Tuesday, June 10, 2014

Inequality: seed of the crisis, thorn in the recovery

The US economic recovery is being built on fragile foundations. The average consumer might be spending more but the extra money isn't coming from substantial wage growth. Consumption is being financed by running down savings and building up debt. Savings ratios are back to levels last seen on the eve of the 2008 financial crisis. The consumer debt ratio - debt payments (excluding housing) as a proportion of disposable income - is on the rise (Figure 1).

Source:  Federal Reserve Board
This pattern is not new or sustainable. In the years prior to the financial crisis, wages of low-income households in the US failed to keep up with rising living costs. In order to maintain spending, these households took on more debt. Meanwhile, incomes at the top grew rapidly. Rising income inequality created political pressure to encourage borrowing (particularly in housing) to maintain demand in the economy. Such action built on the underlying "fault line" that inequality represented rather than resolving it (Rajan, 2010).  

Borrowers bet on higher wages being just around the corner, which would allow them to continue to service their debt. In 1989, the US household debt-to-income ratio was around 60 per cent for the top 10 per cent and around 80 per cent for all other groups. In 2007, the ratio was around 80 per cent for the top 10 per cent and 250 per cent for the bottom fifth. But wages failed to keep up with growing debt burdens. Default rates picked up, the inequality fault line was exposed and the financial crisis ensued.    

Today, for expenditure to be affordable, wages need to rise in line with living costs. One way to do this is to mandate for above-inflation increases in the minimum wage, so that low-paid workers can catch up. In February, President Obama signed an Executive Order increasing the minimum wage for federal contract employees to $10.10 an hour. He also called on Congress to pass a similar proposition for all Americans (the current federal minimum wage is $7.25). Some jurisdictions have implemented or announced their own above-average increases, for example, San Francisco ($10.74) and Seattle ($15). The Center for Economic Policy and Research has demonstrated that if the minimum wage had kept up with labour productivity since 1960, then it would have reached $21.72 by 2012.* 

A reasonable increase in the minimum wage would have a positive impact on the individual and economy. According to the Congressional Budget Office (CBO), an increase in the federal minimum wage to $10.10 by 2016 would lift 900,000 individuals out of poverty. But it is not just those in poverty that benefit. All low-income, and some middle-income, households stand to gain. The CBO reports that the cost of expected job losses that would arise from a higher minimum wage to $10.10 would be more than offset by overall gains.** An increase in consumption that follows from a rise in wages would stimulate business investment. An increase in tax contributions from better-paid workers would improve the state and federal balance sheet.   

But in the medium-term, increasing the wage packet of low-income households does not fully tackle the problem. As a result of technological progress and cheaper labour overseas, many middle-skilled jobs in the US have been eliminated (see "An earthquake on inequality is coming").  What remains are low-skilled and high-skilled jobs.  This makes it very difficult for those at the bottom to progress up the income ladder. What is required to bridge this gap is investment into training and job creation. This would enable low-income individuals to secure decent progression, pay and improve job quality. In turn, this would make it more likely that they are able to participate in the recovery, and not be left behind... again.

This isn't necessarily an argument for increasing the minimum wage to $21.72. But it does demonstrate nicely that much of the gain produced by ordinary workers in recent years has been channeled away, towards senior executives and capital-owners, contributing to rising income inequality.

** Seattle has agreed to raise its minimum wage gradually to $15 by 2021.  As the population of low-paid workers is fairly small in the city, the benefits may outweigh costs arising from unemployment and higher operating expenses.  But further evidence is required before coming to a definitive conclusion.

This post was updated on 12 June, to clarify developments in low, middle and high-skilled jobs in the US.


JD said...

Very interesting Article Priya. I do agree with you regarding the impeding dangers of a rising cost of living which will consequentially squeeze disposible incomes and increases levels of debt. I wonder if a solution is to curb the cost of living rather than a raise in minimum pay rates? I fear a raise in incomes will lead to irresponsible spending and further increases in inflation which will pose its own problems to the economic recovery. Would it not be better to give fuel rebates or grocery bill concessions to those below an income line which are then tied into a savings account or tied into other schemes so that the money they are saving is used responsibly? I fear rapid increases in wages would only further fuel the irresponsible behaviour which led to the last banking crisis. Thoughts?

Priya Kothari said...

Thanks for your comments and questions JD.

Food subsidies would help tackle the health inequalities associated with low incomes. But they would be costly to administer at the Federal level and such an intervention might fall prey to a debate about how much government should intervene in directing individual choice. There are, however, examples at the local level to encourage better choices (which other readers of this blog will be pleased by!). In San Francisco, a number of individuals and agencies have come together to encourage store owners to stock and display healthier food choices, and improve store layouts. With funding support from philanthropists, they have seen positive changes to consumer behaviour.*

However, my argument is about social justice. The study I quoted by the Center of Economic Policy and Research demonstrated that workers have become more productive (their output per hour worked has increased) but have not been rewarded for this through higher wages. Actually, their share of total output/income has been falling. This has been the major factor driving income inequality up in recent decades. That doesn’t seem right. People working should be paid their fair share.

It sounds like you’re worried about irresponsible behaviour, perhaps parents spending the extra money on themselves rather than their children? Both theory and practice give us reassurance that, by and large, this isn’t the case. Higher income allows parents to invest more resources into their children and reduces the stress of growing up in poverty, both of which improve child cognitive outcomes.** For example, in the US, following the 1990s welfare reforms, a $3000 increase in annual income led to a small but significant improvement in child test scores.***