THE REAL ROOTS OF THE GREAT RECESSION UN

THE REAL ROOTS OF THE GREAT RECESSION: UNSUSTAINABLE INCOME DISTRIBUTION MASSIMO FLORIO Working Paper n 2012-01 FEBBRAIO 2012 DIPARTIMENTO DI SCIENZE ECONOMICHE AZIENDALI E STATISTICHE Via Conservatorio 20122 Milano tel ++39 02 503 21501 (21522) - fax ++39 02 503 21450 (21505) http://www.economia.unimi.it E Mail: dipeco@unimi.it MASSIMO FLORIO* THE REAL ROOTS OF THE GREAT RECESSION: UNSUSTAINABLE INCOME DISTRIBUTION Abstract: This article suggests that, at the root of the Great Recession, there are two imbalances: an unsustainable distribution of income in advanced economies, and a growing income gap between them and the rest of the world Several factors have squeezed the share of labour income, particularly of less skilled workers in advanced capitalist economies and hugely increased the share of capital income (sometimes disguised as pay for the work of top managers) In the US and elsewhere, the demand for consumer goods did not fall until the recent Great Recession thanks to the growth of private debt A progressive income redistribution policy is seen as the core structural reform needed to rebalance the system, along with a change in international economic relations Keywords: Great Recession, income distribution, shares of labour and capital income * A revised version will appear in International Journal of Political Economy Introduction: Regulatory or Market Failures? This paper suggests that, while in the short run only a combination of monetary and fiscal policy can counteract the current crisis1, the long-run cure needs to address the core structural imbalances: an unsustainable distribution of income in advanced economies, and a widening income disparity between them and the rest of the world Various interpretations of the Great Recession circulate among economists and politicians that spawn a number of short and medium-term cures2 I shall label them the ‘conservative’, the ‘progressive’, and the ‘alternative’ views The first thesis, favoured by market fundamentalists and other conservative economists, is that the underlying reasons for the crisis are an excess of public interventionism, especially in housing policy, the regulation of financial markets, and loose monetary policy The conservative economists claim that for demagogical reasons the US policy makers forced the financial system to grant home mortgages to poor people who could not afford them, sparking off a cycle of increasing house prices that was totally artificial and could only burst eventually In addition, although aware of the ‘bubble’, the Federal Reserve oscillated in its monetary policy, first by substantially reducing the cost of money for the banks, and then abruptly raising it again, thus providing both the oil to start the fire and the cold shower to put it out, but causing a flash flood instead In short, always for reasons of political opportunism, different US governments and the Congress, officially or unofficially, led the financial system to believe that the excessive risks it was taking would have been covered by various forms of public guarantees The corollary of this view is that governments should now avoid intervening and they should let the crisis take its course in order to find a new, healthier equilibrium, after having swept away the badly managed companies My preferred example of this interpretation is the opinion by Mulligan (2008), a macroeconomist at the University of Chicago in an invited editorial in the New York Times, in the early days of the recession, three weeks just after the crash of Lehman According to Mulligan, “Since World War II, the marginal product of capital, after taxes, has averaged 7% to 8% per year… And what happened during 2007 and the first half of 2008, when the financial markets were already spooked by oil price spikes and housing pricing crashes? The marginal product was more than 10% per year, far above the historical average The third quarter earnings reports from some companies already suggest that America’s non-financial companies are still making plenty of money… So if you are not employed by the financial industry (94% of you are not), don’t worry The current unemployment rate of 6.1% is not alarming…” (Mulligan 2008: A33) The core tenet of this way to react to the then incoming storm is the optimistic interpretation of the “far above the historical average” marginal product of capital in the non-financial sector A sample of additional themes and arguments in this market fundamentalist view of the crisis are given by Smith (2008), according to whom there is nothing new in financial bubbles, which share a simple feature: they come to an end by themselves, and nobody knows how to cure them, until they simply burst In Smith’s view the origin of the crisis is related to a giant real estate bubble, more than a security bubble In turn, the expectations of price increase in the real estate market has been fuelled by legislation in favour of home ownership, particularly the Tax Relief Act of 1997, that exempted from taxation, up to 500,000 USD the capital gains from reselling a home after at least two years In the same vein, Liebowitz (2007) observes that the real estate market had started to invert its pace already in the second quarter of 2006, and, in mid-2007, it was clear that there was a contagion to the financial sector, and subsequently to the securities market He thus finds evidence of the forecast done much earlier by Dand and Liebowitz (1998), that sub-prime lending, particularly to ethnic minorities, i.e nondiscriminatory lending, would have created a solvency problem Liebowitz (2008) shows by simple diagrams two facts: first, expressed in constant USD (1983), the yearly price of homes between 1987 and 1996 was slightly decreasing, while it increased in real terms by more than 80% between 1995 and 2005, and then sharply declined, from 2006 on; second, between 1970 and 1995 the yearly share of households owning a home had been nearly constant, between 64-65%, while it had peaked to 69% in 2004, and then it had started to decline again According to this kind of interpretations, the abnormal trend in the construction industry and in the real estate market would not have been possible without the accommodating role of the Federal Reserve O’Driscoll (2008) is an example of the view that the “Greenspan put” and then the “Bernanke put” in monetary policy are guilty of disturbing the role of prices as the only signal that would help markets to adjust themselves The origins of the sin, according to this view, goes back the federal guarantee on cash deposits in the 1930s, the related moral hazard, and the tendency of non-neutral monetary policy to disturb markets, as pointed out at that time by Friedrich von Hayek and Ludwig von Mises, and later on by Milton Friedman According to O’Driscoll, while the Fed has had over decades an implicit inflation target at around 2% per year, in fact it manipulated the CPI, by for example excluding the prices of food and energy3 In the Hayekvon Mises perspective, any attempt to stabilize the prices of goods and services may help to create an asset bubble See also White (2008) for the view that the recession in the US is intrinsically due to a combined failure of monetary and housing policies The ‘progressive’ thesis, often labelled as “Keynesian”, argued especially by Paul Krugman and Joseph Stiglitz, is that the financial markets have a historical responsibility in the crisis, basically due to an excessive greed for profit4, without adequate controls, which also brought about great imbalances in the distribution of income The cure should entail expansive fiscal policies, far more courageous than the current ones, because global demand seems insufficient, putting on one side for the moment the problem of the sustainability of the public debt and the risks of inflation According to Krugman (2009), the Asian crisis of the 1990s, the Japanese asset bubble, or the crises in Mexico and Argentina had to be considered as a rehearsal for the current troubles, which in turn are related to other histories of the instability of capitalism This is so despite the premature prophecy by Robert Lucas, in his presidential address at the American Economic Association that economists have understood how to tame the business cycle Krugman suggests that the repetition in the US of the episodes of instability, as already experienced elsewhere, has to be in part attributed to the Fed’s unwillingness under Alan Greenspan to curb ‘irrational exuberance’ in the financial markets As there was a conventional view in the 1990s that inflation would not have been accelerating until the unemployment rate fell below 5.5%, in fact with unemployment going down to less than 4% around the turn of the century, inflation remained quiescent This was attributed by Greenspan and others to fundamental changes in technology and productivity, and no need was seen to raise interest rates According to Krugman “Greenspan warned about irrational exuberance, but he didn’t anything about it And in fact, the Fed chairman holds what I believe is a unique record among central bankers: he presided over not one but two enormous asset bubbles, first in stocks, then in housing” Under this view, the ‘dot.com’ bubble, and the related euphoric rise of the price of stocks, and the rise of prices of houses were a combination of irrational expectations, wrong monetary policy, and greed of financial players to take advantage of the situation This interpretation shares with the conservative one the factual identification of the asset bubbles and their burst as the engines of the current crisis, but radically departs from it in terms of the diagnosis of therapy According to Krugman, the origin of the crisis is to be traced back to the irrational functioning of the unregulated financial markets To simplify, the conservative view points to a regulatory failure in the first place that gave rise to a bubble Krugman’s view points to a market failure, not addressed by regulation Hence the policy prescriptions of the two views are diametrically opposed To the conservative economists what is needed is mainly laissez-faire; while, to the progressive economists, what is required is public spending and accommodating monetary policy in the short term and tougher regulation of financial markets as a structural therapy Market failures are also central in Stiglitz’s (2010) interpretation Most of his book is devoted to documenting the manipulation of information by different financial players, and how their customers were not protected, as in fact the Fed and policy-making were captured by the interests of the financial industry Stiglitz also suggests that most economists share some responsibility for what has happened, as they have misunderstood the conditions under which the Arrow-Debreu representation of general equilibrium is valid, particularly perfect information and exogenous technical progress Should the economists had read more carefully the Greenwad and Stiglitz (1986) theorems (on markets affected by externalities and incomplete information), they would have realized that only government can cure some fundamental market failures According to this view, the proposed cures are a combination of public spending, regulation of the financial markets, more progressive income taxation, and a dose of industrial policy to sustain technical progress The “alternative” view departs from both the “conservative” and the “progressive” views, as it suggests a major role for an income distribution shock as an ultimate causal factor, and suggests adding a structural income policy to the short-run fiscal and monetary policy measures The structure of this paper is as follows: section focuses on income distribution disequilibria as the real roots of the crisis; section focuses on factor shares; section further elaborates on this interpretation; and section discusses possible approaches to decrease the weight of capital income and concludes The Role of Income Distribution Stiglitz (2010) observes that the median income in the US in 2008 was 4% lower in real terms than in 2000, while the per capita GDP was 10% higher The average is strongly influenced by asymmetric distribution and by the vertiginous growth of high incomes I briefly elaborate below on this issue, which in my opinion leads to an alternative view of the Great Recession, based on the role of income distribution shocks in the last two decades (see particularly Foster and Magdoff (2009)) 55,000 1999: USD 53,252 53,000 51,000 49,000 2010: USD 49,445 47,000 45,000 43,000 41,000 1967: USD 40,770 39,000 37,000 Figure Real Median Household Income in the U.S., 1967-2010 (in 2010 USD) 2009 2007 2005 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 1973 1969 1971 1967 35,000 Source: Author’s calculation based on data of U.S Census Bureau (2010), Current Population Survey, Historical income Tables, Table H-5 Retrieved from http://www.census.gov/hhes/www/income/data/historical/household/index.html Legend: Dotted lines show the trends over the period considered, with a structural break around 1999 Figure shows the real median household income in the US, between 1967 and 2010 (the last few years being the most affected by the crisis, with, for instance, a decrease of 4.2% between the years 20072009) The figure suggests that 1999 was the peak year, with USD 52,388 income for the median household, a level that was never to be reached again, and that, in fact, began to decline well before the recent crisis Over this 30-year time span, real family income of the bottom 20% decreased in real terms by 7.4%, and the second 20%, those with income between around 27,000 – 48,000 USD, almost stagnated, with an average increase per year of below 0.1% per year In fact, it seems that for one half of the US households the income in the last thirty years did not increase on average, while the increase was mostly concentrated in the top 40%, and particularly with the top 5% The contrast with the previous dynamics, as showed in Figure 2, particularly looking at the bottom of the distribution cannot be exaggerated In terms of income distribution Piketty and Saez (2003)5 find that the share of the top 1% of total pre-tax income was at its top, 23.9%, in year 1928, which as it happens was exactly the year before the Great Depression, then steadily declined, was just 8.6% in 1976, and then increased to nearly 1928 levels, 23.5%, in year 2007, again one year before the current Great Recession In both cases, the turning point was a crash of the stock market, but the increase in income inequality was built over a number of years before the crash, see Figure More in general, according to Piketty and Saez (2003) and updates, when adjusted for inflation, between 1973 and 2005, the average income of the first nine deciles fell by 11%, while average productivity increased by 80% According to Baker (2007) the divorce between productivity changes and pay in the last thirty years is in sharp contrast with the productivity and wages in the previous decades, which increased at the same regular pace of 2-3% every year 120% 100% 80% 60% 1947-1979 1979-2009 40% 20% 0% -20% Bottom 20% Second 20% Middle 20% Fourth 20% Top 20% Top 5% Figure Change in Real Family Income by Quintile and Top 5% in the U.S., 1947-1979 and 1979-2009 Source: Author’s calculation based on U.S Census Bureau data in Lawrence and Bernstein (1994) and U.S Census Bureau (2010), Historical Income Tables: Families, Table F-3 Retrieved from http://inequality.org/income-inequality/ and http://www.census.gov/hhes/www/income/data/historical/families/index.html 30% 25% 2007: 23.5% 1928: 23.9% 20% 15% 2008: 21.0% 10% 1976: 8.9% 5% 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 0% Figure Top 1% Share of Total Pre-Tax Income in the U.S., 1913-2008 Source: Author’s calculation based on Piketty and Saez (2003), updated to 2008 Retrieved from on http://inequality.org/income-inequality/ It seems as the post-war social history of the country can be divided between three decades of cohesive growth, and another three decades of explosive inequality, similar to the situation during the 1920s These trends in income are reflected in their cumulative effects on wealth inequality According to the data reported by IPS from various sources, against a median net worth of US households at 62,000 USD, the top 1% holds 35.6% of total wealth, and the bottom 80% just 12.8% in 2009 In terms of distribution of the US stock market wealth in 2007, while the top 1% holds 38.2%, the bottom 80% owns just 8.9% of the pre-crisis value Turning to an international perspective, the OECD (2011) observes that growing inequality is a common trend across the advanced economies between the mid-1980s and late 2000s They consider disposable household income, deflated for the consumer price index, and find that in the last 20-25 years the average annual change of income of the bottom decile has been 1.4%, and 2.0% for the top decile Countries that show a much larger gap include United States (0.5 bottom, 1.9 top), Austria, Israel, Italy, Japan, Netherlands and Sweden Typically the ratio of the top to the bottom income is nine times in the OECD, but much lower in the Nordic and other European countries, and much higher in the US (14 times), Mexico and Chile (27 times) Taking the Gini index, it increased in 17 out of 22 countries The OECD report acknowledges that the common trend towards increased inequality started in the UK and in the US in the late 1970s and early 1980s, but it has then been spreading everywhere Nevertheless, it is difficult to argue that in past years global demand has been weak Consumption in the USA and in the rest of the world (especially in emerging economies) has risen sharply What seems to be the key point is that while in some countries, for example China, India and Brazil, consumption increased thanks to the sustained growth in household income and saving, in the United States and elsewhere, it increased thanks to the growth in household debt In other words, the problem was not that effective demand was insufficient, but that it was unsustainable, given the income distribution in some key countries of today’s global economy On Factor Shares Perhaps less prominent in the debate on the Great Recession has been the subject of the distribution of income among the factors of production Historically, in the last century, except for major upheavals related to wars and specific economic crises, a sort of social pact had led to an approximately constant ratio in the distribution of income between work and capital out of the gross national product of each country (even though there were oscillations over time and differences between countries) This was one of the stylized facts in Kaldor’s (1961) view of growth, and while the shares can fluctuate year by year, they were assumed to reverse to a constant mean value This ‘pact’ was broken in the 1980s and the share of income from capital rose abruptly, automatically reducing the share of labor Measurement is difficult in this area of the national accounts (see, for example, OECD (2011)), but the intuition of the overall trend is clear enough Perhaps the most revealing aspect of this story, is given by Figure 4, which shows average hourly wages, as a crude way to understand the dynamics of labor versus capital income In terms of constant 2009 USD, the wage between 1947 and 1972 increased by more than 75%, while in the following period until 2009 the increase was only 4% (over 37 years), and in fact it decreased in real terms until the late 1990s At the same time, the federal minimum wage has been declining 22.50 2009: USD 18.63 1972: USD 17.88 17.50 12.50 Average hourly wage 1945: USD 10.18 Federal minimum wage 7.50 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2.50 Figure U.S Federal Minimum Wage (1956 - 2006) and Average Hourly Wage (1947-2009) – US dollars Source: Author’s calculation based on Boushey and Tilly (2009) and Economic Policy Institute data (2011) Retrieved from http://inequality.org/income-inequality/ Note: The federal minimum wage is expressed in 2006 constant dollars and the average hourly wage is expressed in 2009 dollars 54% 53% 52% 51% 50% 49% 48% 47% 46% 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 45% Figure Wage and Salary Disbursement as a Percentage of GDP, 1959-2007 (%) Source: Author’s calculation based on Foster and Magdoff (2009), Chart from Economic Report of the President, 2008 Retrieved from http://monthlyreview.org/2008/12/01/financial-implosion-and-stagnation Additional evidence is provided by Foster and Magdoff (2009) According to these authors, the divorce between wages and productivity changes is a long term process, with falling wages and salaries disbursements as a share of GDP in the US, between 1960 and 2007 (see Figure 5) In Foster and Magdoff’s words: “… real wages of private non-agricultural workers in the United States (in 1982) dollars peaked in 1972 at USD 8.99 per hour, and by 2006 had fallen to 8.24 (equivalent to the real hourly wage rate in 1967), despite the enormous growth in productivity and profits over the past few decades… The truly remarkable fact under these circumstances was that household consumption continued to rise from a little over 60% of GDP in the early 1960s to around 70% in 2007 This was only possible because of more two-earner households…, people working longer hours and filling multiple jobs, and a constant ratcheting up of consumer debt Household debt was spurred, particularly in the later stages of the housing bubble, by a dramatic rise in housing prices, allowing consumers to borrow more against their increased equity…household debt increased from about 40% of GDP in 1960 to 100% of GDP in 2007, with an especially sharp increase starting in the late 1990s” The tendency of labor share in national income to fall is not observed in the US alone The trend is common to most major advanced economies This fact is acknowledged by the IMF (2007), in a report especially focusing on the issue of the structural change of the historical pattern of labor/capital shares and increasing income inequality One explanation of this trend points to explicit labor policies in the late 1970s to stop the increase of wages and to constrain trade unions Additional possible explanations are technological changes, which displace unskilled workers, and the wage competition between workers in developed economies and those in emerging countries, as China, in the context of trade globalization (see OECD (2011)), which also mentions regressive tax-benefit reforms in the last two decades According to the OECD (2011) most of the household income inequality has been driven by rising inequality in wages and salaries, as they typically account for 75% of incomes of working adults Atkinson (2009) observes that top earners have experienced a particularly fast growth What seems difficult, however, is to disentangle capital and labor income of top earners Moreover, the role of self-employment poses additional problems of interpretation It is disproportionately represented in the bottom household income quintile, but also in some business in the top quintile, such as doctors and lawyers, where capital income is often combined with labor income Focussing on capital income, the OECD (2011) suggests that the share of capital income remains modest in average household income, typically 7%, and “not surprisingly where this share increased, it was predominantly due to movements in upper part of the distribution” According to Thompson and Smeeding (2011), the evidence points to the following: a) Until 2007 and starting from 1979, the unemployment rate of less than high-school achievers shows oscillations between a maximum of around 16% in 1983, and a minimum of around 8% in 2006 A similar cyclical pattern is shown by those with high school only, but with a lower average unemployment rate (10 to 4% range), while except in post recession years, those with a bachelor or/and advanced degree have typically experienced a much flatter unemployment rate, between and 4% This points to a high responsiveness of unemployment of ‘blue collars’ to output shocks, which is well explained by lack of unionization and other forms of labor protection b) The inequality of hourly wages increased, with GINI indexed 1979=100 growing to around 121 in 2010, and the ratio percentile 90/percentile 10 raising from 100 to around 140 (see Figure for wage changes by education and age) c) The Congressional Budget Office’s household ‘comprehensive income’, which equals pre-tax cash income (wages, salaries, self employment income rents, interest, dividends and capital gains, retirement benefits etc., plus in –kind benefits such as Medicare, Medicaid food stamps, housing assistance, school lunches, energy assistance, etc.), shows that the top 1%, 5% 10% and 20% have all increased their share in the total during 1979-2007, while all the other quintiles have lost grounds, particularly the bottom two which have lost more than 20% of their share, with the remaining two quintiles having lost each around 10% of their share (see Figure 7) As a result, around the crisis year 2007, in the US, the ‘bottom’ 80% of the households had a share of less than one half of the entire society (47.5%) The top 1% fared particularly well, and according to various income definitions, it enjoyed something of a doubling of the share of household income 35% 30% 25% 20% 15% High school only 10% Bachelor's only 5% Advanced 0% -5% -10% -15% Age 25-34 Age 35-44 Age 45-54 Age 55-64 Figure Real Hourly Wages by Education and Age, Percentage Variation between 1979 and 1910 Source: Author’s calculation from Table 8.A2 in Jenkins et al (2011), based on Outgoing Rotation Group files of the Current Population Survey (CPS ORG) 100% 90% 80% 70% Top 20% 60% Fourth 20% 50% Middle 20% 40% Second 20% Bottom 20% 30% 20% 10% 0% 1979 2007 Figure Shares of CBO Household after-Tax ‘Comprehensive Income’, 1979 and 2007 Source: Author’s calculation based on Figure 8.6 in Jenkins et al (2011) Note: CBO is defined as the Congressional Budget Office's 'comprehensive income' measure: it equals pre-tax cash income plus income from other sources Pre-tax cash income is the sum of wages, salaries, self-employment income, rents, taxable and non-taxable interest, dividends, realized capital gains, cash transfer payments and retirement benefits plus taxes paid by businesses (corporate income taxes and the employer's share of Social Security, Medicare, and federal unemployment insurance payroll taxes) and employees' contributions to 401 (k) retirement plans Other sources of income include all in-kind benefits (Medicare, Medicaid, employer-paid health insurance premium, food stamps, school lunches and breakfast, housing assistance and energy assistance) Having established that in the US, and elsewhere, there have been a sustained series of major redistributive shocks, let us turn to the causal mechanism that may have moved the US economy from there to the crisis As optimistically noticed by Mulligan, the pre-crisis years have been exceptionally positive in terms of corporate profitability This was true despite the slowdown of GDP growth, which was in excess of 4% per year in real terms in the 1950s and the 1960s, in excess of 3% in the subsequent three decades, and around 2.6% per year 2000-2007 While the growth of both non financial and financial sector profits mostly tracked GDP growth until around 1990, then the former sky-rocketed, thereby driving also the latter A most revealing aspect of this story is the decoupling of profits and investments, as shares of GDP Since the 1980s non residential private investment has been decreasing, while profits have been increasing, with a paradoxical opposite trend in 2003 In 2006, the year before the crash, the share of recorded profits as percent of GDP was more than four times the non-residential investment In terms of cash flows this must explain the booming incomes of the top income earners, whose income is obviously mostly capital income Growth of profits as share of the GDP is the counterpart of the abnormally high return to capital We need to dissect this point to understand the role of the income distribution shock When placed in historical perspective, the share of profits out of GDP in the US had been occasionally higher as compared to recent years; but between around 1960 and 1985 the share was mostly decreasing, and then it began to increase strongly, nearly doubling As the share of profits out of GDP changes, something else must accommodate the change From the previous discussion, it seems that the most likely candidate is the share of labor income (in the broadest definition, net of compensation of top managers etc) Under a regressive redistribution shock, you would need to see two partially countervailing effects on savings propensity for any real interest rate The greater share of income going to top income earners would push up the savings rate, while the shrinking of the median household income would push it down Figure shows the personal saving rate in the US, from 1947 to 2010 In the years up to 1982, the saving rate gradually, and with cyclical oscillations, increased from around 4% to nearly 11% by the early 1980s Since then, it collapsed to 1.4% in 2005, and remained at around that level, because of the recent increase due to the precautionary attitude induced by the crisis in the last three years In principle, this effect is compatible with different stories The first one is a widespread optimism Households expect that their income will rise, and are happy to spend a greater proportion of their earnings However, nothing in our story justifies such optimism for the ‘bottom’ 80% of the households 12% 1982: 10.9% 10% 8% 2010: 5.3% 6% 4% 1947: 4.2% 2% 2005: 1.5% 2010 2007 2004 2001 1998 1995 1992 1989 1986 1983 1980 1977 1974 1971 1968 1965 1962 1959 1956 1953 1950 1947 0% Figure U.S Personal Saving Rate as a Percentage of Disposable Income, 1947-2010 Source: Based on Bureau of Economic Analysis (2011), National Income and Product Accounts, Table 2.1 Retrieved from http://inequality.org/wealth-inequality/ At a macroeconomic level, GDP growth was slowing down However at the microeconomic level, the median real income was stagnant, if not declining Thus, any optimism should have been induced by the misperception of a positive wealth effect for homeowners, and even by a misperception of the value of stocks and other securities for those in the middle classes who hold savings in that form While this part of the story seems plausible, even without optimism your propensity to save would fall if your net income shrinks, or if it is stagnant, but your needs increase with age Clearly the misperception can have been helped by the availability of easy credit Since the income of the great majority of the families, which is basically income from labor, showed little growth, it was the “invention” of financing exactly those who were losing on the basis of both absolute and/or relative grounds –– that encouraged families to borrow beyond all reasonable measure According to Foster and Magdoff (2009), household debt was only 0.5% of GDP in 1970, 7% in year 2000, and then nearly doubled by 2007 As shown in Figure 9, this increase was greater than the increase for non-financial firms and government’s debt relative to GDP between 1970 and 2007 The debt/GDP ratio of financial firms, which was modest in 1970, increased more than eleven times Of course, this could only happen with the accommodating support of the lawmakers and the monetary authorities, and here the conservatives’ interpretation is correct Thus, the ‘alternative’ view would suggest that (a) there was both a market failure (because of the complex game of shifting the risks involved in credit to household with inadequate income prospects) and a regulatory failure (because of the protection of financial players by lax monetary and banking policies), that (b) both issues are deeply linked to the need to sustain the rate of return on capital as a countervailing measure against the decrease of the rate of return on the ‘ average’ human capital This interpretation has nothing to with an ethical reaction against ‘greed’ It points to a peculiar form of virtually insufficient demand suppressed by private debt I would describe this regime as repressed stagnation 10 120% 100% 80% 1970 60% 1980 1999 40% 2000 2007 20% 0% Financial firms' Households' debt debt Non-financial Government's business's debt debt (local, state and federal) Figure Ratio of U.S Domestic Debt and GDP by Sector in Selected Years Source: Author’s calculations based on Table of Foster and Magdoff (2008) Note: The federal part of the local, state and federal debt includes only that portion held by the public Discussion It is difficult in general to establish a golden rule for income distribution in a long-run growth perspective This issue, which has a long history of research, starting from the classical economists, including Ricardo and Marx (see Asimakopouls, 1988) and from the empirical studies in the vein of the Kuznets’ curve (Deininger and Squire, 1998) If long term growth is supported by savings and capital accumulation, redistribution from the rich to the poor would decrease the saving rate, hence growth This is the origin of the widely held view of a trade-off between income equality and growth The Solow-Swan neoclassical growth model is, however, not directly dealing with income distribution, as discussed by Stiglitz (1969) The tradeoff is challenged on empirical grounds by Benabou (1996), who suggests that inequality is detrimental to growth, reversing the earlier view Aghion et al (1999) review the evidence of the adverse impact of inequality on economic growth The transmission mechanisms, from inequality to slower growth, in the literature, both theoretical and empirical includes the following ones: capital markets imperfection makes it difficult for entrepreneurs lacking collateral to invest on socially deserving innovations (Aghion and Bolton,1997); demand is constrained by inequality and this may affect innovation incentives; inequality pushes government to implement inefficient transfers (Alesina and Perotti, 1996, and several others) For a general discussion of factor shares and endogenous growth, see also Bertola (1993) More recently, see Ravaillon (2009) A simple mental experiment is sufficient to show that the share of factor inputs in a closed economy cannot be neutral in terms of growth Even the standard Cobb-Douglas aggregate production function, under constant returns to scale, and decreasing returns to factors, will tell you (if you believe the assumptions) which are the optimal shares of capital and labor incomes in a competitive economy As mentioned, one core stylized fact of growth theory according to Kaldor (1961) is the constancy of the factor shares This assumption does not tell you anything, however, about the relationship between growth and income distribution in the economy This is because that aggregate production function per se is mute about who owns the capital in the economy (whatever the logical paradoxes arising in the definition of capital, a much debated issue that is unimportant here) In a closed economy, with no government and no external trade, the value of output must be entirely distributed across factor inputs, but who owns the factors of production is not specified in the standard neoclassical model Let us now consider the augmented version with human capital, which is common in many endogenous growth models In this frame, to go from the aggregate production function to income distribution, you need to make some assumptions about who owns the physical productive capital at the 11 initial time, who owns the human capital, and who owns only unskilled work ability The intuition of the standard neoclassical model is that the economy must be competitive to be efficient This should be associated, however, with an adequately fair distribution of both productive capital and human capital If not, if for example productive capital is owned by just one household, all the firms would be under the control of one capitalist, and this cannot be compatible with the initial assumption of perfect competition Clearly, the sole owner of capital will not allow ‘his’ firms to compete with each other, and will earn monopoly profits by rationing the demand Income distribution will be of course extremely skewed Let us consider the opposite mental experiment, and assume now that each household at the initial time in a multi-period model of the economy is endowed with the same share of productive capital and of human capital Here, income distribution will be extremely egalitarian Intermediate cases can then be considered, from the very egalitarian to the highly unequal The question arises whether growth is sustainable under any range of these ownership patterns, and hence of income distribution In the extreme case of one private shareholder who owns the whole economy, he will be not just a monopolist, but also a monopsonist of labor services Hence, there will be a substantial extraction of rents from both the employees and the consumers (who are the same households) The real wage will be well below the value of the marginal product of labor, in accordance with standard microeconomics Hence, it may be safe to think that savings will be zero on the workers’ side, or perhaps just sufficient to compensate for the depreciation of human capital, for those who own it, i.e the skilled workers The only saving in the economy is then provided by the unique owner of capital, while his consumption may be negligible in terms of aggregate output How can this economy grow? With no savings on the workers’ side, hence no further accumulation of human capital, growth would be possible only if technology and population exogenously grow Exogenous population growth, however, will probably dilute the capital/labor ratio and decrease wages in the extreme conditions of our mental experiment The impact of technological progress is not clear that it will be benign in this specific context You would need to make some special assumptions on the type of technology to hope that exogenous technological progress would be such in this economy that some of the labor productivity improvements are transferred to wages and to consumption You can repeat the thought experiment for the polar case of an equal distribution of ownership, with and without perfect competition, and discover why there should be in principle a certain hidden relationship between income and initial wealth distribution and aggregate growth in any dynamic model with imperfect product and labor markets If you add debt in an inter-temporal context, for example you allow working households to incur debt to acquire human capital, this implies that debt sustainability also depends upon some initial distributive conditions If you allow workers to incur debt to sustain consumption now, you need to assume that wages will increase enough to pay the interest and pay back the debt in the second round But it is not clear if wages can increase enough under such unequal distribution of assets While such an extreme monopolistic-monopsonistic arrangement, as in this thought experiment is certainly unrealistic, oligopolistic markets associated with a very uneven distribution of ownership of fixed and human capital are not Oligopoly coupled with a very skewed income distribution is a feature of real world economies This point was noticed by Sylos Labini (2003), in an important, albeit probably not sufficiently known paper7 Sylos Labini says that he had been “noticing certain similarities between the situation that arose in America in the 1920s – a period that ended up with the most serious depression in the history of capitalism – and the situation that emerged today” He lists three points: the importance of certain technological innovations, notably ICT; the emergence of high and increasing profits; short term and long term debts tied up to investment plans of firms and for families to consumer durables as houses Then he adds to the picture that three other phenomena deserve attention: income distribution, market forms, and sustainability of debts On the latter point, Sylos Labini adapts the Pasinetti (1998) approach to evaluate the sustainability of public debt, to assess the sustainability of private debt in the US Before turning to income distribution, which is my main concern in this paper, it is interesting to report how Sylos Sabini rightly forecasted the current crisis He considered four types of debt: public, firms, households and foreign Pasinetti (1998) discussed the Maastricht criterion on public debt sustainability in terms of the ratio D/Y, debt to income, and as usual concluded that debt sustainability implies that D/Y is stable or decreasing The law of motion of D/Y is governed by the relation S/Y – ((i-g) D/Y) where S is primary surplus, i is the interest rate, and g the growth rate of income Hence, basically the story has to do, as we well know, with (i-g), an issue that should possibly be most seriously considered in the 12 current public debt adjustment process in some European countries The approach by Sylos Labini is to calculate the summation of the difference between S/Y and ((i-g) D/Y) in the long term for the different categories of debt, and then qualitatively look to the inclination of the resulting curve He concludes that, except because of the effect of the Iraqi war, there was no important public debt concern at that time Then he moves to private debt, focussing in this case on the cumulative difference i-g Here he finds clear evidence of an unsustainable path, as shown in his Figure C, here reproduced as Figure 10 50 40 Improving sustainability 30 Worsening sustainability 20 10 -10 -20 -30 -40 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 1960 -50 Figure 10 U.S private debt sustainability, 1960-2002 Source: Author’s adaptation of Figure C, Sylos Labini (2003) Legend: Private debt sustainability is defined by Sylos Labini (2003) as ∑t ሺi-g) where i is the bank rate of interest (prime rate), g is the rate of growth of income and t is the year In other words, it is estimated as the cumulative difference of the interest rate and the growth rate of income He concluded that “The American crisis is, then, to be taken very seriously, as indeed an increasing number of economists are now tending to The diagnoses offered, however, seem superficial, as the recommended policy measures – a new reduction of the interest rate, as well as tax cuts and deficit spending” Let us now go back to what Sylos Labini had to say about the role of income distribution in this context, and why he did not see in the conventional demand side management of the economy the solution He noticed that “In the 1920s the share of income going to the highest quintile rose by six points, from 48% in 1923 to 56% in 1929 (Sylos Labini 1984: 265) From 1992 to 2001 the purchasing power of the lowest median quintile lost 3.6 points, whereas that of the highest quintile gained 0.7 points, so that the gap widened by 4.3 points – no negligible change!” An update of this figure to 2007, using Thompson and Smeeding (2011) after tax comprehensive income and considering 1979 as the base year, according to my guess calculation is that the gap has widened by more than 11 points, which is certainly no negligible as well, and so remains when instead of considering the bottom quintile you take for example the median income level Sylos Labini had very clear things to say about the economic effects of regressive redistribution: “When income inequality increases at least two problems arise: the demand for consumer goods slows down while speculative operations increase, together with the debts contracted to finance them… Income inequality increases systematically either as a consequence of fiscal policy or as an effect of great innovations pushing up profits External dynamic economies of a special kind are now at work: profits increases in successive waves, and this gives rise to speculative waves in the stock exchange with their 13 epicentre lying precisely in the innovations Profits, gains from shares and lavish compensation for managers – especially the top managers – also feed waves of real estate purchase; thus two speculative bubbles appear, one in the stock exchange, the other in the real estates markets” With the benefit of hindsight, we can add that the destabilizing innovations were not confined to the ICT and related sectors, but extended to the finance industry itself, which literally invented new ‘products’ The most explosive part of these innovations was long-term lending to the poor to sustain their consumption of durables, including homes, in such a way that the speculative real estate (and other goods) speculative waves described by Sylos Labini could be enjoyed from the top to the bottom of the society, with fiscal and monetary policy concurring to pave the way for the mess in which we have been engulfed over the last few years There was actually no slow down in consumption, in fact it was a repressed stagnation, achieved through unsustainable private debt The subtle point to be considered here is that the change in factor shares, which has occurred in the US and elsewhere after the 1980s, leading to a new pattern of income distribution, should be considered as a real shock to the economy, which needed a complex pattern of adjustments, including at international level (a topic that I will not discuss here) These adjustments ignited what seems to be a mainly financial crisis, a story of bubbles and of defective regulation, but in fact has its roots in deeper social changes, some of them induced by deliberate policies, as I shall discuss in the concluding section Concluding Remarks: A New Income Policy Under the ‘alternative’ view, the key question is how to reduce the share of capital income, i.e to redistribute in favor of labor income, and to achieve less inequality under a sustainable growth pact Ex-post the corrective mechanism can only be taxation of wealth (see Carey and Rabesona (2002) about statutory tax rates on property and capital income in the OECD countries) An ordinary tax on comprehensive wealth would be a technical tool for permanent ex-post redistribution and it appears to be better than the tax on capital income However, I believe that it would be more effective to combine it with a policy that encourages ex-ante growth in the share of income from work Here the royal road is exactly the opposite of that pursued in recent years There is nothing unavoidable in the labor and other social policy trends of the last decades, in the US and elsewhere They can and should be reversed The OECD (2011), after having discussed the impact of globalisation on the wage structure of advanced economies states that: “ … during the past two decades employment protection legislation for workers with temporary contracts also become more lenient in many countries Minimum wages, relative to average wages, have also declined in a number of countries since the 1980s Wage-setting mechanisms have also changed; the share of union members among workers has fallen across most countries, although the coverage of collective bargaining has remained rather stable over time… These changes in policies affected the ways in which globalisation and technological changes translated into distributional changes tax and benefit systems have been less effective in counteracting the ‘market-income inequality Boushey and Tilly (2009) offer an overview of some changes in the US which have very likely contributed to the worsening of the position of workers These changes include the following ones: a) in the mid 1990s a series of reform of welfare programs have eliminated support to non-working poor, even those with small children at home, while some benefits were given to low-income working families While some households have got more public assistance, nevertheless “most lowincome families with a worker remain ineligible for work supports, and many of those eligible not actually receive benefits” b) costs for health care, child care, housing and other necessities have increased more than inflation, and this fact has forced some workers to increase hours of work-time, but still often without being able to cope with the increase of costs; c) the core elements of the workers-protection system go back to the 1930s , particularly the Fair Labor Standards Act, 1938, and the Social Security Act of 1935 As for the federal minimum wage, established under the FLSA, “beginning in the 1980s, Congress stopped moving to increase the nominal minimum wage In 2006 the purchasing power of the federal minimum wage stood at 45% below it 1968 level and equivalent to only 31% of the median wage” Restaurants and retail industries were particularly active in lobbying against minimum wage legislation 14 d) the FLSA provision that overtime work should be paid at least 50% more than standard wage has been eroded by regulatory changes in 2004; e) employers’ provided benefits for health insurance and pensions have moved away from defined benefit to defined contribution: “Defined-benefits plans tumbled from covering 84% of full time workers holding pensions in 1980 to 33% in 2003 Thus, employers have shifted the risks of retirement savings and planning onto workers” and “The coverage of workers covered by an employer-provided health plan declined from 69% in 1979 to 56% in 2004” Moreover there is now less coverage for employee’s spouses and children; f) according to some studies the percentage of paid childbirth leave has fallen from 27% in 1998 to 16% in 2008, and also the new legislation on Family and Medicaid Leave, providing for unpaid leave, has not been particularly successful; g) unionization has fallen from one in three workers in 1948 to one in eight in 2005, and there is some evidence that pro-union workers face a higher risk of being fired; h) free trade agreements, such as NAFTA, have been negotiated without any requirements for the participants to meet some social, safety or environmental standards This also helped to squeeze wages in the US Can these trends be reversed? I think that this reversal is feasible and should be put at the centre of a policy reform agenda Some frequently cited counter-arguments should be rebutted, as they are not evidence-based The fact that countries where social spending and workers enjoy high levels of protection are also very competitive is often ignored by those who have been supportive of decreasing labour protection For example, De Grauwe and Polan (2005) find that countries that spend a lot on social needs, on average score well in the competitiveness league De Grauwe and Polan (2005) use indices from IMD Lausanne and by the World Economic Forum, which combine scores on cost and price effectiveness, capacity to innovate, quality of human capital, government effectiveness, and others Then they compare the ranking arising with the two sets of indicators and social spending in the OECD countries This includes spending on unemployment, disability, pensions, child and other family benefits, and social housing They find that the “countries that spend larger proportions of their domestic products on social needs also score best in the competitiveness scale” Data refers to the decade around 1998-2002 After checking for possible reverse causality, as competitiveness is regressed on past values of social spending, the authors find a modest, but significant correlation between competitiveness and social spending They also discuss earlier contributions on this topic, as Rodrik (1998) In the words of “ … a race-to-the-bottom is set in motion, whereby the competitive pressures arising from globalisation slowly erode social security If not controlled, this dynamics may destroy one of the great social achievements of industrialized countries – their capacity to guarantee a reasonable income to all citizens hit by unfavourable conditions” To reverse the ‘race to the bottom’ in wages, and promote a general increase of pay we would need an explicit income policy Devising a sustainable income policy of high wages today may seem to be unthinkable, but it is not impossible According to Boltho and Carlin (2009), Germany, for example, has room for further wage growth, in order for the country to be less dependent on exports, and sustain a fiscal stimulus They suggest tax cuts or increased benefits to poorer households, increasing pre-school provision of child care, speeding up the introduction of full-day school, reform the tax treatment of married women to remove disincentive to work, targeting teaching of German language and other remedial education for immigrants, additional teaching resources for children of jobless or low income households, increased provision of training for older workers These examples would go in the right direction in many countries I would, however, suggest that an aggressive income policy package should include a marked fiscal advantage for companies that (a) hire workers, (b) hire workers with a permanent contract, (c) pay salaries above the minimum legal or union rate, also in the form of distribution of profits to employees Increased ordinary taxation of wealth could be combined and sustain a policy of this type, with which companies and their shareholders would have to choose from a menu of tax-incentive system between pursuing a poor wage policy and then paying higher taxes, or pursuing a policy that is more favourable to the worker and then paying lower taxes Secondly, governments should go back to encouraging co-operative or other ‘third-sector’ employment, which even in the technologically advanced sectors could be a valid alternative to the capitalist firm There should be a clear fiscal preference for employees’ ownership, for not-for-profit initiatives in socially deserving sectors, 15 and for channelling savings in these type of companies Thirdly, the wage policy in the public sector should be decent and offer those productive workers in sectors like healthcare and education, and also in the revamped government-owned enterprises, salaries that are competitive with those of the private sector Fourthly, in countries where there is no minimum legal wage, an adequate minimum legal hourly rate of pay for everybody should be introduced, with a built in updating mechanisms, and with employers found to be paying below this rate being liable for appropriate sanctions These are just a few examples, very schematic and merely illustrative The objections that any kind of redistributional policy would cause an increase in tax evasion or the relocation of firms abroad should obviously be taken into careful consideration, but one only has to take a look around the world to see that it is not necessarily so As an analogy, it is not true that countries with stricter environmental safeguards have seen the end of their potentially polluting industries, provided that the rules and the incentives are clear The same could be said for the social pollution arising from low wage policies In advanced capitalist economies the share of traditional manufacturing in GDP is limited and declining Moreover, some aspects of manufacturing are knowledge- and technology-intensive and not easy to relocate Advanced economies are mainly based on the production of services (even within manufacturing) Moreover, most of services are non tradable It seems difficult to see how a fair minimum wage floor to restaurants, laundries, cleaning services, car repair, etc would shift abroad these activities The mechanisms that generate capital incomes in our economies are only linked to a minor extent to the profit of non-financial firms In reality they often actually contaminate real production, for example by attracting brilliant young minds towards activities that are wasteful or damaging instead of producing useful goods A ‘financial product’ is often not really a ‘product’ in this sense, but nothing more than another form of dangerous gambling, as Keynes noticed for a much simpler ‘casino economy’ eighty years ago Preventing capital income from gambling, or, if it is impossible to prevent it, heavily taxing the results and redistributing them in a progressive sense, should be of interest even to the capitalists In this meaning Keynes described his views as moderately conservative, as pointing to capitalism without large inequality, a ‘middle class capitalism’ (Sharpe, 2009) There is no large political support in place today to take into consideration as crucial points on the agenda the two crucial redistributional reforms of capitalism, between countries and between capital and labor For lack of anything better, the most probable forecast, and perhaps even the least dangerous, is that the illness will become chronic, with occasional acute episodes Unfortunately, a chronic disease will in any case fuel much more social suffering than would be possible with real resources available to the economy globally Notes I use the term informally, mainly based on slower growth in some countries and a risk of double dip elsewhere On short run measures immediately proposed at the beginning of the crisis, see e.g Spilimbergo et al (2008), an uncommon example of the IMF taking a pro-public spending position, Krugman (2008) and several subsequent editorials and paper by him, Galbraith J (2008), Banca d’Italia (2010), available at www.bancaditalia.it/studiricerche;convegni/atti etc for an impressive array of studies on fiscal policy and the recession, Jackson (2009), and ILO (2009) on the employment impact As suggested by Goodhart (2001), at least the price of real estates should be included in any price index for monetary policy The role of ‘greed’ touches a traditional nerve of the progressive thinking in the USA, see for example several articles in The Nation, edited by Van den Heuvel (2009) This book is an useful source for the liberal, occasionally radical, views about, to quote the titles of the book’s section: ‘The seeds of disaster’, ‘Alarm Bells’, ‘The crisis hits’, ‘The road to Recovery’ Updated to 2008 at http:emlab.berkeley.edu/users/saez Cited by http:// extremeinequality.org The last time I have met Professor Paolo Sylos Labini (1920-2005) was at the annual conference of Economia e Politica Industriale in Ancona, Italy, 24-25 September 2005 My presentation there discussed the Sapir Report, a study, which focussed on the growth gap between EU and US (Florio 2005a, 2005b) Sylos 16 Labini told me in private that this point was not well taken, as the US growth path was unsustainable I did not know at that time his paper, published the year before I am very grateful to Massimo Cingolani to have recently attracted my attention to it With the benefit of hindsight, Sylos Labini was right, and I was wrong Acknowledgements An earlier version of this paper was presented at the OpsA Seminar, European Investment Bank, Luxembourg, March 10, 2010 I am grateful for comments to Dr Massimo Cingolani and Vice-President Simon Brooks I am also very grateful to Emanuela Sirtori (CSIL) for competent 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FLORIO* THE REAL ROOTS OF THE GREAT RECESSION: UNSUSTAINABLE INCOME DISTRIBUTION Abstract: This article suggests that, at the root of the Great Recession, there are two imbalances: an unsustainable... side for the moment the problem of the sustainability of the public debt and the risks of inflation According to Krugman (2009), the Asian crisis of the 1990s, the Japanese asset bubble, or the crises... in terms of the diagnosis of therapy According to Krugman, the origin of the crisis is to be traced back to the irrational functioning of the unregulated financial markets To simplify, the conservative