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Paul Krugman vs. Joseph Stiglitz

How income inequality could be slowing our recovery from the Great Recession

David McNew/Getty Images News

Given today’s report of economic contraction, it’s worth tuning in to a recent debate between liberal economists Joseph Stiglitz and Paul Krugman. While they agree on most things, the two have been at odds over whether economic inequality is holding back the recovery. Stiglitz says it is, and Krugman, while agreeing the inequality is unfortunate, says it is not. "Economics is not a morality play," Krugman observed.  

The debate is important. After leveling off during the recession, income inequality is growing again according to a study by the Economic Policy Institute. If it is a factor in the recovery slowing, then government, it seems, should try to do something about it.

Stiglitz gives four reasons why he believes "inequality is squelching our economy." First, "our middle class is too weak to support the consumer spending that has historically driven our economic growth"; second, the "hollowing out" of the middle class means that many Americans cannot afford an education for themselves and their children; third, the loss of middle income is "holding back tax receipts"; and fourth, inequality is "associated with more frequent and more severe boom-and-bust cycles." 

Krugman remarks that of these four, only the first and the third bear directly on what might now be holding back the recovery. The other two are about future growth. Krugman is right on this point, and he is also right to find the argument about tax receipts unconvincing. If inequality is limiting tax receipts, it is because of loopholes that the wealthy enjoy. It’s not because of inequality itself. But on the point about consumer spending—which Stiglitz says is the "most immediate"—I think Stiglitz is right and Krugman wrong.

Capitalist economies have to have some inequality to fund investment and spur risk. But the question is whether the kind of soaring inequality that has characterized the American economy recently speeds or slows economic growth. During the boom years from 1947 to 1980 after World War II, the top one percent garnered less than 10 percent of total income and the top ten percent less than 35 percent. On the eve of the Great Recession, the top one percent accounted for almost 25 percent and the top ten percent about 50 percent of all income.  

Stiglitz doesn’t make the whole argument, but it should go something like this: Middle and lower-income people have a much high marginal propensity to consume than the rich and very rich. The rich and the very rich are much more likely to save than to consume their earnings. So in an economic slowdown, where growth needs to be spurred by consumer demand, an economy that is skewed wildly toward the wealthy, as ours is, will not provide sufficient demand to boost the economy.  

There are exceptions to this rule. In an economy like China’s that enjoys huge export surpluses, workers’ wages can be held down without endangering the economy. But the American economy is driven by domestic consumer demand. Flagging wages can also be boosted by cheap credit and low interest rates. That happened in the ‘90s and in the five years before the financial crash.  The bottom 80 percent, as Stiglitz notes, were spending about 110 percent of their income. But that’s a solution that creates greater problems. In the last decades, it caused unsustainable debts that contributed to the financial crisis of 2007-8. Currently, consumers are spending what they earn, but not what they don’t have. So in the current situation, widening inequality should, as Stiglitz contends, be holding down the recovery.

I am not sure I entirely understand Krugman’s objections to this point, but they seem to boil down to a rejection of the idea, which originates with Keynes, that the wealthy have a higher propensity to save. His first objection is a statistical point. He argues that you can’t get an accurate sample among low and high income groups because the high income groups include people "who are [temporarily] having an especially good year and will therefore be saving a lot" and lower income people who are temporarily "having a particularly bad years and hence living off savings." This seems to me a peculiar argument. It’s about the difficult of sampling, not about the truth of the contention. And it also assumes a much more fluid class structure—where Americans regularly climb up and down the income ladder—than actually exists.

Three economists from the Federal Reserve and the National Bureau of Economic Research recently tried to get around Krugman’s sampling impediment by studying the propensity to save among people over their lifetimes. They found a "strong positive relation between savings rates and lifetime income." I don’t know how conclusive this is, but it would tend to favor Keynes’ assumption about saving rates and the wealthy and to buttress Stiglitz’s point.

Krugman also simply asserts that "you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs." That is very possible, but what stands behind Keynes and Stiglitz’s point is that even if the rich were to splurge on all these items, they would still not come close to consuming their incomes. Last fall, a wealthy Seattle venture capitalist Nick Hanauer made exactly this point in Bloomberg View: "There can never be enough superrich Americans to power a great economy. The annual earnings of people like me are hundreds, if not thousands, of times greater than those of the average American, but we don’t buy hundreds or thousands of times more stuff," he writes.

So if widening inequality is slowing the recovery, what can be done about it? How can the United States get back to the kind of income distribution that it enjoyed from World War II to the late 1970s, or can it at all? There are at least four different explanations for why inequality began to grow after the 1970s: first, the decline in the labor movement (which removed a barrier to employers suppressing wages); second, globalization and capital mobility, which brought down wages globally, and destroyed many middle income jobs in the United States; third, the rise of information technology, which put a premium on very educated labor and further destroyed middle income jobs; and fourth, government tax, spending and regulatory policies that furthered inequality. Economists like to insist that only one of these really matters; I prefer to say that all of them were, and are, important.

So what should government do? It should encourage not discourage unionization through strengthening the National Labor Relations Board. That will be difficult given the Republican House of Representatives and a conservative judiciary that recently threw out a year of NLRB rulings. Government should protect the economy against predatory trade tactics from other countries and eliminate any subsidies for companies to export jobs overseas. It should raise the minimum wage. And it should make the tax structure more progressive—which is what Hanauer recommends.

But taken together, these measures might not reverse the trend toward inequality. Unless the government could strengthen and not merely resist the destruction of labor union regulation, it’s unlikely that the labor movement will be able to get back on its feet. And that won’t come without the American working class enjoying its own "American Spring." Trade fights can be self-defeating. Governments can avoid these fights, perhaps, by going through the World Trade Organization, but by the time the WTO rules on a case, it’s likely the damage will already be done.

So government is limited, at least in the short term, to reduce pre-tax economic inequality. What it can do is extract through taxes and fees the surplus savings that accrue to the rich and very rich to fund common benefits for everyone else. It can’t necessarilyy reduce income inequality, but it can prevent a growing inequality in people’s standards of living. Imagine a large house where everyone lives in different size bedrooms, but everyone has equal access to a huge and wonderful living and dining room. It’s an old idea from my former colleague Mickey Kaus, who probably got it by hacking into a listserve. 

Improving common living standards is socially desirable, but it also makes sense for the economy, because the government will be spending income that would otherwise be saved. It will solve the economic problem that widening inequality creates. Government can strengthen rather than weaken Obamacare, pay for Americans to go to college who qualify but can’t afford to do so without huge student loans, ease unemployment and the transition to new jobs through more generous compensation and training, and make our cities and suburbs more livable by improving transportation, parks and recreation, and subsidizing the arts.   

Like measures that would immediately alter pre-tax inequality, these are politically controversial, and would be difficult to get through a Republican House. Since the early 1990s, if not before the Republicans have become the party of gated communities and the selfish rich and have resisted any kinds of initiatives—from raising the minimum wage to providing access to healthcare—that might reduce in equality. But if the Democrats want a program for the future, here it is. It is economics, and it also a morality play with a happy ending.