The Devastating Cost of Inequality

A general complaint that I have about the discussion of inequality and poverty is that the subject is often treated as a zero-sum game. Solutions to inequality involve taking from the rich and giving to the poor, which is a money transfer that only has distributional impacts. The treatment of the topic as zero-sum is what results in the "class warfare" we see in American politics. It is an easy trap to fall into and a difficult one to escape because of its passionate story line with defined characters. Depending on your disposition, it is easy to define one group as virtuous and the other as corrupt. The story line is politically convenient because it is a tried and true formula to energize both conservative and liberal bases during election season, but it ignores the devastating cost of excessive inequality to the macroeconomy.

The effects of income on a child's development and family environment is no secret. Families with greater income security tend to have more stable family environments, better parent-child relationships, and better educational opportunities. The environment and attention a child receives is a major factor in his/her development later in life, which is the motivation for President Obama's push for universal pre-k. Early childhood development is the first and, perhaps, most important step in unlocking the potential human capital of an individual. However, greater degrees of inequality creates a situation where fewer children receive the minimum amount of parental attention and education needed to proceed along a good development path.

Greater inequality disproportionately impacts young children compared to other groups in society due to poor schooling and unstable households. Welfare programs designed to reduce inequality should not be considered as a redistribution based on some idealistic notion of equality. They should be viewed as way to raise the floor of society instead of lowering the ceiling. The lost productivity due to unrealized human capital among low income populations is unknowable, and, in all likelihood, enormous. Policies designed to reduce inequality also reduce the number of children who grow up neglected and under stimulated.

The millennial generation (of which I am a part) grew up on the message of unlimited human potential signified by the slogan "you can be/do anything if you work hard." For the most part, this was a selfish motto used to try to convince ourselves that we will end up rich and respected. However, the magnetism of that often scorned philosophy gains new power when it is applied to the subject of growing inequality. There are millions of children growing up right now who could, but likely won't, be computer scientists, engineers, technicians, analysts, or a thousand other professions. In a time a social and political disunity, the universal human instinct to protect and invest in our children likely provides the greatest return on investment for our tax dollars. The reduction of inequality in this country is an investment designed to avoid the squandered productivity of millions of workers. The story of reducing inequality will be one of productivity and growth once we move past the trap of class warfare.

The Economic Damage of Political Instability in the United States

There is a significant amount of literature that discusses the impact on inequality on economic growth and political stability. One logical hypothesis is that inequality impact economic growth through political instability. Political instability in its extreme form is open conflict between the government and its population. This form of political instability is all too common in Latin America. Developed nations are more likely to experience sub-optimal fiscal policy and government regulation as a less threatening, but still damaging, form of political instability. The United States is a good example of how the second form of political instability can hamper economic growth.

The current levels of inequality is the United States created a less stable economy that has struggled to recover from a debt driven financial crisis in 2008. Fed Governor Sarah Bloom Raskin gave a speech at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies in April that strikes at the heart of how inequality has weakened the economy. Member of the middle class and below had the majority of their wealth tied up in home equity that was destroyed by the collapse of the housing bubble. The past five years has been a painful period of deleveraging (see chart) as many families were stuck with unrealistic mortgages as a result of irrational exuberance in the housing market. Families most damaged by the housing collapse were also the ones most vulnerable to the increase in unemployment. The wealthiest members of society have fared well since the financial crisis while others are still struggling to regain financial stability.

The result of the dramatic disparities in economic circumstances for the different income classes since 2008 has lead to a disturbing increase in political polarization. Below is the Political Polarization Index developed in a study by Marina Azzimonti at the Philadelphia Fed. Polarization has been trending sharply upward since 2008 and reach its highest level at any point from 1981-present during the 2012 election. To a large degree, the political polarization of the country has been driven by inequality and the result of the 2008 financial crisis. Republicans are sternly on the side of low taxes and reduced welfare benefits, which is supported by many extremely wealthy donors and social conservatives. Democrats have been advocating increased taxation of the rich and financial relief for those hit hardest by the financial crisis. The two sides of the wealth spectrum have been placed on opposite ends of the wealth spectrum, and the result has been a contentious partisan environment.

The polarized political environment has done far more than slow down the legislative branch and inspire hateful debates in the last election cycle. It has created sub-optimal policy initiatives that are actively harming economic growth in both the short and long-term. Political polarization has created instability in the legislative process that has damaged fiscal policy in the U.S. Sequestration was intended as a bitter pill to end debt ceiling squabbles that Republicans have been all too eager to swallow. In reality, Sequestration is a temporary band-aid that serves very little purpose in the long-term debt ceiling or budget battles but causes very real damage to portion of society that have been hurt the most by the financial crisis. Long-term unemployment is still a pressing issue for legislators who are barely able to keep the government operational. The future growth path of the economy gets bleaker every day as long-term unemployment remains an issue that politicians are content to stash on their shelves until it becomes politically useful during 2014 or 2016.

Political instability even shares part of the blame for the botched implementation of Obamacare. The Obama administration has been forced to expand the scope of the federal exchange due to state-level intransigence and even the development of the project was damaged by party politics. The administration felt the need to be secretive and insular during the development of the federal exchange because of constant attacks from the right. Now the country gets to wait with bated breath for another doomsday deadline to see if the exchange can be fixed in time to avoid extensive damage to insurance markets. Politics is not an excuse for the mismanagement of the launch, but it is still a reality of the situation.

There is a long strand of literature in academic economic journals discussing the theory of how economic growth might be damaged by inequality and political instability. Lucky for us, we get to see the dirty details of it firsthand.

Labor Market Impacts of a Basic Income Initiative

I wrote a blog post earlier about the Swiss basic income initiative and the political arguments to be made for/against it from a liberal and conservative perspective (from an American political perspective to be clear). But now I am drawn to the economic impact of such an initiative on labor markets.

Earlier in the year, the minimum wage was given a healthy dose of debate thanks to President Obama's minimum wage proclamation during his State of the Union. A national basic income would be an even more dramatic program impacting minimum wage labor markets. In a perfect world (i.e. economic theory), a government-provided basic income would result in the abolishment of the minimum wage. Wages paid out in minimum wage service jobs would drop to the level where wage is equal to marginal revenue product. However, it is much harder to reduce wages in reality than it is in economic theory. The idea of a minimum wage is entrenched in the collective social consciousness and the elimination of that policy would prove difficult, even with the advent of the national basic income. In Switzerland, the effective minimum wage is set through collective bargaining agreements, which might provide the country more flexibility in adjusted its minimum wage policy to fit the new paradigm. Without an adjustment to the new paradigm, a small rise in unemployment as a result of the basic income initiative is likely.

In other sectors of the economy, the initiative might have more impact on wage growth than unemployment. The initiative has the potential to cause upward pressure on wages as workers have more financial security to pursue entrepreneurial projects or commit more time to social responsibilities. Perhaps it won't be reflected in wages but instead in other benefits provided to workers. Work-life balance and the work environment will be more powerful bargaining chips with the increased financial security that a basic income will provide.

The aggregate impact on unemployment will be dependent on how the basic income program is financed. Significant funding could be made available through the elimination of old welfare programs, but an increase in tax revenue would be necessary to make the program anywhere near budge neutral. Anywhere near a significant rise in unemployment would only be likely if the business community was forced to bear the majority of the new tax burden for the program. It might give additional incentive for firms to move toward more capital or technologically intensive operations. For example, the fast food industry might accelerate its process toward automation by replacing workers with kiosks.  

However, there might be interesting long-term trends that could develop as a result of the basic income initiative. It might give additional incentive for firms to move toward more capital or technologically intensive operations. For example, the fast food industry might accelerate its process toward automation by replacing workers with kiosks. Over the past few decades, the return on labor has been fairly stagnant while the return on capital has increased. In the United States, labor is receiving a smaller and smaller proportion of GDP in wages, as shown in the graph below:

The blue line represents the % of GDP that is paid in wages and accrued salary. Paul Krugman wrote about his phenomenon back in December in an attempt to bring the role of the capital/labor relationship to the attention of people worried about rising income inequality. Current trends have capital receiving a far greater share of GDP than it did 30-40 years ago. Real wages have largely stagnated, including in Switzerland. The average growth of real wages in Switzerland has averaged around 0.5% per year as shown below.

 A basic income initiative might be a logical response to the changing composition of the world economy. As capital continues to earn a larger share of GDP, it might be in society's best interest for the government to find a way to distribute the returns to capital among a larger portion of the population. One way to do that would be to increases taxes on capital were increased in order to fund the basic income initiative. Krugman's article brings up fears of a return to the Marxist battle of capital vs. labor but government might be able to help transition society toward a new equilibrium through programs such as a basic income initiative.

A Look At The Swiss Basic Income Initiative

The Swiss initiative to provide an unconditional income to all citizens is an interesting proposal for a number of reasons. It is a policy initiative that lands itself right in the field of battle between liberal and conservative ideologies. I will write a post later that examines the potential economic impacts of such a program but, for now, the ideological arguments is what interests me.

Conservatives are likely to view it as a disaster that will cause perverse incentives for an even larger portion of a nation's society instead of those benefiting from welfare programs. For conservatives, the basic income is a diabolical way to buy the approval of middle income citizens. The number that has been floated for the Swiss initiative is that every citizen will be given $2,800 per month. Theoretically, this monthly value could be strategically placed as the buy the favor of the median voter. For example, if the median voter pays $2,750 in taxes every month, then the transfer will make them better off and they will approve of the program. Anyone paying more than $2,800 per month in taxes will be worse off and the program will be a redistribution of their income to the rest of society.

Liberals are likely to view the policy as the endgame toward which most social welfare programs have been striving toward. It is finally a program that can effectively fight income inequality within a society without legal loopholes and arduous application requirements. A guaranteed state income would finally free important social groups from the need for financial survival. Struggling families will now have more time to spend raising their children properly and artists will break free of financial incentives to create an explosion of creative expression.

The interesting development in these discussion will be to determine how many conservative thinkers will be persuaded to support the initiative. A basic income program might actually reduce the bureaucratic mess of government because the program eliminates the need for many others. A basic income is unemployment insurance, food assistance, and social security all rolled into one. The complex process of applying/qualifying for government programs would be eliminated by simply sending the same check to every citizen. Conservative social values might be strengthened by such a program as divorce rates drop due to more stable marital relationship, absent the pressure of financial circumstances.

The basic income program is unlikely to pass in the short-term because it is too radical. It would be very surprising to see such a dramatic paradigm shift in the government of a developed nation in such a short period of time. However, the initiative will create some very important questions about the ideal future of human society.

REVISION:

I neglected to mention another aspect of the basic income initiative that will appeal to conservatives in my rush to type this up during my lunch at work. A basic income could actually improve the incentive structure of the economy by eliminating the cliff effects inherent in qualifying for many welfare programs. A person will no longer need to avoid getting a raise because it would actually make there circumstances worse by reducing the welfare they receive from the state.

Why the GOP Should Embrace the Beauty of Human Irrationality

There is the often criticized assumption in economics about the rationality of individuals. In theoretical economics, people are generally assumed to be perfectly rational which entails a number of caveats. The assumption does have great value in the field of economics but it tends to be bastardized when used as a pro-free market talking point for politicians. Politicians fail to mention the conditional assumption when they mention the rationality of market participants. The political notion of rationality seems to more closely adheres to the idea of personal responsibility for the cause/effect relationship of one's actions. However, the two different definitions of rationality are often confused because the political definition is never clearly stated. This confusion leads to petty arguments and frustration.

The beauty of the free market and America's economic/political system is its creativity. Advocates of the free market often cite America's leadership in innovation as the ideal of an economic system. The Randian uprising in the past decade in American politics stems from the wish to protect America's economy from developing an incentive structure that halts innovation. Unfortunately, the free market political movement has moved away from its core strength toward an anti-welfare message. The shift in message doesn't change the root of the movement at the grass roots level. People are attracted to the idea of America as a nation of dreamers and idealist who strike oil where everyone else has failed. The strength of the free market message is not in the idea of individual rationality but in individual irrationality. Steve Jobs did not make a rational decision by dropping out of college in order to sit in on random courses and eventually take a job with Atari. Many people have taken similar paths in life and ended with much less desirable outcomes than if they had received a college degree. However, we hear about the one that helped build an international empire that has sales rivaling the GDP of entire nations. We celebrate his decision despite the fact that it was irrational in the face of overwhelming statistics about his probability of success. Americans are a romantic people who worship the trailblazer and not the everyday foot soldier.

 Republicans should embrace the romantic version of the free market by praising the irrational confidence and passion of Americans who attempt to innovate by starting new businesses or applying for patents. The current free market philosophy of the Republican party comes off as a form of paternalism where people need to take responsibility for their lot in life. A shift toward policy objectives centered on patent/copyright reform, deregulation that favors new business formation, and state level changes to professional licensing laws would help to significantly improve the party's public image. The free market can be a great source of hope and inspiration but the current strategy of the GOP has made it seem like a punishing environment that advocates Social Darwinism. The support of the people can be won if the message is focused on the creativity of society instead of its jealousy of the rich.

Why the GOP Kamikaze Strategy Won't Work for Democrats

A few days ago Joseph Weisenthal tweeted that the Democrats need a Ted Cruz of their own:

Dems need their own Ted Cruz. Someone to say: No deal unless it includes a debt ceiling hike and a return to pre-sequester spending.

— Joseph Weisenthal (@TheStalwart) October 2, 2013

This idea was simultaneous appealing and repulsive to imagine as an established part of the American legislative system but there is an important reason why the tactics currently being employed by the GOP would not work for Democrats.

The problem is that there is legitimate uncertainty about the willingness to default on the part of a coalition within the GOP. It is generally believed that the majority of the elected officials on the right are not brazen or stupid enough to force a default of the US government. However, the expected probability of such an event is uncomfortably high due to a growing track record of extremist rhetoric and actions. The existence of this asymmetric information is the source of power being exploited by House leaders.

If the current situation were mapped as a game tree, last year's dabble with the debt ceiling set us down a previously ignored path because the expected payoffs to both political parties was assumed to be negative. However, now there is the creeping doubt that some House Republicans mistakenly believe that there is a positive expected payoff waiting for them at the end of the road.

The same strategy would not be credible if threatened by a coalition within the Democratic party for a number of reasons. For one, the Democratic party has exhibited more effective control of its members in recent history and the growth of such a faction within the party structure would likely be powerless. One motivation of rogue GOP members is the idea that they have nothing to lose from staking out this position. Voter groups adversely affected by the tactic of a government shutdown are can ignored for some Republicans. However, Democrats have built their party image around duty and fidelity to the suffering individual which makes a kamikaze threat by the party ineffective.

More importantly, at the core of the Democratic party, there is a feeling of something almost akin to manifest destiny. The history of the 20th and early 21st century has been a steady (and seemingly unstoppable) movement of progressiveness and liberalism. In the last two decades, America has become more liberal economically and socially. Time has been symbolic ally of liberals and conservatives feel the pressure. Ross Douthat wrote an excellent column about why the right is fighting this battle over Obamacare and the debt ceiling that touches upon the pressures of history. The Democratic party doesn't have a feeling of exasperation that has swelled over the previous decades to embolden them to take extreme measures.

Without the pressure of history and endogenous movements within the Democratic party toward a fervent ideology, there is no asymmetry regarding the intentions of Democrats. Such threats would sound like hollow, desperate attempts to fight fire with fire.