President Obama's second term could spell the end of "trickle-down" and the beginning of something that might be called "middle-out" economics

"We believe that America's prosperity must rest upon the broad shoulders of a rising middle class," President Barack Obama said in his second inaugural address Monday in Washington, D.C. It sounds like a remarkable, even wishy-washy, bromide. In fact, it's the backbone of a bold and somewhat revolutionary new economic policy.

Many people suspect there is a trade-off between what is good for profitability and what is good for workers. It's the underlying narrative for today's economy: Business and government leaders have to make tough choices--choices that sometimes mean a business cannot afford to pay workers a living wage or that our government cannot afford to provide services to the poor or income support to the elderly.

Yet, the reality is that this trade-off is based on a faulty view of economic reality. There is a large--and growing--body of research showing that the economy grows from the middle out and that seemingly "soft-hearted" notions about investing in people or communities are actually the key to a competitive economy.

TOUGH LOVE vs. HARD-NOSED ECONOMICS

Supply-side economics takes what might be called a "tough love" approach to the economy. It starts from the position that for the economy to grow, investors must have access to money to invest in good ideas. Coming from this perspective, high inequality, which allows economic winners to keep more of their income through lower taxes and less regulation, means they have more money to invest in successful projects, leading (eventually) to more growth for the whole economy. But this story about the economy starts in the middle of the story (with investors' cash-on-hand) whereas middle-out economics starts at the beginning.

On its face, the idea that the economy grows from the middle out may sound like some sort of "win-win" notion crafted by gimlet-eyed marketing specialists, rather than a concept grounded in hard-nosed economics. For sceptical, this sense of "too-good-to-be true" is probably underscored by the fact that middle-out economics was a theme pushed by President Barack Obama during his re-election campaign. As the Wall Street Journal put it last September, he "linked helping the middle class to boosting economic growth ... Thus has the fairness argument morphed into a growth argument."

This begs the question: Is middle-out economics a convenient bullet-point of liberal politicking or the basis of serious economic research?

Over the past couple of years, my colleagues and I have been sifting through economics papers and talking to leading economists around the world. We have found that there is a growing body of research showing that high inequality hinders economic growth and stability through a variety of mechanisms. While there isn't one perfect, econometrically unimpeachable paper that proves that the economy grows from the middle out, the abundance of research suggests that the strength and size of the middle has a strong effect on the all the key factors that propel an economy forward.

The extent of the evidence for middle-out economics is a live debate within economics. A series of recent books have sought to tease out the various ways that inequality or the strength of the middle class affects economic growth and stability. In his 2010 book, Fault Lines, former International Monetary Fund chief economist and Chicago Booth School professor Rajan Raghuram argues that the lack of income growth for lower- and middle-income families created an economic fault line in the United States. As income growth slowed to a crawl, families took on more debt to sustain their standard of living, a situation made possible in Raghuram's view by deregulation and government policies to promote home ownership. This was sustainable so long as housing prices kept rising, but once the music stopped, and the bubble burst, millions of families were saddled with mortgages they could no longer afford.

Raghuram, like many economists, notes that in recent decades, most of the economic growth gains have gone to the rich while the middle of the income distribution has lost ground in relative terms. Of course, rising inequality does not have to go hand in with lack of income growth for those in the bottom or middle, but in the United States the trend since the mid- to late-1970s has been for a few at the very top of the income distribution to see their incomes rise sharply, while everyone else has seen relatively slow growth, both compared to the top earners and compared to the 30 years prior to the late 1970s.

The crux of Raghuram's argument is that the problem is not simply that families took on too much debt in the run-up to the crisis; the problem is that high inequality created the macroeconomic conditions for those at the top to have both the capacity and the incentives to lend evermore amounts of money to everyone else.

WHAT DOES INEQUALITY REALLY COST?

In his new book, The Price of Inequality, Columbia University economist and Nobel Laureate Joseph Stiglitz argues that, "today's divided society endangers our future." He, like Raghuram, begins from the recognition that the level of inequality in the United States is unprecedented among modern societies in how vast the gap is between those at the top and everyone else.

Also like Raghuram, Stiglitz focuses his attention on the ways that rising inequality--specifically, the rise of the super-rich--are affecting the U.S. political process and what this portends for economic growth. In his analysis, rising inequality has led to a rise in what economists call "rent seeking," that is, actors seeking to take a bigger piece of the pie, rather than seeking to grow the pie. He points to a variety of ways that the wealthy have used their outsized power and influence to rig the game in their favor, documenting how the financial industry for years focused its energies on selling products to low- and moderate-income families that they could ill afford. And when the bubble collapsed, it was the industry that put all this in motion that received massive taxpayer funds as policymakers sought to avert a full-on repeat of the Great Depression.

Raghuram and Stiglitz's conclusions are not outliers in the economics profession. In November 2011, my organization held a conference with more than 30 economists, including two Nobel Laureates, asking them how inequality and the strength of the middle class affect economic growth and stability. One of themes repeatedly discussed was the idea that inequality--especially the form taken in the Untied States--is associated with the kinds of political institutions that hinder economic growth.

Another book putting the quality of institutions at the center of an economic growth theory is How Nations Fail by M.I.T. economist Daron Acemoglu and Harvard political scientist and economist James Robinson. Their central premise is that there is a "link between inclusive economic and political institutions and prosperity." They take the reader across the globe, through hundreds of years of history to make the argument that "while economic institutions are critical for determining whether a country is poor or prosperous, it is politics and political institutions that determine what economic institutions a country has."

Like Stiglitz, Acemoglu and Robinson hone in on the capacity of rent-seeking behavior to stymie growth. They argue that if political power is concentrated among an economic elite and economic policy works for their advantage, economic growth is hampered. While they do not say much about the United States, we can draw some lessons from their analysis. Starting in the 1970s the United States began moving away from inclusive institutions as unions lost power, states limited voter rights, and thanks to the Supreme Court's Citizens United ruling that corporations are people, the wealthy elites embarked on a record-breaking campaign- spending spree. On the other hand, during this same period there have been broad expansions of civil rights, as African Americans, women, and most recently, the lesbian, gay, bisexual and transgendered community have seen their political and economics rights enlarge.

As the benefits of economic growth have gone primarily to those at the top there's been a reduction in economic opportunity and has led to less political support for the kinds of economic institutions--including public education and infrastructure--that are a necessary foundation for economic growth. College attendance, for example, has been falling for lower-income students. What's more the chances of attending college for the best and the brightest low-income children are no greater than for low-achieving, but wealthier, students. If the United States continues to move toward more limited opportunities for children based on their parent's income, the vitality of our economy will suffer.

A recent series of articles makes the case that U.S. manufacturers cannot find enough skilled workers. The stories typically include an interview with an economist who notes that the problem is one of supply and demand: If employers offer higher wages, skilled workers will appear. And, then there's the argument that skilled workers are not created overnight. It is the collective investments of employers and society more generally, that creates 20-somethings with the math and technical skills to offer in exchange for wages. While an employer may have "cash-in-hand" today, ready to ramp up production, decades of gutted education and infrastructure spending have sharply hindered the potential for growth. This is a story that has other countries taking note: China is now making a $250 billion annual investment in creating the next generation of skilled workers.

JUST REWARDS

Economists have traced a path from high inequality and stagnating incomes among the middle class to the housing bubble, the financial crisis, the massive bailout by taxpayers to the calls for fiscal austerity that typically gut services and programs that benefit middle America, including education. Now employers claim that they cannot find enough skilled workers, but the reasons why aren't just about the wages they are offering, but the ideology pushed for decades that argued that business interests are not the same as those of the middle class.

The real danger to our prosperity lies in political inequality. The United States generated innovation and economic growth for the last 200 years because, by and large, it rewarded innovation and investment. This did not happen in a vacuum; it was supported by a particular set of political arrangements that prevented an elite or another narrow interest group from monopolizing political power and using it for their own benefit and at the expense of society. When politics gets hijacked, inequality of opportunity follows as the hijackers use their power to gain special treatment for their businesses, tilting the playing field in their favor and against their competitors. The best, and in fact, the only bulwark against this unfairness is political equality, ensuring those whose rights and interests would be trampled have a say and the opportunity to prevent it. If my reading of the economic research is any indication, this will be one of the most important economic stories of the next few years.