Matthew P. Drennan-Income Inequality_ Why It Matters and Why Most Economists Didn’t Notice-Yale...

7/24/2019 Matthew P. Drennan-Income Inequality_ Why It Matters and Why Most Economists Didnt Notice-Yale University Pr

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Income Inequality


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Income

InequalityWhy It Matters and Why Most

Economists Didnt Notice

M A H E W P. D R E N N A N

New Haven & London


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Copyright by Matthew P. Drennan.All rights reserved.

Tis book may not be reproduced, in whole or in part, including illustrations,

in any orm (beyond that copying permitted by Sections and o the

U.S. Copyright Law and except by reviewers or the public press),

without written permission rom the publishers.

Yale University Press books may be purchased in quantity or educational,

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Set in Minion type by Integrated Publishing Solutions.

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A catalogue record or this book is available rom the British Library.

Tis paper meets the requirements o ANSI/NISO Z.-

(Permanence o Paper).


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o my wie, Katherine Van Wezel Stone,

My children, Matthew, Maureen, and Erica,

And my grandchildren, Grace and Ava Drennan


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Contents

Acknowledgments ix

Introduction

rends in Income Distribution

Possible Causes o Rising Income Inequality

Consumers Shif to Debt

Panel Regression Analysis o

State and National Data

Consumption Teory and Its Critics

Has Tis Happened Beore?

Conclusion

Notes

Bibliography

Index


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Acknowledgments

Tis work has been more than our years in the making. It

began as an insight in early , in the wake o the initial

shock o the financial crash, when I realized that the dramati-

cally rising income inequality o the past three decades might

have played a role. Te more I explored the data and the de-

bates about causes o the crash and ensuing Great Recession,

the more convinced I became that the conventional economic

explanations were missing a critical piece o the puzzle. I re-

alized then that it was necessary not only to put income in-

equality back into the story but also to explain why that part o

the story had not been told already. Tat is, I wanted to under-

stand why economists had ailed to see the significance o the

most important economic trend o the past three decades

the dramatic rise in inequality.

Many institutions and people have assisted in this work.

Te Russell Sage Foundation generously financed the first

phase o this study. In addition, Cornell Universitys Podell

Emeriti Award or Research and Scholarship provided subse-

quent unding or research expenses. From the beginning o

this project, the Luskin Schools Department o Urban Plan-

ning at the University o Caliornia, Los Angeles, provided

the library resources, an office, I assistance, and most im-


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x Acknowledgments

portantly, colleagues, which are so necessary or academic re-

search. For the semester that I spent in New York City, I wasgenerously provided with an office at the New York University

Schack Institute o Real Estate by the dean, Rosemary Scanlon,

and a proessor there, Hugh Kelly.

UCLAs statistical consulting group at the Institute or

Digital Research and Education gave me invaluable assistance

at every step. I sent them countless email queries that they an-

swered in a day or lessright answers, too. I made many tripsto their walk-in consulting sessions, trips that were always

worthwhile.

I had the good ortune o having a number o astute, sup-

portive, yet critical readers. I particularly want to thank Alan

Altshuler, Charles Brecher, Robert Hockett, Raymond Horton,

Morton Horwitz, Christopher Jencks, and David Rigby or

pushing me to sharpen my arguments and sharing with me im-

portant literature. I also want to thank participants in the Brown

Bag Lunch speaker series at the New York Federal Reserve Bank,

where I made an invited presentation on this project in the all o

. Among the participants, Erica Groshen, Andrew Haugh-

wout, and James Orr offered cogent remarks, and they pointed

me to important data sources. wo anonymous reerees de-

serve thanks or suggestions that markedly improved this

manuscript.

I have had the great benefit o the services o several tal-

ented graduate students at UCLA. Te spare simplicity and

clarity o the tables and figures I attribute to two excellent re-

search assistants at UCLA: Anne Brown and aner Osman.

Tey both know that the sole purpose o tables and figures is

to elucidate the argument, not to drown it in obscurity. O the

nineteen tables, Anne produced sixteen o them, and I did the

other three (ables ., ., and .). O the thirteen figures,


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Acknowledgments xi

Anne produced seven (Figures ., ., ., ., ., ., and

.) and aner produced five (., ., ., ., and .). Onefigure, ., is taken rom an International Monetary Fund

(IMF) paper with permission. Anne Brown has been a critical

assistant in the final preparation o the manuscript to Yales

exacting standards. Mike Manville, a ormer Ph.D. student in

urban planning at UCLA (now an assistant proessor at Cor-

nell), read every word o various drafs in the early stage o

producing this book. He made both substantive and technicalsuggestions that I mostly accepted.

I wish to acknowledge my editors at Yale University

Press, William Frucht and Jaya Chatterjee, who have made

this book production process exciting rather than tedious. My

copy editor, Joyce Ippolito, and my production editor, Ann-

Marie Imbornoni, purged the manuscript and proos o nu-

merous flaws I had overlooked, and they did that with speed

and grace. Teir standards o excellence and respectul treat-

ment would flatter any author.

Most o all I thank my wie, Katherine Stone, who en-

couraged me in pursuing this project rom the beginning and

discussed the ideas in depth. She also read every word more

than once, and her suggestions have enhanced the final manu-

script. She has been an invaluable asset or my project, always

eager to help and always giving excellent suggestions.


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I

Introduction

his book tells two stories. Te first tells how rising

income inequality over the past decades led to rising,

indeed surging, household debt to support consump-

tion, a surge that brought on the financial crisis and

Great Recession o . Te second shows that main-

stream economists have adhered to a theory o consumption

that assigns no role to the distribution o income, and there-

ore is inadequate or ully understanding the Great Recession

or preventing the next one.

O course rising income inequality is only one o the

causes o the surge in household debt, but it is an important

one that is too ofen neglected by economists and policy mak-

ers. Te period rom about to , especially post ,

can be characterized as a perect firestorm o household in-

debtedness, ueled by our actors: () stagnant incomes or

most households related to the long-term rise in income in-

equality; () unusually low interest rates afer ; () legal

and institutional changes that relaxed borrowing standards o

lenders, raised the availability o credit, and made housing a

more liquid asset; and () the housing price bubble. Te burst-


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Introduction

ing o that bubble in precipitated the financial crisis

and the Great Recession, but it was only the last straw. Tedebt-supported expansion o consumption became unsustain-

able afer . Because consumers have begun to reduce their

debtdeleveragingand increase their saving, consumption

will be depressed or some years, producing an anemic recovery.

Most analyses o the financial crash and Great Recession

identiy actors () through () as causes but not (), income

inequality. Some, such as ill van reeck, identiy (), risingincome inequality, as well.

Tere is substantial evidence that the rising inter-

household inequality in the United States has im-

portantly contributed to the all in the personal

saving rate and the rise in personal debt (and a

higher labour supply). Aided by the easy availabil-

ity o credit, lower and middle income households

attempted to keep up with the higher consumption

levels o top income households. Tis has contrib-

uted to the emergence o a credit bubble which

eventually burst and triggered the Great Recession.

Te evidence that lower- and middle-income households were

trying to keep up with the consumption o top-income house-

holds is less substantial than the evidence that they sought to

maintain their living standards in the ace o stagnant or de-

clining incomes.Joseph Stiglitz, Raghuram Rajan, Paul Krug-

man, and Tomas Palley also name rising income inequality

as a cause o the jump o indebtedness and ensuing economic

crash.wo writers go urther, linking inequality to the stag-

nant economic recovery rom the Great Recession.Tey all

make well-reasoned arguments linking growing personal in-


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Introduction

debtedness in part to rising income inequality, but ail to pro-

vide empirical support or such a link.Tis book goes beyond their writings in three ways.

First, it presents econometric evidence supporting such a link.

Second, it uses household budget data to show that house-

holds increased indebtedness was not merely or leisure or

competitive conspicuous consumption. Rather, the drivers o

debt were increased spending on what most would agree are

necessities. Spending on shelter, health, and education has in-creased significantly despite stagnant incomes. In other words,

with stagnant or declining incomes, households maintained

their consumption on essentials through massive borrowing.

And finally, it presents persuasive historical evidence that

the nation has been through this beorethis is not the first

time that rising income inequality accompanied by growing

and unsustainable household debt and the bursting o a real

estate bubble ended in a severe economic crash.

Why did most economists ail to see this problem com-

ing? Te inclusion o rising income inequality as one o the

our major causes o the financial crash and Great Recession

does not comport with the mainstream economic theory o

consumption. Indeed the econometric evidence, the house-

hold budget evidence, and the historical evidence argue that

the mainstream theory o consumption, which posits no role

or income inequality in the economy, is seriously flawed. Te

story here is that increasing consumer indebtedness, which sup-

ported consumption until the crash in , was driven by

the pressure or most households to maintain consumption in

the ace o stagnant income as income inequality relentlessly

rose or thirty years or so. Tat debt-supported expansion o

consumption became unsustainable afer once house

prices tumbled.


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Introduction

Economists have ignored or misunderstood the effects

o rising income inequality on macroeconomic outcomes.Moreover, the mainstream consumption theories cannot ex-

plain recent trends in relative consumption and saving. Nei-

ther Milton Friedman nor Franco Modigliani and Richard

Brumbergthe leading theorists o consumption in recent

economic thoughtposited any role or the distribution o

income in their theories o consumption. Friedmans perma-

nent income theory o consumption does not explain the ob-served rise o debt-ueled consumption in the decade beore

the crash. Modigliani and Brumbergs lie cycle theory o

consumption contains the seed o an explanation, but not one

that they anticipated.

However, i we look urther back in time, Tomas Mal-

thus, writing in the early nineteenth century, had the germ o

an idea that excess saving, brought on by a top-heavy distribu-

tion o income, would curb effective demand and thus crimp

the expansion o total output. But Malthus had no data, and

his prose was less than lucid. A century later, Keynes picked up

on Malthuss idea, which had lain dormant thanks to the tri-

umph o David Ricardos general equilibrium perspective on

the macro economy. Some o Malthuss thinking on effective

demand is echoed in John Maynard Keyness General Teory

o Employment, Interest, and Money().

Keyness theory o consumption, ully developed in the

General Teory and translated into algebra by his interpret-

ers, dominated macroeconomics or many years. It attributed

an important role or income distribution in macroeconomic

outcomesnamely, that the share o all households afer-tax

income spent on consumption, the average propensity to con-

sume (APC), would decline over time as incomes rose, curb-

ing effective demand and perhaps leading to long-term stag-


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Introduction

nation. But the postWorld War II experience contradicted

his inerence. Te APC did not decline; it was either stable orrising. So the Keynesian notion that a more equal distribution

o income would curb the all o the APC disappeared, and

income distribution no longer mattered or the theory o con-

sumption.

Around , however, something strange began. Afer a

long period o stability, as hypothesized by Friedman as well

as Modigliani and Brumberg, the APC began a long-term rise.Tat meant a long-term all in the saving rate or the same pe-

riod because the saving rate is equal to ( APC). Tat event

was not supposed to happen in Friedmans theory.

Was the observed rise o the APC, , unprece-

dented? No. Based on Simon Kuznetss data, there was a orty-

year rise o the APC, to . Kuznetss data on

income distribution, which begins in and ends in ,

shows rising income inequality in the s. Te act that

Kuznetss long period o rising APC includes a decade o ris-

ing income inequality, and that the thirty-eight-year rise o

income inequality, , includes a long period o rising

APC, raises the question o whether there is a causal link rom

rising income inequality to rising APC.

Te mainstream consumption theory o Friedman as

well as Modigliani and Brumberg cannot explain such a link.

Instead, aced with slow or no income growth, households

might resort to increased borrowing to maintain some de-

sired level o consumption. Te demand or borrowing can be

curbed by interest rates and a hard income constraint. But in

the period rom about to , especially post , there

was an unusually huge rise in household indebtedness, ueled

by the our actors noted above.

Tis book does not address the question o how to fix ris-


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Introduction

ing income inequality through public policy. However, it does

address the possible causes o rising inequality.As to policies to redress rising income inequality, some

authors have recommendations that would be moves in the

right direction. Tey include reducing the amount o money

in political campaigns and lobbying, and enorcing the labor

laws and the antitrust laws on the books. But any effort to re-

dress income inequality must begin with a story about why

curbing and reversing income inequality matters or the long-term health o the economy. Tat is the central goal o this

book.

Te book will begin by briefly laying out the acts about

rising income inequality, a topic that has been exhaustively

covered elsewhere. Income inequality has been rising or

almost our decades. Median incomes and wages have stag-

nated, while the share o income going to the top percent has

soared. We will list and evaluate the possible causes o rising

income inequality, and then examine the large rise in con-

sumer indebtedness post . Te rise o debt and income in-

equality has been accompanied by a measured increase in eco-

nomic insecurity among consumers. Also, relative spending

on housing, health, and education has risen markedly, squeez-

ing relative spending on other necessities, so we will see some

reasons why income inequality matters. urning to economic

theory, the book traces the treatment o income distribution,

or lack thereo, in theories o consumption rom Malthus, Ri-

cardo, and Keynes to Friedman, Modigliani, and Brumberg,

to modern critics o mainstream neoclassical consumption

theory, including behavioral economists. Te dominance o

Friedmans as well as Modigliani and Brumbergs theories o

consumption among macroeconomists up to the present ex-

plains why most, but not all, economists have not noticed that


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Introduction

income inequality matters. Ten we present an outline or a

revised theory o consumption that fits the acts. As we willsee, the rising inequality and debt leading up to the Great

Recession matches a similar trend that preceded the Great

Depression.


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II


he changing distribution o income in the United

States has some distinguishing characteristics. Te first

is that the share o national income going to labor

has been declining. Splitting labor income between

the share going to the top percent o wage, salary, and

bonus earners and the bottom percent shows that the top

share is rising. rends in productivity, hourly earnings, male

and emale, as well as all household income show shifs avor-

ing the highest income groups.

It is important to explain what income inequality means,

what it is and what it is not. I the proportion (share) o ag-

gregate income received by the lower end o the income dis-

tribution is alling over time, that is rising income inequality.

But how is lower defined percent, percent, per-

cent? An easier rule o thumb is that i the Gini coefficient

or the Teil index is rising over time, that is rising income

inequality.

Rising income inequality does not necessarily mean stag-

nant real incomes or most households. During the Depression

years, the nation had stagnant incomes or most households

the share going to the top percent o wage, salary, and bonus

earners and the bottom percent shows that the top share is

rising. rends in productivity, hourly earnings, male and e-

male, as well as all household income show shifs avoring the

highest income groups.


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butallingincome inequality. From through the na-

tion had rapidly growing incomes or most households andalso had alling income inequality. And in the decades leading

up to the financial crash and Great Recession, the nation had

stagnant income growth or most households (stagnant here

is defined as real mean income growth o less than percent

per year) and rising income inequality. Te point is that the

two actorsrising income inequality and stagnant household

income growthdo not necessarily always occur together.Indeed, although the data are murky, household income was

likely growing rom to and income inequality was

rising. In what ollows, most o the evidence is about the de-

cades preceding the financial crash, when both rising income

inequality and stagnant income growth or most households

occurred together. Tat was not a coincidence. Te strong

growth o aggregate income, , was cut almost in hal

in the recent period, . At the same time, the share o

income going to the top percent rose rom to percent.

Slower growth plus a declining share or the bottom per-

cent meant that average real income o that group did not rise.

O course, it rose strongly or the top percent.

Labors Declining Share o National IncomeOne o the regularities noted in the past about the United

States economy was the long-run stability o the shares o na-

tional income paid out to labor and to owners o capitaltwo-

thirds to labor and one-third to capital.able . presents the

share to all labor or the years to . Te share barely

changed in the twenty years rom to : . percent to

. percent. But then it began to edge downward, alling to

. percent by .


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Te decline in labors share o national income is not

limited to the United States, but is seen in other rich coun-

tries, as noted by Peter Orzsag.He calculates that the drop

o five percentage points o labors share o private sector in-

come rom to is equivalent to a loss o billion.

He attributes the drop in share to technological change and

globalization. Joseph Stiglitz does not agree. About the declin-

ing wage share, Stiglitz noted, Te pattern and magnitude o

changes in labor compensation as a share o national income

are hard to reconcile with any theory that relies solelyon con-

ventional economic actors. And urther, I technological

change increases the effective supply o labor, and labor and

capital are not very substitutable, then technological change

drives down the share o labor. But the pattern o increase o

wageswith wages at the very top (e.g., o bankers) increasing

so much relative to that o othersis consistent with the view

that something else besides technological change is causing

the decline in the wage share.

able .. Labor Share

of National Income,

Year All Earnings

.

.

.

.

. .

Source:Bureau o Economic Analysis

(n.d.), able ..


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Te Rise o the Percent Among Wage Earners

Tere is a long-standing popular perception that the rich get

their income rom ownership o capital, while workers get

their income rom wages and salaries. Tis was roughly true

during the roaring s, but it is not true any longer. Based on

income tax data, the top percent o tax filers or received

percent o their income rom wages. But in more recent

years, their share rom wages (which includes bonuses) has

ranged rom to percent.It is still certainly the case that

most capital income accrues to the percent, but they, mostly

managerial and proessional workers, are receiving an increas-

ing share o all earnings.able . shows the shares o total

wage income or the top percent and the other percent or

selected years, to . Te two shares sum to percent,

o course. Te share o the top percent moves down rom

percent o all earnings in to percent in . Terea-

ter their share rises to percent in and drops to per-

cent by with the onset o the Great Recession. Te per-

able .. Shares of Earnings to op

Percent and Percent, Year op Percent Percent

. .

. .

. .

. .

. .

. . . .

Source:Based on Saez (), able B.


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cents gain in share since mirrors the percents drop in

share.

Productivity, Hourly and Annual Earnings, andRising Income Inequality

It is a undamental truth o economics that living standards

can rise in the long run only i productivity rises. Although

that condition is necessary, it is not sufficient. Compensationmust rise in tandem with productivity growth or living stan-

dards to improve. Figure . shows the trends o real hourly

compensation and productivity (real output per hour worked)

or the United States or the postWorld War II period. Te

two measures rise together until the s, and then diverge.

Growth o compensation no longer keeps up with growth o

productivity.

But the average growth rates conceal how the productiv-

ity gains have been distributed. In an analysis o Internal Reve-

nue Service (IRS) data examining productivity growth, the au-

thors conclude, Our most surprising result rom the large IRS

data set is that, over the entire period , only the top

percent o the income distribution enjoyed a growth rate o

total real income (excluding capital gains) equal to or above the

average rate o economy-wide productivity growth.Te bottom

percent o the income distribution ell behind or were even

lef out o the productivity gains entirely.Tis pattern o pro-

ductivity growth outstripping wage growth over the past three

decades is repeated or other rich nations.

Te drop in the earnings share o national income, the

drop in the percents share o earnings, and the disconnect

o hourly compensation growth rom productivity growth all

point to relative slowing in the growth o individuals earnings.


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able . documents the slowdown o earnings growth. Panel

A o able . shows trends in median real earnings, male and

emale, o ull-time year-round workers. Te median real wage

or males increased about , in the seven years rom

(the first year o the Current Population Survey income data)

to (the year afer which income inequality began to rise).

However, in the thirty-three years rom to , that wage

barely changed. Te median or emales grew more than the

male median in both periods, but it also slowed markedly in

the long period, .

It is clear that growth o real wages was either stagnant

(or emales, . percent per year) or almost nonexistent (or

males, . percent per year). Some observers have argued that

the massive rise o women in the labor orce post was in

Figure .. Productivity and real hourly compensation, nonarmbusiness sector, through first quarter . Source:Bureau o

Labor Statistics ().


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able .. Summary of Real Earnings and Income ren

Aver

Panel A. Median real

earnings o ull-time

year-round workers,

Male , , , , . Female , , , , .

Panel B. Median

household real

income,

, , , , .

Panel C. Mean

household real

income,

, , , , .

Source:Median real earnings o ull-time year-round workers rom DeNavas-Walt and Procto

mean household real income rom able A-.


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part a coping measure by households to deal with flat wages

or men.

In Panel C o able ., median household income iscompared with mean household income. Growth o both the

median and mean slowed markedly during com-

pared with .

None o the statistics presented so ar measures income

inequality directly. Rising income inequality means that the rel-

ative distribution o income rom all sourcesearnings, divi-

dends, interest, rent, and transer paymentsbecomes smalleror those at the lower end o the distribution and larger or

those at the higher end o the distribution. Tere had been a

long decline in income inequality, a rise in income equality,

that was evident in the years afer World War II. Tat decline

began during the Depression o the s and was accelerated

by World War II.Te turnaround to rising income inequality

occurred in the mid- to late s. In able ., is the

turnaround year, because afer that date, the two measures o

income inequality, the Gini coefficient and the Teil index, are

always above their levels (or both measures, increases

mean greater inequality and decreases mean less inequality).

Panel A o able . presents percentage shares o ag-

gregate income (beore taxes) going to each quintile o house-

holds. Note that in the turnaround year o the relative

distribution is quite similar to the distribution. Income

inequality rose afer . Every quintile, except the highest in-

come quintile, showed drops o share rom to . Loss

o share or the bottom our quintiles continued through .

Panel B o able . shows mean household income by

quintile in dollars or selected years, . Te last

column presents the average annual percentage changes in

the means rom , the turnaround year, to , the last

year beore the Great Recession began. All o the changes are


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able .. Summary of Income Distribution rends

Panel A. Shares o household income o quintiles

Lowest quintile . . .

Second quintile . . .

Tird quintile . . .

Fourth quintile . . .

Highest quintile . . .

Panel B. Mean household income o quintiles,

Lowest quintile , , ,

Second quintile , , , Tird quintile , , ,

Fourth quintile , , ,

Highest quintile , , ,

Panel C. Measures o income inequality

Gini Index . . .

Teil . . .

Panel D. Household income ratios

th percentile/th percentile . . .

th percentile/th percentile . . .

Source:DeNavas-Walt and Proctor (), ables A- and A-.


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positive, but they are quite dissimilar. Quintiles one through

our grew less than percent per year, defined here as stagnantgrowth. Te top quintile grew more than percent per year.

Panel C lists the two measures o income inequality, the Gini

index and the Teil, or the same years. In both the Gini

index and the Teil were slightly lower than in , indicating

reduced income inequality. However, both are markedly

higher in and in the last year, .

Panel D shows the household income ratios o the thpercentile (households in the top percent o the income dis-

tribution) to the th and the th percentiles (households in

the bottom percent o the income distribution and house-

holds in the th percent). A rising ratio over time means that

income growth in the th percentile is alling behind income

growth in the th percentile. A alling ratio means the oppo-

site. Note that the : ratio alls rom . in to . in

, meaning that income growth was aster in the th per-

centile (the bottom group) than in the th percentile (the top

group). Tat trend was reversed afer . In the ratio

was ., and it was still higher in . Te pattern is similar

or the : ratio, although the rise afer is less extreme.

Te national trend o rising income inequality begin-

ning in the mid-s is matched by a state trend o diverging

wage growth beginning in the s. Te neoclassical model

iners that wages in sub-parts o the nation will converge over

time, as lower-wage labor moves to higher-wage areas, putting

downward pressure on wages, and reduced labor supply in the

low-wage areas puts upward pressure on wages. Historical data

or states back to mostly support long-run convergence,

except or the decades o the s and the s, but the di-

vergence in the s and the s was dismissed by Robert

Barro and Xavier Sala-i-Martin as aberrations at the time they


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wrote.A more recent study using metropolitan areas instead

o states ound that the income divergence o the s con-tinued into the decade o the s. Tus divergence o in-

come among cities and states may be replacing convergence o

income argued by theory and mostly supported by the earlier

data. What does this have to do with income inequality? I ris-

ing national income inequality is accompanied by divergence

o income among parts o the nation, then regional divergence

may be one source o the increase in national income ine-quality. James Galbraith provides recent striking examples o

metropolitan areas surging way ahead o the pack in income

levels.

Te survey-based Census data in able . indicate that

strong gains o income are concentrated in the top quintile or

the top decile. Te careul analysis o the long-term chang-

ing distribution o income, by Tomas Piketty, Emmanuel

Saez, and their collaborators, is ocused upon a breakdown o

the top decile.Teir data, based on tax files rather than sur-

veys, produces more accurate estimates o top income shares.

Teir data show that the gains in income share o the highest

quintile illustrated in able . are concentrated in the top

percent and especially the top percent. Figure . shows the

share o income received by the top percent and top per-

cent rom to . Te top percent received over

percent o household income in , a share hardly changed

since . But by , the top percent share was per-

cent. Te top percent ared even better, receiving percent

o household income in , up rom percent in .

Te sharp rise in income shares going to the top per-

cent and percent post is not accounted or by renters.

Te large shocks that capital owners experienced during the

Great Depression and World War II seem to have had a per-


32/168


manent effect: top capital incomes are still lower in the late

s than beore World War I. On the other hand, they show

that wage shares were flat beore World War II and dropped

precipitously during the war. op wage shares have started

recovering rom this shock only since the s but are now

higher than beore World War II.

Figure .. Shares o pre-tax income to top percent and top percent, excluding capital gains, . Source:Saez ().


33/168

III

Possible Causes o RisingIncome Inequality

hy has income inequality been rising or al-

most orty years, as documented in Chapter II?

Tere have been some excellent books andarticles on causes o income inequality. Tey

have one characteristic in commonthey treat the major

causes as political and institutional, not economic.

Tis chapter is no exception. It weighs the evidence and

passes tentative judgment. O our broad categories o possible

causeseconomic, demographic, institutional, and political

the first two seem to be the least important.

Economic Causes

Te view among most economists is that the pre-tax distri-

bution o income is the result o market orces. Te govern-

ment amends the market outcome through taxes, transers,

and expenditures. Tereore, in the search or causes o risingincome inequality among those who hold that belie, political

W


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Possible Causes o Income Inequality

causes are off the table. Among economists, the three most cited

causes o rising income inequality are globalization, skill-biasedtechnological change (SBC), and job polarization. By globali-

zation, they mean a number o actors that have become more

important over the decades in the U.S. economy, including

reduced trade barriers, increased immigration, lower inter-

national transport costs, off-shoring o production, oreign

competition, and increased capital flows. In other words, U.S.

labor is aced with more competition rom oreign labor thanin the past, because tariff barriers and transport cost barriers

have diminished, making labor costs relatively more impor-

tant. Te increased off-shoring o production reflects the rise

in importance o relative labor costs. ransport technology

(container ships, super tankers, jet reight) and political agree-

ments (the World rade Organization, multi-nation trading

blocs) have reduced transport costs and tariff barriers, making

relative labor costs loom larger. It is not only goods production

that has been off-shoring to nations with lower labor cost. Ser-

vices such as call centers, routine legal and medical services,

and sofware production have also shifed abroad, usually to

English-speaking nations. Te shif o services would not have

been possible without the massive decline in cost and time o

telecommunication services over the past fify years. What

does globalization have to do with rising income inequality?

All o the actors noted put U.S. labor at a cost disadvantage

with Asian, Latin American, and eastern European labor. U.S.

wages will tend to rise more slowly than in the past beore

globalization. Most economics texts and media analysts treat

globalization as the end o the story, but there is a problem

in that analysis: Canada, the United Kingdom, France, Ger-

many, and Japan are subject to the same orces o globaliza-

tion as the United States. Have they had the same increases


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o income inequality? Te United Kingdom and Canada have

had increases, though less extreme than in the United States.Germany and Japan have had very little increases o inequality,

and France has had none at all.Te comparison suggests that

there is ar more than globalization underlying the U.S. rise o

income inequality.

Along with globalization, SBC is another cause most

cited by economists in explaining the rise o inequality. SBC

is defined as:

a shif in the production technology that avours

skilled over unskilled labour by increasing its rela-

tive productivity and, thereore, its relative demand.

raditionally, technical change is viewed as actor-

neutral. However, recent technological change has

been skill-biased. Teories and data suggest that

new inormation technologies are complementary

with skilled labour, at least in their adoption phase.

Whether new capital complements skilled or un-

skilled labour may be determined endogenously by

innovators economic incentives shaped by relative

prices, the size o the market, and institutions. Te

actor bias attribute puts technological change at

the center o the income-distribution debate.

Some examples can help here. In the past, the same workers

who dug ditches with shovels could learn to operate a back-

hoe. Te same workers who moved and stacked boxes in a

warehouse could learn to operate a orklif. Productivity rose,

but the labor skills required were not o a higher order. Tat

has changed with the ubiquitous use o computers in actories,

offices, and retail stores. Tere is a premium on inormation


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technology (I) skills, ofen associated with college education.

Even though the supply o college graduates has been expand-ing while the supply o high-school-only graduates has been

shrinking, there has been a growing premium or the better

educated. From to the median hourly wage o those

with college degrees rose our times aster than the median

hourly wage o those with only high school degrees.Tis sug-

gests that demand or highly educated workers has been out-

running the increasing supply. One prominent economist who names SBC as a chie

cause o rising income inequality, even among the top per-

cent, is Gregory Mankiw. He claims that rising income ine-

quality at the top is not because o politics or rent-seeking

but rather supply and demand.In other words, SBC makes

employers search out the best and brightest and reward them

handsomely. Although one would think that SBC does not

affect incomes at the very top, some claim that SBC affects

pay o chie executive officers (CEOs), financial executives,

attorneys, and athletes. o place CEOs in the same cate-

gory as athletes ignores the distinction between market and

non-market orces. As Ian Dew-Becker and Robert Gordon

have argued, Te core distinction is that superstars and other

market-driven occupations have their incomes chosen by the

market, whereas CEO compensation is chosen by their peers

in a system that gives CEOs and their hand-picked boards o

directors, rather than the market, control over top incomes.

Piketty and Saez are critical o the SBC explanation o

rising income inequality. Wage shares in the United States, they

argue, cannot be ully accounted or by skill-biased technologi-

cal change, the avored explanation among economists. But or

one o the same reasons globalization cannot ully explain rising

income inequality in the United States, neither can SBC. All


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industrialized nations experience SBC, yet only the United

States has had extreme increases o income inequality.

Piketty and Saez are not alone in questioning the SBC

explanation or rising income inequality. Joseph Stiglitz notes,

Skill biased technological change has little to do with the enor-

mous increases in wealth at the very top. Political scientists

Jacob Hacker and Paul Pierson note that the rising inequality

story is in the top percent o households. Tey argue that

education differences among workers and skill-biased techno-logical change cannot ully explain the hyperconcentration o

income at the top.

Tere is no doubt that some o the rising inequality below

the very top can be attributed to globalization and SBC. But

that cannot be the ull story, because other rich, developed

nations subject to the same orces have had more modest in-

creases o inequality than the United States, and neither glo-

balization nor SBC can explain the huge gains o income

share o the top percent and . percent.

Te third possible cause o rising income inequality de-

veloped by prominent labor economists is job polarization,

usually defined as stronger employment growth in jobs at the

top and bottom o the wage distribution than in the middle.

Job polarization is commonly described as a hollowing out

o middle-skill jobs. However, the job polarization model does

not well describe changes in the labor market and link them

to the rise o wage inequality. As Lawrence Mishel and his col-

leagues note, upgrading o occupations in the United States

has been a long-term trend that can be traced back to

with available data. Tus, it was occurring in the period oall-

ing wage inequality, , and in the period o rising wage

inequality, in the late s.

In his recent book Capital in the wenty-first Century,


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Piketty identifies an economic cause o rising income inequal-

ity at the top. As the capital-income ratio slowly rises over timeand the annual return to capital grows aster than gross do-

mestic product (GDP), the share o national income going to

the owners o capital rises, and so the share going to labor de-

clines. Te ownership o capital is highly concentrated among

the top percent o the income distribution, and so their share

inexorably rises.But that is a very long-term story and can-

not ully account or the rising share o the top percent docu-mented in the previous chapter. It reflects the act noted there

that one-hal to two-thirds o the income o the top percent

comes rom earnings rather than capital. So Pikettys hypothe-

sis, i true, would be a minor cause or the United States. Tus,

to account more ully or the rise o income inequality requires

looking beyond economic explanations.

Demographic Causes

Te demographic portrait o the United States has undergone

marked changes over the past thirty years or so. Some o those

could raise income inequality. Married couples with young

children have diminished as a share o all households, while

single-person households have risen. Te elderly population

is growing rapidly as the baby boom generation moves into

retirement. One o the most noted changes has been the in-

creased labor orce participation by women, which rose rom

percent in to percent in .One o the demo-

graphic changes that has raised income inequality is the ten-

dency o highly educated employed emales to marry males

o the same status. In the s, college-educated males who

married were ar more likely to have stay-at-home wives than

today. A one-earner amily back then with a college education


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had higher earnings on average than a one-earner amily with

high school only. oday, two-earner amilies, where both havecollege degrees, have ar higher earnings than a one- or even

two-earner amily with high school degrees only. Tus they

are urther apart on the income distribution.

How much o the rise o income inequality could be ex-

plained by demographic shifs like the ones above? Rebecca

Blank undertook a thorough examination o that issue in her

book Changing Inequality(). Blank perorms a number ocareul simulations o effects on income distribution o various

hypothesized demographic changes, such as: What i amily type

and size remained unchanged rom to ? She finds, In

general, the results suggest that none o these changes, by them-

selves, would have major effects on income distribution. . . .

Even large changes, however, leave income inequality closer to

its level than its level, suggesting that a major rever-

sal in inequality is unlikely in the absence o substantial and

currently unoreseen changes. Her rigorous analysis o de-

mographic actors concludes that only percent o the rise o

income inequality since can be attributed to them. As she

summarizes her findings, Te results o this detailed analysis

indicate that changes in amily composition and amily size

account or about percent o the rise in U.S. income inequality,

while changes in income account or the remaining rise in ine-

quality. Most o this rise is due to increases in wage inequality.

Tus, neither economic causes nor demographic causes can ully

explain rising income inequality in the United States.

Institutional Causes

Te most convincing explanation or rising income inequal-

ity lies in an examination o institutional and political actors.


40/168


One is the decline in labor unions. Te peak o unionization in

the United States was percent in . In , union mem-bership was down to percent.One could note orces in a

modern economy pushing union membership downward. For

example, rising productivity in manuacturing has led to ab-

solute reductions in the number o production workers even

as output increases. Furthermore, employment has shifed out

o goods production and distribution industries (manuactur-

ing, wholesale trade, transportation, and warehousing), whereunions were traditionally strong, and into service-type indus-

tries, such as retail trade and health services, where unions

had not been prominent. But those orces are at play in other

modern rich nations without a similar effect on unionization.

When the U.S. unionization rate was percent in , the

rate in Canada was percent. It is still around percent

there. Given that both economies are subject to the same

market orces, how can we explain the precipitous drop in U.S.

unionization while in Canada the rate is where it was orty

years ago? Jacob Hacker and Paul Pierson argue that the differ-

ence in labor law in the two countries account or union cov-

erage shrinking in the United States and not in Canada. Some

Canadian provinces have laws that allow or card check certi-

fication and first contract arbitration. Provinces ban the hiring

o permanent strike replacements and employer intererence

into unionization campaigns. In contrast, anti-union action by

employers in the United States has met little resistance by gov-

ernment authority. As they point out, inaction as well as action

can undercut the power o unions. Te absence o an updat-

ing o industrial relations policy has had brutal effects on the

long-term prospects o organized labor.A major labor law

reorm bill promoted by organized labor in that would

have accomplished an updating o labor policies by banning


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the use o strike replacements was supported by a majority o

the House and Senate and President Jimmy Carter, all Dem-ocrats. However, it was derailed by a filibuster in the Senate,

supported by some Democrats, and was never enacted.

O course the waning power o labor unions is not the

only actor to explain the tremendous rise o income shares

at the top o the distribution. Rather, a large part o the ex-

planation lies in the increasing political power and effective

organization o business interests, including businesses whoseclients are at the top percent o the income distribution, such

as mutual unds and other financial firms. As income going to

the top end o the distribution has been rising, they raise und-

ing to influence political outcomes in Washington and state

capitals by lobbying and political contributions. Te ailure o

progressive labor law legislation is only one example o their

success in influencing social policy. More examples ollow in

the next section.

Political Causes

Economists stress market orces and technology as causes o

rising income inequality. Political scientists stress the median

voter theorem in their analysis o why income inequality has

been rising. But neither o those views takes into account

organized interests. In an article called Winner-ake-All

Politics (), which they later developed into a book with

the same title, Jacob Hacker and Paul Pierson present a co-

gent empirical story about the sharp rise o income shares at

the top developed around three claims. First, government in-

volvement in the modern economy is broad and deep. Second,

policy transormation occurs through both enactment and


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non-enactment. Tird, shifs in organized interests are a major

orce in policy change. Te first, government involvement in the modern econ-

omy is broad and deep, flies against the conventional view

among most economists that the distribution o pre-tax income

is the result o market orces. Te role o government, they

argue, is limited to the fiscal side: taxation and transers that

can alter the market distribution o income. Tis is a naive

view. A number o government policies tilt the distribution opre-tax income in avor o the very top o the income distribu-

tion, including:

. ort reorm and arbitration law trends that cur-

tail power o consumers and stockholders to hold

corporation management legally accountable or

purported wrongdoing.

. Special treatment o corporate stock option

awards.

. Restricting access to bankruptcy protection or

consumers and business.

. Extending time o copyright protection or some

large firms.

. Extending time o patent protection or non-

generic drugs.

. Forbidding Medicare to bargain or lower phar-

maceutical prices.

Note that all six o these policies avor corporations and their

owners. Te current broad and deep involvement o the ed-

eral government in the economy is similar to that o the Gilded

Age. Long ago, in , John R. Commons, an economics pro-


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essor at the University o Syracuse, argued that a substantial

share o U.S. corporations owed their quasi-monopoly mar-ket power to privileges and protections, such as patents and

copyrights, bestowed by the ederal government. Te ensuing

storm o protest rom business and rom economists led to his

dismissal by the University o Syracuse. He was right, and he

touched a nerve.

Te second claim is that policy transormation occurs

through both enactment and non-enactment, or what theycall policy drif. Non-enactment occurs through filibusters

in the Senate, a tactic increasingly pursued in the polarized

body. According to Senate rules, ending a filibuster requires a

supermajority o sixty votes. Tus, a determined minority can

use the filibuster to block legislation. In the fify years rom

to , fify-six motions were filed to stop a filibuster, but

rom through there were , filed, most o them

afer .

Finally, shifs in organized interests are a major orce in

policy change. Hacker and Pierson document a huge rise o

special-interest organizations in Washington beginning in the

s. Corporations with a public affairs office in Washing-

ton went rom one hundred in to five hundred by .

Further, the three giants o promoting and protecting corpo-

rate interests, the National Association o Manuacturers, the

Business Roundtable, and the Chamber o Commerce, greatly

expanded their membership and budgets afer . Needless

to say, the headquarters o all three are in Washington, D.C.

Te National Association o Manuacturers was ormerly in

New York, but it moved to Washington around .

Labor and consumers, the main countervailing powers

to businesses in a capitalist democracy, have no similar weight

in Washington. Unions are the only organizations pushing or


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bread-and-butter issues or workers in Washington, yet they

have a small raction o the lobbyists employed by business,

and they are alling behind. Other liberal organizations push-

ing environmental issues, civil rights, and womens issues are

also alling behind, as shown in able ..

An example o the overwhelming numbers o lobbyists

representing business interests: there are about one thousand

registered Washington lobbyists who list taxes as one o their

areas. Yet in the estate tax fight, an issue o great importance

or income distribution, only one union lobbyist was available

to represent worker and consumer interests.

Although most attention o the media is on election

campaign unding, that apparently is not where corporations

spend more to influence government outcomes. Companies

generally spend about twelve times more on lobbying than

they spend on campaign contributions [political action com-

mittees, or PACs]. Lobbying expenditures in Washington,

adjusted or inflation, have risen percent since . Tat

is ar more than other measures o legislative activity, such as

bills introduced (+ percent), ederal budget (+ percent),

and Federal Registerpages (+ percent).

Shifs in organized interests avoring the issues o corpo-

rations and the wealthy are also reflected in the rise o think

able .. Lobbying Presence

in WashingtonInstitution

Business , ,

Union

Public interest

Source: Based on Drutman ().


45/168


tanks unded by conservative intereststo name the most

prominent, the American Enterprise Institute (AEI), the Her-itage Foundation, the Olin Foundation, the Hoover Institu-

tion, and the Cato Institute. Tey are heavily engaged in lobby-

ing and political suasion on behal o conservative viewpoints.

Older think tanks such as the Brookings Institution and the

wentieth Century Fund (now the Century Fund) could be

described as centrist or liberal, and engage in much less ad-

vocacy than the new conservative organizations. Te HeritageFoundation allocates percent o its budget on public rela-

tions and outreach, whereas Brookings allocates percent.

Many i not all o the objectives o business lobbying,

election campaigning, and advocacy can be described as

rent-seeking. Te economic definition o rent-seeking is

Spending time and money not on the production o

real goods and services, but rather on trying to get

the government to change the rules so as to make

ones business more profitable. Tis can take vari-

ous orms, including seeking subsidies on the out-

puts or the inputs o a business, or persuading the

government to change the rules so as to keep out

competitors, tolerate or promote collusion between

those already engaged in an activity, or make le-

gally compulsory the use o proessional services.

In this definition, rent-seeking is the expenditure o resources

to make ones slice o the pieGDPlarger at the expense o

someone elses share. Resources so spent are wasted because

they do not add to societys total output; they simply change

the shares received by each o the parties. Rent-seeking is not

always acilitated by government action, as implied by the


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quoted definition. It can result rom government inaction as

well as rom actions by private parties. Successul rent-seekingthat shifs more o national output (income) to the top per-

cent or . percent may well be the most important cause o

rising income inequality at the top o the income distribution

over the past orty years in the United States. It is covered here

under political causes because it is most ofen acilitated by

government action or government ailure to act.

In his recent book Te Price o Inequality,Joseph Stiglitzplaces rent-seeking ront and center in Chapter (Rent Seek-

ing and the Making o an Unequal Society). He claims that

some o the most important innovations in business in the

last three decades have centered not on making the economy

more efficient but on how better to ensure monopoly power or

how better to circumvent government regulations intended to

align social returns and private rewards.Mankiw argues to

the contrary that there is no good reason to believe that rent

seeking by the rich is more pervasive today than it was in the

late s. But there is a good reason. Te top marginal tax

rate was around percent in the late s. It has since been

lowered a ew times as well as raised and is now . percent.

Tat means any successul rent-seeking effort by those in the

top tax bracket today has an afer-tax payoff almost double the

size o a similar one in the s.

For example, it is assumed by economists that perect

competition requires parties to transactions to be equally en-

dowed with inormation. Yet bankers, the sellers o derivatives,

have been fighting to keep derivatives in the opaque over-the-

counter market where the bankers know ar more about the

derivatives they trade daily than the sometime buyers.

Echoing Commons in , Stiglitz argues that patent

law can protect monopoly power. Te details o patent law


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can extend the lie o the patent, reduce entry o new firms,

and enhance monopoly power. Americas patent laws havebeen doing exactly that. Tey are designed not to maximize

the pace o innovation but rather to maximize rents.

Te ailure o government to act in corporate govern-

ance provides what might be the largest single cause o rising

income inequality at the very top. As is well known, average

CEO pay has been growing rapidly since about , with

some cyclical ups and downs. But the base o corporate reve-nues, value added, or stock prices has been growing slower. In

other words, CEOs are taking a bigger slice rom a moderately

growing pie. Tat is rent-seeking. Te losers are lower-level

employees and stockholders. But there is not agreement on

that issue. In a paper examining why CEO pay has increased so

much, the authors develop a model that can explain the recent

rise in CEO pay as an equilibrium outcome o the substantial

growth in firm size. Gordon and Dew-Becker are skeptical:

We endorse their idea [principal-agent control o stockholders

should be reversed] that managerial power lies behind some

o the outsized gains in CEO pay, while also recognizing that

stock options created an automatic spillover rom the stock

market gains o the s directly into executive pay.

It is difficult to show rent-taking with available data.

However, Josh Bivins and Lawrence Mishel present evidence

showing growth o CEO pay (including options exercised) o

the top Standard & Poor (S&P) firms based on sales.

By looking at the S&P stock index over many years, they

show that when the S&P went up in (+ per-

cent), CEO compensation went up much more (+, percent).

When the S&P went down in ( percent), CEO

compensation went down about the same ( percent).


48/168

R

IV


ecent years have seen a huge rise o household debt,

and rising income inequality has likely been a major

cause o this increase in debt. Here we will take a

look at the rise o debt and examine the economet-

ric evidence that supports the argued link rom rising income

inequality to the rise o household debt. Debt-to-income ratios

rose sharply as growth o household debt ar exceeded growth

o income. Households stagnant incomes and rapidly rising

house values induced them to take on ar more debt, a move

acilitated by relaxed credit standards and low interest rates.

Household Debt: National Macro Data

Te System o National Accounts financial data indicate that

households, combined with nonprofit institutions, were net

lenders or most o the long period since the s. Tat is,

their net savings exceeded their net capital ormation (primar-

ily residential investment).

Figure . illustrates that pattern o households shifing

rom long-term net lenders to net borrowers in relative terms.


49/168


Te top line in the lef part o Figure . is net saving (lend-

ing) as a percentage o disposable income. Te lower line is net

capital ormation (primarily residential investment) as a per-

centage o disposable income. Both are or the household and

nonprofit institutions sector. From the mid-s to the early

s, the share o savings fluctuated around percent o dis-

posable income; thereafer it mostly declined through .

Te net capital ormation (borrowing) share o disposable in-

come fluctuated below percent in the early years, and then

in the mid-s it began rising to its peak in . By the

late s, the net capital ormation share moved above the

declining net savings share. Afer , both lines abruptly

change direction, so that by the net savings share is well

above the net capital ormation share. Te act that households

Figure .. Net saving and net capital ormation as percentage odisposable income, . Source:Bureau o Economic Analysis

(n.d.), National Economic Accounts, able S..a, December .


50/168


went rom a long-term net lending position to a massive net

borrowing position beginning in suggests that the Systemo National Account data had pointed to an imminent finan-

cial crisis.

o get a detailed picture o the rising indebtedness among

amilies alone, excluding nonprofit institutions, requires data

rom the Survey o Consumer Finances (SCF), which is pro-

duced by the Federal Reserve Board every three years. Te

earliest SCF data is rom , and the latest rom . Broadvariables covered by the SCF are income, assets, and debt o

amilies. Because the SCF collects data on assets that are heav-

ily concentrated among the richest amilies, in order to be rep-

resentative and meet validity standards, the sample is designed

to capture sufficient numbers o upper-income amilies.

Te dollar value o debt holdings, in real terms, has risen

sharply. able . presents the median value o debt holdings by

debt categories or three years: , , and . (Te SCF

data are only collected every three years). Note that amilies

with no debt in a given category are excluded rom the calcula-

tion o the medians. Residential mortgage debt dwars the other

three categories in size. It includes not just first mortgages on a

amilys primary residence but also second mortgages, refinanc-

ing, home equity loans, and vacation homes. Te median amily

mortgage debt in constant dollars rose rom , in to

, in . Most o that rise occurred rom to ,

the period when aggregate mortgage liabilities increased by

. trillion (see able .). Te to increase in median

real mortgage debt, percent, is many times larger than the

increase in median household real income over that period

only percent.It has diminished somewhat since its peak o

, in , reflecting the bursting o the housing price

bubble and the resulting reduction o mortgage lending.


51/168


Te largest part o consumer debt is mortgages, as noted

above. Te Federal Reserve publishes two measures o house-

hold debt burden: the Debt Service Ratio (DSR) and the Finan-

cial Obligation Ratio (FOR). Te DSR measures debt payments

as a share o disposable income or all households. Te FOR

measures mortgage debt, home insurance, property tax, and

consumer debt as well as automobile leases as a percentage o

disposable income or homeowners only. Both are shown or

selected years in able .. Although both indices are higher

in than in , the individual years data reveal no trend.

In some years beore the indices are higher, and in some

years lower. Tat changes post when most year-to-year

changes are positive. Te values shown are record highs

able .. Median Value of Family Debt Holdings

( thousands)

Year

Primary

residence

and other

residential

mortgage

debt

Credit card

and lines

o credit

other than

residential

Installment

loansa OtherbAny

debt

. . . . . . . . . .

. . . . .

Percent change

. . . . .

a Includes education, vehicle, and other.b Includes cash value o lie insurance loans, pension account loans, margin account loans,

and other miscellaneous loans.

Source:Federal Reserve Board ().


52/168


or each index. But ollowing the financial crash and Great Re-

cession, both measures were lower than their values.

Household Debt by Income Group

Growth in median amily residential mortgage debt among

different quintiles and deciles o the income distribution over

the to period was substantial and broadly similar, as

reported by the Survey o Consumer Finances and presented

in able .. Shown is the largest debt category, mortgages on

primary residences, which increased substantiallyrom

percent in quintile two to percent in the second-rom-the-

top decile (..).

Based on data rom the SCF, Figure . shows debt-to-

income ratios or the top percent o the income distribution

and the bottom percent. Te authors note about the figure,

In the top income group is somewhat more

indebted than the bottom group, with a gap o

around percentage points. In , the situation

was dramatically reversed. Te debt-to-income

ratio o the bottom group, at . compared to

an initial value o ., was now more than twice

able .. Household Debt Burden

First Quarter o Year DSR FOR

. .

. .

. .

. .

Source:Federal Reserve Board (b).


53/168


as high as that o the top group. Between and

, the debt to income ratio o the bottom group

thereore more than doubled while the ratio o the

top group remained fluctuating around .

But the figure also shows that the huge run-up o the debt-to-

income ratio or the bottom percent occurred in the period

afer . Te authors iner rom Figure . that it is part o

the explanation or why consumption inequality has not in-

creased nearly as much as income inequality. Tat is, the bot-

tom percent o the wealth distribution has taken on much

more debt in order to maintain their consumption.

Subprime Mortgages

One o the direct causes o the financial crash was the increased

volume o subprime mortgages that were bundled into securi-

ties and sold to investors. Te collapse o prices or those secu-

ritized debt obligations touched off the financial crisis. Tere

able .. Median Family Residential Mortgage Debt by

Quintiles, , , and ( thousands)Percent change

Quintile

Quintile . . . . .

Quintile . . . . .

Quintile . . . . .

Quintile . . . . .

nd top decile, . . . . . .

op decile, . . . . .

Source:Federal Reserve Board (), ables through .


54/168


was a stunning rise o subprime mortgage originations rom

slightly over , in to over two million in , the

peak year.Te total o originations is split between refinanc-

ings and purchases. In every year rom through , the

refinancing with subprime mortgages is to percent o total

originations. A major purpose o mortgage refinancing is to take

out cash. As shown in Figure ., the ratio o debt to income or

the bottom percent o the wealth distribution shot up sharply,

rom percent in to near percent in . Some part

o that rise reflects the fiveold increase in subprime mortgages.

Tat rise has not been geographically concentrated so

much as credit score concentrated. In a paper that splits a

huge sample o zip codes into quartiles based on credit scores,

the bottom quartile is labeled subprimethat is, it has the

highest share o households with credit scores o or less.

Te authors ound that the mortgage deault rate in o

subprime zip codes was three times higher than the rate in

Figure .. Debt-to-income ratios, . Source:Reprintedwith permission rom Michael Kumho, Romain Ranciere, and

Pablo Winant (), Inequality, Leverage and Crises: Te Caseo Endogenous Deault, International Monetary Fund Working

Paper, WP//, November, p. .


55/168


prime zip codes. Additionally, mortgage credit growth in sub-

prime zip codes (the quartile with the highest share o creditscores below ) was two times greater than mortgage credit

growth in prime zip codes (the quartile with the lowest share

o credit scores below ). Subprime zip codes are not region-

ally concentrated but rather are present in most metropolitan

areas. Correlation between mortgage credit growth and in-

come growth was negative in the period, whereas it

was positive in the prior fifeen years. Beore the expansion insubprime mortgage lending, applications or mortgage credit

rom subprime zip codes were more likely to be denied than

those rom quartiles with higher credit scores. However, rom

to , denial rates or subprime zip codes all dispro-

portionately. An examination o house price indices by zip

code shows that house price gains or subprime zip codes in a

county are greater than gains or non-subprime zip codes.

Christopher Mayer and Karen Pence established that

the use o subprime mortgages is not ubiquitous over states

or metropolitan areas, or in demographic characteristics o

borrowers. Looking at the data by state, they showed that sub-

prime originations as a percentage o all originations in ,

the peak year or subprime originations, were percent or the

nation. Te our states with the highest concentration o sub-

prime and Alt-A mortgages as reported by the New York Fed-

eral Reserve Bank in had subprime originations in at

or above the national average: Nevada, percent; Florida,

percent; Arizona, percent; and Caliornia, percent. Te

state shares o subprime originations range rom the high o

percent in Nevada to the low o percent in West Virginia.

Te same data or metropolitan areas in show much

greater variation. Te average or large metro areas is

percent. Memphis and Bakersfield, Caliornia, are tied or


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first place with percent. Madison, Wisconsin, is in last place

with only percent. Anecdotal comparisons that spring tomind in thinking o those three places are that both Memphis

and Bakersfield have high shares o minority population, low

median incomes, and low levels o educational attainment.

Madison is the opposite on all three measures. Te top ten

places in share o subprime mortgage originations include the

most likely suspects because o large house price increases and

construction booms: Las Vegas, Miami, and Houston, as wellas Detroit, which had well under average price appreciation

and certainly no construction boom. Four o the top ten are

mid-size Caliornia metros ar rom the coast, some o which

had construction booms, and all o which have large Hispanic

population shares and low educational attainment.

Mayer and Pence ound that subprime lending is not

elevated only in metros with strong housing price surges.

Tey cite New York and Boston as places with relatively high

house price appreciation, but not much in the way o subprime

mortgages. But subprime lending surged in depressed housing

markets o the Midwest because conventional lending had di-

minished. Looking at neighborhoods with zip code data, they

ound that subprime mortgages are concentrated in locations

with high proportions o black and Hispanic residents, even

controlling or the income and credit scores o these zip codes.

Household Debt, Bankruptcies, andHouse Prices: State Data

Te strong rise o household indebtedness documented here

was not underpinned by a strong rise o household income. It

was underpinned by the housing price bubble and supply-side

actors that increased the availability o creditsubprime mort-


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gage lending, low interest rates, relaxed credit standards, and

financial deregulation that made residential property more liq-uid. Both the explosion o debt and allout rom the collapse o

the housing price bubble were mostly ubiquitous across states,

although our states stand out or larger gains and more severe

declines: Arizona, Caliornia, Nevada, and Florida. Tose are

the states that had the highest concentration o toxic real es-

tate assets: subprime and Alt-A mortgages. Although the our

states share o all housing units in the nation is percent,they account or percent o all subprime mortgages and

percent o all Alt-A mortgages.Te top panel o able .

summarizes debt, mortgage debt, house prices, and median

household income or all states and the District o Columbia

rom to and then to . Te bottom panel repeats

those measures or the our more volatile states named above.

For all states in the period , per capita total debt,

mortgage debt, and the house price index rose strongly, while

median household income hardly changed, gaining less than

percent. But then in the ollowing years, , they all

moved in the opposite direction, including median household

income, which ell almost percent. Large as those swings are,

they are more extreme in the our states with high concen-

trations o subprime and Alt-A mortgages. Note that the data

in able . are simple averages or states. Excluding the our

states rom the calculations or the top panel, the picture does

not change much. Tat is, debt and house prices rise some-

what less rom to , and decline somewhat less rom

to . Te point is that the huge run-up in debt and the

housing price bubble cannot be attributed only to toxic mort-

gages in the our states with high concentrations o such loans.

Te sluggish growth o household income by state com-

pared with soaring per capita household debt and house prices


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rom to , presented in able ., points to a precari-

ous financial condition or many households. A surge o per-

sonal bankruptcies post prompted a strong pro-creditor

reaction by Congress so that upward trends were abruptly

halted in . Te Bankruptcy Abuse Prevention and Con-

sumer Protection Act enacted in April and effective in

October o that year briefly slowed the rise. Te purpose o the

law was to curb the rise o bankruptcies, both business and

non-business, by raising the barriers to filings. Te declines

able .. Household Debt Compared with House Prices

and Median Income,

Year

otal debt

per capita

(

thousands)

Mortgage debt

per capita

(

thousands)

House

price index

( Q = )

Median

household

income

(

thousands)

Simple averages or states and District o Columbia

. . . .

. . . .

. . . .

. . . .

Simple average or our statesa

. . . .

. . . . . . . .

. . . .

a Arizona, Caliornia, Florida, and Nevada.

Source:Household debt per capita rom Federal Reserve Bank o New York ().

Median household income in dollars rom U.S. Census Bureau (n.d.), Current

Population Survey. House price index rom Federal Housing Finance Agency ().


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rom to are around percent. However, the earlier

upward surge was resumed in , so that by per capitabankruptcies were well above their levels.Te intention

o Congress was apparently overtaken by overwhelming fi-

nancial hardship post . Te act o Congress was inspired

more by the perception o bankruptcy abuse than by a desire

or consumer protection. Te characterization o personal

bankrupts as deadbeats was probably important or passage

o the bill. But that characterization was alse. A careul studyo non-business bankruptcies ound that Bankrupts incomes

are low at the time o filing, the consequence o about two-

thirds o the amilies reporting a job loss, ailure o a small

business, a cutback in hours worked, or some other income

interruption. But when they are measured by the enduring

criteria o education, occupation, and home ownership, about

o the debtors qualiy as solidly within the middle class.

REGRESSION RESULS LINKING RISING HOUSEHOLD

DEB O RISI NG IN COME I NEQUALIY: SAE DAA

A central argument o this book is that the huge run-up in

household debt that was one o the major causes o the finan-

cial crisis, and the Great Recession wa

Matthew P. Drennan-Income Inequality_ Why It Matters and Why Most Economists Didn’t Notice-Yale...

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