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Wednesday, November 24, 2010

More Income Redistribution Will End the Great Recession?

With increasingly widespread recognition of the failure of Keynesian economic policies, all the Progressives are left with are claims whose acceptance requires a suspension of one’s logical faculties. An excellent example of this is a September 2, 2010, New York Times op-ed by Robert Reich, the Clinton administration secretary of labor and professor of public policy at the University of California, Berkeley.

In “How to End the Great Recession” (an apparent teaser for his new book, Aftershock: The Next Economy and America’s Future), Reich attempts to provide another way to justify forced income equalization as well as rehabilitate Keynesian economics. After lamenting that trillions of dollars spent on standard Keynesian policy prescriptions have failed to end the Great Recession, Reich argues that “structural” problems in the economy prevent aggregate demand from rising enough to bring about a sustained, healthy recovery. More precisely, “[C]onsumers no longer have the purchasing power to buy the goods and services they produce as workers.” Reich’s primary culprit preventing the middle class from engaging in the “economically necessary” amount of spending is rising income inequality.

The problem, according to him, is that the rich are getting richer much faster than the middle class: “In the late 1970s, the richest 1 percent of American families took in about 9 percent of the nation’s total income; by 2007, the top 1 percent took in 23.5 percent of total income.” (Most sources put the 2007 income share at 19 percent.) Then Reich presents his bottom line:

Keynesian policies have been ineffective because of this rising income inequality. The reason is that “the rich spend a much smaller proportion of their incomes than the rest of us . . . so when they get a disproportionate share of the total income, the economy is robbed of the demand it needs to keep growing and creating jobs.” Quite ingenious! In one fell swoop Reich gets Keynesianism off the hook for its failures of the past two years and promotes more income redistribution, a key goal of Progressives.

Let’s apply data and logic to Reich’s argument.

Income inequality is an issue the left usually presents in a highly disingenuous way. The focus is on income statistics, which inevitably show a great deal of inequality. What they fail to point out is that income statistics are by their nature static and hide temporal movement of individuals between income groups. Dynamic studies have shown a remarkable amount of income mobility. Most people start off their working lives with small incomes, but as they become more experienced and more valuable to their employers—and, most importantly, to their customers—they move into higher income categories. The important implication is that the richest 10 or 25 percent are often quite different people from year to year. In addition, the people experiencing the greatest fluctuations in income through their lifetimes are entrepreneurs, who in some years may do extremely well, but in other years barely stay afloat—and occasionally even go bankrupt.

There’s a more fundamental problem with the Progressive interpretation of static income statistics: It demonstrates a complete lack of understanding of how wealth is created. Reich writes, “The rich are better off with a smaller percentage of a fast-growing economy than a larger share of an economy that’s barely moving.” He implies that income is distributed in some mysterious, potentially conspiratorial and certainly unfair way—like a fat kid who is constantly taking a bigger piece of the pie from the malnourished orphans through cheating and brute force. There is no recognition that income is the result of effort and creativity. There is no indication that prudent investment and wise allocation of one’s resources, including labor, have a great deal of influence on one’s income.

It is a cliché, but a valid one, that a true free market is a meritocracy (though luck has a role) and that there are thus important reasons for income inequality, which are beneficial for society. Granted, we don’t live in a true market economy, so some high incomes are made through government subsidies and protection from competition. But that’s not the case for everyone. Real flesh-and-blood human beings react to incentives—a fundamental fact of life. If they will not receive rewards for their greater efforts, risk-taking, and innovation, they will not undertake these actions. It is only through income inequality that we can get wealth creation in the first place, and all attempts to reduce income inequality will result in less wealth being created. This is why the Great Recession marches on: Entrepreneurs see the full weight of the government starting to bear down on them in the name of greater “social justice” and they decline to expand, to hire, or to invest.

Another way in which the left is highly disingenuous in their presentation of income statistics is by failing to point out that while the richest 1 percent made 19 to 23 percent of the total income, they paid 40 percent of total federal income taxes in 2009! The richest 10 percent paid 71 percent, and the top 25 paid a whopping 87 percent! This is a remarkable fact. One has to wonder what degree of income-tax progressivity Reich and his ilk would like if they find this unfair. Furthermore, those percentages for the highest-earning groups have risen over the years. So income-tax revenues have become more progressive even as tax rates on the wealthy have declined. Also, in the three years following the 2003 tax cuts, federal revenues grew by three-quarters of a trillion dollars (roughly 30 percent of the average annual federal government budget in those years).

Finally, it should be pointed out that it is probably the greatest and most destructive fallacy of Keynesian economics that aggregate demand—of which consumer spending accounts for roughly 70 percent—is the key driver of the economy. (See Mark Skousen’s article in the October Freeman.) The federal government under both Bush and Obama has done its best to compensate for any loss of consumer spending by increasing its own spending, and yet the economy continues to falter. There is an insufficient number of jobs being created today not because there is not enough consumer spending, but because businesses do not expect to be able to make a profit if they expand and hire more employees. This is due to the recent dramatic and unpredictable expansions of the regulatory regime, along with expectations of rising long-term taxes on both businesses and business owners. All these factors increase the cost of doing business. Should it come as much of a surprise that we see less business activity? It has nothing to do with insufficient consumer demand and everything to do with the greater pursuit of “social justice.”

Reich’s argument is simple demagoguery intended to achieve his ideological goals. It is highly encouraging that Americans increasingly appear to see through these attempts to manipulate them. Let us hope that this most recent failure of Keynesian economics will keep “Count” Keynes from rising from his grave once and for all.

  • Ivan Pongracic Jr. is an associate professor of economics at Hillsdale College, where he holds the William E. Hibbs/Ludwig von Mises Chair in Economics. He is a member of the FEE Faculty Network