Inequality, the crash and the crisis. Part 2: A model of capitalism that fails to share the fruits of growth
Today we publish the second of three articles on inequality and the crisis by Stewart Lansley, visiting fellow at The Townsend Centre for International Poverty Research, Bristol University and the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012. He was one of the speakers at the 2012 OECD Forum session: How Is Inequality Holding Us Back?
The driving force behind the widening income gap of the last thirty years has been a shift in the distribution of “factor shares” – the way the output of the economy is divided between wages and profits. In the first two decades after the Second World War, a transformed model of capitalism emerged – across the rich world – in which it was accepted that the fruits of growth should be more evenly shared than they had been in the pre-War era. In the US, the share of output allocated to wages rose and stayed high. In the UK the “wage-share” settled at between 58 and 60 per cent of output, a higher rate than achieved in the pre-war era and the Victorian age. It was this elevated wage share that helped drive the “great leveling” of the post-war decades.
From the late 1970s, the capitalist model underwent another transformation, one characterised by a backward shift in the way the proceeds of growth were divided. By 2007, the share of output going to wages had fallen to 53 per cent in the UK. In the US, the fruits of growth became even more unevenly divided, with the workforce ending up with an even smaller share of the economic cake. There were similar, if shallower trends in most rich nations.
This process of decoupling wages from output has led to a growing “wage-output gap”, with a very profound, and negative, impact on the way economies function. This is for three key reasons. First, by cutting the purchasing power needed to buy the extra output being produced, the long wage squeeze brought domestic and global deflation. Consumer societies started to lose the capacity to consume.
The solution to this problem – which would have brought a prolonged recession much earlier – was to allow an explosion in private debt to fill the demand gap. In the UK, levels of personal debt rose from 45 per cent of incomes in 1981 to 157 per cent in 2008. In the US, debt reached a third more than national income by 2008. This helped to fuel a domestic boom from the mid-1990s but was never going to be sustainable. Far from preventing recession, it just delayed it.
The same factors were at work in the 1920s. The 1929 Crash was preceded by a sharp rise in inequality with the resulting demand gap also filled by an explosion in private debt. In 1920s America, the ratio of household debt to national income rose by 70 per cent in less than a decade.
Second, the intensified concentration of income led to the growth of a tidal wave of global footloose capital – a mix of corporate surpluses and burgeoning personal wealth. According to the pro-inequality theorists, these growing surpluses should have led to a boom in productive investment. Instead, they ended up fuelling commodity speculation, financial engineering and hostile corporate raids, activity geared more to transferring existing rather than creating new wealth and reinforcing the shift towards greater inequality.
Little of this benefitted the real economy. Of the £1.3 trillion lent by British banks between 1997 and 2007, 84 per cent was in mortgages and financial services. The proportion of lending going to manufacturing halved over the same period. It was this combination of the erosion of ordinary living standards and the accumulation of massive global cash surpluses that created the bubbles – in housing, property and business – that eventually brought the global economy to its knees. Again there are striking parallels with the 1920s when swelling surpluses in the US were poured into real estate and the stock market creating the bubbles that triggered the 1929 Crash.
Third, the effect of these trends has been to intensify the concentration of power with wealth and economic decision-making heavily concentrated in the hands of a tiny minority. In the US, such is the concentration of income, 5 per cent of earners account for 35 per cent of all consumer spending. A new elite has been able to exercise their muscle to ensure that economic policies work in their interest. Hence the inaction on tax havens, the blind-eye approach to tax avoidance and the scaling back of regulations on the City and Wall Street, policies that have simultaneously accentuated the risk of economic failure.
Not only did the growing income divide help to drive the global economy over the cliff in 1929 and 2008 it is now helping to prolong the crisis. UK wage-earners today have around £100 billion less in their pockets (roughly equivalent to the size of the nation’s health budget) than if the cake was shared as it was in the late 1970s. In the bigger economy of the US the sum stands at £500 billion. In contrast, the winners from the process of upward redistribution – big business and the top one per cent – are sitting on growing corporate surpluses and soaring private fortunes that are mostly sitting idle. This is a perfect recipe for paralysis.
The economic thrust of the last thirty years – greater reliance on markets, the weakened bargaining power of labour and hiked fortunes at the top – was aimed at dealing with the crisis of the 1970s, a mix of “stagflation” (stagnation and rising inflation ) and falling productivity. It succeeded in squeezing out inflation but replaced these fault lines with an equally toxic mix – global deflation, rising indebtedness and booming asset prices – that eventually brought economic collapse.
Part 3 looks at the lessons to be drawn for these trends.
Today we publish the first of three articles on inequality and the crisis by Stewart Lansley, visiting fellow at The Townsend Centre for International Poverty Research, Bristol University and the author of The Cost of Inequality: Why Economic Equality is Essential for Recovery, Gibson Square, 2012. He was one of the speakers at the 2012 OECD Forum session: How Is Inequality Holding Us Back?
Does inequality trigger economic instability? A few years ago this was a issue that did not register on the political Richter scale. Nor did it attract much attention amongst professional economists. As James Galbraith, the economist son of John Kenneth Galbraith, has put it, those few working in inequality research were in an economics “backwater”. Proving his point, the academic Journal of Economic Literature has no section examining inequality and economic instability.
There is one key reason for this lack of interest. For the last thirty years, the economic orthodoxy has been that inequality is a necessary condition for economic success. We can have greater equality or faster growth but not both. That orthodoxy emerged out of the global crisis of the 1970s when, it was claimed, the move towards more equal societies in the immediate post-war decades had gone too far and had led to economic sclerosis. What was needed to put economies back on an upward and sustainable path was a stiff dose of inequality.
Since the late 1970s that theory – for theory it was – has been put to the test in a real life experiment in both the US and the UK, and more latterly in a number of rich countries. As a result, the income gap in America and Britain has grown to levels last seen in the inter-war years. So has the experiment in “unequal market capitalism” worked in the way predicted by the theory? The answer appears to be no. The income gap has surged but without the promised pay-off of wider economic progress.
On all measures of economic success bar inflation, the post-1980 era of rising inequality has a much poorer record than the egalitarian post-war decades. In the UK, growth and productivity rates have been about a third lower since 1980 than in the post-war era, while unemployment has averaged five times the level of the 1950s and 1960s. The three post-1979 recessions have been deeper and longer than the shallow and short-lived ones of the two post-war decades. The main outcome for the countries that have embraced the post-1980 model of market capitalism most fully has been economies that are both much more polarised and much more fragile, culminating in the great crash of 2008 and today’s increasingly prolonged and intractable crisis.
So does this mean the theory is fundamentally wrong? Do high levels of inequality lead to economic collapse? Was rising inequality from the 1980s in fact a central player in driving the global economy over the cliff in 2008, and in the dogged persistence of the current slump?
The official view is that inequality played no part in the present crisis. The report of the bipartisan US Financial Crisis Inquiry Commission into the causes of the 2008-9 Crash, published in January 2011, for example, failed to mention “inequality” once in its 662 page report.
Two years ago the handful of economists who argued that inequality was the real cause of the current crisis were easily dismissed as an insignificant and heretical minority. The political consensus remained that inequality was not an economic issue. Yet gradually, opinion is beginning to turn. At the 2011 World Economic Forum in Davos, Min Zhu, former Deputy Governor of the People’s Bank of China and a special adviser at the International Monetary Fund, told his audience: “The increase in inequality is the most serious challenge facing the world.” In his economic address in Kansas last December, President Obama attacked the long period of stagnant earnings facing most Americans, or what he called the erosion of the “basic bargain that made this country great”. “But this isn’t just another political debate’, he continued, ‘This is the defining issue of our time.”
At the OECD’s annual conference in Paris last month, the packed agenda was dominated by the issue of the growing divide, while the IMF has produced several reports that question the orthodox explanation of the role of inequality. In one study, two IMF economists, Andrew Berg and Jonathan Ostry, argue that the 1970s theory – by Arthur Okun in his highly influential book Equality and Efficiency, The Great Trade-Off – has failed to stand up to real world application: “When growth is looked at over the long term, the [efficiency/inequality] trade-off may not exist. In fact equality appears to be an important ingredient in promoting and sustaining growth.”.
Not only has the rise in inequality failed to deliver on faster growth, history shows a clear association between inequality and instability. The great crashes of 1929 and 2008 and the deep-seated recessions that followed were both preceded by sharp rises in inequality. In contrast, the most prolonged period of economic success and stability in recent history – from 1950 to the early 1970s – was one in which inequality fell across the rich world and especially in the UK and the US.
Of course, association is one thing, causation is another. In part 2, we will look at the reasons why the link may run from inequality to crisis, at why economies that allow a small minority to colonise an increasing share of the economic cake hike the level of economic risk and the likelihood of implosion.