 1990 levels? Okay, but will that solve the problem. I live in California. I believe that Sacramento and Washington have enough of my money already. I do not make a lot of money (<50k) but I paid an aggregate of 52% of my income to various levels of government through fees, taxes, and expenses. This is just demoralizing.

    I believe in a society that allows for equal opportunity, not promotes equal outcome. I am afraid that Mr Bernstein is promoting the latter.

    • Chigliakus says:

      Regarding the 1990’s, if you get acquainted with more of Dr. Bernstein’s blog and previous articles you’ll see that his problem is that historically the benefits of productivity were shared across society. In more recent times the share of the profits from productivity gains have gone mostly to the ultra rich and not to the poor and middle class. See

      He has also covered your point about the differences between the collapse post real estate bubble vs the collapse post dotcom bubble. The painful deleveraging after the loss of asset values for the middle class’ primary asset (their homes) takes longer then when a bunch of rich investors get bilked on crazy investments in internet businesses. This should not be used as an excuse to do nothing, quite the opposite really.

      Your claims on mobility have been debunked thoroughly in previous posts. Class mobility is an important fig leaf for a society with such wealth and income inequality, the problem is that inequality and (lack of) mobility are linked. See among other posts, he has written a lot on this subject and backed it with solid data.

      You are simply wrong in your accusation that Dr. Bernstein is promoting equal outcomes, it’s pretty obvious you haven’t read any of his previous blog entries on inequality. Show some solidarity with your class, accusing someone who is obivously looking for equality of opportunity of promoting equal outcomes is shilling for the 1%.

      • Jared Bernstein says:

        Exactly–equal opportunity not outcomes. I’ve actually yet to hear anyone of any note in this debate raise “equal outcomes” except smoke blowers accusing phantom bogie men.

        • John J says:

          You are right, I have not read much of Mr Bernstein’s blog. I had a friend post this article from Huffington Post and began to read it. I am familiar with Mr. Berstein from his appearances on Kudlow and other business programs.

          I guess we will have to just agree to disagree. I have read Friedrich Hayek and believe in his prescription. It seems to me that you believe in John Keynes. Maybe I am just ignorant.

          I do believe that allowing people to fulfill what is in their own best interest is the best prescription for America. I understand that some people will fail and remain poor. It happens and there is nothing that anyone can do about. The weak and inefficient die off.

          I think attacking the successful (i.e. rich, 1%, etc.) is not helpful. I work to hopefully achieve that status. I believe anyone in America can as well. However, I continue to run into challenging regulatory road blocks and thousands of taxes and fees that slow me down. Maybe I am not meant for entrepreneurship, but I am going to keep going even if I fail. I want to be a 1%.

  7. readerOfTeaLeaves says:

    Powerful forces prefer YOYO and outdated economic ideologies. Unfortunately, that economic model is too simplistic and rigid to explain networked businesses like UPS or eCommerce operations, which use logistics and constantly adapt to feedback.

    I associate YOYO with the era of “Donna Reed” and “Father Knows Best” (1960s) up through “Mork and Mindy” (1978 – 1982) when America had three major television networks. If you wanted to watch a program, then you sat down in front of the telly at a specified time in the week.
    That was an era when things were centralized, top-down. You conformed to television’s time schedule. (Yeah, ancient history – my kids roll their eyeballs….)

    However, these days I stream Netflix and C-SPAN on demand. Unfortunately, YOYO doesn’t do an adequate job of explaining an ‘on demand’ technology, nor the business models they require.

    Hanauer’s economic model, on the other hand, with its emphasis on flexibility, adaptability, feedback loops, and building relationships over time — is a better fit for our YouTube-iPod-latte-filled world than anything YOYO can manage.

    The YOYO model, upon which specious views of capital tax rates are based, seems to be acting like a huge economic anchor. This conversation, and others like it give me some optimism that we may yet escape the yoke of bogus economic thinking and outdated economic ideologies.

  8. DHFabian says:

    “Middle class” is the leading marketing term today. We’re all for the middle class, life revolves around the middle class, and the middle class is the alpha and omega. Problem is, there isn’t much left of it. Another problem is, while focusing on the middle class exclusively is what sells today, it won’t resolve our problems. Reasons: You need to think of the US economy like an old house. The rich are the top floor, the poor are the basement. You can spruce up everything in between, give it a fine paint job, new windows with decorative shutters, but if you keep neglecting the crumbling basement, that whole house is going to collapse. America has a very large basement, which has been neglected as it has crumbled for the past four decades. This old house is going down.

  9. David says:

    Another way that increasing inequality results in lower mobility is simply IQ. Those at the bottom of the income scale are much less likely to have good prenatal care, are much more likely to be born prematurely or with low birth weight, and have much poorer nutrition in early childhood. All of these factors cause overall intelligence to be lower, averaged over a group. And if you aren’t as smart, you don’t do as well in school, even in good schools.

    • Richard says:

      I agree with your statement David, but I would only add that there will always be people along the entire IQ-scale; we can’t just say “you’re dumb and thus blame yourself”, can we? I’m sure there are many millionaires with low IQs, and many poor people with high IQs, thus I think assuming wealth/standard of living is simply the result of IQs, is simplifying the problem a little too broadly (though I would never argue that there isn’t a correlation).