The Inequality Trap

.08 March 2012
Kemal Derviş

WASHINGTON, DC – As evidence mounts that income inequality is increasing in many parts of the world, the problem has received growing attention from academics and policymakers. In the United States, for example, the income share of the top 1% of the population has more than doubled since the late 1970’s, from about 8% of annual GDP to more than 20% recently, a level not reached since the 1920’s.

While there are ethical and social reasons to worry about inequality, they do not have much to do with macroeconomic policy per se. But such a link was seen in the early part of the twentieth century: capitalism, some argued, tends to generate chronic weakness in effective demand due to growing concentration of income, leading to a “savings glut,” because the very rich save a lot. This would spurtrade wars” as countries tried to find more demand abroad.

From the late 1930’s onward, however, this argument faded as the market economies of the West grew rapidly in the post-World War II period and income distributions became more equal. While there was a business cycle, no perceptible tendency toward chronic demand weakness appeared. Short-term interest rates, most macroeconomists would say, could always be set low enough to generate reasonable rates of employment and demand.

Now, however, with inequality on the rise once more, arguments linking income concentration to macroeconomic problems have returned. The University of Chicago’s Raghuram Rajan, a former chief economist at the International Monetary Fund, tells a plausible story in his recent award-winning book Fault Lines about the connection between income inequality and the financial crisis of 2008.

Rajan argues that huge income concentration at the top in the US led to policies aimed at encouraging unsustainable borrowing by lower- and middle-income groups, through subsidies and loan guarantees in the housing sector and loose monetary policy. There was also an explosion of credit-card debt.

These groups protected the growth in consumption to which they had become accustomed by going more deeply into debt. Indirectly, the very rich, some of them outside the US, lent to the other income groups, with the financial sector intermediating in aggressive ways. This unsustainable process came to a crashing halt in 2008.

Joseph Stiglitz in his book Freefall, and Robert Reich in his Aftershock, have told similar stories, while the economists Michael Kumhof and Romain Ranciere have devised a formal mathematical version of the possible link between income concentration and financial crisis. While the underlying models differ, the Keynesian versions emphasize that if the super-rich save a lot, ever-increasing income concentration can be expected to lead to a chronic excess of planned savings over investment.

Macroeconomic policy can try to compensate through deficit spending and very low interest rates. Or an undervalued exchange rate can help to export the lack of domestic demand. But if the share of the highest income groups keeps rising, the problem will remain chronic. And, at some point, when public debt has become too large to allow continued deficit spending, or when interest rates are close to their zero lower bound, the system runs out of solutions.

This story has a counterintuitive dimension. Is it not the case that the problem in the US has been too little savings, rather than too much? Doesn’t the country’s persistent current-account deficit reflect excessive consumption, rather than weak effective demand?

The recent work by Rajan, Stiglitz, Kumhof and Ranciere, and others explains the apparent paradox: those at the very top financed the demand of everyone else, which enabled both high employment levels and large current-account deficits. When the crash came in 2008, massive fiscal and monetary expansion prevented US consumption from collapsing. But did it cure the underlying problem?

Although the dynamics leading to increased income concentration have not changed, it is no longer easy to borrow, and in that sense another boom-and-bust cycle is unlikely. But that raises another difficulty. When asked why they do not invest more, most firms cite insufficient demand. But how can domestic demand be strong if income continues to flow to the top?

Consumption demand for luxury goods is unlikely to solve the problem. Moreover, interest rates cannot become negative in nominal terms, and rising public debt may increasingly disable fiscal policy.

So, if the dynamics fueling income concentration cannot be reversed, the super-rich save a large fraction of their income, luxury goods cannot fuel sufficient demand, lower-income groups can no longer borrow, fiscal and monetary policies have reached their limits, and unemployment cannot be exported, an economy may become stuck.

The early 2012 upturn in US economic activity still owes a lot to extraordinarily expansionary monetary policy and unsustainable fiscal deficits. If income concentration could be reduced as the budget deficit was reduced, demand could be financed by sustainable, broad-based private incomes. Public debt could be reduced without fear of recession, because private demand would be stronger. Investment would increase as demand prospects improved.

This line of reasoning is particularly relevant to the US, given the extent of income concentration and the fiscal challenges that lie ahead. But the broad trend toward larger income shares at the top is global, and the difficulties that it may create for macroeconomic policy should no longer be ignored.

Kemal Derviş, a former minister of economics in Turkey, administrator of the United Nations Development Program (UNDP), and vice president of the World Bank, is currently Vice President of the Brookings Institution.
Copyright Project Syndicate

Markets Insight

March 7, 2012 9:49 pm

Greek deal will buy time but hard work lies ahead


It is as complex as it is big. Greece’s €206bn debt restructuring has left people drowning in a sea of figures, struggling to make sense of the deal.

Investors will get up to 24 new securities for each existing bond, a 66 per cent threshold for use of so-calledcollective action clauses” but a 50 per cent quorum, and a participation rate that needs to be 95 per cent – or is it 90 or 70 per cent instead? Confused?

The simple fact is that, for all its complexity, Greece has structured this deal so that it is likely to be reasonably successful. Retroactively inserting collective action clauses, which allow the decision of a majority of bondholders to bind all investors, may seem unfair to holdouts. But it all but ensures that Greece will be able to get all its Greek law bondholders to take part, giving it about 86 per cent participation.

The question will then be to see how many international law bonds, which account for the other 14 per cent of the €206bn, are tendered in the exchange. It is unlikely enough will be tendered to reach the 95 per cent the International Monetary Fund has said is necessary to get Greece’s debt down to 120 per cent of gross domestic product by 2020.

Greece has threatened not to pay any international law holdouts at all. That would open the way for a legal battle. But it also raises the prospect that Athens could raise more money than expected by simply not paying some bondholders.

All this is enough to give anyone a headache. Indeed, many investors have largely switched off, suffering from a two-year-old disease called “Greek fatigue syndrome”. Others deride the deal as almost irrelevant as they believe Athens will have to default again soon to have any chance of getting its debt burden down to manageable levels.

But the deal matters for several reasons. First, it is likely to serve as a test-bed for any future eurozone restructurings, despite protests to the contrary from policymakers.

The 53.5 per cent debt relief Greece is expecting to achieve could well prove enticing to politicians in other indebted countries such as Portugal and even Italy or Ireland in the future, particularly when weighed against demands ever more austerity.

Second, the deal is already in some ways determining the future shape of eurozone government bond markets, and not in a particularly healthy way. The issue of seniority is a big worry for some investors. The European Central Bank managed to get its €40bn-odd of bond holdings excluded from the swap in a move that irritated many investors. Then, the European Investment Bank also secured implied seniority by having its small holding taken out of the swap.

Seniority of such institutions may matter little in good times. But, against a backdrop where international investors have left peripheral bond markets in their droves, the notion that there are bondholders alongside you who may suddenly declare themselves to be superior is an unsettling thought.

The possible use of CACs is also something that investors in eurozone government bonds will have to get used to with all new eurozone debt due to have them inserted. That may be no bad thing, but their use in Athens shows how they introduce an extra element of credit risk for bond investors.

Take a step and the big issues in the eurozone crisis remain unresolved. The debt swap only marks the latest step in Europe’s long-running strategy of trying to buy time.

True, closure of the Greek debt swap allied to the ECB’s cheap three-year loans to banks would give policymakers some breathing space. But, as a central banker from outside the eurozone says: “Buying time only works if you use the time for some purpose.”

On that basis, the strategy cannot be declared a wholehearted success despite all the positive gloss from European leaders at this month's EU summit. They still need to ensure that the firewall to protect Italy and Spain, in particular, from contagion is as big as possible. Given the not insignificant chance that a combination of public austerity and recession could cause both of these countries’ economies to contract later this year, Europe cannot afford to be complacent.

The danger now, even as Greece moves towards a deal with its creditors, is that the familiar narrative of the crisis reasserts itself: policymakers achieve something, markets relax, and policymakers lose momentum before the job is done. Investors have shown patience so far this year. But the foundations for the rally in Italian and Spanish bond markets remain fragile, with many international investors staying on the sidelines.

There will be relief should Greece pull off its debt exchange this weekend. But the hard work lies ahead for the rest of the eurozone.

Copyright The Financial Times Limited 2012

US Budget Deficit Hits All Time High In February

Submitted by Tyler Durden
on 03/08/2012 19:20 -0500

For a global economy that is "improving" we sure are getting a whole lot of records in the won't direction in the last two days. Yesterday it was Japan which printed a record current account deficit (yes, the most indebted country in the world was once upon a time supposed to export its way out of debt). Today, we learn that in February the US will report its largest budget deficit in history, as the Keynesian floodgates open full bore, and as Zero Hedge has noted repeatedly, tax revenues just refuse to come in at anything close to the pace of accelerated spending, forcing the US to borrow 54 cents for every dollar it spends (not the often cited 42 cent number which does not take into account tax refunds - see here). We would comment more on this, but frankly the chart speaks for itself. And now that the US has to fund an additional $100 billion due to the taxcut extension this means that things are only going to get worse, fast.



And a longer term chart which is also self-explanatory... and quite sustainable


Nuclear power
The dream that failed
A year after Fukushima, the future for nuclear power is not bright—for reasons of cost as much as safety
Mar 10th 2012

THE enormous power tucked away in the atomic nucleus, the chemist Frederick Soddy rhapsodised in 1908, could “transform a desert continent, thaw the frozen poles, and make the whole world one smiling Garden of Eden.” Militarily, that power has threatened the opposite, with its ability to make deserts out of gardens on an unparalleled scale.

Idealists hoped that, in civil garb, it might redress the balance, providing a cheap, plentiful, reliable and safe source of electricity for centuries to come. But it has not. Nor does it soon seem likely to.

Looking at nuclear power 26 years ago, this newspaper observed that the way forward for a somewhat moribund nuclear industry was “to get plenty of nuclear plants built, and then to accumulate, year after year, a record of no deaths, no serious accidents—and no dispute that the result is cheaper energy.” It was a fair assessment; but our conclusion that the industry was “safe as a chocolate factoryproved something of a hostage to fortune.

Less than a month later one of the reactors at the Chernobyl plant in Ukraine ran out of control and exploded, killing the workers there at the time and some of those sent in to clean up afterwards, spreading contamination far and wide, leaving a swathe of countryside uninhabitable and tens of thousands banished from their homes. The harm done by radiation remains unknown to this day; the stress and anguish of the displaced has been plain to see.
Et tu, Japan

Then, 25 years later, when enough time had passed for some to be talking of a “nuclear renaissance”, it happened again. The bureaucrats, politicians and industrialists of what has been called Japan’snuclear village” were not unaccountable apparatchiks in a decaying authoritarian state like those that bore the guilt of Chernobyl; they had responsibilities to voters, to shareholders, to society. And still they allowed their enthusiasm for nuclear power to shelter weak regulation, safety systems that failed to work and a culpable ignorance of the tectonic risks the reactors faced, all the while blithely promulgating a myth of nuclear safety.

Not all democracies do things so poorly. But nuclear power is about to become less and less a creature of democracies. The biggest investment in it on the horizon is in Chinanot because China is taking a great bet on nuclear, but because even a modest level of interest in such a huge economy is big by the standards of almost everyone else. China’s regulatory system is likely to be overhauled in response to Fukushima. Some of its new plants are of the most modern, and purportedly safest, design. But safety requires more than good engineering. It takes independent regulation, and a meticulous, self-critical safety culture that endlessly searches for risks it might have missed.
These are not things that China (or Russia, which also plans to build a fair few plants) has yet shown it can provide.

In any country independent regulation is harder when the industry being regulated exists largely by government fiat. Yet, as our special report this week explains, without governments private companies would simply not choose to build nuclear-power plants. This is in part because of the risks they face from local opposition and changes in government policy (seeing Germany’s nuclear-power stations, which the government had until then seen as safe, shut down after Fukushima sent a chilling message to the industry). But it is mostly because reactors are very expensive indeed. Lower capital costs once claimed for modern post-Chernobyl designs have not materialised. The few new reactors being built in Europe are far over their already big budgets. And in America, home to the world’s largest nuclear fleet, shale gas has slashed the costs of one of the alternatives; new nuclear plants are likely only in still-regulated electricity markets such as those of the south-east.

A technology for a more expensive world

For nuclear to play a greater role, either it must get cheaper or other ways of generating electricity must get more expensive. In theory, the second option looks promising: the damage done to the environment by fossil fuels is currently not paid for. Putting a price on carbon emissions that recognises the risk to the climate would drive up fossil-fuel costs. We have long argued for introducing a carbon tax (and getting rid of energy subsidies). But in practice carbon prices are unlikely to justify nuclear. Britain’s proposed carbon floor price—the equivalent in 2020 of €30 ($42) a tonne in 2009 prices, roughly four times the current price in Europe’s carbon market—is designed to make nuclear investment enticing enough for a couple of new plants to be built.

Even so, it appears that other inducements will be needed. There is little sign, as yet, that a price high enough to matter can be set and sustained anywhere.

Whether it comes to benefit from carbon pricing or not, nuclear power would be more competitive if it were cheaper. Yet despite generous government research-and-development programmes stretching back decades, this does not look likely. Innovation tends to thrive where many designs can compete against each other, where newcomers can get into the game easily, where regulation is light.

Some renewable-energy technologies meet these criteria, and are getting cheaper as a result. But there is no obvious way for nuclear power to do so. Proponents say small, mass-produced reactors would avoid some of the problems of today’s behemoths. But for true innovation such reactors would need a large market in which to compete against each other. Such a market does not exist.

Nuclear innovation is still possible, but it will not happen apace: whales evolve slower than fruit flies. This does not mean nuclear power will suddenly go away. Reactors bought today may end up operating into the 22nd century, and decommissioning well-regulated reactors that have been paid for when they have years to run—as Germany didmakes little sense. Some countries with worries about the security of other energy supplies will keep building them, as may countries with an eye on either building, or having the wherewithal to build, nuclear weapons. And if the prices of fossil fuels rise and stay high, through scarcity or tax, nuclear may charm again. But the promise of a global transformation is gone.

March 9, 2012
A Look at the Global One Percent
The remarkable similarity in income distribution across countries over the past century means domestic policy has less effect than many believe on who gets what

While the Occupy Wall Street movement may be waning, the perception of growing income inequality in America is not. For those on the left, the widening gap between the top 1% of earners and the remaining 99% is proof that American capitalism is unjust and should be traded in for an economic model more closely resembling the social democracies of Europe.

But an examination of changes in income distribution over nearly 100 years, not just in the United States but elsewhere in the developed world, does not bear this out. In a 2006 study titled "The Evolution of Top Incomes in an Egalitarian Society," Swedish economists Jesper Roine and Daniel Waldenström compared the income share of the top 1% of earners in seven countries from the early 1900s to 2004. Those countries—the U.S., Sweden, France, Australia, Britain, Canada and the Netherlandsall practice some type of democratic capitalism but also a fair amount of redistribution.


As the nearby chart from the Roine and Waldenström study shows, the share of income for the top 1% in these seven countries generally follows the same trend line. That means domestic policy can't be the principal reason for the current spread between high earners and others. Since the 1980s, that spread has increased in nearly all seven countries. The U.S. and Sweden, countries with very different systems of redistribution, along with the U.K. and Canada show the largest increase in the share of income for the top 1%.

The main reasons for these increases are not hard to find. Adding a few hundred million Chinese and Indians to the world's productive labor force after 1980 slowed the rise in income for workers all over the developed world. That's the most important factor at work. The top 1% gain relatively because they are less affected by the hordes of newly productive workers.


But the top 1% have another advantage. Many of them have unique skills that are difficult to replicate. Our top earners include entrepreneurs, rock stars, professional athletes, surgeons and lawyers. Also included are the managers of large international corporations and, yes, bankers and financiers. (Interestingly, the Occupy movement seldom criticizes athletes or rock stars.)

The most dramatic change shown in the chart is the decline in the top 1% of Swedish earners' share of total income to between 5%-10% in the 1960s from well over 25% in 1903. The Swedish authors explain that drop as mainly due to the decline in real interest rates that lowered incomes of rentiers who depended on interest and dividends. Capitalist development, not income redistribution, brought that change.

Income-redistribution programs that became widespread in the 1960s and 1970s had a much smaller influence than market forces. Between 1960 and 1980, the share going to the top 1% declined, but the decline is modest. The share of the top percentile had been reduced everywhere by 1960.

Massive redistributive policies in Sweden did more than elsewhere to lower the top earners' share of total income. Still, the difference in 1980 between Sweden and the U.S. is only about four percentage points. As the chart shows, the top earners in both countries began to increase their share of income in 1980.

AFP/Getty Images
Occupy Wall Street demonstrators in New York

The big error made by those on the left is to believe that redistribution permits the 99% or 90% to gain at the expense of top earners. In much current political discussion, this is taken as an unchallenged truth. It should not be. The lasting opportunity for the poor is better jobs produced by investments, many of which are financed by those who earn high incomes. It makes little sense to applaud the contribution to all of us made by the late Steve Jobs while favoring policies that reduce incentives for innovators and investors.

Our system is democratic capitalism. In every national election, the public expresses its preference for taxation and redistribution. It is a democratic choice, not a plot controlled by one's most despised interest group. The much-maligned Congress is unable to pass a budget because it is elected by people who have conflicting ideas about taxes and redistribution. President Obama wants higher tax rates to pay for more redistribution now. The Republicans, recalling Ronald Reagan and Margaret Thatcher and much of the history of democratic capitalist countries, want lower tax rates and less regulation to bring higher growth and to help pay for some of the future health care and pensions promised to an aging population.

Regardless of one's economic philosophy, the public deserves an accurate presentation of the reasons for the change in income distribution. The change is occurring in all the developed countries. The chart shows that policies that redistribute wealth and income have at most a modest effect on income shares. As President John F. Kennedy often said, the better way is "a rising tide that lifts all boats."

Mr. Meltzer, a professor of public policy at the Tepper School, Carnegie Mellon University and a visiting scholar at Stanford University's Hoover Institution, is the author most recently of "Why Capitalism?" just published by Oxford University Press.

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