Why High Income Inequality Heralds Economic Crises

Review of Robert Reich’s 2013 Documentary “Inequality for All” – part 2 of 4

‘There comes a point where money has no real utility” (Warren Buffett, September 2016)

In his 2013 film, economist Robert Reich says: Income inequality appears to be a harbinger of oncoming economic depression

Reich bases this hypothesis on research by two other economists about US income tax rates over the 100 year period from 1913 to 2013. In particular, a graph that takes the same shape as the iconic Golden Gate bridge.

Golden Gate Bridge stock photo

Reich points out the two peaks of highest US income inequality between the rich and middle class on the graph occurred in 1928 and 2007, the year before the Great Depressions of 1929 and 2008.

Robert Reich’s answer to why income inequality ‘correlates’ (is associated) with economic depressions in the United States is: because the wealthiest Americans do not spend enough money.

The rich save money instead, by putting it in funds of funds, i.e. hedge funds. Consumer spending makes up 70% of US national income. This is why Reich thinks we need a middle class.

Reich points out that this spending makes the middle class the TRUE JOB CREATORS.

What stopped the middle class from creating jobs? During times of high income inequality, speculative bubbles created by investors create debt bubbles for the middle class. This is what happened in the US in 1929 and 2008.

But while real wages of US workers have declined steadily for the last three decades, the numbers of employed have not declined. Many workers now hold two or three jobs just to get by and pay their bills. Some can’t manage to do even that.

Reich says that as wages declined in value over the last 30 years, the middle class used three ways to cope: (1) more women entered the job market, (2) men and women both began working more than one job, and (3) the middle class resorted to using credit to pay bills.

Before the speculative bubble in mortgages burst in 2007-2008, the middle class spent $500 billion from home refis and credit cards to buy new things and pay down bills. When the mortgage-backed-securities investment bubble broke, the middle class was badly hit.

Credit became very costly. Consumers no longer could keep the economy growing or maintain job creation. Nor could the bloated financial system that caused the middle class’ debt bubble.

My comments:

Ever since Ronald Reagan was elected US President in 1980, there has been a huge split among Americans over “trickle down” (supply-side) economics versus Keynesian (demand-side) economics.

Supply-side economics asserts that if wealthy people have more money, they will create more jobs. Reich, a Keynesian, nails the difference in a nutshell when he says the middle class are the true job creators, not the rich.

My take on this argument is that it is a false dichotomy. It’s like the old question “Which came first? The chicken or the egg?”

As Robert Browning, the English poet once wrote:

“Ah, but a man’s grasp should exceed his reach
Or what’s a heaven for?”

This quote tells us why supply usually comes first, even if it merely stays in the imagination of the entrepreneur.

But that idea may die there if there’s no money to launch a product. The entrepreneur’s dream may die too if the costs of ‘making it so’ are too high. This is why market research exists—to help make a good guess if the entrepreneur’s or an independent contractor’s goods and services can sell in the marketplace.

What makes a dream product take off in the market? There must be enough buyers willing and able to pay a price above what the dream will cost the entrepreneur.

This price has to cover the suppliers’ expenses: labor, raw materials, overhead and equipment costs, marketing costs, and an income for the business owner(s). All of those costs must be offset by sufficient demand for the business owners’/workers’ product(s).

In other words, we can’t just have “supply” in the form of sellers (aka entrepreneurs and business owners) who have the money they need to create goods and services. We also need to have enough “demand” by buyers (aka consumers) who have enough money to pay for those goods and services.

Money is the measure we use for judging whether the quantities of total supply and demand are in balance. Supply and demand, aka, investment and consumption, are the two sides of the same coin.

This means Entrepreneurs/Investors and Consumers both create jobs. We need the right balance between these two groups for our market system to work.

When these two groups are way out of balance we have economic crises. As Reich suggests:

Income inequality correlates directly with the distance between earnings of top earners and their workers

Today, that inequality appears to be growing at all levels of the US economy, not just at the top. The vast majority of American jobs are in the service sector. This lower middle-class sector serves mainly the shrinking upper middle-class in the United States.

Picture the driver of the buses in San Francisco which take Google employees to work for free, or the caterer who brings in their lunches, or the part-time freelancers who drive for Uber.

Corporations and their well-paid employees seem to be recovering fully from the financial crises of 2008-2009. But jobs and wages as a whole, while rising a tiny amount during the past couple of years, have not been catching up.

Picture all the renters being forced to move out of large cities like San Francisco and now Oakland and Berkeley, California over the past three decades as wages declined. Picture manufacturing areas like Detroit and Flint, and miners in Appalachia behind left to struggle to survive. Why has this happened? Read on.

Next time: Taxes – Impact on Income Inequality



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