Saturday, February 28, 2009

Robert Reich's Economic Goofiness

Robert Reich is back at it, praising the President's budget for raising taxes on the most productive members of society and transferring the proceeds to those who work hard but nonetheless produce less. Here is an excerpt from Reich's praise, offered on February 26:

"It's about time a presidential budget uneqivocally redistributed income from the very rich to the middle class and poor. The incomes of the top 1 percent have soared for thirty years while median wages have slowed or declined in real terms. As economists Thomas Piketty and Emanuel Saez have shown, in the 1970s the top-earning 1 percent of Americans took home 8 percent of total income; as recently as 1980 they took home 9 percent. After that, total income became more and more concentrated at the top. By 2007, the top 1 percent took home over 22 percent. Meanwhile, even as their incomes dramatically increased, the total federal tax rates paid by the top 1 percent dropped. According to the Congressional Budget Office, the top 1 percent paid a total federal tax rate of 37 percent three decades ago; now it's paying 31 percent.

Fairness is at stake but so is the economy as a whole. This Mini Depression is partly the result of a widening gap between what Americans can afford to buy and what Americans when fully employed can produce. And that gap is in no small measure due to the widening gap in incomes, since the rich don't devote nearly as large a portion of their incomes to buying things than middle and lower-income people. The rich, after all, already have most of what they want."  (emphasis added)

Let's think for a moment about the highlighted language. Reich tells us that we are in a "mini-Depression." Really? Our unemployment rate is less than 8 percent. How is that a "mini-Depression?" Are Italy and Germany, which always seem to have rates above 8 percent, in a constant state of (mini) Depression? If they are, should we really be adopting economic policies along the lines of the high tax and high regulation models of these countries ?  Hmmmmm.

What, though, about Reich's diagnosis of the cause of the current economic contraction, which he attributes to "the widening gap between what Americans can afford to buy and what Americans when fully employed can produce." This gap, he says, is the result of "the widening gap in incomes, since the rich don't devote nearly as large a portion of their incomes to buying things than [sic] lower income people." The remedy, then, is to raise taxes on the rich and ship the money to the non-rich, thereby narrowing the gap between what (some) Americans want and what they can afford to buy.

This is, for lack of a better word, goofy. It is certainly true, as I have pointed out earlier, that many Americans are consuming or trying to consume more than they produce. Indeed, here is what I said on January 29th of this year.

"When economic historians write the history of this past couple of decades, they will likely conclude that Americans lived high on the hog, consuming far more than we produced, with the gap financed by borrowing from China, Japan and the Middle East, who purchased government securities and bonds backed by mortgages and credit card receivables. The only way to reverse this trend is to reduce our consumption significantly (and unlikely scenario) or increase our productivity significantly."

It is incorrect, however, to attribute low or stagnant productivity in the middle class to a "widening gap in incomes" between rich and poor. For one thing, Reich has the causation exactly backwards. In a free society, income and thus income gaps are determined by relative productivity gains, and not vice versa. Moreover, additional productivity, and thus higher incomes, among those in the upper income brackets does not magically reduce or even slow the actual productivity of those in the middle or lower classes. (In the same way, reduced or stagnant middle class productivity does not increase the productivity of those in the upper brackets.) To take a simple example, when Apple and Steve Jobs invented and marketed the I-Phone, reaping tremendous profits for their efforts, they did not thereby REDUCE the productivity of barbers, autoworkers, airline mechanics and other hard-working Americans in the middle class. If anything, one might expect such increased productivity among the wealthy to increase the productivity of the middle class as well. For instance, by inventing the Windows Operating System and facilitating its distribution, Microsoft (and its shareholders) enhanced the productivity of millions of American workers, who previously relied on electric typewriters, hand-held calculators and the postal service !

What, though, about Reich's apparently separate claim that "the rich" already have most of what they want, and thus will spend a smaller proportion of their income than those in the middle and lower classes ? This is simply a replay of the old Keynesian theory of "secular stagnation," which predicted that, as societies became wealthier, average consumption as a percentage of national income would continually fall, as a more affluent citizenry would enjoy so many material comforts that individuals would be less inclined to spend their incremental income of consumption. As a result, it was said, government should tax the more affluent and spend the proceeds, thereby lowering the national savings rate and stimulating aggregate demand. The theory fell out of favor in the late 1940s and 1950s, as the economy grew despite massive reductions in the federal spending as a percentage of GDP compared to the period of 1941-1945.

There are a couple of things wrong with Reich's invocation of this theory in this context. First, the theory does not support or depend on Reich's claim that increased affluence for some reduces or stifles the productivity of others. On the contrary, individuals who consume less save more, and such savings will, over the medium and longer run, find its way into productivity-enhancing investments in plant and equipment, education, research and development, etc. Second, Reich's claim that we are in a period of secular stagnation assumes that current year incomes are a good proxy for the sort of permanent income that actually determines consumption. If, on the other hand, there is a high variance between annual and permanent incomes, then a snapshot of annual income data cannot tell us whether we have entered such a period. Third, the theory of secular stagnation would seem to predict that more affluent nations like the United States would have ever increasing rates of unemployment, unless offset by ever rising government spending, measured as a share of GDP. On the contrary, however, real per capita income has risen significantly over the past three decades, while government spending as a share of GDP has been relatively flat. Fourth and finally, if the rich have all that they want, why are they working so hard to earn so much income ?

To sum up, Reich's claim that increasing incomes for the rich has reduced or stultified the productivity of those in the middle class is nonsense. Moreover, the evidence does not support his "secular stagnation" thesis. Higher taxes on the more productive members of society will have to be justified in some other way.