(See below**Chapter 3 excerpt, “Pay Inequality and World Development”)
(See below**Chapter 6 excerpt, “The Geography of Inequality in America, 1969 – 2007”)
(See below**Chapter 13 excerpt, “Economic Inequality and the World Crisis”)
Inequality and Instability: A Study of the World Economy Just Before the Great Crisis by James K. Galbraith:
Excerpt from Chapter 1:
In the late 1990s, standard measures of income inequality in the United States – and especially of the income shares held by the very top echelon – rose to levels not seen since 1929. It is not strange that this should give rise (and not for the first time) to the suspicion that there might be a link, under capitalism, between radical inequality and financial crisis.
The link, of course, runs through debt. For those with a little money, it is said, the spur of invidious comparison produces a want for more, and what cannot be earned must be borrowed. For those with no money to spare, made numerous by inequality and faced with exigent needs, there is also the ancient remedy of a loan. The urges and the needs, for bad and for good, are abetted by the aggressive desire of those with money to lend to those with less. They produce a pattern of consumption that for a time appears broadly egalitarian; the rich and the poor alike own televisions and drive automobiles, and until recently in America members of both groups even owned their homes. But the terms are rarely favorable; indeed, the whole profit in making loans to the needy lies in getting a return up front. There will come a day, for many of them, when the promise to pay in full cannot be kept.
The stock boom of the 1920s was marked by the advent of the small investor. Then the day came, in late October 1929, when margin calls wiped them out, precipitating a run on the banks, from which followed industrial collapse and the Great Depression. The housing boom of the 2000s was marked by a run of aggressively fraudulent lending against houses, often cash-out refinancings to the small homeowner. The evil day came again in September 2008, when Fannie Mae, Freddie Mac, Lehman Brothers, and the giant insurance company AIG all failed. Over the months and years that followed, home values collapsed, wiping out the wealth and financial security of the entire American middle class, accumulated for two-thirds of a century. The associated collapse of the mortgage bond and derivatives markets precipitated a worldwide flight to safety, which in Europe developed into the crisis of sovereign debt for Greece, Ireland, Portugal, and Spain.
Thus in a deep sense inequality was the heart of the financial crisis. The crisis was about the terms of credit between the wealthy and everyone else, as mediated by mortgage companies, banks ratings agencies, investment banks, government-sponsored enterprises, and the derivatives markets. Those terms of credit were what they were, because of the intrinsic instabilities involved in lending to those who cannot pay. Like any Ponzi scheme, or any bubble, it is a matter of timing: those who are in and out early do well and those who are not nimble always go bust. As Joseph P. Kennedy said in the summer of 1929, “Only a fool holds out for the last dollar.”
Yet to those economists whose voices dominated academic discourse this was an invisible fact. Their models of “representative agents” with “rational expectations” treated all economic actors as if they were actually alike…. Further, in their notions of “general equilibrium” financial institutions such as banks made no appearance. In the classification system of the Journal of Economic Literature there was (and is) no category for work relating inequality to the financial system. In other words, both inequality and financial instability were largely blank spots in dominant theory; neither concept was important to mainstream economics, and the relationship between them was not even thought of.
The economists in the tradition espoused, for example, by Professor Benjamin Bernanke at Princeton were devoted to the view that – except for occasional bouts of bad policy, caused by a central bank creating either too much money or too little – the economy always tends toward stability at full employment. Following the stabilizing prescriptions of Milton Friedman, bad policy could be avoided and crises of the sort we endured in the 1930s could not recur. Wise policy, inspired by wise principle, had given us a “Great Moderation” – a new world of stable output growth, high employment, and a low-and-stable inflation rate. This would not be disturbed in any serious way by credit markets. Until just a month before the crisis broke into public consciousness in August 2007, the official prognosis of the Federal Reserve Board – by then chaired by the same Professor Bernanke – was that all problems in the housing sector were “manageable.”
This was the pure product of something economists called the quest for “logically consistent microfoundations for macroeconomics”: an economics completely disengaged from the sources of financial and economic instability. Not only was there no recognition of inequality, and not only was there no study of the link of inequality to financial instability; there was practically no study of credit and therefore no study of financial instability at all. In a discipline that many might suppose would concern itself with the problems of managing an advanced financial economy, the leading line of argument was that no such problems could exist. The leading argument was, in fact, that the system would manage itself, and the effort (by government, a human and therefore flawed institution) to “intervene” was practically certain to do more harm than good. In retrospect, it all seems almost unbelievably odd. (p. 3 – 5)
Excerpt from Chapter 2, “The Need for New Inequality Measures,” “Obtaining Dense and Consistent Inequality Measures,” Inequality and Instability: A Study of the World Economy Just Before the Great Crisis by James K. Galbraith
Around 1996, researchers associated with the University of Texas Inequality Project (UTIP) bean exploring the use of semi-aggregated economic datasets – that is, data organized and presented by industry or economic sector or by geographic region – as a source of information on levels and changes in inequality. The work is far advanced and the methods, which are very simple, are now well established, with many articles and two books published on various specialized topics.
This work is based on a simple insight. The distribution of economic earnings is built up in any given national economy out of deeply interlaced institutional entities: firms, occupations, industries, and geographic regions. That being so, consistent observation of the movement of these entities, taken at their average values and compared to each other, is often sufficient to reveal the main movements of the distribution as a whole. This is true even if the coverage of the economy is not comprehensive or wholly representative, so long as the grouping structures are kept consistent from one observation to the next….
Further, the movement over time of inequality is often determined by forces that work from the top down. These forces broadly differentiate the income paths of people working in different industries or parts of the country. Therefore, datasets that capture the average incomes of major groups of people, such as by industry or sector or region, may contain a sufficiently large share of information on the evolution of economic inequality to serve as good approximations for the movement of the distribution as a whole. These semi-aggregated, categorical datasets, in other words, are an important data resource, with strong potential for improving our knowledge of the level and change in economic inequality, and for comparing one entity to the next. But – possibly because economists tend to be trained to the virtues of the survey and the primacy of the individual – they have been largely overlooked, and except by UTIP they have not been used much in work of this kind.
Datasets of this type are, from a computational point of view, extremely simple. One needs a dataset divided into groups, with the only restriction being that the groups are “mutually exclusive and collectively exhaustive” (MECE). This means that groups cannot share members, and you can calculate an inequality measure only for the populations covered by the groups. We need just two facts about each group: its total income (or payroll) and its total population (or employment). From this, one can easily calculate two ratios: the share of each group in the whole population under study, and the ratio of each group’s average income to the average of the population as a whole The “Theil element,” as we’ll call it, is just the product of these two terms, multiplied by the log of the second term.
What we’ll call the “between-groups component” of Theil’s T is equal to the sum of the Theil elements [group population weight, ratio of average group income to average whole population income] across all groups.… Because of the logarithmic term, Theil elements are positive for groups with above-average income and negative for groups with below-average income….
[Henri] Theil [“a University of Chicago econometrician”] showed that this measure is a consistent lower-bound estimate of total inequality, meaning that actual inequality will always be equal to or higher than the observed between-groups component. But actually the measure contains much more information than what this very modest statement indicates, particularly if you calculate it repeatedly, always in the same way, over time….
For any given geographic region – such as a continent, country, or province – once a reasonable degree of segmentation is achieved the fact of proportionality in changes is easily established even though the constant of proportionality remains unknown. That is, the main patterns of change in inequality are going to be reflected in changes between the groups into which that region is divided. Thereafter, further refining the classification scheme increases the measure of inequality, but it does not greatly alter the pattern of change….
…The basic point is that it would be hard to conceive of a simpler, more flexible, or more generally reliable way to measure inequality or to track changes in inequality over time.
A first advantage of this approach is that economic data suitable to calculations of this type are very common. Within the OECD coverage is universal, detailed, and available in consistent formats over long periods with short sampling intervals, annually back to the early 1960s, and even monthly in many cases….
Second, sector and regional data yield richly detailed information concerning the precise pattern of relative gains and losses as inequality changes….
Third, there are international datasets with harmonized category schemes. They have the interesting property of imposing the same number and type of group structure – industries or sectors – on different countries. It turns out that this works to normalize the measures of pay or earnings inequality drawn from these sources. Such measures are therefore comparable between countries and are excellent instruments for the (unavailable) survey-based measures…
This was a surprising finding, and it retains (even for us) a touch of mystery after many years of working with the data. But it checks out repeatedly, and perhaps most dramatically in the simple fact that neighboring countries with closely linked economies tend to report similar inequality measures, while the differences between countries grow as the geographic and economic ties between them weaken. (p. 29 – 33)
** Chapter 3 excerpt, “Pay Inequality and World Development”
Excerpt from Chapter 3, “Pay Inequality and World Development,” Inequality and Instability: A Study of the World Economy Just Before the Great Crisis by James K. Galbraith
In his 1955 presidential address to the American Economic Association, Simon Kuznets offered a simple, elegant argument relating inequality to the process of industrialization. Before industry, say in late-feudal Great Britain or the early northern United States, agriculture consisted largely of small freeholds, tenantry, and family farms. Income from work was limited by the natural scope of family labor and the talents and efforts of the village craftsman. Factories and city life introduced division of labor, leading to higher living standards for a rising urban working class, including factory workers and eventually professionals, engineers, and machinists. Since this group enjoyed more income than their country cousins, economic inequality rose.
Later on, migration and ultimately the industrialization of agriculture displaced the farmers from their land. As the agricultural population declined in proportion to the total, so too did the significance of the urban – rural income gap. Therefore, inequality would decline as incomes continued to rise, simply because the population transitioned from being primarily rural to primarily urban. Cities, with all their economic diversity, are naturally more unequal than the countryside, so matters would not again return to an egalitarian starting point. But Kuznets did expect that as industrialization matured, unionization and social democracy would reduce the initially high inequalities of the townsfolk, so that overall inequality would continue to decline as industrial development deepened.
What Kuznets Meant
The basic mechanism of Kuznets’s argument was thus the transition from country to town and from farm to factory as average incomes rose. The consequence was a definite relationship between inequality and income: inequality would first increase and later decline as cities swallowed the rural population. This was the inverted U that later economists would call the “Kuznets curve.” Given the sectoral transition that lies behind it, this is something that can happen just once in the history of any particular country. It is also a relationship limited strictly to the distribution of pay for work. Under feudalism and colonialism as well as in the American South, great estates, plantations, and slavery were the norm, and the distribution of total income could not have been more equal on the farm than in the town. Kuznets was aware of this, and he explicitly excluded nonlabor incomes – such as the rents due to landlords, or monopoly profits or (later on) technological “quasi-rents” – from his argument.
The essential point in Kuznets’s analysis was, therefore, not the discovery of some universal pattern in the relationship between inequality and income. It was the statement of a principle: that change in (pay) inequality is largely guided by intersectoral transitions in economic activity. Such transitions are a characteristic phenomenon of economic development and change. The key determinant of economic inequality is the structural composition of the economy itself – as among agriculture, industry, mining, services, finance, and government, for example. This is obviously very slow-moving. There is a second key, which can move more quickly, namely, the differential between average incomes earned in each of these areas. Change in the proportions (long run) and in the differentials (short run) is the key to change in inequality; this is the enduring lesson of Kuznets’s 1955 argument….
…as economic regions integrate it becomes necessary to consider the relationship of each to all the others. Patterns of trade, movements of labor, and interdependencies of the financial system may all cause the distributional characteristics of one system to influence those of another. In the limit, a global economy may have global forces that affect intersectoral differentials and the movement of inequality.
We take the view here that this layered vision is almost obviously correct. At the foundation, economic inequality must depend primarily on economic structure and the stage of development: all agrarian feudal societies, all countries in the early stages of industrialization, all advanced technological economies, and all oil fiefs will resemble each other more than they resemble other countries. In a second layer, and especially in complex systems with strong financial sectors and asset markets, short-term movements of the intersectoral differentials take on an important role. And there must be a transnational element, reflecting the integration of economies and the influence of the large and strong over the small and weak.
But we also think that all this is in no contradiction to Simon Kuznets. He combined theory, history, and common sense, and he was very well aware that the world continues to change. He would not have been surprised or disturbed to see his original historical description modified in this way by events. The question to ask next is, Was it? (p. 47 – 50)
New Data for a New Look at Kuznets’s Hypothesis
So, in the sense just given, was Kuznets basically right after all? Is there a systematic relationship between economic structure – taking into account also the differentials between structural elements of an economy – and economic inequality? Is there a relationship, in particular, between the level of income and the level of inequality, allowing the relationship to be elaborately nonlinear and to shift from time to time? Having restated the argument, the question requires another look…. (p. 50 – 51)
Apart from the theoretical questions of what exactly to expect, as an empirical project the issue of a consistent relationship between inequality and the level of development is obscured by the gaps, inconsistencies, difficulties of clear interpretation, and general noisiness of the datasets that have been deployed to analyze this question….
…China is a low-income country still in the canonical transition of agriculture to industry; hence inequality rises with more rapid growth there, and this connection shows up even in a dataset restricted only to inequality inside manufacturing. This is Kuznets’s classic vision for early development, prolonged in the Chinese case by the vast reserve of peasantry even as the country builds the world’s largest cities. However – outside of sub-Saharan African where in most cases industrialization never seriously got under way – most of the world is past the early stages of urbanization.
As expected from our discussion above, the United States and a few other rich countries, notably the UK and Japan, are on upward-sloping income-inequality surfaces. These countries supply capital goods and financial services to world markets, and so their highest incomes vary positively with the business associated with rapidly growing investment or rising exports, income in the high-income sectors, especially technology and finance, tends to rise rapidly – in part because (as discussed above and below) these incomes derive partly from activities in the capital markets. Thus rising income is associated with rising inequality of incomes. And the phenomenon shows up in manufacturing wages, because some of the affected industries – notably the advanced electronics sectors that formed the core of the information-technology boom – are conventionally classed as manufacturing activities. They stand in for the whole of the advanced-technology sector as drivers of increasing inequality. (p. 52)
We conclude that even after fifty-five years, the insights of Simon Kuznets are, in broad terms, hard to improve on. Yes, the world does change, and having left their agrarian roots behind countries do not return to them. But the levels of inequality across countries appear largely determined by their place in the hierarchy of incomes, and the movement of inequality over time is still, to a substantial extent, a consequence of the intersectoral transitions that continue to occur, modified by fluctuations in the relative pay between major sectors.
And yet, this is not the whole story either. Kuznets largely restricted himself, as development economists are wont to do, to the trajectories of individual countries. It is, however, not only necessary but also possible to use these data to inquire into the relationship between countries. We are no longer in the age of empires, it is true. Still, the fact that there exist over two hundred countries in the world does not make it reasonable to assume that each goes its own way, independently of the others. (p. 69)
Global Rising Inequality: The Soros Superbubble as a Pattern in the Data
…The investor George Soros has identified the period after 1980 as a “superbubble” in world financial markets. By this, he means it was a time when economic growth became dependent on unstable financial relations. This work demonstrates that the superbubble was also a supercrisis for the world’s poorer people – a prolonged period of worsening pay gaps in most countries around the world. This pattern strongly suggests that the proper conceptual domain for the study of global inequality is macroeconomic, and that macroeconomic forces common to the entire global economy can be identified in the data. Indeed the evidence strongly suggests that global finance is a principal source of changing global patterns of pay inequality…. (p. 73)
** Chapter 6 excerpt, “The Geography of Inequality in America, 1969 – 2007”
Excerpt from Chapter 6, “The Geography of Inequality in America, 1969 – 2007,” from Inequality and Instability: A Study of the World Economy Just Before the Great Crisis by James K. Galbraith
Interpreting Inequality in the United States:
The fact is that income inequality is real; it’s been rising for more than 25 years. The reason is clear: We have an economy that increasingly rewards education, and skills because of that education. (George W. Bush, speaking in 2007, quoted on p. 147)
And Federal Reserve chairman Ben Bernanke, a veteran economist, gave himself over to reflections on the same topic a month later:
Three principles seem to be broadly accepted in our society: that economic opportunity should be as widely distributed and as equal as possible; that economic outcomes need not be equal but should be linked to the contributions each person makes… and that people should receive some insurance against the most adverse economic outcomes.
…Thus the prevailing view on the political right.
What is striking about these concerns, though, is how little they reflect the actual phenomena of rising inequality in America from the mid-1970s to the present. (p. 147)
Conclusion:
In recent decades in American, economic inequality increased. This was, however, not some general social process, widely spread across the structures of pay and income. It was, rather, mainly due to extravagant gains by those in finance and in the leading sectors of the day: information technology in the 1990s, and the military and mortgage booms of the 2000s. What is astonishing, however, is how few people actually enjoyed the income gains. At their peak of expansion, the winning sectors did not generate many jobs; at best their success facilitated job creation in the many sectors that did not, themselves, experience rising wages.
What we can see, plainly, is that the American economy became leveraged, in such a way that its performance as a whole came to depend on the possibility of a very small number of people becoming very rich in very limited lines of work. In the first wave, information technology in the 1990s, the process could be justified, perhaps, by the potential gains affecting us all. In the 2000s, where growth was driven first by war and then for a few brief years by abusive mortgage lending, the saving grace is harder to see.
The deeper issue with inequality of this type is surely instability. That which rises like a rocket above the plain also eventually falls back to earth. And the problem with the trick of generating prosperity through inequality is simply that it cannot be continually repeated. The false starts to economic expansion since the Great Crisis in 2008 – so quickly depleted by rising oil and food prices – are a sign that bubbles are no longer a plausible way to generate economic growth. (p. 148 – 9)
** Chapter 13 excerpt, “Economic Inequality and the World Crisis”
Excerpt from Chapter 13, “Economic Inequality and the World Crisis,” from Inequality and Instability: A Study of the World Economy Just Before the Great Crisis by James K. Galbraith
What have we learned? Are there lessons to be taken from the diversely measured experiences of the United States, Europe, Latin America, and China? Are there central facts or common patterns that emerge unambiguously from the evidence?
First, the evidence points clearly at the need to redefine the study of economic inequality, and to restructure, to a degree, the main lines of research in the field. In the study of global inequality, trends and common patterns emerge with great clarity and persistence. This fact alone proves that the dominant forces affecting the distribution of pay (and therefore incomes) worldwide are systematic and macroeconomic. They are the product of forces affecting the global economy in common and systematic ways, forces impinging on individual countries and perhaps modified by the institutions those countries have and the policies they apply – but nevertheless forces that originate beyond their control.
Second, these forces are largely financial in character. They have to do first and foremost with interest rates, the flow of financial investments, and the flow of payments on debts, internal and international. At the global level, the data give no support to the vast outpouring in the professional literature arguing that changes in inequality are based on so-called real factors – such as a “race between technology and education” (Goldin and Katz 2008). There is also little comfort here for the view that rising international trade and competition from low-wage countries played the dominant role – or even an important one – in the inequality statistics. On the contrary, common and financial factors explain a very large share (practically everything) that can be explained….
Third, the superbubble in the world economy that began in 1980 and peaked in 2000 was also a supercrisis for lower-income countries and for lower-income people. Debtors lost out, relative to their creditors, at the personal and international levels. The simplest, clearest, and most compelling explanation for this phenomenon is that it was the willed consequence of policies. In particular, aggressive high-interest-rate policies transformed world finance beginning in the early 1980s; as those policies interacted with falling commodity prices and the debt burdens accumulated in Latin America, Eastern Europe, and ultimately in parts of Asia, they also transformed the balance of economic power and the structure of incomes.
Fourth, the study of national experiences substantially confirms the evidence of the global statistics. In rich countries such as the United States, we find that economic performance has become dominated since 1980 by the credit cycle; financial booms and busts drive the performance of employment, and thus prosperity is associated with rising income inequality. Further, as we examine the structure of rising inequality we find practically everywhere the same signature of a rising share of total income passing through the financial sector. The difference between the financial sector and other sources of income is – wherever we can isolate it – a large (and even the prime) source of changing inequalities. In the wake of crises, as we observe directly in the United States and in Latin America, the financial sector shrinks and inequalities tend modestly to decline.
Fifth, the ability or willingness of political systems to affect the movement of inequality is very limited in the world today. The most egalitarian regime types – communist states – have largely disappeared (though Cuba remains as a dogged exception). Islamic republics, another egalitarian type, are few and idiosyncratic. They will not be found anytime soon outside their limited range in the world.
Apart from these, we find that in the handful of stable social democracies (most of them in Northern Europe) that remain in the world today, it is economic institutions rather than the political structure per se that explain the persistence of low inequality in spite of an unstable world climate. There is no evidence that transitions to democracy can be relied on as a general matter to reduce inequality. However, the case of Brazil under Cardoso and Lula (and now Dilma Rousseff) does demonstrate that progress toward reduction of poverty and of inequality remains possible in the modern world, given favorable external conditions, low interest rates, and a determination by government to pursue a steady policy over many years.
Sixth, there is a systematic relationship between inequality and unemployment in the workings of labor markets around the world (and especially in Europe), but it is not the one that the advocates of “labor market flexibility” have been claiming with great passion for many years. Quite the reverse: following the general insights of Harris-Todaro and Meidner-Rehn, we find that more egalitarian societies tend to have lower steady-state unemployment. They also tend to have lower rates of technical progress and productivity growth, in part by importing advanced sectors and exporting or closing down backward ones. It is therefore not an accident that over time the egalitarian social democracies of Northern Europe became rich.
The same principles apply in the United States, where wage and pay compression – which cannot be confused with income inequality – moves with and not against the rate of unemployment. It helps to explain why European integration has produced higher chronic unemployment, since integrated international labor markets are more unequal than the national labor markets were when the latter could be taken alone. And it helps to explain the relationship between the floating population (largely unemployed, much of the time) and interprovincial economic inequality in China….
…The panoramic views provided on these pages should serve to demystify the study of economic inequality. In point of fact, even though there are many interesting developments to study, there are very few actual puzzles in the record. Similar patterns appear again and again.
What, then, is the relationship between economic inequality and the world financial and economic crisis? Here two distinct facts require treatment.
First, the massive rise of inequality in the global economy from 1980 to 2000, with a peak in most countries – including the United States – in the millennial year, is a fundamental reflection of the concentration of income and wealth among the richest of the rich, and the corresponding financial fragility affecting everyone else. Crises, and especially debt crises, are thus not new or sudden; in global perspective we see that they have cascaded across the world for a generation, hitting Latin America and Africa in the early 1980s, the Soviet Union and its satellites in the late 1980s and through the 1990s, and much of Asia in the late 1990s.
Throughout this period inequality rose in the United States, but the prevalence of external crises also meant that the United States benefited throughout from its position as a refuge for capital….
The problem facing the incoming administration of George W. Bush in January 2001 was thus two-fold. Externally, there was little scope remaining for extracting capital from the rest of the world. Every region that was open to crisis, with the possible exception of China and India, had already had one. Internally, the appeal of the major American leadership sector had worn out. What to do?…
Thus the Bush administration launched the “ownership society,” overtly encouraging massive expansion of lending to weak credits, and relaxing the regulatory standards that had previously protected credit quality in this area….
The financial crisis (and the world economic crisis it engendered) thus represented not so much the natural outgrowth of rising inequality as a further phase; it was the consequence of a deliberate effort to sustain a model of economic growth based on inequality that had, in the year 2000, already ended. By pressing this model past all legal and ethical limits, the United States succeeded in prolonging an “era of good feeling,” and in ensuring that when the collapse came, it would utterly destroy the financial sector. (p. 289 – 293)
(Please consider, as you read the above, the following: Why do we have pundits?... My reference to this commentary is not a comment on Galbraith but on the "as-old-as-'class'" issue of the relationship between 'poverty' and 'plenty'.)
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