Will Inequality Keep Getting Worse?

Last October, after a conversation with Chicago Booth professor Steve Kaplan, I posted this graph showing that the share of national income going to the top 1% had fallen dramatically.

This confirmed what I had expected--the taxable income of the wealthy generally tends to fall in recessions.  But since earlier census data had seemingly contradicted that expectation, I thought it was worth blogging.  As I explained:

The larger question is "how much does it matter"? I doubt Occupy Wall Street will be assuaged by learning that the top 0.1% now only receive 8% of the income earned in the US, even if that number is the lowest it's been since 2003.

But I think it does matter. If we think there's a real problem, we need the best possible data so that we can understand its contours. Income inequality has been rising for so long that people have started to assume that it has just kept rising, even when the data show otherwise. We don't want to spend years focused on income inequality, only to learn that the financial crisis fixed it for us.

Tim Noah, who I believe is working on a book about the growing problem of inequality, shot back:

No, we don't. Nor do we want to spend years trying to cure cancer, only to learn that the financial crisis fixed it for us. The likelihood of that happening would be roughly the same.

. . . Barring major changes in government policy (changes I would welcome even at the expense of book sales!) I see no reason to believe that the 32-year trend in income inequality will end anytime soon, and every reason to believe the precise opposite: It will get worse.

It was a witty enough retort to something I hadn't really said (he clipped the first paragraph). I never got around to responding, though I meant to, and there, I guess I just did.

But the reason I bring it up now is that it did get me thinking: how likely is inequality to simply keep getting worse?  It's a question that came back to mind when I saw this post from the Tax Foundation showing that inequality is now back to roughly where it stood at the beginning of Clinton's second term (via TaxProf):

But as I mentioned in this post (and the original), this may well only be temporary.  The financial crisis destroyed a lot of wealth.  Maybe we're just in another cyclical downturn that will, as Noah thinks, soon give way to the inexorable underlying trend.

What are the reasons to think that we might actually be witnessing a permanent change--a flattening of the trend, or even a reversal?  Some possibilities:

1. If something can't go on forever, it won't.  Trends like this come to seem inevitable because they have been going on for a long time--but since inequality cannot actually rise until the 1% own everything in the world while the rest of us suck on wood chips, the longer inequality has been growing, the closer that trend must be to slowing, or reversing.  So the more you feel that inequality growth is a state of nature, the less likely this is to actually be true.  And even very smart, knowledgeable people who have read a lot have an abysmal record at forecasting these things.  Look at Karl Marx, the intellectual grandfather of mindless trend extrapolation bolstered by entirely plausible theoretical mechanisms.


2. 2008 was a major discontinuous event.  Earlier recessions wiped out a sizeable chunk of income potential that later recovered, but they didn't fundamentally reorganize markets and institutions the way that 2008 did.  The last time that happened was 1929, which was followed by decades of declining income inequality.
   
   Of course, that doesn't mean that 1929 predicts our future, either; the Great Depression was worse and deeper than what we're going through, the regulatory response was more sweeping, and of course, there was that little spot of bother in Europe during the 1940s.  The point is only that 1929 is probably a better parallel for comparison than 1987 . . . which really just means that we're in uncharted territory.


3.  Both regulatory and public opinion has turned on the banking industry.  No, we didn't gut the bankers and hang their heads on pikes outside the offices of the SEC.  But the new regulatory environment, with less leverage and more poking around in the company books, is going to make it harder to make money for many financial types.  Even if you think that it should be made harder still, I think you have to acknowledge that things like Dodd-Frank should put some downward pressure on future bank profits.


4. Markets are getting more efficient all the time  By this, I don't mean that they approach some platonically true price.  I mean that they trade away relatively "free" opportunities to make money, by say, exploiting differences in the price of the same asset in different markets.  A few years ago, when I went to Warren Buffett's annual meeting, I talked with a lot of value investors who said that the proliferation of stock screening tools had made it much harder to find the sort of stock bargains that had driven Buffett's early success; if anything was conspicuously undervalued, other investors quickly found it and drove the price up.  That means you have to work harder (and pay more) to make wealth multiply itself.


5. The long secular rise in asset prices is over.  A number of factors have been driving up asset prices over (broadly) the last thirty years.  Baby boomers poured more of their savings into the stock market than their parents, aided by looser regulation and cheap mutual funds.  Falling inflation, and then falling interest rates, boosted the price of bonds, meaning that bondholders got to enjoy healthy capital appreciation along with their coupon payments.  Foreign capital poured into US markets looking for high and stable returns.  All these things inflated asset prices, which now have nowhere to go but flat or down.  Ordinary savers are seeing virtually zero returns, and it's not all that much better for rich people.  Ultimately, asset growth cannot permanently outstrip the growth in the underlying cash flows.  Just look at the P/E ratio of the S&P--still near the high end of its historical average, even after the greatest financial crisis since the Great Depression.  That's not because corporate profits are growing so fast--corporate profits are the denominator.  It's because people are paying a high price for securities.
   

   

6. Globalization faces a lot of challenges.  China's having some growing pains, protectionism has grown noticeably over the last decade, and institutions like the EU are in near-meltdown.  I have a lot of issues with the "trade immiserates the poor" story, but globalization has certainly helped boost the income of the small cosmopolitan class that is well positioned to take advantage of its opportunities.


7. Many of the other stomping grounds of the 1% are also changing.  Doctors are under reimbursement pressure from both private insurance, and governments.  Firms are looking for ways to replace those armies of expensive lawyers that help boost partner salaries.  Professional athletes (and sports teams) got an enormous income boost from the proliferation of national broadcasting, but that trend is mostly played out.  Real estate development--well, 'nuf said.  How many Facebook IPOs would it take to replace a permanent decline in surgery reimbursements?

Of course, we should also consider the reasons the trend might continue.  Globalization is still expanding.  The new economy still delivers a wage premium to people who are good at gathering and analyzing information, which is not everyone's strength.  Prolonged unemployment destroys human capital, and has been most prevalent at the bottom.  If you believe that rich people have wormed their way into the political system and used it to redirect wealth to themselves . . . well, I haven't noticed any deworming.

And there's the simple fact that, in the short term, mindless trend extrapolation is a pretty good predictive model--assuming that growth, inflation, unemployment, etc will look about the same next quarter as they do this quarter is as good a forecasting method as anything else.

Of course, right now, that would lead us to predict that inequality would keep falling.  Maybe.  There's a lag in the data, so we don't actually know what it looks like now, only two years ago.

I think the answer at the moment is that we simply don't know--I'm not sure there's empirical reason to prefer one story or the other.  I do think that we should be wary of confident extrapolations in either direction.