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.

An earthquake on inequality is coming….

In the debate about rising inequality, the behaviour of Chief Executive Officers (CEOs) has been cited as a major cause.  They are accused of putting short-term (shareholder) interests ahead of long-term (firm) interests.  Their actions are hardly surprising considering that CEO remuneration has historically been tied to short-term objectives such as annual shareholder returns.

But are politicians equally guilty of short-termism?  Consider that their time horizon is the electoral cycle.  Their objective is to be re-elected.  Their method is policies that target the median voter.  A problem that, until recently, affected only a minority, is unlikely to be adequately addressed by the political process.  Cue civil society.  Over the past few years, as a direct response to the discontent caused by rising inequality, we have seen the emergence of the Occupy movement, the UK Living Wage campaign and the Arab Spring. 

Grass-root movements have a long history of affecting change in the United States and beyond.  Giving women the right to vote in the UK, the campaign for equal rights in the US, the fall of the Berlin Wall in Germany.  Activists were drawn together by a shared set of principles, which helped spread their reach and eventually spurred national and global campaigns. 

But in generating a sufficient mass, they also drew the attention of political parties.  The slow rumblings of discontent transformed into substantive political pressure, that forced the hand of politicians into declaring an active policy response.  Such events mimic the “stick-slip” dynamics of an earthquake, where the forces below the earth’s surface eventually generate enough strength to push against the forces holding the plates together, to produce an earthquake (Jones and Baumgartner (2012)).  In this case, the political system with its procedures, rules and norms acts as a retarding friction against the public movements that generate information about pressing issues of the day that require action.

 

The rise of the Occupys, the election of Bill de Blasio to Mayor of New York on an agenda of tackling inequality, the rejection of the Conservative-led coalition in recent UK elections, all suggest that the time is ripe for a major political earthquake.  Yet, the world is still waiting for a major set of policies to resolutely tackle income inequality in the US and beyond.  In the language of our earthquake analogy, what further information is required to overcome such political frictions, taking into consideration the time horizon over which politicians operate? 

First, dispelling the myth that monetary and fiscal stimulus have put the economy on a path of stable, inclusive growth and that no further action is required.  In the US, the wealthiest one per cent captured 95 per cent of post-financial crisis growth between 2009 and 2012, while the bottom 90 per cent became poorer (Oxfam (2014)). The vulnerabilities that formed the basis of the 2008 financial crisis still exist and could generate another crisis in the near-term.  

 

Second, agreeing that reducing inequality can be growth enhancing, as the IMF has strongly argued.  Elections have been won and lost on the state of the economy.  The 2015 election in the UK and the 2016 Presidential election in the US will be no different.      

Third, an acceptance that, because of the nature of technological progress that is driving rising income inequality, for the first time, our children could be worse-off than us (Kotlikoff and Sachs (2012)).  This, unlike the first two, may fall outside of a politician's traditional time horizon, but is surely the strongest argument for action.