Saturday, September 19, 2009

It's Not Class Warfare, It's Just Math

I came across this neat little thought experiment on a blog recently, so unfortunately I have no idea who to attribute it to. But here it is:

Suppose you have a population where the top 1% of income earners make 10% of the income at Year Zero (this is approximately where the US stood in 1980). Suppose the overall economy grows at a real rate of 2.5%, while the incomes of the top 1% grow at 6%. (This is basically what has happened in the US since 1980--ignoring the last 12-18 months, more on that later.) This seems perfectly reasonable since, after all, the top 1% are probably far more productive (at least by 2x) than the rest of society, so why shouldn't their wages grow slightly over twice as fast? As long as everybody is making more money, everybody should be happy even if a very slightly larger share goes to the top 1%. So after 25 years at these growth rates, what has happened to incomes? In our hypothetical world, Year 25 would have the top 1% earning a little over 20% of the income. (This is basically the situation in the US in 2005, 25 years after 1980.) The top 1% earning 20% of the income might not sound so bad. After all the top 1% may be far more productive, produce far more jobs, provide far more investment, etc. After another 25 years in our hypothetical world, the top 1% are now earning over 50% of the income. From a purely economics point of view, this may be entirely reasonable. Of course, in the real world, one must consider the political reality of whether a population will stand for 1% receiving the majority of all income. History suggests dramatic revolutions occur at far lower levels of wealth for the highest ranks. The US launched into a vast campaign of wealth redistribution in the '30's at a time when the top 1% received about 20% of income. But enough reality, let's continue for another 25 years in our hypothetical world. By year 75, the top 1% is earning (drum roll, please) 120% of income! Clearly, this situation is not sustainable from any perspective.

So here's my thoughts on the thought experiment:

Of course, for a fraction of the population to earn 120% of the income is a statistical impossibility. (Although recent events have demonstrated in reality this may be possible if the bottom 99% simply borrow money in excess of their incomes to give to the top 1%.) So what does this thought experiment mean? The most obvious conclusion is that our historic rates of overall growth and growth for the top 1% are mathematically unsustainable and will have to change, certainly within the lifetime of most young people today. Let me restate that: Mathematically speaking, the income distribution in America has to change from what it has been in the last 3 decades. This is not class warfare. It is a simple application of math. It took me about 5 minutes to set up a spreadsheet to run the numbers--I'd be happy to send a copy to anybody who wants it and isn't sure how to create it themselves.

The real question is, how will this change occur? History suggests two possibilities, and ideologues suggest a third. Let's start with the ideologues. There is a libertarian fantasy that a middle-class is a naturally occurring phenomenon. In this line of thinking, at some magic number, the share of income earned by the top 1% will level off, reflecting some sort of "natural" balance, and the overall economy would grow at the same rate as the income growth of the top 1%. (Basically, any time the top 1% grows at a rate faster than the overall growth, no matter how small the difference, the result will be unsustainable over a long enough period of time.) There is no need for government to get involved, rational people making rational decisions about their money will lead to a perfectly efficient and stable economy. It sounds good in theory, but never in history has anything like this ever come close to happening. History does not reveal any examples of a society experiencing economic growth that is evenly distributed across the population without a government intervening to make it happen. And, historically speaking, there are only two ways to achieve evenly distributed income growth. The first is revolution. This method involves overthrowing the government, forcibly seizing assets of the wealthy, and effectively ending economic growth so that income inequality can not rise...because nobody's income is rising. I would call that a very bad method. The second way history shows that income growth can achieve even distribution is through incremental change--more evolution than revolution. This is what happened in the US in the '30's & '40's, and most of western Europe at about the same time, particularly at the end of WWII. The result was decades of growth shared across populations with incredible improvements in living standards for nearly all. The alternative method, revolution, was tried by Russia and the nations that came under its influence with considerably less positive results.

So there we have it: basic math demands that something must change in the way income is distributed in America. History indicates there are 3 options for how this change can happen. We can:
a) do nothing at a governmental level and hope for a miracle to occur--or simply ignore the problem presented by basic math.
b) start a revolution to overthrow the current government and economic order and try another Soviet-style experiment.
c) repeat the methods used successfully in the US (and most western European nations) in the '30's and '40's in which the government makes incremental changes through tax policy, social programs, and the like, to achieve a more sustainable distribution of incomes without destroying the entire economic system that has worked in the aggregate quite successfully for centuries.

I enthusiastically support c). Of course, once we all agree on c) there's still the question of what policies and programs need to change and how. But the conversation would sure be a lot easier to have if the room weren't full of people shouting for option a).

One last point: I mentioned earlier that I was ignoring the last 12-18 months. Some might pounce on the last 12-18 months as an example of how natural economic cycles will return income distributions to more sustainable levels. After all, this downturn has not been kind to the rich, with many losing vast amounts of wealth and seeing huge cuts in their income. But this ignores two things. First, all economic levels have taken huge hits in terms of wealth and income. Second, and far more important to my point, recessions have come and gone over the last 3 decades and not interrupted the long term trend of increasingly skewed wealth distribution. In fact, nearly every analysis I've seen about boom-bust cycles indicates that the net effect of boom-bust cycles is nearly always to increase the skewing of wealth toward the top 1%. The wealthy nearly always bounce back from recessions at a much faster rate than the general population (witness the fact stock market securities, held disproportionately by top income earners, rise quickly at the end of recessions while unemployment, far more important to low income earners, is widely considered a "lagging indicator" because of its generally slow rate of recovery). Assuming the US emerges from this recession, it seems safe to assume, barring government intervention, that the wealthy will more than make up for their losses and the long-term trend of increasingly skewed wealth distribution will continue to hold.


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