“An imbalance between rich and poor is the oldest and most fatal ailment of all republics.”
–Plutarch, Greek historian, first century AD
“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”
–Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen,” 1850
“Still one thing more, fellow-citizens – a wise and frugal Government, which shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government, and this is necessary to close the circle of our felicities.”
–President Thomas Jefferson, first inaugural address
Plutarch argued over 1900 years ago that it was income inequality that lay at the heart of the failure of the Greek republics. Other writings of that period demonstrate that the leaders were worried about the distribution of wealth in society. The causes of unequal distribution have certainly changed over time, but it seems to be built into our DNA to obsess over what we have relative to what others have.
That we are living in the most splendid golden age in the history of humanity – if by golden age we mean that for the world at large there is less hunger, longer lives, less poverty, better healthcare, better and more universal education, and a host of other factors that are manifestly superior as compared to 2000, 1000, 200, 100, 50, and even 20 years ago – is patently evident. We are far from the world Thomas Hobbes described in 1651 in Leviathan when he said “[T]he life of man [is] solitary, poor, nasty, brutish, and short.” He would be amazed at the relative abundance achieved by mankind in the last 263 years.
And still, authority after authority the world over, in rich country and poor, from the President of the United States to the leaders of some of the most impoverished nations, describes income inequality as a fundamental injustice and the source of many problems .
We have spent three letters (so far) dealing with the topic of income inequality. The topic is everywhere in our daily conversation and in economic research. I’ve dealt with many of the facts of income inequality in these three issues and will try to conclude the topic this week. We’ve discovered so far that income inequality is a fact; however, income mobility has remained roughly the same over the last 40 years. That is, a person’s chances of rising from a lower stratum of wealth distribution to a higher stratum is approximately the same as it was in 1975.
We have liberals and progressives who use data to demonstrate the correlation between income inequality and recessions or slow growth and then erroneously equate correlation with causation. I think we have sufficiently shown the absurdity of their conclusions. This week we will look at some of the actual causes of income inequality, and in an argumentum ad absurdumI will offer “solutions” that I guarantee can absolutely reduce income inequality just as easily as taking money from the rich and giving it to the poor. In fact my solutions are far more direct, as they affect the causes rather than the effects of income inequality. I must warn you, however, that if you harbor a religious passion for pursuing higher taxes rates on the rich and rely on income inequality as your excuse, you may not be happy with my suggestions or with the rather inconvenient facts I present.
I would like to begin this week’s letter with a quote that might at first appear to have nothing to do with income inequality, but it strikes me that it is at the heart of the argument advanced by those who favor more progressive taxation. Charles Gave argues that there is a correlation (and he sees causation) between the financial repression perpetrated by central banks and the reduction of growth in the developed-world economies. And he links the low-interest-rate policies of central banks to an increasedGini coefficient and income inequality. Those of us who are of a more classical economic persuasion will find this correlation more attractive than we do the supposed one between income inequality and recessions. And we will see that the logic behind Charles’s argument is more compelling.
The simple fact is that there are many correlations to be found in the economic world, and politicians find economists useful in supplying justifications to support almost any policy. The fact that economists might not agree on the data that is used in this way is immaterial to politicians who are simply looking for an excuse to do what they want to do anyway. In this regard, economists perform the same function as shamans and witch doctors in tribal societies, who regard the entrails of sheep or some other unfortunate animal and predict the future, which generally corresponds to what the chief wants to hear. Economists are far more advanced than that, of course. We painstakingly gather data and develop complex computer models to show what our politicians want to hear.
I realize that I argue at the extreme and that most economists are actually well-intentioned and trying hard to figure out how the world works. But they cleave to economic theories in much the same way that people hold religious beliefs to try to explain how the world functions. These theories often predetermine the conclusions economists come to when they analyze data. Maybe someday we will have more precise models and better theories, but until then it is probably best to be somewhat humble in setting forth our conclusions.
Now, let’s devote a few moments of our attention to six paragraphs from Charles Gave’s latest note (gavekal.com – subscribers only) (emphasis mine):
I read everywhere that the US budget deficit is contracting because government consumption is falling as a percentage of GDP, now that the worst of the crisis has passed. This would be very good news indeed; however, I am not so sure that this decline is for real. In fact, I believe it is an accounting illusion.
Over a period of time long [interest] rates, if left to their own devices, always converge to the nominal GDP growth rate (this was called the “golden rule” by Economics Nobel laureate Maurice Allais, and [this] is the core belief in Knut Wicksell’s theory). However, a central bank can fight against this natural tendency by maintaining short rates at abnormally low levels, as the Federal Reserve did from the early 1970s until 1980 and again since 2002. During these two periods long rates were conspicuously lower than growth rates, violating the golden rule.
If negative, the difference between long bond rates and the economic growth rate is effectively a subsidy paid by the saver to the government. In short, this difference measures the amount of financial repression taking place in an economy. The fact that it is not paid to the Treasury does not mean it doesn’t exist. It is a tax paid by a nation’s savers – e.g., pensioners in Peoria….
This shows us that US savers have been paying a virtual tax equivalent to between 1% and 2% of GDP almost every year since 2002 – a sign of the “euthanasia of the rentier” central to every Keynesian analysis. The problem is that subsidizing government spending ultimately leads to lower productivity, slower structural growth and higher financial-crisis risk.We saw a similar euthanasia from 1966 to 1980, when the real structural growth rate of the economy was also in collapse…. The re-imposition of that dreadful tax by Alan Greenspan in 2002, only to be further aggravated by his successor Ben Bernanke, is a key factor behind the falling structural growth rate, the financial crisis and the subsequent slow recovery.
Unnaturally low funding costs undermine the structural growth rate of the US economy, because of capital misallocation. The losers in this deal are usually ordinary folk. Pensioners get no interest on their savings, while rich investors use cheap capital to chase up the cost of property, oil, etc. The Gini coefficient rises, as the poor are seldom asset-rich, and real disposable incomes take a hit as prices rise. Sometimes banks are pressured to make up the shortfall with consumer loans to the struggling classes – adding to the bonfire when the inevitable financial crisis comes.
At the end of the day, it is simple. Savings equal investments, so any tax on savings leads to lower economic growth over time. We may be seeing declining ratios in government spending as a percentage of GDP, but this is really an accounting decline. Financial repression means the government is still taxing the savers, leaving less aside for meaningful investment in the future.
Charles’s fellow Frenchman, Bastiat, argued (as I quoted in the opening of the letter) that in economics there is both what we see and what we don’t see. Charles argues that what we see is declining government spending as a percentage of GDP, but what we don’t see is the “contribution” of financial repression and a tax on savers in making up the difference.
With regard to income inequality, what we see is the growing gap between the 1% and the rest of the world. What we don’t see (because it is not often talked about in the New York Times or economics journals) are the natural and real reasons for that inequality. Most of the reasons for income inequality are in fact things we do not want to discourage. While we could devote multiple chapters of a book to each reason (and there is a massive amount of research on each), today we’ll stay focused on the big picture.
Getting Old Has Its Rewards
The most significant factor in income inequality, which some research suggests is close to 75% of the problem, is that human beings get older. And the older you get, the more money you make and the more net assets you typically have. Let’s look at a few charts to give us a visual picture.
At every point across the net worth curve, the older you are the more likely you are to be wealthier, up until the time you cross into serious retirement and begin to consume your savings.
Furthermore, your income tends to rise the older you get (again, up until retirement age). The data shows that the peak earning period stretches between ages 45 to 65. This is not a shocking revelation, but it doesn’t get mentioned often enough in the debate about income inequality.
I think you can make the case that rising income inequality is significantly attributable to Baby Boomers reaching their peak income years. There are other factors, of course, but the demographics are what they are. Boomers are reaping the rewards from investing time and money in themselves and their businesses over 40+ year careers. They are able to develop and capitalize on three factors. (I’m pulling these off the top of my head; there may be more.)
1. Savings compounded over 40+ years in the workforce
2. Skills developed over 40+ years in the workforce
3. Networks developed over 40+ years in the workforce
It therefore seems logical that income inequality should be rising as the pig in the US population python reaches age 45-65.
The question that goes begging is … what happens next? What happens if medical technology allows Boomers to extend their lifetimes, and perhaps dramatically?
If you really want to start pondering very-long-term issues, what happens when medical technology allows the next generation of elders to live not a mere 10 years longer but to the age of 120 or 150? Will the age at which people are subjected to the Soylent Green solution be 130 instead of 30? Sadly, that will be a problem my kids get to deal with. But I digress.
Academic scholars are beginning to argue that conclusions about income inequality should be adjusted for age-related reasons. You can see one such paper, from Norway, with links to many others, athttp://www.arts.cornell.edu/poverty/kanbur/InequalityPapers/Almas.pdf. The authors demonstrate that age factors are significant across a range of countries and that when you adjust for age, income inequality (with the obvious exception of the extreme 1/10 of 1%) narrows dramatically.
(Hopefully we will see a detailed research paper on aging and income inequality written by retired North Carolina State professor John Seater in an upcoming Outside the Box.)
The Usual Suspects
While it may be inconvenient for those who want to blame income inequality on factors deemed politically correct, it should not come as a shock that much of the inequality can be attributed to characteristics that most people hold as positive values.
A report from the American Enterprise Institute gives us a good summary. Notice in the chart below that while the income of the highest fifth of the US population is almost 18 times that of the lowest fifth, there is only a 3.5x differential when it comes to the average earnings of the people actually working and making money in the household. It is just that high-income households have more than four times as many wage earners (on average) as poor households.
And married and thus two-earner households make more than single-person households. That seems obvious, of course, but it is a significant factor in income inequality. That doesn’t make the plight of the single working mom any better or easier, but it does help explain the statistical difference. And it does make a difference in lifestyle. Marriage drops the probability of childhood poverty by 82%.
And as we noted in previous letters on income inequality, education is an important factor, too. The relationship between families with higher incomes and the educational attainment of their children is also quite statistically significant.
The AEI report ends on this positive note:
Bottom Line: Household demographics, including the average number of earners per household and the marital status, age, and education of householders are all very highly correlated with household income. Specifically, high-income households have a greater average number of income-earners than households in lower-income quintiles, and individuals in high income households are far more likely than individuals in low-income households to be well-educated, married, working full-time, and in their prime earning years. In contrast, individuals in lower-income households are far more likely than their counterparts in higher-income households to be less-educated, working part-time, either very young (under 35 years) or very old (over 65 years), and living in single-parent households.
The good news is that the key demographic factors that explain differences in household income are not fixed over our lifetimes and are largely under our control (e.g. staying in school, getting and staying married, etc.), which means that individuals and households are not destined to remain in a single income quintile forever. Fortunately, studies that track people over time indicate that individuals and households move up and down the income quintiles over their lifetimes, as the key demographic variables highlighted above change…. And Thomas Sowell pointed out earlier this year in his column “Income Mobility” that:
Most working Americans who were initially in the bottom 20% of income-earners, rise out of that bottom 20%. More of them end up in the top 20% than remain in the bottom 20%. People who were initially in the bottom 20% in income have had the highest rate of increase in their incomes, while those who were initially in the top 20% have had the lowest. This is the direct opposite of the pattern found when following income brackets over time, rather than following individual people.
It’s highly likely that most of today’s high-income, college-educated, married individuals who are now in their peak earning years were in a lower-income quintile in their … single younger years, before they acquired education and job experience. It’s also likely that individuals in today’s top income quintiles will move back down to a lower income quintile in the future during their retirement years, which is just part of the natural lifetime cycle of moving up and down the income quintiles for most Americans. So when we hear the President and the media talk about an “income inequality crisis” in America, we should keep in mind that basic household demographics go a long way towards explaining the differences in household income in the United States. And because the key income-determining demographic variables change over a person’s lifetime, income mobility and the American dream are still “alive and well” in the US.
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