Does wealth inequality spawn economic meltdown?

The Economist surveyed the economic data in the issue of March 17, 2012 (p.87).

What I take away from the article is when the average worker is experiencing long term stagnant buying power while the rich are getting richer the likelyhood of deficit spending by the government and some sort of meltdown in financial markets is high.  But why is not yet completely clear.

One theory with some evidence shows that part of the problem is expectation - the old "keeping up with the Jones" syndrome.  As relative income of workers begins to fall in comparison with wealthier folks, they begin to try to keep up with the life style they see in their town and in the media which they regard as the norm.  To do so they have to borrow money to purchase things through credit cards or refinancing a home.  If the inequality continues to grow, the growth of debt increases until it hits a crisis point.

Another theory is that government plays a role by trying to make it easier for folks to obtain credit.  Researchers analyzing congressional votes on bills that expanded the availability of credit found that congressmen who represented districts with more inequality in income were more inclined to vote to loosen mortgage rules.

Another group of economist looked at 22 OECD countries and found evidence when inequality increases, governments seeking to keep growth on track pick up spending to make up for the falling consumer buying power of average workers.   A common OECD mechanism is increasing spending on social safety nets.  I would make the case that here in the US in the last thirty years we have been more inclined to use military spending, which actually exacerbates the income inequality.

Finally another group of researchers caution against assuming there is always a link between income inequality and financial meltdown.  They say they find a strong relationship between credit booms and financial meltdowns, but don't find a link between income inequality and credit booms.  They note that credit booms more often accompany rising real wages by the average worker.   I haven't seen the original research but the Economist article gives no indication this study considers the fact not all credit booms lead to busts, or the possibility credit booms based on inequality from falling real incomes lead to deficit spending and eventually a meltdown, while credit booms based on rising real incomes (which usually occur in developing countries pulling themselves up out of poverty) can correct themselves without deficit spending and a meltdown.  In short the meltdown hinges on whether the people in the country perceive their lives to be improving, or are trying to maintain a life they have become accustomed to in the facing of falling purchasing power.

Comparing countries with high income inequality

Here is some data relating to income inequality.  First, the top 10 most unequal from an article in the Huffington Post first posted in May of 2011 - search under income inequality) -

1.  Chile
2.  Mexico
3.  Turkey
4.  United States
5.  Isreal
6.  Portugul
7.  United Kingdom
8.  Italy
9.  Australia
10.  New Zealand

The Huffington Post article was based in part on a 2011 OECD study.  There seems to me to be some inconsistency between the Huff Post top 10 and what the OECD actually says.  So here is how the OECD summarizes their findings.  (The OECD stands for Organization for Economic Development - an organization consisting of 30 democracies) The OECD analyzed their findings by grouping countries into 5 categorys.

1.  Far below average - Denmark and Sweden have the least income inequality.

2.  Below average - Most of the rest of Northern Europe and Australia.

3.  Around average - Korea, Canada, Spain, Japan, Greece, Ireland, New Zealand and the UK.

4.  Above the average -  Italy, Poland, the US and Portugul.

5.  Way above average - Turkey and Mexico.

One can't help but notice that none of countries whose economic instability is rocking the global economic boat are in the below average category.

Was Ike was the most Responsible Republican President since Lincoln?

He was in my opinion.  He accomplished a number of things, but most astoundingly, when he swept into office in 1953 he brought so many Republicans on his coattails that Republicans had majorities in both houses of Congress for the only time between 1932 and 1995.  That situation only existed for two years, but during that two year session Congress enacted the 1954 Tax Code that had tax rates as high as 90% on the income of really wealthy people.  It solved the huge budget deficit problem that we had developed during the great depression and WW II.

In the two prior sessions of Congress Democrats had a majority and had first enacted many of the taxes on the income of the wealthiest Americans, but I don't think that diminishes Ike's leadership on the issue.  It would have been easy to have cut those high tax rates back to keep wealthy constituents happy as he looked forward to his reelection campaign, but he recognized we needed to deal with the debt and pushed the Republicans in Congress to act responsibly.

He still got reelected (although Republicans lost their majorities in both houses) and he left office with the country in pretty sound financial shape.  Certainly no Republican President since then can say that.

Comparing the Federal budget with a household budget

It is currently popular among politicians and pundits to compare our National budget and National debt to a household budget.  A recent article (SF Chronicle Insight, 3/25/12, p.E.3) argued knocking off a lot of zero's to make the Federal figures more like a household budget could make the Federal budget  more comprehensible to the average voter.  The article then argued the problem with solving the deficit was the Democrats not wanting to take up Medicare reform.

I think the household budget comparison is a grand idea, but needs to be refined a bit to make it fit reality.

The article, after knocking zero's of the Federal figures, came up with an example of income at $24,700 and expenditures of $38,000. This produces a yearly deficit of $13,000 with a total accumulated current debt of $115,800.   Sounds bad.

But lets look a little closer.  If are going to treat the Federal government the same as a household, it immediately becomes apparent that the $24,700 figure isn't really household income, it is just what we choose to put in the bank to cover bills.  In fact, the actual income figure would be somewhere around $90,000 (using US Treasury data that Revenue as about 30% of gdp).

So our actual expenses are far below our income, and our debt only slightly larger than our yearly income.  But we still do have some significant debt.  Where did it come from?

The Federal government has two primary sources of income, the income tax and the payroll tax.

The income tax, 50% of which goes to fund defense spending, is what we use to fund government operations.  It is sort of like what we put in our checking account to pay bills.

The payroll tax funds employee benefits like Social Security, Medicare and unemployment insurance.  It is sort of like what we put in our savings account for retirement, illness or emergencies.

Since the 1930's the household arrangement has been that members of the household contribute to the checking account based on a percentage of their income, while the savings account is funded by each person paying a much smaller percentage of their income on their earnings up to $100,000 per year.  Any income over $100,000 isn't counted.  The savings account amount is significant for most members of the household, but is chump change for the wealthier.  Someone making 5 million dollars a year will pay the same amount as someone making $100,000 a year, and not much more than someone making $25,000 a year.  So the savings account is funded largely by the working folk.

So lets look at our household history.   In the 1980's the wealthier members of our Federal household convinced enough household members to vote for them to take over the budget.  They cut the required contributions to the checking account, particularly for the wealthier members.   At the same time they also boosted spending out of the checking account,primarily on household defense.  They paid for the increased spending by borrowing money.  Over the years as the debt accumulated they sometimes borrowed from the savings account, giving the savings account an IOU.

This was a double reward for wealthier household members since, besides lower contributions to the checking account many of the wealthier members had financial interests in the defense companies on which the household was now spending more money.  So the household was now spending more to the business benefit of the wealthier members, even as the wealthier members were paying less toward household expenses.  So individually they were doing quite well even as the household debt accumulated.

In the last decade the wealthy members of our household again managed to grab complete control of the household budget and again they cut contributions to the checking account even as defense spending was climbing.  Out came the credit card and up went the deficit.

How good a deal have the wealthier members of the household cut for themselves in the last 30 years?  Profits to private business from household Defense spending were about $645 billion in 2010.  If we knock a bunch of zero's off to make it fit our household example that means rich members of our Federal household profited last year to the tune of about $5000 to $6000 from our household defense spending.   The wealthier members of the household also profit from the borrowed money the household uses to buy complex computer systems from companies the wealthier members own, and from all the other household spending out of our checking account.  It is more math than I want to do but I imagine that if we identified all the profits our wealthier members are making from our household spending, it would vastly exceed our $13,000 household budget deficit.  Yet their contributions to the checking account have shriveled over the years as the deficit rose.

Lets examine the Savings account history.  The savings account (payroll tax) has always brought in way more than it spent.  The taxes that support the savings account  have actually crept up, instead of down, over the last thirty years.  The savings account has been partially depleted by IOU's from the checking account, but it still runs a big surplus.

Now some household members are trying to pin the responsibility for the deficit, not on the fact we have failed to fund the checking account , but on the savings account program, because there is not enough in the savings account to cure the checking account deficits and still pay for what the savings account was created to pay for.

The simple fact I take away from comparing the Federal budget to a household budget is the wealthiest members of the household have been shuffling the household accounts to their advantage for 30 years.  Now that folks are concerned about the rising deficit those representing the wealthier members of our household want to preserve their wealth by raiding the savings account working folk are relying on to make their old age more comfortable.