The Strange Case of American Inequality
J. Bradford DeLong
DEC 31, 2013
BERKELEY – Unless something goes unexpectedly wrong in 2014, the level of real per capita GDP in the United States will match and exceed its 2007 level. That is not good news.
To see why, consider that, during the two business cycles that preceded the 2007 downturn, the US economy’s real per capita GDP grew at a 2% average annual pace; indeed, for a century or so, the US economy’s real per capita GDP grew at that rate. So US output is now seven years – 14% – below the level that was reasonably expected back in 2007. And there is nothing on the horizon that would return the US economy to – or even near – its growth path before the 2008 financial crisis erupted. The only consolation – and it is a bleak consolation indeed – is that Europe and Japan are doing considerably worse relative to the 2007 benchmark.
The US economy’s annual per capita underperformance in 2014 will thus amount to $9,000. That means $9,000 per person per year in consumer durables not purchased, vacations not taken, investments not made, and so forth. By the end of 2014, the cumulative per capita waste from the crisis and its aftermath will total roughly $60,000.
If we project that forward – with nothing visible to restore the US to its pre-2008 growth path – at the annual real discount rate of 6% that we apply to equity earnings, the future costs are $150,000 per capita. If we use the 1.6% annual real discount rate at which the US Treasury can borrow via 30-year inflation-protected Treasuries, the future per capita costs are $550,000. And if we combine the costs of idle workers and capital during the downturn and the harm done to the US economy’s future growth path, the losses reach 3.5-10 years of total output.
That is a higher share of America’s productive capabilities than the Great Depression subtracted – and the US economy is 16 times larger than it was in 1928 (5.5 times larger in per capita terms). So, unless something – and it will need to be something major – returns the US to its pre-2008 growth trajectory, future economic historians will not regard the Great Depression as the worst business-cycle disaster of the industrial age. It is we who are living in their worst case.
One would think that such a macroeconomic disaster – one that robs the average American family of four of $36,000 per year in useful goods and services, and that threatens to keep Americans poorer than they might have been for decades, if not longer – would focus policymakers’ minds. One would think that America’s leaders would be clambering to formulate policies aimed at returning the economy to its pre-2008 growth path: putting people back to work, cleaning up underwater mortgages, restoring financial markets’ risk-bearing capacity, and boosting investment.
But no. Part of the reason is that, at the top, there is no crisis. According to the best estimates, the income share of America’s top 10% probably crossed 50% in 2012 for the first time ever, and the 22% income share that went to the top 1% was exceeded only in 2007, 2006, and 1928. The incomes of America’s top 10% are two-thirds higher than those of their counterparts 20 years ago, while the incomes of the top 1% have more than doubled.
Those who fall into the top strata thus regard themselves as doing well in the current US economy. And indeed they are. Only those who spend more time talking to competent macroeconomists than is healthy know that they could be doing even better if the economy were rebalanced at full employment. So the absence of distress among America’s top 10% and its top 1% – and hence political pressure for measures to return the economy to its pre-2008 growth path – is understandable.
But, for everyone else – roughly 90% of the US population – there has been no jump in income share relative to ten or 20 years ago to offset what now looks to be a permanent lost decade. On the contrary, the bottom 90% has continued to lose ground.
When income inequality began to rise in the 1980’s and 1990’s, those of us who cut our teeth on the long march of North Atlantic history expected to see a political reaction. Democratic politics, we thought, would check the rising power of a largely parasitic economic over-class, especially if its influence caused governments to fail to live up to their commitments to provide full employment with increasing – and increasingly shared – prosperity.
After all, in early-nineteenth-century Britain, growing inequality caused by the Industrial Revolution gave rise to movements for government regulation in the interests of the middle and working classes, and for a rebalancing of real incomes away from rich landlords. Similarly, the Great Depression produced enormous political pressure for reform and change (often for destructive and dangerous change, to be sure, but pressure nonetheless).
Why can’t America launch similar movements today? To the extent that this has become a valid question, most Americans should be as worried today about the quality of their democracy as they are about the inequality of their incomes.
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.
Real GDP in the US (left) and eurozone
In case you had forgotten, China has imposed an Air Defence Indentification Zone (ADIC) covering the Japanese-controlled Senkaku islands. The purpose of this escalation in the East China Sea is to test US willingness to back its military alliance with Japan, just as Kaiser Wilhelm provoked seemingly petty disputes with France to test Britain's response before the First World War.
The ploy has been successful. The US has wobbled, wisely or not depending on your point of view.
While American airlines comply, Japanese airlines fly through defiantly under orders from Japan's leader Shinzo Abe. Mr Abe has upped the ante by visiting Tokyo's Yasukuni Shrine - the burial place of war-time leader Tojo - in a gesture aimed at Beijing.
Asia's two great powers are on a quasi-war footing already, one misjudgement away from a chain of events that would shatter all economic assumptions. It would leave America facing an invidious choice: either back Japan, or stand aloof and let the security structure of East Asia disintegrate.
Trade this if you wish. The Dow Aerospace and Defense index (ITA), featuring the likes of Raytheon and Lockheed Martin, has risen 60pc over the past year, compared with 29pc for Wall Street's S&P 500.
Fuji Heavy Industries (robotics) is up almost 200pc this year in Tokyo, and Yamaha (also robotics) has doubled. Equities are pricing in rearmament. Japan raised spending on military equipment by 23pc last year.
It has launched an 800-foot long DDH-class helicopter carrier, an Osprey aircraft carrier in all but name.
The US is stepping back from the Middle East, leaving the region to be engulfed by a Sunni-Shia conflict that resembles Europe's Thirty Years War, when Lutherans and Catholics battled for supremacy. Sunni allies are being dropped, Shia Iran courted. Even Turkey risks succumbing, replicating Syria's sectarian fault lines.
Some blame Barack Obama for abdication, but the roots lie in two botched wars before him. Besides, Gulf oil is passe. Shale promises to turn the US into the world's top oil producer by 2017.
In Europe, the EU Project has by now lost so much caste that Ukraine's leaders dare to tear up an association accord, opting instead for a quick $15bn from Vladimir Putin's Russia. We seem to be reliving the mid-17th century when Bohdan Khmelnytsky turned his back on the West and embraced Tsarist suzerainty, locking Ukraine's borderlands into Russia for the next 300 years.
This is our brave new world of 2014. The democracies are on the back foot. It is no longer Francis Fukuyama's "End of History", but history returning in tooth and claw.
So with that caveat let me try to make sense of global economic forces. Bearish as usual, I doubt that we are safely out of the woods, let alone on the start of a fresh boom. How can it be if the global savings rate is still rising, expected to hit a fresh record of 25.5pc this year? There is still a chronic lack of consumption.
As the Fed tightens under a hawkish Janet Yellen, a big chunk of the $4 trillion of foreign capital that has flowed into emerging markets since 2009 will come out again. It is fickle money, late to the party.
Some say last May's "taper tantrum" was a timely tremor that released pressure and gave the BRICS and mini-BRICS a few months to adjust. This is oddly complacent given warnings by the International Monetary Fund, a body that specialises in such "sudden stops". As the IMF says, the taper tantrum may equally be a foretaste of something worse.
The Bank of England's Mark Carney says the epientre of stress in global finance now lies in the shadow banking system of emerging countries. My guess is that the Turkish lira will be the "Thai baht" of this episode - for those who recall the East Asian crisis of 1997-98 - although it could be a multiple fuse of those with big current account deficits, whether Egypt, Niger, Ukraine or South Africa, spreading thence to the next tier of Brazil, India and Indonesia.
It is a myth that emerging markets borrow only in their own currencies these days. External debt will reach $7.36 trillion in 2014, double 2006 levels (IMF data), mostly in dollars. Some $2 trillion is short-term. It must be rolled over continuously.
Euroland will be hit on two fronts by Fed action. Bond yields will ratchet up, shackled to US Treasuries. Emerging market woes will ricochet into the eurozone.
The benefits of US recovery will not leak out as generously as in past cycles. Dario Perkins from Lombard Street Research says the US is now more competitive than at any time since the Second World War. America is poised to meet its own consumption, its industries rebounding on cheap energy. Europe will have to generate its own stimulus this time. Don't laugh.
The European Central Bank can counter imported tightening by loosening pari passu, with a €1 trillion blast of QE that ingites the wet kindling wood. That would require a Damascene conversion in Frankfurt, or a debtors' cartel of Latin states to wrest control of policy and force through reflation. Such a cartel is taking shape. Chancellor Angela Merkel was badly mauled at the EU's December summit. Romano Prodi - former "Mr Euro" - has called for France, Italy and Spain to join forces and "bang their fists on the table". But no leader has yet emerged.
The ECB's Mario Draghi has, of course, eliminated the acute tail-risk of sovereign defaults in Italy and Spain with his bond-buying ruse, though the German constitutional court has yet to rule on the scheme. All five expert witnesses questioned its legality. But even assuming there is no bombshell from Karlsruhe, the deeper crisis keeps grinding on.
Credit to firms is still contracting at a rate of 3.7pc, or 5.2pc in Italy, 5.9pc in Portugal and 13.5pc in Spain. This is not deleveraging. The effects have been displaced onto public debt, made worse by near deflation across the South.
Italy's debt has risen from 119pc to 133pc of GDP in three years despite a primary surplus, near the danger line for a country with no sovereign currency. For all the talk of reform - Orwellian EMU-speak for austerity - Italy is digging itself deeper into one hole even as it claws itself out of another, its industries relentlessly hollowed out. Much the same goes for Portugal and, increasingly, France.
Markets cannot be counted on to stop this. They often abet destructive policies. Europe's wasting disease can go on for a long time, so like the Gold Standard years of 1934 and 1935.
There is just enough growth on offer this year - the ECB says 1pc - to sustain the illusion of recovery. Those in control think they have licked the crisis, citing Club Med current account surpluses. Victims know this feat is mostly the result of crushing internal demand. They know too that job wastage is eroding skills (hysteresis) and blighting their future. Yet they dare not draw their swords.
It will take politics - not markets - to break this bad equilibrium, the moment when democracies cease to tolerate youth unemployment of 58pc in Greece, 57.4pc in Spain, 41.2pc in Italy and 36.5pc in Portugal.
Unemployment in the eurozone (yellow), US (red) and Japan (light blue)
The European elections in May will be an inflexion point. A eurosceptic landslide by Marine Le Pen's Front National, Holland's Freedom Party, Italy's Cinque Stelle and Britain's UKIP, among others, will puncture the sense of historic inevitability that drives the EU Project.
French leader Francois Hollande will have to choose between conflicting loyalties to the Project and to the Parti Socialiste, fast shedding support to "Left Le Penism". He will opt for his own political survival and for the French national interest, now closely aligned. There will be no showdown with Berlin, just a series of escalating tiffs. The Franco-German EU marriage will die the death of a thousand cuts.
Latin rebels will increasingly invoke the example of the US - and loosely the Anglo-Saxon QE bloc - as it pulls ever further ahead. The US outgrew Euroland by three percentage points in 2012 and again in 2013. US growth may be 2pc higher in 2014, with powerful compound effects.
The jobless rate was similar on both sides of the Atlantic in 2009. It is now at a five-year low of 7pc in the US, and a near record 12.1pc in Euroland.
It is becoming harder to disguise this from Europe's citizens. By the end of 2014 the macro-policy failure in Europe will be manifest. We forget now how the "demonstration effect" of the Reagan boom was the coup de grace for the dying Soviet model. All pretensions were empty by 1986. That is when the last apologists for Soviet misgovernment stopped defending it and melted away. It was a moral collapse in the end.
Over all else hangs the fate of China. The sino-bubble is galactic. Credit has grown from $9 trillion to $24 trillion since late 2008, as if adding the US and Japanese banking systems combined. The pace of loan growth - 100pc of GDP over five years - is unprecedented in any major economy, eclipsing the great boom-bust dramas of the past century.
The central bank is struggling to deflate this gently, with two spasms of credit stress in the past six months. I doubt it will prove any more adept than the Bank of Japan in 1990, or the Fed in 1928, and again in 2007.
This will be a bumpy descent.
China may try to cushion any hard-landing by driving down the yuan. The more that Mr Abe forces down the Japenese yen, the more likely that China will counter with its own devaluation to protect the margins of it manufacturing industry. We may be on the brink of another East Asian currency war, a replay of 1998 but this time on a much bigger scale and with China playing a full part.
If so, this will transmit an a further deflationary shock through the global system, catching the West sleeping with its defences against deflation already run down. The US may be strong enough to cope. For Europe it would be fatal. The denominator effect would push Club Med into a debt compound spiral. Let us give it a 30pc probability. Happy new year.