How economists have misunderstood inequality: An interview with James Galbraith

at 11:37 AM ET, 05/03/2012

Before 1980, few academics in the United States gave much thought to the idea of economic inequality. It just wasn’t a glaring concern. But in the last 30 years, the incomes of the nation’s wealthiest 1 percent have surged, and more and more economists have been paying attention.


Occupy Wall Street protests in Los Angeles (LUCY NICHOLSON - REUTERS)
Yet there’s still plenty about economic inequality that’s not well understood. What’s actually driving the gap between the richest and poorest? Does it hurt economic growth, or is it largely benign? Should it be reversed? Can it be reversed? Surprisingly, there’s little consensus on how to answer these questions — in part because good data on the topic is hard to come by.

In his fascinating new book, “Inequality and Instability,” James K. Galbraith, an economics professor at the University of Texas at Austin, takes a more detailed look at inequality by assembling a wealth of new data on the phenomenon. Among other things, he finds that economic inequality has been rising in roughly similar ways around the world since 1980. And this rise appears to be driven, in large part, by the financial sector — and the changes that modern finance has forced in the global economy. We talked by phone recently about his book.

Brad Plumer: You bring together a lot of new data on inequality in the book across a variety of countries, from the United States to Europe to China to Latin America. What’s different about what your book discovers?

James Galbraith: One thing we found is that there are common global patterns in economic inequality across different countries that appear to be very strongly related to major events affecting the world economy as a whole. The most important have been changes in financial regimes and changes in systems of financial governance. It made a big difference when the Bretton Woods system ended in 1971. The debt crisis of the 1980s made a big difference. The debt crisis of the 1980s made a big difference. It made a big difference in 2000 when the NASDAQ crashed and interest rates were reduced These things all had global repercussions, and they affected inequality around the entire world in different ways.

BP: And this isn’t how many economists have looked at inequality, correct?

JG: No. The most unconventional thing in this book is about how inequality relates to macroeconomic performance and financial factors. The discussion of inequality tends to be heavily dominated by a marketplace perspective that stresses individual-level characteristics like the demand for skill. Economists have always classified this as a microeconomic problem. ... But when something’s happening at the same time around the world, in different countries that are widely separated, that’s a macro issue. There was a global movement toward higher inequality as a result of the financial stresses that the world is under.

BP: So let’s unpack this a little bit. The current rise in U.S. economic inequality really only gets underway starting in the late 1970s. What changed then?

JG: Between the end of World War II and 1980, economic growth in the United States is mostly an equalizing force, and job creation isn’t dependent on rising economic inequality. But after 1980, economic booms and rising inequality go hand in hand. So what’s going on? In 1980, we really went through a fundamental transformation. We stopped being a wage-led economy with a growing public sector that was providing new services. Programs like Medicare and Medicaid were major drivers of growth in the 1970s.

Instead, we became a credit-driven economy. What the evidence in the U.S. shows is that the rise in inequality is associated with credit booms, which are often periods of sometimes great prosperity. One was in the late 1990s with information technology and one in the 2000s with housing, before everything fell apart. But this is also a sign of instability — the crash that follows is very ugly business. If we’re going to go forward with growth on a more sustainable basis, then controlling inequality and controlling instability are the same issue. One is an expression of the other.

BP: You make a distinction in the book between wage inequality and income inequality. The former has always tended to rise and fall with unemployment, while the latter is something that’s really surged since 1980, driven largely by bubbles in specific fields, like tech or housing.

JG: This is a point I’ve published on before, but yes. Inequality of pay is an attempt to measure what people actually earn for their work, and it’s strongly dependent on the state of the economy. It goes up and down with the unemployment rate. That’s not surprising. Workers down at the bottom of the wage spectrum are often hourly workers, and their hours are affected by slack demand.

Income, on the other hand, is a tax concept, it’s defined as what the IRS tells you to report. And income inequality in the United States is very strongly influenced by the variability of incomes at the very top, which is driven by the stock market and related capital markets. And you can see this very clearly not only by looking at the timing, but also where incomes are rising. During the technology boom, for instance, it’s Silicon Valley, it’s Seattle, it’s Wall Street and Manhattan. This was a small group of people grouped into small geographic units. It’s the top 0.1 percent, but it had a very significant effect on overall income inequality.

BP: And now this view runs counter to what a lot of economists argue, which is that economic inequality has been driven by a “skills bias,” where there are growing returns to being well-educated.

JG: Yes, I think the skills bias argument — the notion that inequality is being driven by technological change and education and the supply of skills — is comprehensively rebutted by the evidence. What you had was a concentration of income in very particular sectors. In addition to finance, in the 1990s it was tech, and in the late 2000s it was in real estate. And those were closely related to the credit cycle. That’s what’s driving the data.

And this distinction has important implications for policy, for how one thinks about what should be done about this. If skills bias is the explanation, then that, at most, supports a case for more investment in education and training. It’s essentially saying that inequality is the result of technological change, and since technological change is wonderful, we should just accept it. But that’s not what the evidence shows.

BP: But if inequality is rising everywhere in the world in much the same way — and if it’s a result of finance-driven changes in the global economy -- then doesn’t that suggest there’s only so much we can do policywise to thwart it?

JG: Yes, it suggests that particularly small countries are very vulnerable to global financial forces, and there are limits to what those countries can do. But the countries that control these financial forces, however, have enormous control. For instance, after 2000, interest rates fell, commodity prices started recovering, and inequality actually declined in much of the world outside of the United States. Interest rates and debt crises have an enormous impact on inequality around the world.

And some larger countries have more domestic control. For instance, inequality in China has been strongly affected by the movement of people from rural areas to urban areas, as anyone who’s been there can plainly see. As incomes in the city increase, that increases income inequality. But China has been trying to spread the benefits of growth more widely across the country. And up until 2007 or so, inequality between regions in China had actually been declining a bit because of more widespread dispersions of income.

BP: You also look at Argentina and Brazil and find that income inequality in both of those countries rose before the 2000s and then fell in accordance with the growth and shrinkage of their financial sectors.

JG: Yes, for a lot of countries one can get very good detail in terms of who is up and who is down at any one time. What we found in Argentina and Brazil is that you had a rise in inequality accompanied by massive inflows into their finance and banking sectors. There were a small number of people making lots of money. That started going down in Brazil in the early 2000s, and one can see that over the last 12 years you’ve had a steady implementation of social policy there, with a higher minimum wage, housing, education. And inequality has declined, and the share of public sector activity has gone up, as the financial sector has gone down. Society was reallocating resources toward the poor.

This has been the case across Latin America as a whole in the past decade. Countries paid off the [International Monetary Fund], stayed away from external indebtedness, relied more on commodity exports, diversified their economies away from the United States and Europe, and pursued stable economic growth. And that region has seen inequality decline; that does show up in the evidence.

BP: Now let’s switch to Europe. One of your more notable points is that if you look at the E.U. as a whole, rather than just focusing on individual countries like Germany or Denmark, it’s actually more unequal than the United States. What’s the significance of this?

JG: My argument is that one needs to take the concept of an integrated European economy seriously, and that means measuring inequality at a Europe-wide scale. Countries in the north tend to be very egalitarian, but the gap between the north and south in Europe is larger than the gap between north and south the United States. And that’s an illustration of the stresses affecting the European Union right now. They don’t have effective mechanisms to allow the poorer regions to pay their debts to the richer ones. Whereas the United States does: Since the 1930s we’ve had an integrated Social Security system, regional development programs like the TVA -- the kind of things that help bring up the poorer regions of the country. But those simply aren’t present in Europe to the same degree.

BP: And now a lot of economists are calling on countries like Spain to cut their wages in order to alleviate their unemployment woes. This is called “wage flexibility.” But you find that this policy won’t work.

JG: We found systematically within Europe that more egalitarian regions have less unemployment than unequal regions. And inequality is a measure of labor market flexibility. But there’s no sign that being more unequal or having more wage flexibility attracts jobs to a region. In fact, the causality runs the other way. When you have a lot of inequality, more people tend to leave their bad jobs in order to hunt for better ones. And that leads to a rise in the unemployment rate. More equal societies tend to have less of that. … We also look across Europe and find no evidence that falling wages are associated with rising employment. There’s no evidence for it at all.

Transcript has been condensed and lightly edited for clarity.

 
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