The Political Economy of American Economic Inequality (Opinion)

The Political Economy of American Economic Inequality
23 November 2011
Keith T. Poole and Howard Rosenthal

Keith T. Poole is Philip H. Alston Distinguished Chair, Professor of Political Science at the University of Georgia and Professor Emeritus at the University of California, San Diego.

Howard Rosenthal is Professor of Politics at New York University and Roger Williams Straus Professor of Social Sciences, Emeritus, at Princeton University.

Inequality in the distribution of income and wealth has risen sharply in the United States over the past 40 years. The really big winners are the top 1 percent and especially the top one-tenth of one percent. What happened?

We and Nolan McCarty produced Polarized America: The Dance of Ideology and Unequal Riches (MIT Press) in 2006. This volume pursued linkages between political polarization, immigration, and economic inequality. To these three topics we can now add regulation of financial markets, thanks to the work of Thomas Philippon and Ariell Reshef. In 1984, the two of us published “The Polarization of American Politics” (Journal of Politics), perhaps the first work to detect a sea change in American politics, a situation that has only gotten much, much worse over the past three decades. The work cited suggests paying attention to three mechanisms that relate to inequality: political polarization, immigration, and financial regulation. The last two can be directly controlled by government policy; the first cannot. Moreover, the political feasibility of beneficial policy changes is always in doubt, a problem that is exacerbated by the rise of polarization. The three mechanisms we have identified and many other possible contenders may all be important. (Text continues below the figures)

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Polarized America had an historical focus. We recap and embellish in a manner that identifies some of these other possible contenders.

The golden age of the middle class and low income inequality corresponds to the period between the end of World War II and the passage of the Great Society legislation of the Johnson administration. What else was going on in this period, besides low income inequality? As stylized by the TV series Mad Men, America was white-male, largely Protestant, dominated. Female participation in the labor force was low. Women and blacks encountered tremendous labor market discrimination in the North while Jim Crow persisted in the South. There were strong barriers to immigration, and the percentage of the population that was foreign born had been declining since the 1920s. Pensions were predominantly defined benefit plans, totally at risk in a corporate bankruptcy. Manufacturing had a strong presence in the private sector. Globalization and outsourcing were far away. Public sector employees, particularly teachers, were rarely unionized. Class sizes in schools were about fifty percent larger than they were at the onset of the financial crisis. Schools did not have to devote large amounts of resources for special ed. The (white) middle class was able to move to the suburbs and fund schools through local property taxes. The disabled were not enabled. Medicare did not exist. Americans both had more children and died earlier. Gays and lesbians were closeted. Major cities had severe air pollution.

Except for household income inequality, then, the golden age may not have been so golden. There were, to be sure, government policies dating from the Roosevelt, rather than the Johnson, era that may have fostered economic equality. These would include a very progressive income tax, a substantial estate tax, social security, and a minimum wage. In real terms, the minimum wage reached its peak under Johnson and has largely declined ever since. Labor legislation from the 1930s also facilitated the organization of private sector unions. Financial markets were highly regulated. Public utilities were highly regulated. In a less “free” market, growth was higher than it is now.

Politics in the golden age were less polarized than they are now. Polarization had declined since the 1930s. The turning point, which took a while to manifest itself in Congress, was perhaps marked by the Goldwater presidential candidacy of 1964. At the time, there was no Congressional Black Caucus or Hispanic Caucus, no Tea Party, no Alan Greenspan grooving out on Ayn Rand. Polarization has led to a tension between two ideologies, free market capitalism and egalitarianism. We think both of these are absolutely nuts. We need to abandon both. We need equality of opportunity but not equality of results.

Briefly, ideology drives polarization and polarization leads to the absence of corrective policy change. The main tenets of free market conservative ideology are no taxes, no domestic government spending, particularly on social welfare, and no government economic and environmental regulation of firms. The Republicans made the main contribution to polarization by moving sharply rightward (see Figures Below) to make markets freer than ever and government smaller than ever. To grasp the change, recall that George H. W. Bush, as a presidential candidate, thanks to economist Paul McAvoy, termed Reaganomics “voodoo” economics, then catered to the base with “read my lips”, and paid dearly for some modest tax increases. The Democrats have more abetted than countered free market capitalism. There’s a photograph of the signing of the repeal of Glass-Steagal, with Bill Clinton and even Larry Summers smiling along with Alan Greenspan and Phil Gramm. At the signing, Gramm declared “We have learned that government is not the answer”. Of course not, as Gramm departed for UBS and his spouse for Enron, and as Obama had a 2009 golf game on the Vineyard with Robert Wolf, CEO of UBS North America. UBS got a big bailout in the financial crisis but paid a much smaller, slap on the wrist, penalty for the thousands of accounts it hid for tax-evading Americans. One mechanism that allows free market capitalism to produce income inequality is that the ideology disguises crony capitalism and rent seeking.

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The Democrats have not moved nearly as much to the left as the Republicans have to the right (see Figures above), but they have contributed to polarization, in our opinion, by embracing identity politics. The Democrats can be seen as the party of African-Americans, of Latinos, of feminists, of gays and lesbians but not of white middle class males—those who defined the golden age of low household income inequality. Thus, when Fannie Mae, run at the time by Clinton’s OMB director Franklin Raines, embraced Angelo Mozillo in its 2003 annual report, the emphasis was on achieving equality of home ownership rates for minorities. Voters aren’t naïve. The Democrats do not win a majority of the white vote in presidential elections, and they do particularly poorly with white males. Doing something politically about inequality would require convincing people that government can be beneficial and that government will benefit the general population. The financial crisis of 2008 may have been an opportunity to move forward, but the 2010 midterm elections moved Congress sharply to the right.

Polarization contributed to the policy failures of Obama’s first two years. Before the rise of free market capitalist ideology, the filibuster was rarely used. It was used overwhelmingly on civil rights policy but not on economic policy—FDR did not have a filibuster proof majority in 1933-34. Today the filibuster is used to obstruct nearly all legislation, and Obama and the Democrats had to fish for 60 votes on the stimulus package, health care, and Dodd-Frank. One can readily argue that all three of these policies were compromised by concessions made to Olympia Snowe, Scott Brown, and others. Polarization, in a nutshell, induces gridlock or weak compromises. (Examples “No Child Left Behind”, prescription drugs for seniors, Sarbanes-Oxley, Dodd-Frank.) More recently, polarization has prevented the adoption of policies that would address the growing national debt of the United States. As political scientists, it is not our place to downgrade the public and private debt of the United States. On the other hand, we can give it an F, F for failed democracy.

To lower inequality, a return, at least partially, to Roosevelt policies on taxation and labor markets might well be beneficial, but to do so would require an end to polarization, which would require a huge change in ideology. On the right, irrational linkages that enshrine markets and reject evolution and global warming are likely to persist. On the left, coalition politics may not lead quite so far as to reparations but they may continue to promote entitlement and standing among groups that have indeed suffered in the past.

Polarization may also impact how the nation can deal with immigration. The end of immigration in the 1920s may have been important to the first black migration to the North, opening employment opportunities and lowering income inequality. Now we have to be open to the evidence on whether low-skilled rather than high-skilled immigration (as in Canadian policy) affects income inequality. There are two aspects of the problem that merit attention. The first is that some members of society are insufficiently productive to generate economic returns that cover the cost of goods and services they receive. In such cases, an employment contract does not internalize the social cost. In the case of citizens, there can be a sense of obligation for covering the costs. In the case of non-citizens, that sense will be diminished (as Alberto Alesina and Eliana La Ferrara have remarked for ethnic divisions among citizens). If the lower tail of the income distribution and those without health care are disproportionately non-citizens, there will be less support for redistributive policies, such as national health care. The second is that non-citizens don’t vote. The median citizen household has not fared as badly as the median household. Having a large non-citizen population makes it politically more difficult to enact policies that would build a middle class. Polarization accentuates the problem. Free market capitalists like open markets, particularly ones in which low-wage workers don’t vote while Latino constituencies push for weak border controls (but also for amnesty leading to voting rights). We suspect that the economic interests of Americans in the twentieth to the seventieth percentiles of the income distribution have little impact on the debate.

Our third mechanism is financial regulation. The evidence here is clear. Glass-Steagal symbolized an era of regulation that began in the 1930s and reached its peak at the end of the 1950s (Philipon and Reshef, see figure above). During this period the relative wage and education in financial services fell. At the same time, government developed a significant role in the housing market. Economic growth was robust with regulation and government enterprise. Fannie Mae was privatized, in 1968, not to promote growth but to allow the Johnson administration to finesse the accounting of a growing government deficit. Fannie and Freddie went on to generate rents for Democrats like Franklin Raines and James Johnson and Republicans like Newt Gingrich. Interest rates were deregulated and ARMs permitted, under Carter, not to promote growth but to allow S&Ls to finesse a deteriorating situation. The following wave of deregulation and non-regulation, accompanied by a growing wave of exotic financial products, led to a dramatic increase of the share of corporate profits arising in the financial sector and to a sharp rise in the relative wage and education in finance (Phillipon and Reshef). Ivy League undergraduates abandoned productive careers elsewhere for the lures of Wall Street.

We should, nonetheless, be sensitive as to how much constructive regulation of the financial sector, including compensation, can reduce inequality. Of the Forbes 400 for 2011, only 32 come from the financial sector, largely from hedge funds. (One could add 13 if “leveraged buyout” wealth were included.) None of the 32 shows a connection to a firm receiving TARP funds (unless one counts David Rockefeller). The wealthiest, George Soros, is a patron of liberal causes. The infamous Dick Fuld of Lehman never made it above the low 200s, even before 2008.

A huge chunk of the wealth is post golden age wealth that comes from entrepreneurial activity (Microsoft, Oracle, Wal-Mart, Bloomberg, Amazon, Facebook, Google, and Dell). The “mechanisms” that created such wealth may have increased inequality as a byproduct, but one would be wary of interfering with the mechanisms, as one would be wary, more generally of altering the increasing returns to higher education. Similarly, to the extent that increased female participation in the labor force, the availability of greater employment opportunities for women, and possibly assortative mating increase the demand for unskilled immigrants, household income inequality may increase. As highly skilled women have exited primary and secondary school teaching (Sean Corcoran, William Evans, and Robert Schwab), there could be a negative effect on long run human capital formation and growth. But one would hardly want to interfere with this “mechanism”.

Let us end by discussing two political mechanisms that have not been highlighted in our research. One is rent seeking. Tocqueville wrote of the “tyranny of the majority”. Harold Hotelling, Duncan Black, and Anthony Downs suggested that the tyrant would be the median voter. The median voter might be a nasty tyrant. There could be aggressive redistribution of income and wealth. A racial majority could discriminate against a minority. Official discrimination, still present in the golden age, has ended, and direct redistribution is severely limited. The median voter is a wimp, largely neutered by the checks and balances in our political system. Downs, however, also wrote of politics operating as a coalition of minorities, with each “minority” seeking rents. This certainly seems true of the private sector—think ethanol, think drug companies and insurance companies in health care, think the military-industrial complex outed by President Eisenhower.

Rent seeking also appears in the general population. Those over 65 are currently only 13 percent of the population. The percentage should not go over 20 percent for the next two decades. Those under 18 represent 24 percent of the population. Yet in 2009 and 2010 nominal spending on primary and secondary education fell while spending on social security and Medicare continued to rise. Of course those under 18 do not have voting rights and those over 65 do. Over the years turnout rates of the elderly have increased sharply (Andrea Campbell, 2005). Rent seeking by the elderly and their service providers is eating the seed corn, diminishing the opportunities for future growth and a solid middle class. While one might laudably abate the rents of the service providers and improve the efficiency of the health care system, the political effectiveness of the elderly is part of the problem.

Coalitions between providers of services and recipients are promoted by “charitable” donations of the providers to the “victims”. The “victims” in turn lobby the federal government for expanded coverage . This is true of drug introductions. It may also apply to extending reimbursement for mammography, PSA tests, and prostate surgery after scientific studies had questioned the usefulness of such procedures. It may also apply to the inclusion of expensive items, such as pre-school care of autistic children, in health insurance. We thus have a double whammy of rent seeking.

Rent seeking also permeates the revolving door between Wall Street and Washington. This is as true for Democrats as for Republicans. When the Rubins, the Orszags, the Summerses, the Emmanuels know that post-Washington riches await them, they are likely to do little to address inequality.

More generally, the supposed “meritocracy” has been ineffective in dealing with inequality. We suspect that inequality in university endowments has increased. The last four presidents have all had Ivy degrees. The Supreme Court, the Court of Citizens United, is now all Ivy. The Harvard Business School has contributed the COO of Enron, two professors who were principals in LTCM, and a Yale legacy who initiated a disastrous war in Iraq. Harold Koh, as Dean, told Rosenthal that one of the wonderful things about Yale Law School was that the Clintons and Clarence Thomas were there at the same time. Really? We suspect the nation would be better off if universities like Carnegie Mellon where we both were for many years had more resources and Princeton and Harvard had less. In France, it is said that in turn for getting nothing else, the left gets to educate the children. In the US, the Ivy left gets to educate the children of the global rich. We are not sure what is the appropriate benchmark or counterfactual, but we conjecture that the national elite serve us poorly.

Even if Democratic presidents and their top meritocratic staff were totally public serving, there would be two severe problems of implementation. First, the political class just below them (think former Illinois congressman and governor Rod Blagojevich, think former Louisiana congressman William Jefferson, think the New York state legislature) is rife with incompetents and corrupts. We have heard state legislators described as lawyers who can’t make it in the private sector. Without rebuilding the party from the base, the public will most likely be disappointed after electing a charismatic president. Second, the permanent bureaucracy lacks resources and capability. Madoff, the failure to shut down IndyMac, and the SEC lacking the firepower to analyze flash trades are just three of many examples.

The corruption of Blagojevich and Jefferson leads into our final topic. Much rent seeking is perfectly legal. But there is also rent seeking by cheating. Shortly after his inauguration, President Obama spoke of the financial crisis as having been the work of a “reckless few”. President Bush made similar remarks after Enron/World Com. This is good politics but inaccurate. One is unlikely to find a constituency for punishing Wall Street among employees of the Long Island Rail Road or among the thousands of wealthy Americans with illegal overseas bank accounts. Regulatory enforcement and tax collection is weak because a substantial “minority” likes it that way. Rent seeking, legal through the political process and illegal through cheating, increases inequality between those who succeed in such activities and those who don’t. Permitting it saps the confidence of citizens in what passes for democracy.

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