Understanding economic inequality and growth at the bottom of the income ladder

Posted on by Bridget Ansel

Today the official poverty rate in the United States is back to levels we haven’t seen in 20 years, and the incomes of families at or near the bottom of the income ladder are at the same level they were in the early 1970s. Studies show poverty rates on the decline since the beginning of Great Society programs in the 1960s until the late 1990s, but seeing as wages have not improved, this decrease in poverty was almost entirely due to increased government transfers.

Poverty is back up because wages at the bottom have stagnated or fallen. Over the past 40 years, workers in the bottom 40 percent of the wage spectrum experienced negligible wage growth, and wages have fallen for those in the bottom 10 percent, after accounting for inflation. The trends have been worse for men than women, in no small part because women’s increased educational attainment and on-the-job experience have boosted their wages over the past few decades.

Graphical-bottom

Researchers find that the lack of wage-and-income growth for families at the bottom of the income ladder in particular results in serious economic consequences. First, the continued lack of income growth harms low-income children’s development, which affects our nation’s future human capital. Second, a growing body of evidence suggests that the lack of income gains at the bottom have macroeconomic consequences because it either reduces consumption or encourages more debt, both of which are destabilizing.

But there are remedies for these problems, such as raising the minimum wage. Research by economists Daniel Aaronson and Eric French at the Federal Reserve Bank of Chicago and Sumit Agarwal of the University of Singapore find that increasing the minimum wage boosts the consumption of affected workers.And a battery of other research shows that raising the minimum wage does not reduce local employment and reduces employee turnover.

The three essays in this section of our conference report—by Christopher Wimer, a research scientist at Columbia Population Research Center, Arindrajit Dube, an associate professor of economics at the University of Massachusetts-Amherst, and Gavin Kelley, chief executive of the Resolution Foundation in the United Kingdom—look the overall exclusion of low-wage workers from the benefits of economic growth and how that affects the future growth and stability of our economy. They also consider whether the government should focus on raising market wages though policies such as the minimum wage, anti-poverty assistance or some better combination of the two approaches.

Reversing inequality at the bottom: the role of the minimum wage

by Arindrajit Dube

There are many factors affecting the growth in wage inequality in the United States over the past four decades. When it comes to workers on the bottom rungs of the income ladder, one important factor is the minimum wage.

The federal minimum wage reached its high-water mark in 1968, when it stood at $9.59 per hour in 2014 dollars, declining to a still-respectable $8.59 by 1979. During the 1980s, however, the real (inflation-adjusted) minimum wage declined substantially. And over the past 20 years, the minimum wage has largely treaded water, reaching a historical low of $6.07 per hour in 2006 just before the last federal increase in 2009. The minimum wage now stands at $7.25 per hour in today’s dollars.

The failure of the minimum wage to keep up with inflation means that, for workers earning the minimum wage, each hour of labor purchases less goods and services today than it did in the past.

Minimum wage workers are not only (contrary to popular belief) teenagers and young adults whose low wages are supplemented by their families. In fact, between 1979 and 2011, the share of low-wage workers—defined as those with wages of $10 or less in 2011 dollars—under the age of 25 years of age fell to 35.7 percent from 47.1 percent. Instead, minimum wage workers are increasingly adults who must rely exclusively on their meager earnings to support basic household consumption. The decline in the value of the minimum wage affects female workers in particular, as they tend to be paid lower wages.

Low minimum wages are also problematic when they deviate too far from the median wage because that means minimum-wage earners are falling farther behind on the income ladder. This is why economists often use the ratio of the minimum to the median wage. The so-called 50/10 wage gap—the median wage earner compared to those with earnings in the bottom 10 percent of the income ladder— captures this type of wage inequality over time. Since 1979, around a third of the changes in the 50/10 wage gap have been driven by changes in the minimum wage.

There are two main reasons to pay attention to this measure. First, a comparison of the minimum wage to the median offers us a guide to how many workers are affected by a particular minimum wage increase, and what level of minimum wage the labor market can bear. When this ratio is low—say around 0.2—the policy is not raising wages of many workers. In contrast, a high ratio—say around 0.8—indicates a highly interventionist policy where the minimum wage is dramatically compressing differences in wages for nearly half the workforce.

Second, the median wage provides a reference point for judging what is a reasonable minimum wage level. No one expects that the minimum wage should be set equal to the median wage, but fairness concerns matter when the minimum wage falls below say, one-fourth or one-fifth of the median wage.

A natural target is to set the federal minimum wage to half of the median wage for full-time workers. This target has important precedence historically in the United States. In the 1960s, this ratio was 51 percent, reaching a high of 55 percent in 1968. Averaged over the 1960–1979 period, the ratio stood at 48 percent. Today, the ratio stands at 38 percent. Raising the federal minimum wage to around $10/hour would restore the value of the minimum to around half of the median full-time wage, yet efforts at raising the minimum wage have largely stalled in a deeply divided Congress despite widespread political support around the country.

This federal inaction has led to a flurry of activities at the state and local level. States have stepped in during periods with a stagnant federal minimum wage in the past, especially the 2000s, but for the first time in U.S. history we have many major cities establishing citywide minimum wages for all (or most) private-sector workers. The growing list of cities with such a policy now includes Albuquerque, Chicago, San Francisco, San Diego, San Jose, Santa Fe, Seattle, and Washington, DC. Other cities such as Los Angeles and New York are actively exploring possibilities.

This push to increase minimum wages in big cities coincides with organizing by workers in fast-food chains in major metro areas. The target minimum wage in most of these areas is substantially higher in nominal (non-inflation-adjusted) value— with $15/hour a focal point for these campaigns. The confluence of these factors raises the possibility of substantially altering wage standards in the U.S. labor market.

How should we think about these sizable increases in the minimum wage? First, we should be careful not to overstate the size of the increases or the levels of the minimum wages because the cost of living and overall wage levels vary tremendously by region. Setting the minimum wage to half the full-time median wage would produce $10/hour policy nationally, but much higher figures in major metro areas such as Washington, DC ($13.51), San Francisco ($13.37), Boston ($12.85), New York ($12.25), and Seattle ($11.85).

Moreover, these higher nominal wages are usually phased in gradually. In Seattle, the hourly minimum wage will eventually rise to around $14 in 2014 dollars. This constitutes around 59 percent of the median full-time wage in that metro area, which is certainly higher than historical standards but not outlandishly so.

So what we do know about the impact of minimum wages over the past few decades and the importance of particular channels for the higher, local wage standards? First, most careful recent work points to relatively small impact on employment—be it for sectors such as restaurants or retail or for groups such as teens.3 As a result of wage increases and small impact on employment, family incomes rise at the bottom. A 10 percent increase in the minimum would reduce the poverty rate among the non-elderly population by around 2 percent, and generally raises family incomes for the bottom 20 percent of the family income distribution.

It is possible that the much larger increases in minimum wage may induce greater substitution of low-skilled labor with automation, or with fewer but more high-skilled workers? If this is true then we would expect evidence of growing “disem­ployment” (workers out of a job due to lack of skills or education) from these higher city-wide wage standards. Yet recent research also identifies some additional benefits that may be more important than larger wage increases. A growing body of research shows that while the impact on employment stock is small, there are larger reductions in employment flows or turnover. The reduction in turnover provides additional evidence that search frictions in the low-wage labor market are quantitatively important and offer some clues as to the way cost increases may be absorbed.

Given the cost of recruiting and training new workers, for example, reduction in turnover can be expected to offset about a fifth of the labor-cost increases associated with minimum wage hikes in this range. I think the large city-wide increases will provide us with some additional evidence on this topic. In particular, I believe it should be possible to assess whether the lower turnover regimes lead to substantially different training policies as would be predicted by some models incorporating “search friction”—things that prevent or make it more difficult for workers to find the kind of jobs they want. Moreover, it will be interesting to see whether change comes from the extensive margin (growth in high-training/low-turnover firms) or the intensive margin (change within firms).

The nature of high-cost metro areas means that a substantially higher minimum wage may allow more lower-wage workers to live closer to their place of work (inside the city) and reduce commute time. The labor-supply effect from this “in-migration” also can reduce recruitment costs and improve the quality of the service work force. These additional channels will be useful to keep in mind in future research.

Evidence also suggests that, in part, cost increases associated with a higher minimum wage are passed on to customers as price increases, especially for industries that employ high levels of low-wage labor. The best evidence suggests that a 10 percent increase in minimum wage would raise fast food prices by around 0.7 percent. There are reasons to believe that the higher income customers inside major cities are better able to absorb price increases without cutting back on demand. Limited evidence from San Francisco tends to confirm this observation.

Finally, there is some evidence that low-wage workers substantially increase consumption in response to wage hikes.  Daniel Aaronson and Eric French at the Federal Reserve argue that the higher marginal propensity to consume among low-wage work­ers is likely to lead to some short-term increases in economic growth from a minimum wage increase. My reading of the evidence is that it is somewhat difficult to accurately assess the importance of this channel, in part because the relatively small number of minimum wage workers makes any aggregate demand effect fairly small. But I do think that the size of increases and possible in-migration of low-wage workers into urban areas may increase the local demand impact of a city wage standard.

Minimum wage policies are a powerful lever for affecting wage inequality in the bottom half of the labor market. Modest increases in minimum wages can raise the bottom wage, and family incomes, without substantially affecting employment. But minimum wages are limited in their reach, and cannot be expected to solve all our problems when it comes to wage inequality. At the same time, the much higher wage standards being implemented in some of the cities offer the possibility of taking this policy “to scale.”

Along with this greater promise, however, come added risks. The reality is that we do not know very well how these policies will affect the local economy. Future researchers would do well to utilize the careful identification strategies that have been the hall­mark of recent minimum wage research to study these high city-wide minimum wage increases. Doing so will deepen our understanding of the functioning of the low-wage labor market, and help us gauge the proper scope of this important public policy.

Economic inequality and growth in the United Kingdom: Insights for the United States

by Gavin Kelley

After an extraordinarily long and deep economic downturn, the United Kingdom is finally enjoying belated but comparatively strong growth. The current recovery is jobs-rich, with employment growth massively outper­forming expectations relative to gross domestic product. That’s the good news. In stark contrast, however, pay growth remains unprecedentedly weak and productiv­ity has plummeted. Real (inflation-adjusted) wages have fallen for six years straight, with even nominal wages growing at less than 1 percent in recent months—the lowest increase ever recorded.

This apparent collapse in the link between economic growth and real wage gains is more extreme than anything we have seen before. But the trend has not emerged completely out of the blue. Even as the U.K. economy continued to grow steadily prior to the financial crisis and global recession in 2007-2009, workers across the earnings distribution experienced a major slow-down in wage growth.

This unhappy story about the weakening relationship between wages and growth is all too familiar in the United States. But the U.K. experience is different in important respects—and potentially offers some relevant insights for U.S. policymakers to ponder.

First, let’s look at what happened. The simple ratio of GDP growth to growth in median wages in the United Kingdom weakened markedly in the period from 2003- 2008 compared to the 1990s and 1980s. In those earlier decades, wage inequality grew sharply—those at the top pulled away from the middle, and the middle pulled away from the bottom—but pay was rising across the board. In contrast, a big deceleration in the growth rate of earnings characterized the early 2000s. For the first time, median pay trailed way behind growth in real GDP per capita.

Between 1977 and 2002, average annual real wage growth for workers at the median was around 2 percent, but from 2003 to 2008 it fell to around 0 percent to 1 percent (depending on the measure of inflation used). This stagnation happened even while real GDP per capita had an average annual growth rate of 1.4 percent. The squeeze was broadly felt: the only earners on the income ladder who experienced stronger growth were those near the bottom rungs (buoyed by increases in the minimum wage) and those at the very top (especially due to bonus payments in finance).

In the wake of the financial crisis of 2008 and amid the Great Recession of 2007- 2009, the fall in real wages (around 8 percent) has also been relatively evenly spread across the earnings spectrum, though it is far bigger if we include the self-employed (who are excluded from official data). Younger workers have suffered the most, while older workers have been the least affected.

Wages, however, don’t give the full-picture when it comes to living standards. If we look at household income growth, from 1994-95 to 2011-12, the bottom half of households took just 16 percent of pre-tax growth. Upper-middle households (those in the 50th to 90th percentiles) took 45 percent of household income pre-tax growth (44 percent post-tax), proportionate to their population share. The richest 10 percent of households took 38 percent of pre-tax growth (29 percent post-tax) while the richest 1 percent took 14 percent pre-tax (9 percent post-tax).

In short, redistribution boosted the bottom half’s share of income growth from 16 to 26 percent.

Why has the link between economic growth and wages weakened? The share of GDP flowing to the wages of those on the low and middle part of the income spectrum has fallen markedly since the mid-1970s, from 16 percent to just 12 percent—a decline of 25 percent. In simple accounting terms, this relationship depends on three factors:

  • How much of GDP growth goes to profit rather than labor?
  • How much of that share of economic growth goes to labor in the form of non-wage benefits and how much actually gets paid out to workers in wages?
  • Of this wage share, how much reaches low- and middle-income earners?

It is often assumed that the United Kingdom and the United States alike face a long-term decline in the labor share of GDP as more of our national incomes are sucked up into corporate profits due to a mix of changing globalization, technology, increased financialization and, relatedly, deregulation spurred by the impact of big money on democratic politics.

From the U.K. perspective, there has been a slight shift in this direction over time, though it is an issue that is often overstated. Changes in the U.K.’s labor share of national income accounted for only a fifth of the cleavage that had opened up between pay and productivity since the early 1970s. The decline in the labor share of income has been less marked than in the United States.

Another U.K. perspective is that workers’ wages have primarily been under pressure because of the rising burdens on employers to provide more non-wage compensation such as higher national insurance and pension contributions. These employment costs have certainly risen, but again they can be overstated, with such increases accounting for a bit over a quarter of the gap between productivity and pay. That said, it is true that the rising cost of non-wage compensation appears to have played a more important role in the period of wage stagnation from 2003 in the United Kingdom.

But by far the most important factor explaining the declining share of the cake going to the bottom half of U.K. workers since the 1970s has been rising wage inequality, although this played a smaller role in the immediate pre-crisis period of 2003 to 2008.

How these three trends are likely to evolve over the next decade and beyond is far from clear. The intellectual zeitgeist expects there to be a redistribution of income over time from labor toward capital due to the “rise of the robot” (technology replac­ing workers) and French economist Thomas Piketty’s now famous observation that “r >g” (returns on capital are greater than the returns on economic growth).

Equally troubling is the outlook for non-wage costs. The tricky balancing act over the past decade of securing adequate pensions savings for an aging society and pro­tecting the wages of today’s workers in the United Kingdom is unlikely to go away. Similarly, most projections anticipate that, following the recent downturn period where wage inequality remained fairly level, it is now likely to increase again as the highest earners pull away from the rest.

Yet the idea that resumed growth is pre-destined to mean ever higher inequality is bogus. It was not long ago, after all, that the United Kingdom experienced broadly shared eco­nomic growth. So what observations can we make based on the U.K.’s experience?

First, standing still takes a lot of effort when the ground is shifting. A rising minimum wage and aggressive use of tax-credits made a significant and positive difference in the United Kingdom, but policymakers were pushing against the grain and didn’t do enough to confront the structural economic challenges such as inadequate business investment, lack of employee bargaining power, and weak demand for skilled labor.

Second, successive waves of “welfare reform,” together with the long-term decline in labor union collective bargaining, appears to have shifted the wage-unemployment relationship since the early 2000s. Wages have become significantly less responsive to falling unemployment than was the case in the 1980s and 1990s.  At the same time, and despite the gains from the minimum wage, working poverty has become far more pervasive. Arguably, these shifts put even more onus on aggressive monetary and fiscal policy to help generate a tight labor market and wage growth.

Third, the U.K.’s policy on the minimum wage was a success but we shouldn’t rest on our laurels. The Low Pay Commission, the body that oversees the minimum wage, is widely judged to have been highly effective if perhaps too cautious. The wage gap between the bottom and middle of the distribution has fallen (slightly) since its introduction. Fifteen years ago the whole notion of the minimum wage was highly partisan. Now each of the political parties jockey for position on this issue.

The Low Pay Commission’s blend of operational independence, technical expertise, and social partnership (employer and union representation) has worked well. And this flexibility has been an advantage; in the UK context, linking the national mini­mum wage to inflation would be a mistake. But there is now a sense that we need to revise our minimum wage framework to reflect learning over 15 years and to inject more ambition into the process.

Finally, policy wonks need to think hard about the political economy of tax credits. Most experts think tax credits increased the incentive to work (boosting single-parent employment rates in particular), helped bring about a major fall in child poverty, and shored up the post-tax transfer share of income going to the bottom 50 percent of society. Yet the rapid expansion of the policy (around 8 in 10 families with kids were eligible in 2010) raced ahead of popular support, making it surprisingly easy for the current governing coalition of Conservatives and Liberal Democrats to cut them. Tax credits have been characterized as “welfare” for the work-shy, whereas “tax-relief” is generally perceived more positively.

So what is the outlook for wage inequality in the United Kingdom? Broad-based economic growth is very unlikely to return by chance. Securing such an outcome will require a number of elements, including:

  • A more aggressive strategy for raising the wage floor during the current period of economic recovery, drawing confidence from growing research about the capacity of buoyant labor markets to absorb steady minimum wage rises
  • Tackling the extraordinary rents that have accrued to small numbers in the finance sec­tor over the past decade as the link between run-away rewards, financial instability, and fiscal retrenchment is all too clear (and is toxic for those on low and modest incomes)
  • Ditching the notion that increasing payroll taxes (on employees and employ­ers) are a politically cute way of raising extra revenue (not least when large and regressive tax-reliefs remain untouched)
  • Boosting the woefully inadequate business and public investment as there is no other path to higher labor productivity
  • Remedying perennial weaknesses in U.K. education policy, especially the awful wage and productivity returns to many low and intermediate level vocational qualifications (respectively, the qualification level that a 16 or 19 year old is expected to attain)

This last point is key. Education may not be the panacea that political leaders claim it to be, but the wage-penalty arising from poor quality sub-degree level vocational qualifications in the United Kingdom is particularly punitive.

More speculatively, there is a desperate need for experimentation with new labor mar­ket institutions that could offer employees some greater form of bargaining power, but in a manner that is compatible with the realities of a relatively flexible, heavily service-dominated economy. This is pretty much a policy void in the United Kingdom today.

Recreating more equitable, broad-based economic growth requires as prerequisites a tighter jobs market together with a higher wage floor. But to restore the link between economic growth and wage growth also will involve bold policy experimentation in pursuit of higher wages for those on the low- and middle-income rungs on the economy in the United Kingdom.

Inequality and the wellbeing of the poor in the United States

by Chris Wimer

How does the rise in economic inequality affect workers and their families at the bottom of the income ladder? To begin to approach an answer to such a question, it is important to first understand the facts on the ground. What have these workers and their families experienced over the past several decades? A common but deeply flawed measure of their wellbeing over the years is the official poverty rate, which fluctuates over a fairly narrow band but remained essentially flat since President Lyndon B. Johnson’s declaration of the War on Poverty in the mid-1960s.

This is not the forum to rehearse the litany of reasons why the official poverty rate is fundamentally flawed. But perhaps its biggest shortcoming is that it doesn’t count the many resources directed toward low-income families when measuring income. These resources include in-kind benefits such as supplemental nutrition assistance (what we used to call food stamps) and housing assistance, but also after-tax benefits such as the Earned Income Tax Credit and the Child Tax Credit.

When these resources are properly accounted for in a poverty measure, my colleagues and I at Columbia University demonstrate that poverty rates fell by about 40 percent over the past half century, from 26 percent in 1967 to 16 percent today. We have made more progress than we thought in fighting poverty in the United States since the 1960s. That is the good news. The bad news is that the declines I note above have come entirely because of the work of government policies and programs—not because low-income workers and families have succeeded in the workplace.

Indeed, aside from the latter half of the 1990s, low-income workers and families generally fared poorly relative to their more advantaged peers in the middle class and especially compared to the wealthy in terms of income growth. Absent resources from government programs, poverty (properly measured) would have actually increased between the 1960s and today—from 27 percent to 29 percent, equal to about 37 million people.

Focusing exclusively on numbers and percentages surrounding a specific poverty line, however, obscures other trends in income and the wellbeing of the poor. Recent data that my colleagues and I are collecting for a new longitudinal study of New York City residents tells us that actual levels of material hardship—the inability to meet one’s routine expenses—are actually quite a bit higher than poverty rates, even as properly measured. This means we need to think about those at the bottom of the income spectrum as not just those who fall below some predetermined poverty line but also those who find themselves consistently struggling to keep pace with what it costs to get by in contemporary society.

So a key question is whether the run-up in income inequality over the past five decades is a driving force of the economic woes of the less fortunate or simply another measure of it. The poor are doing better than in the past thanks to govern­ment programs that help alleviate poverty and give them the opportunity to climb the bottom rungs of the income ladder, but at the same time we know the fortunes of those at the top are far outpacing those at the bottom.

If, as some contend, the wellbeing of the poor is dampened by the rise in inequality, then we are justified in attempting to reduce income inequality in order to improve the lots of the less fortunate. But if the two are merely jointly determined—say by the rising returns on a better education that are (partially) the result of market forces—then reducing income inequality by itself is likely do little to improve the long-run wellbeing of the poor aside from helping the poor to get by and consume more from their income.

What do we know about whether rising income inequality in the United States reduces the wellbeing of the poor? Unfortunately, not very much. Cornell University economist Robert Frank argues that as inequality rises we see a pattern of so-called “expenditure cascades” as people further down the economic ladder essentially try to consume enough to “keep up with the Jones’” just above them. University of Chicago economist Marianne Bertrand finds that rising inequality leads to reduc­tions in disposable income further down the income ladder, though she is not explicitly focused on the wellbeing of the poor.

But these studies spark very provocative questions. Does increased inequality not only lead to an increase in consumer prices but also changes in consumption patterns in a way that causes income to not go as far for the poor as it might? And do these pro­cesses have actual negative effects on the overall wellbeing of the poor? Identifying such effects using common econometric methods, however, remains challenging.

So it is still an open question whether rising levels of inequality harm less-skilled and lower-earning families. Even if government programs and policies keep disad­vantaged individuals and families afloat, sociologists still might question whether income that comes once a year in the form of tax refunds or once a month in the form of a Supplemental Nutrition Assistance Program card is as useful as income from a regular paycheck, which provides benefits both remunerative and potentially cumulative, given that over time, that job may turn into a career.

What is ultimately most important is not whether people have enough resources over the course of a year to meet a somewhat arbitrary line of what experts think they need. Rather, we need to know whether people are truly able to harness their resources to meet both their daily and monthly expenses while simultaneously investing in their own and their children’s future.

In short, understanding whether and how economic inequality affects those at the bottom of the income spectrum is central to the success and wellbeing of our nation.

 

Afternoon Must-Read: Matt O’Brien: The Latest Dumb Inflation Argument from a Billionaire

Posted on by Brad DeLong

Matt O’Brien: Here’s the latest dumb argument from a billionaire that will hurt the economy: “Hedge fund billionaire Paul Singer….

…Never underestimate the ingenuity of inflation truthers…. His latest investor letter recycles all these ideas, inveighing against the Fed’s ‘fake prices,’ ‘fake money,’ and ‘fake jobs,’ before zeroing in on where inflation is really showing up–his wallet: ‘Check out London, Manhattan, Aspen and East Hampton real estate prices, as well as high-end art prices, to see what the leading edge of hyperinflation could look like.’ That’s right: Paul Singer thinks Weimar-style inflation might be coming because he has to pay more for his posh vacation homes and art pieces…. The Fed, you see, isn’t worried about the Billionaire Price Index. It’s worried about inflation on goods and services we all face…. Just because the super-rich are bidding up the prices of houses in the Hamptons doesn’t mean that middle-class people, whose wages are flat, are going to bid up the price of, well, anything…. If this is the best the inflation truthers can do, they should probably follow Mark Twain’s advice and keep their mouths closed…

Afternoon Must-Read: Hugo Panizza: Rashomon in Euroland

Posted on by Brad DeLong

Ugo Panizza: Rashomon in Euro Land: “Expansionary monetary policy is better than nothing…

…but a more stable euro zone requires expansionary fiscal policy now…. The problem is that northern countries do not want to implement expansionary fiscal policy…. Public debt is riskier in countries that cannot print their own currency… and the fiscally fragile periphery cannot implement expansionary policy without a backstop that can rule out debt runs. The only institution that can play this role is the European Central Bank…. If peripheral countries undershoot ECB’s ‘close, but below 2%’ inflation target, somebody needs to overshoot it. If Germany wants peripheral countries to become more like Germany, Germans may need to become more like southern Europeans….The euro zone is flirting with deflation and yet there are members of the ECB board who oppose a more aggressive policy stance. It would be good to know what economic model they have in mind. Charles Wyplosz asked; Mr Weidmann did not answer.

Afternoon Must-Read: Kevin Drum: Are Central Banks Losing Their Credibility on Inflation?

Posted on by Brad DeLong

Kevin Drum: Are Central Banks Losing Their Credibility on Inflation?: “We now have three major economies—the US, Japan, and Europe…

…which have persistently undershot their own inflation targets despite having enormous incentives to at least meet them as they try to recover from the Great Recession…. Everyone has assumed all along that if they were sufficiently motivated, central banks could always generate high inflation…. But what if it turns out that in practice it’s all but impossible for a modern central bank to meet even a modest inflation target during a severe economic downturn? How do we know whether this is due to lack of will; lack of technical firepower; or lack of political support? And how long does it take before markets decide it doesn’t much matter? After all, at some point there’s no practical difference between unwillingness and inability…. The longer this goes on, the more their credibility gets shredded. It’s a mystery why this isn’t an issue of bigger concern.

Can more effective management of household debt help foster equitable growth?

Posted on by Bridget Ansel

In the wake of the Great Recession, policymakers and economists alike need a better understanding of the implications of unfettered private debt. In the last three decades, household debt has expanded dramatically, while wages and income have remained stagnant. This debt, however, was not accumulated evenly across the income distribution.  Barry Cynamon of the Federal Reserve Bank of St. Louis and Steven Fazzari of Washington University in St. Louis show that the vast majority was concentrated among households in the bottom 95 percent of the income distribution.

This is not just a story about debt and inequality, but one with much greater consequences for overall economic stability. Amir Sufi at the University of Chicago and Atif Mian at Princeton University demonstrate that it was exactly this unequal distribution of household debt which helped spark the housing and finance crises that led to the Great Recession of 2007-2009. Between 2002 and 2005, mortgage debt and household income became negatively correlated, leading to expanded debt among those whose incomes were declining.

What happened next is familiar to us all: home foreclosures piled up, and those directly and indirectly affected by falling housing prices cut back sharply on spending. This drop in consumption was not evenly distributed. Sufi and Mian show that while national overall consumption fell by about five percent in the United States, the hardest-hit counties saw consumer spending drop by almost 20 percent. The vast majority of these counties were comprised of low-income homeowners whose wealth was almost entirely tied up in home equity.

In order to better understand the implications of these recent patterns in private consumption and debt accumulation, the Washington Center for Equitable Growth awarded one of its inaugural grants to Will Dobbie, assistant professor of economics at Princeton University. His grant proposal posits that research and evidence from the Great Depression of the 1930s shows that debt forgiveness can help mitigate the most severe effects of a deep recession, especially when targeted at the hardest hit regions. Despite the historical evidence on the efficacy of debt forgiveness as an effective policy lever, little is known about the modern-day effects of debt forgiveness on either the debtors themselves or the economy as a whole.

Dobbie will study the effects of debt forgiveness since 2001. First, he will explore the role of non-profit credit counseling agencies that offer debt management plans to help debtors fully repay their debt within three to five years after negotiating creditor concessions on interest rates and fees.  Second, he will look at for-profit debt settlement companies, which for a fee negotiate with a debtor’s creditors to settle the debt for a fraction of the balance. In both cases, Dobbie will examine the outcomes for debtors and their subsequent financial health, advancing our knowledge on the effectiveness of debt forgiveness programs. Identifying the best ways to reduce household debt may help policymakers advance programs targeted at those that need them most, especially lower income families.

More broadly, Dobbie’s research will help policymakers understand the implications of personal debt accumulation for an individual’s financial health, and the health of the overall economy. Household debt was a primary cause of the Great Recession and recent research suggests that the unequal debt overhang among homeowners is one reason that subsequent economic growth has remained tepid. Developing a better understanding of the effects of individual debt forgiveness could provide an additional tool to prevent future recessions and encourage more robust growth.

Things to Read on the Morning of November 6, 2014

Posted on by Brad DeLong

Must- and Shall-Reads:

 

  1. Atif Mian and Amir Sufi: The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis: “The sharp increase in mortgage defaults in 2007 is significantly amplified in subprime ZIP codes, or ZIP codes with a disproportionately large share of subprime borrowers as of 1996. Prior to the default crisis, these subprime ZIP codes experience an unprecedented relative growth in mortgage credit. The expansion in mortgage credit from 2002 to 2005 to subprime ZIP codes occurs despite sharply declining relative (and in some cases absolute) income growth in these neighborhoods. In fact, 2002 to 2005 is the only period in the past eighteen years in which income and mortgage credit growth are negatively correlated. We show that the expansion in mortgage credit to subprime ZIP codes and its dissociation from income growth is closely correlated with the increase in securitization of subprime mortgages.”

  2. Paul Krugman: Japan on the Brink: “Japan’s current plan to hike consumption taxes a second time… has become… a sort of Rubicon for policy. And let me admit that people I respect–like Adam Posen, and some officials at international organizations–believe that Abe should go through with the hike. But I strongly disagree…. Right now, Japan is struggling to escape from a deflationary trap; it desperately needs to convince the private sector that from here on out prices will rise…. The pro-tax-hike side worries that if Japan doesn’t go through with the increase, it will lose fiscal credibility and… the bond vigilantes will attack. Why don’t I share that view? Partly because I don’t see how this supposed crisis of confidence is supposed to work…. When a country borrows in its own currency and doesn’t face inflationary pressure (quite the contrary), it’s very hard to see how a Greek-style crisis is even possible. Short-term interest rates are controlled by the Bank of Japan; long-term rates mainly reflect expected short rates. Yes, investors could push the yen down, but that would be a good thing from Japan’s point of view. Posen says stocks could crash, but I guess I don’t see why if interest rates stay low and corporate Japan becomes more competitive thanks to a weaker yen. Seriously: tell me how this is supposed to work… [how a] fear that Japan might eventually monetize some of its debt–isn’t actually a positive development. Meanwhile, it seems to me that Japan should be very, very afraid of losing momentum in the fight against deflation…. Could I be wrong?… Of course…. But it’s all about weighing the risks. Right now, the risk of losing anti-deflation credibility looks much worse than the risk of losing fiscal credibility. Please, don’t hike those taxes!”

  3. Nick Rowe: Worthwhile Canadian Initiative: Neo-Fisherites and the Scandinavian Flick: “If you look at Sweden, reality just confirmed that beloved economic theory. The Riksbank raised interest rates because it was scared that low interest rates would cause financial instability. Lars Svensson resigned in protest. Then inflation fell, and the Riksbank needed to cut interest rates even lower than before…. If you don’t know how to drive a car, and you don’t even have a clue whether you turn the steering wheel clockwise or counter-clockwise if you want to turn right, one good strategy is to borrow a car, and a wide open field, and experiment. Make a random turn of the wheel, and see what happens. The recent data point in Sweden was a natural experiment like that…. Theory says, and the data confirm, and the advice of experienced practitioners confirms, that if it wants to raise inflation the central bank should first lower interest rates. Then, when inflation and expected inflation starts to rise, it can raise interest rates, higher than they were before. Then, and only then, does the Fisher effect kick in…. That is the Scandinavian flick we saw recently… the wrong way round…. Figuring out the intuition behind John Cochrane’s paper, to see what was really going on in his model, really drained me. Do I really have to wade through that Stephanie Schmidt-Grohe and Martin Uribe paper too, and reverse-engineer their result as well? I’m too old for this. Don’t any of you young whippersnappers have an economic intuition? Do you all get snowed by every fancy-mathy paper that comes along? I expect I will have to. Pray for me.”

  4. Ian Millhiser: Millions More Votes Were Cast For Democrats In The Incoming Senate Than For Republicans: “When the new, GOP-controlled Senate opens its first session next January, it will be strikingly unrepresentative of the voters who elected its members… millions more Americans actually cast a vote for a Democratic Senate candidate than voted for a Republican candidate during the three election cycles that built the incoming Senate…. Republican Senate candidates outperformed Democrats by 2,733,121 votes in 2010, while Democrats outperformed Republicans by a much larger 10,867,709 votes in 2012…. [Our estimates] as of 9 a.m. Wednesday morning, was a total of 22,524,388 votes cast for Republicans and 19,594,164… in the 2014 cycle…. When the results from all three elections are combined, a total of 5,204,364 more votes were cast for Democrats than Republicans…”

  5. Narayana Kocherlakota: 2015 Rate Hike ‘Inappropriate’ : “[He] said it would be ‘inappropriate’ for the Fed to lift rates at any point in 2015 as PCE, the central bank’s measure of inflation, is unlikely to reach 2 per cent until 2018…. He said that inflation below 2 per cent was ‘just as much of a problem’ as inflation above that level, adding that the Fed should clarify that its inflation objective is symmetric…. Traders currently bet the Fed will lift rates at its September meeting, according to Fed Funds Futures contracts analysed by Bloomberg.”

Should Be Aware of:

 

  1. Richard Green: Jung Hyun Choi and I write about Income Inequality across Cities: “Negative labor market conditions, concentration of skilled workers, and racial segregation are positively associated with the level of income inequality. The level of inequality in these cites also tends to rise grow at a faster pace. While differences in the minimum wage level do not seem to have any association with income inequality across cities, we find some evidence that differences in unemployment insurance benefits and greater unionization lowered increases in the income inequality.”

  2. Tuan-Hwee Sng and Chiaki Moriguchi: Failed by #EconomicGrowth?: “Before 1850, both [China and Japan] were ruled by stable dictators[hips] who relied on bureaucrats to govern their domains…. In a large domain, the ruler’s inability to closely monitor bureaucrats creates opportunities for the bureaucrats to exploit taxpayers. To prevent overexploitation, the ruler has to keep taxes low and government small. Our dynamic model shows that while economic expansion improves the ruler’s finances in a small domain, it could lead to lower tax revenues in a large domain as it exacerbates bureaucratic expropriation…. We find that the state taxed less and provided fewer local public goods per capita in China than in Japan. Furthermore, while the Tokugawa shogunate’s tax revenue grew in tandem with demographic trends, Qing China underwent fiscal contraction after 1750 despite demographic expansion. We conjecture that a greater state capacity might have prepared Japan better for the transition from stagnation to growth…”

  3. Joyman Lee: “What this narrative does not explain, however, is why China pursued such an inefficient mode of fiscal management. Given the challenges of graft and the fear of revolt, Sng and Moriguchi assume that it was the most rational or “optimal” course. The authors point to but dismiss lightly the question posed by Qing historians that the goals of the late imperial Confucian state might not have been compatible with “rational” state expansion. In other words, rather than fearing peasant revolt, the choice of tax rate might have to do with ideological reasons. Similarly, the idea that the Japanese state shared a “Confucian” outlook (p4) is overly simplistic, especially as consistently high levels of taxation in Tokugawa Japan undermine the idea that Tokugawa Japan was a “benevolent” state…”

Morning Must-Read: Atif Mian and Amir Sufi: The Consequences of Mortgage Credit Expansion

Posted on by Brad DeLong

Atif Mian and Amir Sufi: The Consequences of Mortgage Credit Expansion: Evidence from the U.S. Mortgage Default Crisis: “The sharp increase in mortgage defaults in 2007…

…is significantly amplified in subprime ZIP codes, or ZIP codes with a disproportionately large share of subprime borrowers as of 1996. Prior to the default crisis, these subprime ZIP codes experience an unprecedented relative growth in mortgage credit. The expansion in mortgage credit from 2002 to 2005 to subprime ZIP codes occurs despite sharply declining relative (and in some cases absolute) income growth in these neighborhoods. In fact, 2002 to 2005 is the only period in the past eighteen years in which income and mortgage credit growth are negatively correlated. We show that the expansion in mortgage credit to subprime ZIP codes and its dissociation from income growth is closely correlated with the increase in securitization of subprime mortgages.

Blog You Need to Read: Tim Duy’s Fed Watch: Daily Focus

Posted on by Brad DeLong

As all of you know by now, I am a big fan of Tim Duy of the University of Oregon and his Fed Watch. Here is a sample–ten very useful and informative takes from the past half-year or so:

Always judicious, always giving a fair shake to all the currents of thought in the Federal Reserve, to the data, and to the live and serious models of how the economy works.

Read Tim Duy, and you have a sophisticated, broad, and truly balanced understanding of what the Federal Reserve is thinking, what it is doing, why it is doing it, and what the likely outcomes of its actions are. That is a package that is very hard to find anyplace else.

It still surprises me that Tim Duy does not get significantly more airplay in the general conversational mix than he does…

Who Really Thinks That Japan Is Argentina?: Daily Focus

Posted on by Brad DeLong

Paul Krugman: Japan on the Brink: “Japan’s current plan to hike consumption taxes a second time…

…has become… a sort of Rubicon for policy. And let me admit that people I respect–like Adam Posen, and some officials at international organizations–believe that Abe should go through with the hike. But I strongly disagree…. Right now, Japan is struggling to escape from a deflationary trap; it desperately needs to convince the private sector that from here on out prices will rise…. The pro-tax-hike side worries that if Japan doesn’t go through with the increase, it will lose fiscal credibility and… the bond vigilantes will attack. Why don’t I share that view? Partly because I don’t see how this supposed crisis of confidence is supposed to work…. When a country borrows in its own currency and doesn’t face inflationary pressure (quite the contrary), it’s very hard to see how a Greek-style crisis is even possible. Short-term interest rates are controlled by the Bank of Japan; long-term rates mainly reflect expected short rates. Yes, investors could push the yen down, but that would be a good thing from Japan’s point of view. Posen says stocks could crash, but I guess I don’t see why if interest rates stay low and corporate Japan becomes more competitive thanks to a weaker yen. Seriously: tell me how this is supposed to work… [how a] fear that Japan might eventually monetize some of its debt–isn’t actually a positive development. Meanwhile, it seems to me that Japan should be very, very afraid of losing momentum in the fight against deflation…. Could I be wrong?… Of course…. But it’s all about weighing the risks. Right now, the risk of losing anti-deflation credibility looks much worse than the risk of losing fiscal credibility. Please, don’t hike those taxes!

Continuing to worry my head about our intellectual adversaries here–including the very sharp and serious Adam Posen, over their fear that unless Japan raises taxes to begin closing its (admittedly huge) current budget deficits it runs serious risks of becoming “Argentina”.

I get that part of the argument is that Japan can hit the same nominal GDP growth target by pairing a looser monetary with a tighter fiscal policy, and should do so. And to the extent that that is what is at issue–a call for fiscal tightening coupled with even more aggressive monetary loosening to hit the same nominal GDP growth target, and that what is being advocated is not just an increase in taxes but an increase in taxes coupled with full monetary offset in the form of additional monetary goosing, I get the argument. I even agree with it.

But to the extent that it is more than that…

The basic model of the taxmongers is, I think, the following:

  1. E(π) = π + δ(rD – σ) :: Inflation Expectations
  2. π = E(π) + β(u* – u) :: Phillips Curve
  3. r = r* + γ(u – u) + θ(π – π) :: Monetary Policy

That is:

  1. Inflation Expectations: Expected inflation E(π) is equal to current inflation π plus some parameter times the difference between debt amortization rD and the expected primary surplus of the government σ.

  2. Phillips Curve: Current inflation π is equal to expected inflation E(π) + a parameter times the difference between the natural rate of unemployment and the actual rate of unemployment.

  3. Monetary Policy: The higher either the gap between the current inflation rate π and the central bank’s target inflation rate π* or the higher the required gap between the natural rate of unemployment u* and the current unemployment rate u, the more the central bank must raise the interest rate r over the Wicksellian natural rate r* in order to achieve its monetary policy target–and then the higher is required debt amortization rD.

It then follows that the unemployment rate and the real interest rate will both be increasing functions of the fiscal financing gap rD-σ:

  • u = u* + (δ/β)(rD – σ)
  • r = r* + (γδ/β)(rD – σ) + θ(π – π*)

Taking differentials in response to a shock dr* to the Wicksellian natural rate r*, we get:

  • du = D(δ/β)dr
  • dr = dr* + D(γδ/β)dr
  • du = [(δ/β)D/(1 – D(γδ/β))]dr*

Which tells us that if the debt D grows so large that Dγδ/β approaches one, even a very small adverse shock to the Wicksellian natural rate of interest dr* could cause the unemployment rate u to explode–unless the central bank abandons its monetary policy of inflation control, that is, of non-permanent-monetization of the debt.

For a country that does not borrow in its own currency, it is very easy to see why it must seek to avoid even a whisper of debt monetization. Such a whisper is an upward shock to E(π), and to the extent that is transmitted through to the current inflation rate such transmission produces an immediate jump in required debt service which makes the situation much worse.

But in a country that does borrow in its own currency and does control its own interest rates debt monetization and a resulting burst of inflation is no biggie: some of the debt is no-longer interest-bearing D that must be amortized but is money M. And to the extent that the rest of the debt has a duration greater than zero the increase in the price level reduces the value of the debt and thus the seriousness of the debt overhang problem.

Yes: I realize that this is arcana imperii. I do realize that I am not supposed to point out that reserve-currency issuing sovereigns with exorbitant privilege that thus control their own interest rates and borrow in their own currencies have a degree of freedom to use inflation as a tool of debt management that the Argentinas of the world do not. But an upward shift in expected inflation is what we are trying to generate here and now in Japan. And such an upward shift is only to be feared if Japan pretends that it is Argentina, and that it thus has no ability to monetize any of its debt.

If you are Argentina, then yes, sure: as Dγδ/β approaches one you get into the territory where a small upward shock to interest rates will cause either a Great Depression or force a price-spiral that, absent a currency reform, turns into hyperinflation.

But who thinks that Japan is Argentina?

Evening Must-Read: Paul Krugman: Japan on the Brink

Posted on by Brad DeLong

Paul Krugman: Japan on the Brink: “Japan’s current plan to hike consumption taxes a second time…

…has become… a sort of Rubicon for policy. And let me admit that people I respect–like Adam Posen, and some officials at international organizations–believe that Abe should go through with the hike. But I strongly disagree…. Right now, Japan is struggling to escape from a deflationary trap; it desperately needs to convince the private sector that from here on out prices will rise…. The pro-tax-hike side worries that if Japan doesn’t go through with the increase, it will lose fiscal credibility and… the bond vigilantes will attack. Why don’t I share that view? Partly because I don’t see how this supposed crisis of confidence is supposed to work…. When a country borrows in its own currency and doesn’t face inflationary pressure (quite the contrary), it’s very hard to see how a Greek-style crisis is even possible. Short-term interest rates are controlled by the Bank of Japan; long-term rates mainly reflect expected short rates. Yes, investors could push the yen down, but that would be a good thing from Japan’s point of view. Posen says stocks could crash, but I guess I don’t see why if interest rates stay low and corporate Japan becomes more competitive thanks to a weaker yen. Seriously: tell me how this is supposed to work… [how a] fear that Japan might eventually monetize some of its debt–isn’t actually a positive development. Meanwhile, it seems to me that Japan should be very, very afraid of losing momentum in the fight against deflation…. Could I be wrong?… Of course…. But it’s all about weighing the risks. Right now, the risk of losing anti-deflation credibility looks much worse than the risk of losing fiscal credibility. Please, don’t hike those taxes!