S&P Economists And Inequality

by: John Cochrane

Neil Irwin at the New York Times writes interesting coverage of a report titled "How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide" by S&P economists.

The article starts with interesting comments about business economists

...you have to know a little bit about the many tribes within the world of economics. There are the academic economists...many labor in the halls of academia for decades writing carefully vetted articles for academic journals that are rigorous as can be but are read by, to a first approximation, no one.


Then there are the economists in what can broadly be called the business forecasting community. They wear nicer suits than the academics, and are better at offering a glib, confident analysis of the latest jobs numbers delivered on CNBC or in front of a room full of executives who are their clients. They work for ratings firms like S&P, forecasting firms like Macroeconomic Advisers and the economics research departments of all the big banks.

The key difference, though, is that rather than trying to produce cutting-edge theory, they are trying to do the practical work of explaining to clients - companies trying to forecast future demand, investors trying to allocate assets - how the economy is likely to evolve.

They're not really driven by ideology, or by models that are rigorous enough in their theoretical underpinnings to pass academic peer review. Rather, their success or failure hinges on whether they're successful at giving those clients an accurate picture of where the economy is heading.

The latter part really isn't true. Few business economists are measured or rewarded for the accuracy of their forecasts. They are rewarded for, well, doing a good job offering glib comments on CNBC and entertaining rooms-full of executives. As, I readily admit, academic economists are rewarded for "influence" among other academics and increasingly in the media, rather than accuracy. Nor is this a criticism - offering supply to meet demand is always a noble calling to a free-market economist.

Read that again

They're not really driven by... models that are rigorous enough in their theoretical underpinnings to pass academic peer review.

This is damning with strong praise. Irwin is saying that business economists are happy to make predictions based on models that are completely internally incoherent and illogical, so much so that the graduate student assigned to referee a paper at a second-rate journal would spot the logical holes, if those models forecast well.

Well, that's what forecasting is about. "The weather forecaster causes rain" is a model that forecasts well. Until you try to kidnap the forecaster and make a sunny day. Unconditional forecasting and cause-and-effect are separate businesses in economics, and being good at one does not make you good at the other. Just as the guy who can tell you if it will rain tomorrow may not be that good at tornado thermodynamics.


But back to inequality and growth. Just how does inequality hurt growth? That should be the central thing we learn from such a report, no? That is, after all, its title!

Conventional wisdom says that often the opposite occurs, that in times of great opportunity and technical change - railroads 1880, radio 1920, internet 1990 - fortunes are made while stoking growth. That might be called "good inequality."

There is also "bad inequality" in which politically powerful interests make great fortunes rent-seeking and drive the economy to stagnation. (A conundrum not yet faced on the left: if rent-seeking is driving inequality, just how is giving the government more power to redistribute incomes, increasing the incentives to rent-seeking, going to help? High tax rates are catnip for tax lawyers, lobbyists, and rent-seekers.)

Welcome to economics, there is always supply and demand, and it's hard to tell which is moving.

And since inequality is so popular (welcome to the rewards of getting on MSNBC, or the New York Times), economists of all "tribes" are busy concocting stories about how inequality might lower growth.

Well, business economists do have a lot better contact with the real world than academics. The ones I know are really sharp, and very well informed. We should expect a lot of "real-world" insights on this crucial mechanism from the S&P economists, right?

Irwin's article offers only

Because the affluent tend to save more of what they earn rather than spend it, as more and more of the nation's income goes to people at the top income brackets, there isn't enough demand for goods and services to maintain strong growth, and attempts to bridge that gap with debt feed a boom-bust cycle of crises, the report argues... Those ideas go back to John Maynard Keynes,

Oh please. Yes, the problem with America is... our darn national thriftiness?

Anyway, can't we do better than spewing some half-remembered undergraduate course from the mid 1970s in which a sleepy professor with long hair and bell bottoms pushed around IS LM curves and talked about "demand" and "marginal propensity to consume" a lot? Didn't Milton Friedman demolish the whole concept of "marginal propensity to consume" 70 years ago? Is this it for the connection between inequality and growth?

Most of all, if the reason that inequality is bad is that it is bad for growth, and if the reason it is bad for growth is that it leads to insufficient consumption and lack of demand, then that can easily be addressed in the same Keynesian framework with lots of stimulus spending. If you play the Keynesian game, it seems to me you have to play by the Keynesian rules. Even if you accept the diagnosis, then you do not accept the conclusion that very high - and very distorting - taxes and transfers are the best remedy. Unless... you really don't believe the mechanism, or the connection to growth, and this is all rhetoric in favor of taxation for other reasons. It is interesting how the diagnoses seem to follow the prescription, and redistributive taxation is a perennial answer in search of a question.

Update: Another example. If the reason inequality is bad is that it is bad for growth, and if the reason it is bad for growth is that it leads to insufficient consumption, and if the remedy is going to be to take money from people with low marginal propensity to consume and give it to those with high marginal propensity to consume, well, do it. Income is a poor proxy for mpc.

My wife's relatives are mostly in the thrifty poor category - they unplug toasters when not in use just to be sure, and slowly save for retirement. When Michael Jackson died, he had borrowed about $100 million bucks all for consumption - a private amusement park and petting zoo. If you want to transfer money from low mpc to high mpc people, then you tax my wife's thrifty relatives and give it to people like Jackson, who will surely do a better job of consuming it. They're not hard to find. Look for the maxed out credit cards, the garage full of cars, the ostentatious house. What, you think it would be awful to tax thrifty poor people and give it to spendthrift rich people? Well, then this is about redistribution, isn't it. You don't really believe it's about giving money to high mpc people to stimulate growth. So let's stop obfuscating and get to the point.

Well, maybe Irwin is summarizing a bit too much. I read the report looking for something deeper. I did not find it.

Here's what I did find.

  • "Is inequality increasing?" Boilerplate numbers, no need for more comment.
  • "When ends don't meet." Boilerplate summary of speculation about causes - globalization, technology, superstars, etc. All curiously "good inequality." Curiously little on rapacious cronies, the one good mechanism I can think of for "bad inequality."
  • "Not just the fruits of our labor." Capital income accounts for a lot of measured income inequality.
  • "The impact of government policy." Back of the envelope on how changes in (highly progressive) social programs and taxes affect inequality.
  • "Undereducated workers." A nice long section on how bad education lowers GDP and makes inequality worse. But that's not inequality lowering growth, that's bad education causing both more inequality and lower growth. Let's not repeat the classic third cause fallacy

Finally, in "Catching up with the Joneses" some hints of the point, mechanisms by which inequality might hurt growth.

As income inequality increased before the crisis, less affluent households took on more and more debt to keep up-or, in this case, catch up-with the Joneses, first by purchasing a new home. Further, when home prices climbed, these households were willing to borrow against their newfound equity-and financial institutions were increasingly willing to help them do so, despite slow income growth. A number of economists have pointed to ways in which this trend may have harmed the U.S. economy.

This is incoherent - this is how poor people spent more, not spent less. Inequality - growth is supposed to be about long run trends, not boom and slow recovery.

Professor of Public Policy at U.S. Berkeley Robert Reich argues that increased inequality has reduced overall aggregate demand. He observes that high-income households have a lower marginal propensity to consume (MPC) out of income than other households

Here we go again. So the deep analysis was passing on Reich's "argues" which is more accurately "speculates."

A brief review of Mian and Sufi - good data on housing and debt but little to add on inequality leading to growth, and also mired in "marginal propensities to consume." A sentence summarizing Rajan

Raghuram Rajan claims that, while high-income individuals saved, low-income individuals borrowed beyond their means in order to sustain their consumption, and that this overleveraging, as a result of increased inequality, was a significant cause of the financial crisis in 2008.

(Actually Rajan's story is political - politicians, noticing inequality, handed out mortgage subsidies to pacify the peasants. But that's for another day)

OK, so the idea in this report is that somehow truck drivers in Las Vegas found out that hedge fund managers in Greenwich CT were upgrading from Gulfstreams to 737s. This made them feel bad, so they went out and took out huge mortgages that they had no chance of repaying. When house prices went up, they refinanced and bought TVs giving them even less chance of paying off their mortgages. Now they're broke and not spending a lot. And "spending," not productivity is the key to long-run growth. If you want to do your bit for growth this afternoon, don't learn Python, don't write a new app, don't invest in a startup - head down to the mall and grab some stuff you don't need.

At best this is a theory of boom and slow recovery. But growth and inequality is about the long run. Why were we growing too slowly in the 2000s?

An IMF paper by Michael Kumhof and Romain Ranciere also details the mechanisms that may have linked income distribution and financial excess and have suggested that these same factors were likely at play in both the Great Depression and Great Recession (43).

May have. Suggested. Likely. And whatever they were, this report can't even coherently summarize them.

...former Secretary of the Treasury Lawrence Summers has said that the U.S. may be mired in a period of slow growth...what he called "secular stagnation" (48). This refers to an economic era of persistently insufficient economic demand relative to the aggregate saving of households and corporations....While specific causes of secular stagnation are still uncertain, possible reasons include slower population growth, an aging population, globalization, and technological changes. An increasingly unequal distribution of income and wealth is also cited as a contributing factor.

Summers is smart and clever, but these are speeches, opinions, not models or facts. And income distribution isn't even central in Summers' speeches. He sort of throws it in a laundry list because he knows it's popular these days.

In his influential 1975 book "Equality and Efficiency: The Big Tradeoff," economist Arthur Okun argued that pursuing equality can reduce efficiency. He claimed that not only would more equal income distribution reduce work and investment incentives, but the efforts to redistribute wealth-through, for example, taxes and minimum wages-can themselves be costly (54).

Argued. Claimed. Where or where did models, logic, and data go? Well, if you're going to be Paleo-Keynesian, you might as well quote opinions from the heyday.

At last some faintly sensible speculation:

Income inequality can contribute to economic growth, and a degree of inequality is a necessary part of what keeps any market economic engine operating on all cylinders. Indeed, a degree of inequality is to be expected in any market economy, given differences in "initial endowments" (of wealth and ability), the differential market returns to investments in human capital and entrepreneurial activities, and the effect of luck.

Yeah, but how much? We seem to have gotten nowhere on diagnosing "good inequality" from "bad inequality"

However, too much of the focus in the debate about inequality has been on the top earners, rather than on how to lift a significant portion of the population out of poverty-which would be a good thing for the economy. And though extreme inequality can impair economic growth, badly designed and implemented efforts to reverse this trend could also undermine growth, hurting the very people such policies are meant to help (57).

Well there's some nice one hand-other hand economics. So, it would seem we really have no idea where we are on the good or bad spectrum. But then

There is no shortage of proposals for tackling extreme income inequality.

Excuse me, we just went through a long review that got nowhere documenting that our inequality was even of the bad vs. good type, no causal mechanism for inequality to hurt growth as economists understand growth - just rich people invest, poor people consume and IS/LM lasts forever - and suddenly it's "extreme" and needing "tackling?"

So, Irwin's paragraph did accurately reflect what's in the report. There just wasn't any there.


Well, at the end, what did we learn from our "business" economists at the S&P, which Irwin praised for their practicality and remoteness from academic angel on head of pin counting?

Nothing. Despite Irwin's distaste for academia, it turns out that the best this report can do is collect opinions from the softer writings of... academics! And the best these opinions can do is to speculate that "lack of demand" from excessive aggregate thriftiness lasts forever. The practical opinions of people with clients to please and ears to the ground is completely absent in this report. Or any other independent thought or analysis.

Well, at least it is nice to know that to a second approximation, someone is reading academic writing - the authors of the S&P report.

(Again, I mean nothing ill here about the actual merits of business economists in general, as the ones I know are very well informed and insightful. I'm just complaining about Irwin's marketing and this report.)

What is going on here? Why would the S&P put out such an awful report, collecting second-hand opinions and speculations from popular books and speeches, doing no serious independent analysis, and then endorsing as settled fact that "inequality" - of all stripes, no distinction made between kinds - is bad for "growth" - completely confusing business cycle and long run? Why is it so important for the S&P - and the IMF - to go out on a limb to declare themselves for measures to address "extreme" inequality, by endorsing cocktail party stories about their connection to growth?