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Economists Rediscover the Distribution Question

Higher taxes for the rich-traditionally a horror to liberal economists-appear in a new light as state transfers to poorer sectors. Those richer than 99% pocket around 20% of the total income. It was less than half as much at the end of the 1970s. State debts come from reduced corporate tax revenue, not from excess spending (see Manifesto of Appalled Economists, 2011).

For a long time many academics saw the differences between poor and rich positively. Inequality was regarded as a driving force of a flourishing market economy. This is changing.

By Olaf Storbeck

[This article published in: DIE ZEIT, 2/1/2011 is translated from the German on the Internet,  http://www.zeit.de/wirtschaft/2011-02/arm-reich-oekonomie.]

The trip took 50 minutes. By car, the trip from posh Montgomery County in Maryland to the southeast of the capital Washington takes that long. It is a journey from one of the richest regions in the US into one of the poorest. This is not only reflected in bank accounts. With every mile, life expectancy of people falls seven months - from 81 to 60 years.

For a long time such distinctions left economists cold. Income inequality was only a niche theme in modern economics. Most economists saw the clear gulf between poor and rich as a consequence of high economic growth. This disparity was even an important prerequisite for the market economy functioning well.

Not only liberal economists were convinced of the myth. When the rich become even richer, this will gradually trickle down to the lower income classes. No one has paraphrased this attitude as well as British Labor politician Peter Mandelson who conceded in 1998: "Whether people are stinking rich is not our concern - as long as they pay their taxes."

In the meantime many economists are changing their ideas. Increasing evidence shows crass differences between poor and rich wreak steady economic damage and have more than a moral dimension. Some researchers even see a cause for the financial crisis from 2007 to 2008 in the drastically higher income inequality.

The new economic consciousness has lasting consequences for economic policy. Higher taxes for the rich - traditionally a horror to liberal economists - appear in a new light as state transfers to poor sectors.

"Great income inequality causes many problems in rich, highly developed economies," Adair Turner, head of the British financial market oversight FSA is convinced. Ignorance of income inequality is one of the crucial mistakes made by the discipline in the last decades. "Inequality," the Mannheim economist Hans-Peter Gruner stresses, "is a central economic reality that cannot be simply ignored."

In the past decades, income inequality has drastically increased in the US above all. For a long while there has been a chasm between the super-super rich and the great majority of society, not only between poor and rich.

When economists peak about the rich, they speak of the "top one-percent" of income distribution, not the "top ten-thousand." They mean the group of persons richer than 99 percent of all other inhabitants of a country. In the US, this includes everyone earning more than $368,000 a year.

Statistics of the Berkeley economist Emmanuel Saez awarded the 2009 John Clark Bates prize for top economists under 40 by the "American Economics Association: shows: the super-rich at the very top of the income pyramid have gained enormously in the past decades.

Between 1993 and 2008, the real income of these top earners rose almost four percent a year on average. The rest of American had to be content with a plus 0.74 percent per year. Those richer than 99 percent of the population pocket around 20 percent of the total income in the US today. It was less than half that much at the end of the 1970s.

The picture of the wealthiest 0.01 percent is even more extreme. More than five percent of total income falls to this little group today. Thirty years ago it was only around one percent.

The group of top earners, the richest two to five percent of society, has taken their place in the last decades. People who earn well below average must put up with bitter losses.

The causes for this development are complex and controversial among economists. The experiences of the last decades permanently put in question the thesis that increasing prosperity of the rich sooner or later trickle down s to the lower social strata.

Empirical studies also raise many questions. A research team around Dan Andrews of Harvard University analyzed the connection between inequality and growth in twelve industrial states from 1905 to 2000, "We find no systematic relation between the income of top earners and economic growth," they concluded.

Simultaneously the evidence grows that an excessive income inequality in a society is joined with considerable social and economic dislocations. "When income distribution develops so separately, social cohesion is endangered," Mannheim economist Gruner emphasizes.

In their 2009 book "The Spirit Level," British epidemiologists Richard Wilkinson and Kate Pickett argue that all social evil is closely connected with income distribution in a country. The greater the gulf between poor and rich, the higher the criminality and drug consumption in a country.

The enormous income inequality in the US was also the cause of the financial and economic crisis of the last years. Raghuram Rajan, former chief economist of the International Monetary Fund (IMF) and today economics professor in Chicago, agrees with their thesis. "There was enormous political pressure to do something against this" Rajan said. However the traditional instruments of economic policy - higher taxes for those with good salaries and direct transfers to the lower sectors - have been unpopular since the 1980s. Therefore US economic policy has tried to solve the problem with cheap money and available credits,

"For a long while, this functioned marvelously," Rajan said. "With borrowed money, people could purchase houses that rose in value and served as security for new credits. This money could then be used in consumption." The problem of growing inequality was thus covered up for a long time.

IMF economists Michael Kumhof and Ronald Ranciere undergirded this argumentation with a theoretical model. They show increasing income inequality leads poorer classes to attempt to maintain their living standard more intensively through credits. For a long while they could always borrow easy money.

In the long run, this makes the financial system unstable and susceptible to crises. More traditional social policy could solve the problem, the IMF economists write. If the state redistributes income, the economy could be made more stable.

"The Spirit Level: Why Greater Equality Makes Societies Stronger" by Kate Pickett and Richard Wilkinson VIDEO: The Spirit Level: Equality and the Good Life Rightwing pundits jumped on candidate Obama for saying we do better when we share. These two British researchers show the correlation of inequality and level of trust, murder rates, imprisonment rates and mental illness. John Kenneth Galbraith decried the public squalor existing alongside private opulence. Will the crisis lead us to a balance of public and private?
To hear the BookTV discussion from March 21, 2010, click on
"IMF Working Paper: Inequality, Leverage and Crises" by Michael Kumhof and Romain Ranciere
"Economists rediscover the distribution question" is the title of a German article by Olaf Storbeck. Maybe inequality isn't a magic elizer.

IMF economists in the IMF Working Paper "Inequality, Leverage and Crises" show the speculative 5% leveraged their capital enormously at the expense of the rest, 95 percent of the people.

"A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But restoration of the lower income group's bargaining power is more effective."

"The paper studies how high leverage and crises can arise as a result of changes in the income
distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large
increase in the income share of the rich, a large increase in leverage for the remainder, and an
eventual financial and real crisis. The paper presents a theoretical model where these features
arise endogenously as a result of a shift in bargaining powers over incomes...

The United States experienced two major economic crises over the past century—the Great
Depression starting in 1929 and the Great Recession starting in 2007. Both were preceded by
a sharp increase in income and wealth inequality, and by a similarly sharp increase in
debt-to-income ratios among lower- and middle-income households. When those
debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the
crisis. In this paper, we first document these facts, and then present a dynamic stochastic
general equilibrium model in which a crisis driven by income inequality can arise
endogenously. The crisis is the ultimate result, after a period of decades, of a shock to the
relative bargaining powers over income of two groups of households, investors who account
for 5% of the population, and whose bargaining power increases, and workers who account
for 95% of the population."

to read the 38-page pdf "IMF Working Paper: Inequality, Leverage and Crises" published in November 2010, click on

"Manifesto of Appalled Economists," January 2011, 32-pages pdf
State debts do not come from excess spending but from reduced corporate taxes. Corporations in the US and Europe play off states in competition for subsidies and tax cuts. "Job creation" is the clarion call that leads fragile states to pour out "incentives."

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