Friday, August 8, 2014

S&P economists and inequality

The article starts with interesting comments about business economists 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.

 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 only weakly correlated with "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. Transfer based on mpc, not income. 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 raising the aggreagte mpc 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 -- gloabalization, 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 Summer's 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 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 tuns 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?


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

    The growth rates for the Gilded Age were slower than those in the more egalitarian, high-tax Postwar Period, though. The average growth rate was something like 1.8% a year, while in the Postwar Period it was around 2.5% or higher IIRC.

  2. John, I agree with you that "undereducated workers" causes both inequality and slow growth. But it is a feedback loop. If I live in Chicago and I am doing very well and my kids go to private school, I may not care about the issue of undereducated workers enough to have my tax dollars diverted to solve this issue. This is the specific mechanism by which inequality reduces growth. The top 10% is doing well enough - they don't want higher taxes necessary to improve the education system and they are capturing enough growth so that they are not concerned with lack of growth for the remaining 90%. Think of 17th century France, as an example.

    Why do we need higher taxes to improve the education system - because a big part of this education problem is really caused by broken homes, etc. Doing things like increasing earned income tax credit would indirectly help education as well, in the medium term. Hiring better teachers and paying them more would also probably matter as well.

    1. Do you truly believe the issue is not enough money going to the public educators of the great city of Chicago?

      Another thing these selfish wealthy tend to do.... Not throw good money after bad.

    2. Actually, yes, I do believe that. If you were to properly normalize for difficulty of the problem, you would find that Chicago schools in bad neighborhoods are severely under resourced. But I agree that the wealthy don't want to throw a lot of money at the problem at least in part because they simply don't care enough about solving it

    3. Resources (ie. spending) is not the problem. Chicago Public Schools spend $14K per student per year while suburban Napervillle spends $9K. CPS schools are typically in the bottom quartile while Naperville schools are typically in the top quartile. Incompetent teachers, administrators and parents are the problem. If you want to put a dent in income inequality, close failing public schools, issue vouchers and open more private charter schools. Too many inner city kids are "Waiting for Superman."

  3. Yes, Irwin's analysis is superficial. But, your rejection doesn't drive into the heart of the problem. Here are some basic points everyone should agree with:

    1. With declining marginal utility, wealth variance leads to below maximum utility in the cross-section just as it is in the time-series.
    2. The prospect of inequality is necessary to motivate people to help others (ie: earn)
    3. Wealth persistance is a problem because perception of it discourages people from playing the game once they are behind.

  4. I am just surprised you decided not to end your post with this zinger:

    "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." ;-)

    Though, it admittedly is somewhat of a cliche to do so.

  5. "Didn't Milton Friedman demolish the whole concept of "marginal propensity to consume" 70 years ago?"


    1. Steve - if you are going to dispute Cochrane's claim, the least you can do is to man up and back up your claim, instead of giving a terse "no".

    2. Friedman's model assumes no liquidity constraints. But poorer people DO have liquidity constraints. Therefore I would expect that Friedman's model would hold for the better-off (transitory changes in income make no difference to spending) but not for poorer people who face liquidity constraints.

    3. As your reply indicates, you're beyond thinking about a single marginal propensity to consume that sticks through life. Some are "liquidity constrained" -- meaning they want to borrow now against a much brighter future. (You need the second part!). That has something to do with poverty, but not necessarily. That comes and goes too. We just got much more sophisticated than this whole discussion.

    4. One key conceptual problem I see:

      MPC is almost always discussed as MPC relative to income, ignoring MPC relative wealth (net worth) or assets (the left-hand side of the wealth balance sheeet).

      This is as much Keynes' fault as anyone's, as his consumption function is purely income-based. But it's also the fault of most Friedmanites, who essentially capitalize projected lifetime income as "wealth" ignoring the fact that projected lifetime expenditures must also be capitalized to arrive at a present value of wealth (again, net worth). For a large chunk of real-sector actors, that value (and current wealth) is at or near zero throughout their lifetimes.

      Some economic modelers have incorporated MPC relative to wealth/assets into their consumption functions (though often using the phony above-mentioned income-but-not-expenditures capitalization), but this approach is very much not a part of the mainstream discussion, or most economists' mental modeling -- notably true in this post.

      An added problem: the kind of representative-agent modeling implicit in this post, by its very essence, is incapable of modeling a complex system of heterogenous agents with wildly varying individual conumption functions -- which are inevitable even if you only consider wildly varying wealth endowments at birth. (Circa 60% of American wealth is currently inherited -- and rising.)

      These conceptual problem are compounded by the patient lender/impatient borrower mental model. Households don't borrow from the patient rich. They borrow from banks, who create funds ex nihilo -- and burn those funds when loans are paid off. (Friedman noted that banks have both printing presses and furnaces.)

      When there's more or less borrowing, so real-sector and financial-sector balance sheets expand/contract together, the real-sector players spend more/less. Neither causes the financial sector (the so-called patient lenders) to change their spending in an economically significant way. Banks are not optimizing or smoothing their lifetime consumption. Their reaction functions are nothing like those of "patient savers."

      If a large proportion of real-sector actors are chronically both income- and liquidity-constrained, and don't effectively smooth or optimize their lifetime consumption, the result is chronically less lifetime spending by that group, with little or no deferral of that spending into the future via financial intermediation. Abba Lerner: "In the long run we're always in the short run."

      There is clearly a large group that fits that description. Twenty percent of Americans approaching retirement have no savings, and a much larger percentage have almost none. This is much lower than, say, the Great Depression, but it's still a chronic economic condition that the representative-agent lifetime-income hypothesis (even the overlapping-generation version of same) rather sweeps under the rug.

    5. I am sorry, but Milton destroyed many Keyensian theories with good humor and simple facts.

  6. I think the poor were smart to take the options offered to them by CountryWide et al: no downpayment and non-recourse means it's a cheap call option, and with some mortgages (reverse amortization) actually free! The FHA was promoting lending with only 3.5% down, and the $8k tax credit for buying a house less than $200k. A good realtor can apply the tax credit to last years taxes, making sure that the buyer actually gets the money right away, and the HUD was OK with using the $8k to cover the down payment. So it was often a free call option.

    The kicker: when it blew up, they were morally blameless, supposedly duped by evil bankers. Thus, Citi recently paid $7B in their latest installment for giving cheap mortgages that defrauded investors, and the Feds said they will use the fine for restitution for the borrowers! Add in the fact hat current Treasury Jack Lew was actually head of mortgages at Citi during this time, and you can see that our betters in Washington aren't the cure, they are the disease.

  7. Professor, as for your question in your last paragraph:
    "Why would the S&P put out such an awful report...."

    Maybe because S&P is a crony firm, who wants to make nice with the Feds. Thus, every now and then, their respectable business economists put out a silly report, just to prove to the Feds and the current administration that they are in line with the current Zeitgeist coming out of Washington DC.

    1. My thoughts exactly. Currying favor with the Crown.

    2. Allysia Finley, writing at The Wall Street Journal, answers the question:

      “The ratings agency, which had accused the Obama administration of retaliating for its 2011 downgrade of U.S. sovereign debt, may be trying to soften up the White House before restarting settlement discussions. As the Journal reported last month, the government ‘had previously demanded more than $1 billion before talks broke down. It then filed a lawsuit in February 2013 seeking $5 billion.’ Embracing the White House's economic agenda may seem like a small price in comparison.”

  8. So what should S&P be doing?

    I agree that I've never found the arguments about inequality and growth compelling. I always thought it would be something like: "Inequality redistributes income to patient people, which reduces growth through some kind of endogenous growth effect on entrepreneurship/research." But I've never seen anyone say anything like that.

  9. Dear Prof. Cochrane: Greetings from a long-time reader but a first-time commentator. Re your entry today on S&P and inequality, you take apart S&P’s report, but mention the IMF only in passing. I take it you are referring to Ostry et al. “Redistribution, Inequality, and Growth” from last April. I have just read that report, which tries to separate out the effects of redistribution. Even as a layman, I can anticipate some objections to looking at aggregate redistribution, i.e. changes to the GINI Index. Just as there is good inequality and bad inequality, I suppose there is good redistribution (e.g. educating poor children) and bad redistribution (e.g. paying people to have low market incomes). But I would be most interested in your assessment of the IMF’s report. Larry O’Neill

    1. I need to read it first. I try very hard only to comment on stuff I've actually read, and life is short. I do notice this drumbeat coming out of the IMF more and more these days.

  10. “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.)”

    A most excellent point as well as a very uncomfortable question for those advocating a government privilege economy.

  11. can you please explain (or link to an explanation) of how milton freedman demolished the concept of "marginal propensity to consume". perhaps this is my ignorance, but the argument that the poor will consume a greater percentage of their income than the rich made sense to me.

    1. Google 'permanent income hypothesis' and 'consumption smoothing.'

  12. Okay, once I got over my snit about my bellbottomed pants being disparaged...and my hair back then was wonderful...I wish I still had it....

    There is an interesting case study in history, regarding that left-winger Douglas MacArthur. Not once but twice (Japan and the Philippines) MacArthur instated land reform in conquested nations.

    There is an idea that a society could develop a very wealthy but ultimately decadent upper class that lets wealth go idle. Why develop property if you already have more money and women than you can use? Why the headaches?

    Could this explain decreasing new business formation rates in the USA? The huge increase in super-wealthy people who also engage in copious public sniveling?

    Actually, I doubt it (although Citigroup released some studies a few years back about "the plutonomy." Basically, they said that the wealthy control a lot more than before, and when the wealthy get cold feet the economy freezes up).

    We have reached an interesting era in which private-sector bank and rating agency economics are more "left" than academics!

    I still favor an elimination of corporate income taxes and a move to consumption taxes. But at some point the concentrations of wealth and income in the USA could be deleterious to overall economic growth. Are we there yet? Doesn't seem likely---but USA growth was very robust in the 1960s, when the Gini co-efficient was more equal and the top tax rate was 90 percent.

    My mind is not closed on this. Especially after that crack about bellbottomed pants.


  13. 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.

    So as long as money changed hands, the moral content of misdirection and lying is moot? Externalities....

    1. Well put isomorphismes (and Manfred the Mantooth) (above).

      To me it's long seemed that most economists (with very few exceptions, such as Friedman and Cochrane) are employed either to justify the government's doing things to the monetary infrastructure that would get the rest of us put in jail (such as counterfeiting -- that is, printing extra money, resulting in some getting goods/services for free at the expense of devaluing the worth of a dollar to everyone else)), or to figure out the effects of the government doing so.

      Thus, in a true free-market society there would be much less demand for economists. (Only for the truly gifted, such as Cochrane and Freidman.) Which is why I was never interested in becoming an official ecomist.

  14. Majors that stress quantitative aptitudes have a tendency to have graduates with the most elevated lifetime income. The most astounding procuring majors are those in designing fields, economic researcher, operations and logistics, physical science, mass trading, and fund.


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