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Saturday, August 04, 2007

Robert Frank: How Rising Inequality Harms the Middle Class

Daniel Gross reviews Robert Frank's book Falling Behind: How Rising Inequality Harms the Middle Class:

Thy Neighbor’s Stash, by Daniel Gross, Book Review, NY Times: ...In his new book “Falling Behind: How Rising Inequality Harms the Middle Class,” Professor [Robert H. ] Frank deftly updates the argument for our current gilded age. The rise of an overclass, he convincingly argues, is indirectly affecting the quality of life of the rest of the population — and not in a good way.

Knowing that Steve Schwarzman of the Blackstone Group made almost $400 million last year, or that he spent $3 million last February on his 60th-birthday party..., doesn’t simply make the typical American green with envy, and hence unhappy. Rather, Frank argues, the problem is that extreme consumption ... helps shape norms for the whole society, not just his fellow plutocrats. “The mere presence of ... larger mansions, for example, may shift some people’s perceptions about how big a house one can build without seeming overly ostentatious,” Frank writes.

That shifting perception combines with the powerful driving force of “relative deprivation.” ... Frank urges fellow economists to look at numbers and data in relative terms, not absolute ones. A Web surfer with a 56K modem today knows, intuitively, that he is better off than he was 20 years ago, when he had to rely on a 1,200-baud modem. But when everybody else has broadband, that 56K makes you feel like a cyberloser. The desire to avoid such relative deprivation drives consumption in a range of goods, especially those that Frank calls “positional goods” — things like housing and cars, in which differences in quality and size are readily visible. ...

What does this society-wide arms race for goods have to do with income inequality? Frank trots out sobering data. ...[S]ince 1979, gains have flowed disproportionately to top earners. In an economy where the wealthy set the norms for consumption..., that spells trouble. In today’s arms race, the top 1 percent are armed to the teeth and everybody else is scavenging for ammunition. ... The end result? Frank methodically presents data showing that the typical American now works more, saves less, commutes longer and borrows more to maintain what he or she views as an appropriate standard of living.

Oh, and it’s getting worse. Frank notes that “many of the forces that have been causing inequality to grow seem to be gathering steam.”  ... Frank’s elegant solution? A progressive consumption tax that would discourage those at the top from spending more, thus lowering the bar. ...

Here's part of the first and second chapters (the points are explained more thoroughly in the article):

‘Falling Behind: How Rising Inequality Harms the Middle Class’, by Robert H. Frank, First Chapter, NY Times: ...I want to begin by asking you to conduct not one but two thought experiments. ... Try as best you can to imagine that you are actually confronting the hypothetical choices...

In each case, you must choose between two worlds that are identical in every respect except one. The first choice is between World A, in which you will live in a 4,000-square-foot house and others will live in 6,000-square-foot houses; and World B, in which you will live in a 3,000-square-foot house and others in 2,000-square-foot houses. Once you choose, your position on the local housing scale will persist.

According to the standard neoclassical economic model..., which holds that utility depends on the absolute amount of consumption, the uniquely correct choice is World A..., since everyone has a larger house there than the largest house in World B. The important thing, though, is to focus on how you would feel in the two worlds.

In fact, most people say they would pick B, where their absolute house size is smaller but their relative house size is larger. Even those who say they would pick A seem to recognize why someone might be more satisfied with a 3,000-square-foot house in B... If that is true for you as well, then you accept the main premise required for the arguments I will present.

In the second thought experiment, your choice is between World C, in which you would have four weeks a year of vacation time and others would have six weeks; and World D, in which you would have two weeks of vacation and others one week. This time most people pick C, choosing greater absolute vacation time at the expense of lower relative vacation time.

I use the term positional good to denote goods for which the link between context and evaluation is strongest and the term nonpositional good to denote those for which this link is weakest. In terms of the two thought experiments, housing is thus a positional good, vacation time a nonpositional good. ...

The argument I will advance in this book can be reduced to four simple propositions.

1. People care about relative consumption more in some domains than in others. ...

2. Concerns about relative consumption lead to "positional arms races," or expenditure arms races focused on positional goods. ...

3. Positional arms races divert resources from nonpositional goods, causing large welfare losses. ...

Because proposition 3 contradicts standard assertions about efficient resource allocation in competitive markets, the impulse of many economists will be to reject it. ...

4. For middle-class families, the losses from positional arms races have been made worse by rising inequality. ...

Chapter Two Recent Changes in Income and Wealth Inequality

...During the past several decades, the distributions of income and wealth in the United States have changed in such a way that the economic environment for most upper-middle-class people has become much more like that of World A than of World B in our earlier thought experiment. ...

The conventional wisdom has long been that a growing gap between the rich and the middle class is a bad thing. But that view is now under challenge. Some revisionists, respected economists among them, argue that inequality doesn't really matter so long as no one ends up with less in absolute terms. Using income levels to measure the well-being of individual families, these inequality optimists argue that since the rich now have much more money than before and the middle class doesn't have less, society as a whole must be better off.

Yet "having more income" and "being better off" do not have exactly the same meaning. I will argue that changes in spending patterns prompted by recent changes in the distributions of income and wealth have imposed not only important psychological costs on middle-income families but also a variety of more tangible economic costs. . . .

    Posted by on Saturday, August 4, 2007 at 03:06 AM in Economics, Income Distribution | Permalink  TrackBack (0)  Comments (55)

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