The beautiful and the damned

THERE was not a single year between 1952 and 1986 in which the richest 1% of American households earned more than a tenth of national income. Yet after rising steadily since the mid-1980s, reckon Thomas Piketty and Emmanuel Saez, two economists, in 2007 the income share of the richest percentile reached a staggering 18.3%. The last time America was such an unequal place was in 1929, when the equivalent figure was 18.4%. The similarities in the evolution of income inequality in the years leading up to the Depression and the global economic crisis make for one of the most striking parallels between the two episodes. Some talk of a repeat of the Roaring Twenties, when Jay Gatsby threw lavish parties at his Long Island mansion—although this time round, the dubious profits have been made from real-life finance, not fictitious bootlegging.

Economists have been thinking hard about the causes, extent and consequences of the recent rise in inequality. At the annual meeting of the American Economic Association (AEA) in Denver this month, there was a spirited debate about one of the most controversial hypotheses so far. That has been advanced by Raghuram Rajan, of the University of Chicago Booth School of Business, in a recent book, “Fault Lines”. He argues that increased inequality—more precisely, the political response to it—helped to cause the financial crisis.

Mr Rajan reckons that technological progress increased the relative demand for skilled workers. This led to a widening gap in wages between them and the rest of the workforce, because the supply of the skilled did not keep pace with demand. This reasoning is widely accepted. But Mr Rajan goes further than most when he argues that this growing gap lay behind the credit boom whose souring precipitated the financial crisis.

Governments, he argues, could not simply stand by as the poor and unskilled fell farther behind. Ideally, more should have been spent on education and training. But in the short run, credit was an easy way to prop up the living standards of those at the bottom of the economic pile. This was especially true in America, with its relatively puny welfare state.

Mr Rajan thinks, therefore, that it is no coincidence that America in the early 2000s saw a boom in lending to the poor, including those folks that banks used to sniff at. He points to the pressure the government put on the two state-backed housing giants, Fannie Mae and Freddie Mac, to lend more to poorer people. Affordable-housing targets, slacker underwriting guidelines and the creation of new “low down-payment” mortgages were all used as instruments of public policy.

The push for affordable credit worked. Subprime mortgages, whose share of all mortgages serviced rose from less than 4% at the turn of the century to a peak of around 15% before the crisis, were the most visible examples of this. They helped push American home-ownership rates to record highs. But the credit boom also inflated an enormous housing bubble, whose collapse precipitated a financial crisis brought on by defaults on those very subprime mortgages. According to Mr Rajan, therefore, well-intentioned political responses to the rise in inequality that many found disturbing ended up having devastating side effects.

This is a provocative idea. But do the facts support it? Two prominent economists—Daron Acemoglu of the Massachusetts Institute of Technology and Edward Glaeser of Harvard University—argued at the AEA meetings that Mr Rajan’s hypothesis, for all its plausibility, is flawed. Neither critic doubts that inequality rose and that poorer people gained access to more credit. But they disagree with Mr Rajan on the link between the two.

Mr Acemoglu argues that the expansion in credit came far too late for Mr Rajan’s hypothesis. The subprime boom began around 2000. Yet those at the bottom of the income distribution were getting hammered by technological change in the 1980s. Since then, the least-skilled workers in America have not become still worse-off, largely because they work in service industries which are hard to automate. Inequality has continued to rise because the rich have done even better; it is those in the middle who have fared relatively poorly. Why would the state try to help the poorest at a time when they were doing better than before?

Mr Glaeser has a different criticism. He thinks that the role of easy credit in the housing bubble was not as large as Mr Rajan believes. He refers to research by Atif Mian, of the University at California, Berkeley, and Amir Sufi, of the Booth School, which shows that increased mortgage availability pushed up American home prices by only around 4.3%. This was a small fraction of the rise in prices during the boom. Irrational exuberance and a willingness to bet on prices rising for ever were probably much bigger contributors to the bubble than credit expansion.

Let’s all agree to blame the speculators and lobbyists

Mr Acemoglu does believe that there is a link—albeit not a causal one—between increased inequality and the crisis. He thinks both were the consequence of politicians’ willingness to deregulate the financial sector, which partly reflected the industry’s lobbying prowess. A consequence, documented by two more economists, Ariell Reshef and Thomas Philippon, was that salaries in finance soared, causing a substantial part of the explosion in top incomes noted by Messrs Piketty and Saez. Runaway lending and lax standards, which fuelled the boom and contributed to the crisis, were others. So he thinks Mr Rajan is right to focus on politics but that they did not play out in quite the way he believes.

Ultimately it may be hard to prove a causal connection between inequality, subprime lending and the Wall Street boom. Even so, most economists at the AEA gathering agreed that the three forces combined in the American economy in an unsustainable and unhealthy way. To misquote “The Great Gatsby”, the rock of the world was founded securely on a fairy’s wing.

from PRINT EDITION | Finance and Economics

http://www.economist.com/node/17957107?fsrc=scn/fb/wl/ar/econfocus

 

What seems like social injustice is actually simply am intrinsic characteristic from the capitalist system.

You are certainly aware that wealth distribution in all capitalist systems is distributed as a power law. What do you think causes the fat tail?

The fact that wealth attracts wealth and that the richest become richer is a fact of the capitalist system.

The same mechanisms can be found in a variety of other domains. For instance, the number of friends on facebook also is a power law. Empirically you can observe that people with the most friends get more new friends than the others, which creates the fat tails.
You can also show it theoretically.

To sum it up, what you call injustice is actually a characteristic of the capitalist system and can't be modified unless you change the system.

Ninna

 

I met Daron Acemoglu 10 years ago in an MIT party. Very cool down to earth guy. At the time he was not a professor there. He is also a Jewish guy from Turkey and I think highest ranked Economist in the world from Turkey, 90th or so (as of 1999). I don't know what his ranking is now.

 

It's only Leftists/Socialists who are concerned about inequality of income... they seem to forget that America is (or was) the "land of opportunity" before it became the "land of entitlement".

There are no laws or policies which specifically prohibit any group of Americans nor any person from become part of the "1%".... if they have the ability and gumption.

What made America great economically was our capitalistic economic system and our freedoms. What's grinding us down are Socialist policies and government destroying our freedoms.

Socialists and tit-suckers should stop bitching that "somebody made it and I didn't... it's not fair". Wah, wah wah!

What Americans SHOULD be bitching about is how our Government is spending us into oblivion and destroying the country!

 

imho this view is myopic and glosses over real dangers. Many individuals who are financially successful, politically independent and libertarian in their leanings are nonetheless concerned about income inequality gaps and rightfully so.

The strange thing about the current juncture is the way socialism, corruption and state-enabled financial oligarchy have become intertwined.

There is a difference between a free market system in which the winners do extremely well in exchange for providing high quality goods and services to society (e.g. Steve Jobs), and a system in which the big winners were bailed out with taxpayer dollars, continue to receive implicit government backing via "too big to fail" realities, and control the flow of dollars via leveraged lobbying efforts in Washington (e.g. Lloyd Blankfein, Jamie Dimon).

James Grant labeled it well as "socialism for the rich, capitalism for the rest." The financial oligarchy at the center of the system, as facilitated by a handful of too-big-to-fail politically connected institutions, threatens the health and functioning of the real free market economy.

Japan is a fair example of what happens when connected players embrace socialistic policies in pursuit of their own interests. Part of the reason Japan has been in malaise for two decades -- and why it will eventually collapse under an impossible debt burden when Japanese savers can no longer finance JGBs -- is because of the corrupt construction companies and "zombie banks" that have consistently drained the lifeblood out of Japan's economy since 1990.

As a happy and successful individual without an envious bone in my body, I am further concerned about inequality in the system because it threatens to tear the system apart. The Federal Reserve is clearly and without doubt operating in accord with its true mandate -- serving the financial oligarchy and, more specifically, the money center banks at the heart of the system. Bernanke et al couldn't give a flying fuck about those at the periphery, which is why they don't care that their paper asset pumping strategies are real-economy-destructive in respect to jacking up food and energy prices.

But what happens when the average man in the street finds this out? It's easy to write off the "losers" as whiners, but when the "losers" get to the point where they are 70% of the total population and mad as hell, bad things happen to the economic system.

The real danger for America, as I see it, is not "going broke" or having its triple-A credit rating revoked as the debt doomers talk about. Instead the real danger is cultural in my opinion. If we keep going down the present path, the very important idea that America is a land of opportunity may be rejected as a myth, or perhaps an ideal that was once true but has now died. When a critical mass of naive optimists suffer death by broken heart, the floodgates are opened for a truly bitter populism to take hold.

In order to save the system, the Federal Reserve is implementing policies, at the behest of the banks, that are eating away at the real economy and causing economic pain for millions of hard-up Americans. In a very real sense, the free market ideal is being corrupted by government connections and lopsided mandates.

It is still possible to "win" and do well in this system as a sufficiently educated and motivated individual. Skilled traders in particular are in a good spot.

But, to the increasing degree that Joe Sixpack looks around and sees himself on a treadmill to hell, in a system where he has neither the government connections nor the trading moxie nor the entrepreneurial firepower to compete, even as his food and gas and grocery bills are going up day after day and the GS and JPM bankers are raking in billions in bonuses provided through taxpayer largesse and monetary policies that are killing him, eventually poor Joe will say "fuck this." And then the temptation will be to either start rioting, in the manner we are already seeing among the austerity-oppressed vanishing middle classes of Europe, or else to start electing fire-breathing political demagogues who will seek to fix the problem with a chainsaw rather than a scalpel.

So, yeah, there is plenty of legit reason to be concerned. And there is a huge difference between inequality of income born of genuine free market competition and inequality of income facilitated and cultivated through corrupt government connections and real economy destructive policies. You can shear a sheep many times but you can only skin him once. If the majority of the American population starts feeling too skinned, even the "winners" will feel the pain.

p.s. Bitching about government intrusion while missing the dangers of income inequality (and the deep connection between the two) reminds me of the Tea Party movement. A nice idea in theory, but unfortunately Tea Party proponents aren't bright enough to understand the complex interwoven nature of the real issues at stake. They are like angry country bumpkins trying to deal with slick big city lawyers. The shit the lawyers are pulling is too smooth and slippery for them to even grasp, let alone analyze and challenge properly.

 

ET remains a hotbed of leftie/liberal sentiment - the ill-bred blue collar notion that being very rich is bad. Yet the purpose of ET is about pure capitalism: making money out of stocks and futures markets.

Those owning 10 to 18% of national wealth provide an indepensible element intrinsic to freedom: alternative sources of power/money outside government. They are the only counterweight to the all controlling money and power of
government.

 

People are poor because they believe they deserve it, it's easy, and it's fun.
People are wealthy for the exact same reasons.

 

well stated darkhorse.

Every -non govt trough feeding - tax payer knows we are being skinned, we just hope it is not to late.

We have got to stop the lobbying money. Obamacare showed that the politicians on the left are bought by the same team who buys the right.

Our Congress is so crooked they could not even pass real health care reform. The insurance lobby got them to pass a ridiculous bill.
A bill which shows they are all crooked and brain dead.

A bill which is unconstitutional and a bill which will get half of them replaced.... yet they passed it. How crooked are they?

And the right is no better.

 

You have a few good points that I would agree with, although bashing the Tea Party at the end takes away some of your credibility. But you're still missing big pieces of the puzzle in regards to income inequality.

For too long, income inequality has been used by the far left to push for more generous welfare programs, but the argument that the poor are remaining poor while the rich are getting richer is fundamentally flawed. The reason is that looking at income changes by grouping the country into income percentiles, ie: the richest 10% and the poorest 10% ignores the fact that people are constantly transitioning from one income group to another.

It doesn't matter if everyone in this country starts out at minimum wage, IF there is the potential for them to become wealthy through hard work and perseverance in a reasonable amount of time. Income inequality metrics do not capture this, but income mobility metrics do. To make this abundantly clear, take a look at the income mobility graph below covering a 10-year span from 1996-2005. Instead of lumping people into income groups and assuming they do not better/worsen themselves over time, income mobility tracks the changes in income of individuals over time. This graph clearly illustrates the facade that liberals have set up to pander to the wealth distribution crowd. The notion that the rich continue to get richer and the poor continue to stay poor is a myth and a lie that is perpetrated by those with socialist intents. The truth is completely opposite as the graph below demonstrates:

http://economistsview.typepad.com/photos/uncategorized/2007/11/13/mobility.gif

From 1995 to 2006, the poorest who were in the lowest quintile (lowest %20 of incomes) had their incomes grow 90.5% over that time span. Those in the 20%-40% quintile had their incomes grow 35%. The richest, however, in the top 20% of incomes, only had their income grow 10% over this time period. The richest 5% actually had their incomes decline -7% over this period, and the big kicker - the richest 1% had their incomes fall a whopping -26%.

Below is another way of showing income mobility. This chart demonstrates it not by raw percent incomes but by the percent of people moving from one income group to another over time. Again, the result is the same and the conclusion is inescapable. Those advocating for wealth redistribution are wrong. These graphs suggest that our hugely progressive tax system is unfairly punishing those in the top income brackets, making wealth accumulation more and more difficult the wealthier the person becomes.

http://www.house.gov/jec/middle/mobility/fig-2.gif

 

You are correct. Well thought-out post. The ones pro free markets should be at least as mad at the world as the socialist commies, considering nothing is free about the markets anymore with "too big to fail".

The state of a country is decided in large part by its ideology, as you correctly say. If the ideology that the US is the land of opportunity, freedom and entrepreneurialism had not taken hold, the US would be nowhere near as far ahead of the rest and would be more like Canada (not that that's necessarily bad, just different).

I'm not a US citizen, but I emphasize greatly with the (intended) spirit of the country and I also am getting the idea that this spirit is in a diminishing state (as opposed to the Asian world, which seems very go-hung about mattering in the world). In the end the numbers are far less relevant than a country's spirit, and for a defeatist mentality to take an even stronger hold of the US population would be worse for stock values in P/E and real terms as well as the real economy than the latest ADP number.