Income and Wealth Inequality
and Financial Crises
Shreyes Jayaram
Siddharth Dholaria
Soham Wankhade
Other Siddharth
Abstract
This project offers an overview of what we have learned from a collective study on the effects of Inequality on modern society. Using data from a variety of sources, we intend to present an economic link between Inequality and financial crises. We were instructed by our Macroeconomics Professor Abhinav Pal to write a report on an economic crisis that unfolded in the past, present or future. In this project we seek to demonstrate how rising inequality is likely to lead to a major economic collapse. We shall begin with a historical analysis of how America became an unequal society followed by a more general theory of Inequality and Financial Crises. Finally, we conclude with what steps can be taken to mitigate such crises.
Introduction
In this project we seek to demonstrate a link between the concentration of income in the hands of the few and financial crises. In both the major crises felt by the United States in the last century – the Great Depression in 1929 and the Great Recession in 2007 – the years prior to the collapse were marked with high income inequality between richer and poorer households, and high increases in the Debt- to- GDP ratio, with debt concentrated in the hands of the poorer and middle classes.
We were inspired to focus our project on income and wealth inequality after watching a documentary in our Macroeconomics course on UBI (Universal Basic Income). The documentary, called “Money for Free” sought to demonstrate the need for Universal Basic Income due to high levels of poverty, even in developed countries. The documentary included scenes showing the effects of UBI, documenting how it could transform the lives of poor families in Netherlands and Germany. When we rank countries by GDP (at Purchasing Power Parity) Per Capita, we can see that Netherlands has the 15th highest income and Germany 18th (“Report for Selected Countries and Subjects”, World Economic Outlook Database, 2016). Despite this, we saw so many people living in squalor and poverty in those two countries. We were also inspired by another documentary “The Meltdown” which attempted to analyse the causes behind the Great Recession.
Another major inspiration came from Joseph Stiglitz’s book “The Price of Inequality”, which provided a wealth of information and insights regarding the causes for inequality and its effects on society. We were also inspired by a conference held in NIMHANS Bangalore on July, 2016 on Global Inequality. The conference included two presentations, one by Stiglitz and the other by Branko Milanovic, on the consequences of inequality on our societies.
This project seeks to demonstrate the “Price of Inequality” and how it is destroying the social fabric that has held nations together since the Second World War. The interested reader will find out the link between Austerity policies and rising inequality, the link between concentration of wealth and concentration of political power, and the effects of cutting social benefits to low income populations. In the following sections we shall begin with a general analysis, followed by a case by case analysis with a focus on Europe.
How America became an equal and then unequal society
After the disastrous Great Depression and the Capital shocks of the Second World War, the world appeared to be moving into a more egalitarian direction, with high redistributive taxes, social security and safety nets. With the advent of the Neoliberal ideology in the 1980s however, reductions in redistributive taxation, cuts in social security and the dismantling of safety nets has led to a situation wherein income inequality worldwide is once again rising.
The Great Compression
“The money changers have fled from their high seats in the temple of our civilisation. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.
Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy and moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits.” – Franklin D. Roosevelt, Inaugural Address, 1932
The Great Depression led to the election of Franklin D. Roosevelt whose campaign promised a New Deal for the American people – a series of socially liberal programs enacted to fend off the effects of the Great Depression. The New Deal included several policies such as the Glass-Steagal Act, the Wagner Act, the Works Progress Administration, the Social Security Act, and the Wages and Hours Act. To understand the reasons behind the fall of inequality that was the characteristic trait of the 1950s till 70s, it is imperative that we understand the far reaching power of these 1930 bills.
The Glass-Steagal Act was a banking regulation passed in 1933 which separated Commercial Banks (which lend money) and Investment Banks (which sell securities). Commercial Banks which directly hold the savings of the public are expected to be conservative in their management of people’s money. They are expected to only invest in “safe” investments, with very low chances of non-recovery of the loans or investment expenditure. Investment Banks on the other hand traditionally handled the money of the rich and were expected to take large risks to bring about larger returns. By passing Glass-Steagal, the FDR administration prevented speculation with the savings of the public. By separating commercial banks from investment banks, the FDR administration was able to ensure that the deposits people made with commercial banks would not be utilised in risky investments, irrespective of their potential payoffs, leaving that for the Investment banks that specialised in such decisions. The government would thus bailout those commercial banks that happened to fail to protect the interest of the public depositors.
The Wagner Act, 1935 was a key victory in the struggle for workers rights. The Wagner Act attempted to correct the inequality of power between employees and employers. The act guaranteed the rights of workers to join and form Unions, engage in collective bargaining for better terms and conditions at work, and legalised collective action such as strikes, picketing, and mass demonstrations. This act formed a key basis in reducing inequality, by enabling workers to collectively bargain for better wages and form unions to improve their standards of living.
The Works Progress Administration, started in 1935, was the largest and most ambitious of all the New Deal programs. The Great Depression led to unemployment rising to almost 25%. As part of his campaign promises and the Democratic platform, Franklin D. Roosevelt promised that his first task would be to put people to work. Inasmuch, the WPA employed millions of unskilled labourers to carry out public work projects. As part of the functioning of the WPA, almost every community had a new park, bridge, or school constructed, by an agency with a budget nearing 7% of the GDP of America, and by 1942, full employment was successfully reached.
The Social Security Act was passed in 1935 as an insurance scheme for those who were primarily old and infirm. It utilised a payroll tax paid into by all citizens to provide benefits to people over the age of 65 to keep them out of poverty. The Social Security Act is one of the few New Deal programs to survive the Reagan revolution and remain in existence to this day.
From the data on the previous page, taken from Piety and Saez (2003), we can see the fall in the share of total income of the top 10% of the population with the introduction of the majority of the New Deal policies in 1935.
From the image given above we can see the effects of the Capital shocks of the Second World War which led to widespread reduction of capital stock.
In the above diagram we can see the effects of the Great Depression and the Second World War on the income share of the Top 0.01% of the population. The Great Depression and the following Second World War caused massive capital shocks from which the topmost sections of society were unable to recover from for over 50 years post the war.
These Capital shocks coupled with the effects of redistributive policies issued in a period of prosperity known as the Golden Age of Capitalism. The Golden Age of Capitalism was an economic boom that took place post the Second World War almost all over the world. During this time there was high economic growth, near full employment in the Western world, and sustained growth in countries devastated by the Second World War. Globally, this was also a period of financial stability, with the Golden Age of Capitalism contrasting with the current Washington consensus, with the Golden Age only having 39 international financial crises in its entirety (1945 – 1973) whereas the Washington Consensus era having over 139 crises within just 24 years (1973 – 97), and the greatest economic crisis since the Great Depression.
The reader will no doubt question, why was it that so soon after the most devastating war in human history, such a great productive boom has taken place? The answer lies in the continuation of the redistributive policies favoured by Franklin D. Roosevelt across both major political parties in the United States and the adoption of Keynesian policies all over the world.
Firstly, in the United States Union membership rose up to the highest level ever in United States history, encouraged strongly by Republican President Eisenhower in his term from 1952 – 60.
Union membership, which was granted as a right to all workers by the Wagner Act, 1935 promoted collective bargaining rights among workers, which greatly promoted a more equitable distribution of income.
Governments all over the world focused on eradicating unemployment, to achieve full employment equilibrium, and the horrors of the World War succeeded in bringing people together socially. The defeat of the Axis forces destroyed the credibility of the Right wing in Europe and as a result Social Democrats were elected all over Europe, primarily in Scandinavia and the United Kingdom. Whether it was the Clement Attlee government in the United Kingdom, or the Truman administration in the United States, the governments came up with policies to promote social solidarity, with the Roosevelt administration passing the GI Bill, 1944 which entitled returning veterans to educational institutions, low interest mortgages, and low interest rate loans to start businesses. The GI Bill was a major success enabling millions of Americans to gain access to education.
Source: US Federal Individual Income Tax Rate History, 1862 – 2013 accessed on 11/8/2016 from http://taxfoundation.org/article/us-federal-individual-income-tax-rates-history-1913-2013-nominal-and-inflation-adjusted-brackets
The Roosevelt, Truman and Eisenhower administrations kept extremely high marginal tax rates (above 90%) on the richest members of the US population and utilised these to continue funding massive projects, culminating in the US interstate Highway system built in the Eisenhower administration. These massive public works acted as stimuli to the economy, and succeeded in providing gainful employment to millions of workers who laboured on the projects.
In short, the policies from the 1930s laid the foundation for a more equitable and just society. By raising Union membership, through collective bargaining wages improved alongside productivity, and even those workers who did not belong to a union were protected by minimum wage laws. Through government stimulus markets kept booming, and the high marginal tax rates ensured that the income earned through production were distributed evenly.
The New Deal policies of the 1930s were complemented by President Johnson’s Great Society legislation. The Great Society policies were a set of policies attempting to end poverty and racism in the United States of America. Central to the Great Society was the War on Poverty. Under the War on Poverty, Johnson established the Jobs Corps and the Community Action Programs, which provided free vocationally training to young workers to enable them to find gainful employment. Since its establishment in 1964, approximately 75% of Job Corps graduates have been able to find gainful employment, or service in the military, which greatly contributed in cutting poverty in America.
The War on Poverty also included the Food Stamps program, which provided aid to low income households to purchase sufficient foodstuffs to meet healthy diet. The Food stamps programs expanded access to nutritional food to the American public and facilitated the purchase of food by poor income households, thereby helping in the reduction of poverty.
The Great Society programs also expanded education funding and began programs known as Medicaid and Medicare designed to provide low income and senior citizens with healthcare respectively.
Within seven years of the introduction of the Great Society programs, poverty fell from 22% to 13% and among African – Americans 55% to 27%, the greatest reduction in poverty in American history.
The New Deal and Great Society programs contributed greatly in creating a more equal and just society. Hence, the period between 1945 till 1973 is called the Great Compression due to the reduction in equality between those on the top and those on the bottom.
The Great Divergence
The Great Compression ended in 1970s when wages began stagnating and inflation drastically pushing prices up. The reasons behind the raging inflation were the 1973 and 1979 oil shocks wherein OPEC (Organisation of Petroleum Exporting Countries) chose to drastically hike their prices by over 70% as action against western countries for their support of Israel in the Yom Kippur War of 1973. This decision drastically inflated prices in the United States forcing the Nixon administration to set price and wage controls which led to large shortages manifesting themselves in long lines to wait for gas and petroleum for ordinary Americans.
The supply shocks drastically reduced the productive capacity of the American economy. Producers were forced to reduce production due to the higher costs involved, but at the same time prices started rising due to producers attempting to pass on the costs to consumers. This also led to a price/wage spiral between producers and labourers. The rises in prices caused by business owners attempting to stay viable forced workers to push for wage increases to keep abreast with inflation, thereby raising the costs involved for production for the firm, thereby forcing the firm to raise prices again.
The Carter administration recognised the drastic problem that stagflation (stagnation as well as inflation) was exacerbating all over the country, and hence appointed Paul Volcker as Chairman of the Federal Reserve. Volcker declared that it was necessary to first solve the problem of inflation and focus on economic growth later, and hence went about a policy of drastically raising interest rates to cut inflation. Volcker, an inflation hawk, raised interest rates to nearly 20% in 1980, successfully cutting inflation which had reached its highest point of 15% in 1980 to less than 3% by 1983.
The high unemployment combined with drastically rising prices (inflation nearing 11% in the early portion of the Carter administration and rising to 15% by 1980) led to a situation of stagflation, which provided a breeding ground for the anti – government right wing to make their case.
The case they made was that the Stagflation of the 1970s was caused by government interference. They argued that government policies were inherently ineffective and that true growth occurred through the markets. Born out of the musings of Hayek and Mises, the Neoliberals attempted to bring about a resurgence in laissez faire economic policies. Neoliberalism promoted policies like privatisation, deregulation, and reduction of government expenditure to promote private sector involvement in the economy.
In America, following the long gas lines and inflation of the Nixon-Ford-Carter era, Reagan who defeated Carter to become President in 1980, ended the price and wage control systems stating them to be byproducts of an older era where “big government” attempted to dictate things to society. Decrying big government, Reagan famously stated “government doesn’t solve problems, government is the problem,” effectively summarising the neoliberal ideology.
Reagan, and likeminded neoliberals abroad such as Margaret Thatcher called for the deregulation of markets stating that such regulations were stifling and that their governments would harness the power of the free market. The belief in the powers of deregulating markets became espoused by both the major political parties in the United States, culminating with the Clinton administrations decision to repeal Glass- Steagal in 1998.
The 1980s saw a drastic increase in income inequality. In the1980s the top 1% took in 15% of all income earned by the people of the USA. Just 10 years previously that had been just 9%, however the dismantling of unions and tax cuts for the super rich greatly intensified American inequality. Despite great strides in productivity, wages refused to rise alongside them. It is interesting to note that the differences between productivity and wages only started to appear once union membership started declining.
As wages fell, inequality began to rise. America was growing, but not everyone was feeling the effects of the growth. From 1980 till 2011 those in the bottom 90% of society have seen their incomes increase by only 15%, while those in the top 1% 150% and those in the top 0.1% 300 times. As inequality raged, households were forced to turn to debt to maintain their levels of income.
The total Debt – to – GDP ratio measures the amount of debt collected per capita in the United States. Debt is a useful tool to facilitate growth in the short run, but it reduces the long term ability to accumulate capital since it reduces the purchasing power over a longer period of time than it provides aid. However, it is necessary to note that government debt is not necessarily the same thing as Private debt. The government is almost always in a position to pay back the debt that it possesses, since it controls the currency and hence can use quantitative easing if necessary. However, private indebtedness is a major problem, whether it is the mortgage loans of the early 2000s or the current $1.2 trillion dollars of student debt present in America.
This section ends with a description of the state of inequality present just before the 2007 financial crisis. By 2007 the top 0.1% of American households had an income 220 times the mean of that of the bottom 90%. Wealth was even more unequally distributed than income – the top 1% of American households owned 33% of all wealth. In the early years of the Bush Presidency saw the top 1% seize more than 65% of the gain in National Income. Meanwhile, the income of the median worker has stagnated for over 30 years. George Bush’s tax cuts had successfully transferred wealth from the bottom and middle classes to the rich, and income inequality had reached levels not seen since the 1920s. The Great Divergence had taken place, with society becoming increasingly divided between the rich and the poor, with only one class receiving the fruits of development.
Source: Economic Policy Institute analysis of Kopczuk, Saez and Song (2010) and Social Security Administration wage statistics, November 2015
An in depth focus on the 2007- 09 crisis would be out of place in this project, and it is necessary to conclude this section at this point, however, it is imperative that the reader acknowledge that the years before the Great Recession saw a highly unequal society, with a mounting pressures of debt – the same picture before the Great Depression.
The General Theory of Inequality and Financial Crises
From the above historical perspective it is clear that both the major economic crises that affected America had similar factors involved. Both followed decades of extremely large income and wealth inequality, and a massively increasing debt-to-GDP ratio. And when those Debt-to-GDP ratios became unsustainable they became triggering points for the crises.
The key mechanism which facilitates the occurrence of Financial crises is the differing Marginal Propensity to Consume among different income groups. As people’s income’s rise their Marginal Propensity to Consume falls as the cost of their human needs becomes a smaller fraction of their income. Inasmuch, their tendency to save rises.
As the rich save more, their savings
and with the rise in inequality came the political pressure for redistribution. A recession in 1991 convinced the new Chairman of the Federal Reserve that his predecessor, Volcker’s policies of high interest rates were leading to unemployment and limited economic expansion. The federal Reserve responded to the situation of low demand by stimulating it through low interest rates and easy access to credit.
The low interest rates and easy access to credit facilitated massive investments in the technology sector causing the dot com bubble of the 1990s. Consumer confidence in the internet fuelled rapidly increasing stock prices, however the prices eventually fell when the bubble burst in 2001 causing a recession.
When the bubble burst, the demand for credit in the economy decreased dramatically. In fact, aggregate demand in general in the market was extremely low. To analyse why, it is imperative that we acknowledge the difference in consumption patterns between the rich and the poor. According to Keynes’s Psychological Law of Consumption, when income increases, Consumption increases less than proportionately. Inasmuch, the more rich a person is the greater the amount he saves. The rising inequality from the 1980s acted as a transfer of income from the poor and the middle class to the rich. As unions were busted, and minimum wage increases suppressed, this coupled with massive tax cuts for the super rich we can see in one of the above figures, resulting in far lesser consumption than there would be had distribution of income been more equitable.
The burden of maintaining low inflation, high growth and full employment lies on the Federal Reserve, and something needed to be done to rekindle the fires of the American economy, but the political calculus in Washington made that impossible. Since the Presidency of Reagan the Republican party had openly been the party of the rich, calling for trickle down economics, stating that when the rich became richer they would invest in more jobs, and thereby create employment for the rest of society. The Democrats too did not take part in the “politics of envy” choosing to demarcate their position with Kennedy’s famous words “A rising tide lifts al boats”. Redistributive taxation, employment programs, or any such schemes had no hope of passing through US Congress, and hence the Federal Reserve chose to greatly expand access to credit.
The massive expansion in credit, especially to low income individuals who were scarcely capable of repaying the loans made to them, led to a massive bubble which burst in 2007 destroying the world financial markets.
An in depth focus on the 2007- 09 crisis would be out of place in this project, and it is necessary to conclude this section at this point, however, it is imperative that the reader acknowledge the main points this section was attempting to expound upon to the reader.
Redistributive policies successfully increased Aggregate Demand at a time when it was extremely low without causing inflation and helped pull millions out of poverty.
High marginal tax rates, high union membership rates and public expenditure led to the Golden Age of Capitalism which successfully reduced poverty and inequality.
Poverty and Inequality returned in the 1970s and 1980s after the election of Reagan who dismantled many of the policies of the New Deal, calling for privatisation, tax cuts, and deregulation. Since the introduction of these policies, inequality rose drastically in America.
Inequality leads to lower Aggregate Demand in the economy, thereby forcing governments to utilise low interest rates and cheap credit to stimulate the economy, since actual stimuli were politically infeasible.
Although easy access to credit can boost investment, it can also create bubbles or trade in an asset at a price far greater than its intrinsic value. When these bubbles burst they often lead to recession and unemployment.