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Friday, May 11, 2007

What is the Cause of Rising Inequality?

We've had a long and ongoing debate here over the existence and source of rising inequality and whether the rise is due to economic or socio-political forces. Brad DeLong has a nice summary of the debate over the cause, including comments from Greg Mankiw, Ezra Klein, Matthew Yglesias, Paul Krugman, and many others:

Driving Forces Behind Rising Income Inequality: Tracking the Internet Debate, by Brad DeLong: To a good neoclassical economist, the statement that the relative price of a factor of production--like the labor of the elite top 1% of America's wage and salary distribution--has risen is the same thing as the statement that the relative productivity of that factor of production has risen. But we need to distinguish between these statements in order to make sense of the ongoing argument between Andrew Samwick on the one hand and Paul Krugman and Mark Thoma on the other.

In a nutshell: Is the statement that there is a higher return to education today merely an assertion that the rich today earn more in relative terms than their counterparts in the past? Or is it also a statement that the rich today are more productive in relative terms than their counterparts in the past?

Andrew Samwick takes the first definition, and concludes that rising inequality is the result of a higher return to education. By his lights, he is clearly correct.

Paul Krugman and Mark Thoma take the second definition and conclude that that rising inequality is not primarily the result of a higher return to education but instead primarily the result of socio-political factors that have raised the relative price of what the rich and well-educated do. And they too have a strong case. Piketty and Saez's latest numbers estimate that top 13,000 American households have multiplied their relative real incomes nearly fivefold since the 1970s. Then they received some 0.6% of national income. Now they receive nearly 2.8% of national income--an average of $25 million each, compared to roughly $5 million each had the relative income distribution remained at its 1970s levels. What are the CEOs, CFOs, COOs, elite Hollywood entertainers, investment bankers, and the very highest levels of professionals doing differently now in their work lives that makes them, in relative terms, worth five times as much as their predecessors of a generation and a half ago? ...

Which leads Andrew Samwick to respond:

...Krugman begins by criticizing Treasury Secretary Paulson for "falsely implying that rising inequality is mainly a story about rising wages for the highly educated."... In order for Krugman to validate that criticism, he has to show us that "rising inequality is mainly a story about... something else." His choice for that something else is a thesis that "it matters a lot which political party, or more accurately, which political ideology rules Washington." So he's got to show us how the political ideology ruling Washington over the last 25 years has generated the following outcomes.... Here is what he says about that 25-year period:

Finally, since 1980 the U.S. political scene has been dominated by a conservative movement firmly committed to the view that what's good for the rich is good for America. Sure enough, the rich have seen their incomes soar, while working Americans have seen few if any gains.... [I]t seems likely that government policies have played a big role in America's growing economic polarization -- not just easily measured policies like tax rates for the rich and the level of the minimum wage, but things like the shift in Labor Department policy from protection of worker rights to tacit support for union-busting....

He mentions the level of the minimum wage and the tacit support for union-busting. Let's just grant him that those are relevant for the 1 percent decline in real wages in manufacturing. But what is the mechanism for ideology driving outcomes in the top 1 percent?... [H]e cites no evidence to link the policies of the ruling political ideology to the income gains for the top 1 percent....

In the race between these two arguments, Paulson is way out in front of Krugman.... Krugman is a perfect example of someone whose real income is high because the returns to being educated are higher, not because the dominant political ideology has conspired to increase his earnings capacity in some pernicious way.... [T]o support Krugman's thesis rather than Paulson's, Mark would have to tell us how the dominant political ideology, rather than simply a higher return to education, has changed that system...

...Mark Thoma writes further:

Economist's View: The Debate over Inequality: Factors like top marginal income tax rates and social norms are connected to the political environment.... A lot of the change is driven by.... [f]actors such as the New Deal's very large tax increases on the wealthy, both directly on income and indirectly on corporate profits are an important factor connected to the political environment at the time. It's an open question how much of the change in inequality that might explain by itself.

Unions are also worth taking seriously, with union membership nearly tripling to about a third of the workforce from the mid 1930s to the mid 1940s. This would affect all wages, not just those in sectors where unions are prevalent. The decline of unionization after the 70s is also a factor to consider, and there's a strong case to be made that this was made possible by a political environment that allowed union busting to occur. In any case, I don't think this is a settled question and I hope to follow up with more later...

There's quite a bit more discussion in Brad's post, but let's turn to the new evidence noted by Dani Rodrik:

Inequality and institutions in the U.S., by Dani Rodrik:  A new paper by Frank Levy and Peter Temin makes the important point that rising inequality in the U.S. is not just the result of the free play of market forces, but also of a changing institutional landscape which has altered the bargaining environment between workers and employers. Here is what they say:

Many economists attribute the average worker’s declining bargaining power to skill-biased technical change: technology, augmented by globalization, which heavily favors better educated workers. In this explanation, the broad distribution of productivity gains during the Golden Age is often assumed to be a free market outcome that can be restored by creating a more educated workforce.

We argue instead that the Golden Age relied on market outcomes strongly moderated by institutional factors. Following the literature on economic growth that emphasizes the role of institutions in economic outcomes, we argue that institutions and norms affect the distribution of economic rewards as well as their aggregate size. Our argument leads to an explanation of earnings levels and inequality in which skill-biased technical change, globalization and related factors function within an institutional framework. In our interpretation, the recent impacts of technology and trade have been amplified by the collapse of these institutions, a collapse which arose because economic forces led to a shift in the political environment over the 1970s and 1980s. If our interpretation is correct, no rebalancing of the labor force can restore a more equal distribution of productivity gains without government intervention and changes in private sector behavior.

Among other useful stuff in the paper is a "Bargaining Power Index" for labor between 1950 and 2005. This is defined as the ratio of median compensation (including fringe) to non-farm business sector labor productivity. The index shows steady decline through this period, especially since the mid-1980s.

Dani's post shows a few of the graphs in the paper.

    Posted by on Friday, May 11, 2007 at 09:54 AM in Academic Papers, Economics, Income Distribution | Permalink  TrackBack (0)  Comments (71)

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