Krugman raises a false alarm

by Russ Roberts on July 21, 2006

in Inequality

I’m a week late getting to this Krugman column (SR) (discussed here and here among many places) but it makes such important errors that it is still worth discussing. Krugman begins by saying that the economy may look healthy but appearances can be deceiving. He quotes an archetypal informed economist:

Informed economist: “But it’s not a great economy for most Americans.
Many families are actually losing ground, and only a very few affluent
people are doing really well.”

He continues:

Many observers, even if they acknowledge the growing concentration
of income in the hands of the few, find it hard to believe that this
concentration could be proceeding so rapidly as to deny most Americans
any gains from economic growth.

Yet newly available data show that that’s exactly what happened in 2004.

Why
talk about 2004, rather than more recent experience? Unfortunately,
data on the distribution of income arrive with a substantial lag; the
full story of what happened in 2004 has only just become available, and
we won’t be able to tell the full story of what’s happening right now
until the last year of the Bush administration. But it’s reasonably
clear that what’s happening now is the same as what happened then:
growth in the economy as a whole is mainly benefiting a small elite,
while bypassing most families.

That’s a very strong statement. Is it true? Krugman bases his claim on work by Piketty and Saez:

The answer comes from the economists Thomas Piketty and Emmanuel Saez,
whose long-term estimates of income equality have become the gold
standard for research on this topic, and who have recently updated
their estimates to include 2004. They show that even if you exclude
capital gains from a rising stock market, in 2004 the real income of
the richest 1 percent of Americans surged by almost 12.5 percent.
Meanwhile, the average real income of the bottom 99 percent of the
population rose only 1.5 percent. In other words, a relative handful of
people received most of the benefits of growth.

Wow. No wonder Krugman’s alarmed–the average income of the top 1% grew a whopping 12.5% while everyone else is just limping along.

Krugman then dismisses the usual explanation for rising inequality–increasing returns to education. Curiously, perhaps, he doesn’t give his own explanation. He simply states that the current administration and current Congress is unlikely to do anything about it.

There are two reasons to ignore Krugman’s angst. The first I have written about before—it’s incredibly misleading to talk about the top 1% gaining this much or that much year-to-year. 

THEY’RE NOT THE SAME PEOPLE.  Even if Piketty and Saez’s numbers are perfectly estimated and analyzed, their numbers do not mean what Krugman implies–if you took the people in the top 1% in 2003 and added up their income, then did the same thing in 2004, the average rose by 12.5%. Piketty and Saez don’t follow individuals. They just take the top 1% in each year. So what the numbers mean is the people in the top 1% earn, on average, 12.5% more than the people who were in the top 1% the year before.

Some of them, of course, are the same people. But it’s not like the top 1% are sitting off to the side in their own guarded compound living like kings at the expense of everyone else, making the rules of the economic game that somehow let them do well while punishing others.

And because it’s not the same people, you have to be very careful drawing conclusions about changes in the average American’s well-being over time. As I’ve written before, those numbers are affected by immigration, divorce and demographic changes. The median can fall but the median person can still do better over time.

The other mistake in the Krugman analysis is that you really don’t want to base a big policy conclusion on one data point. Do you really want to look at one year (one!) and draw big conclusions about something complex as the distribution of income?

Let’s look at more than one year.

Here are the increases by decade, in the average incomes of the top 1% using the Piketty and Saez calculations (go here to read their original paper and click on the word "NEW" to download the file I used–it’s Table A4 column 3 in the excel spreadsheet):

1920-1930   23%    
1930-1940     0      
1940-1950   15      
1950-1960   -5      
1960-1970   23      
1970-1980     1
1980-1990   71
1990-2000   46
2000-2004   -6%

What do you conclude from these numbers? One interpretation is that in times of strong economic growth–the 1920′s, the 1960′s, the 1980′s and the 1990′s for example, some people do really well, and that pushes up the incomes measured in the top 1%. Mediocre or negative economic growth is not good for the rich or other living things.

And in case you’re wondering, excluding 2000—a very good year for the economy—and looking at just 2001-2004, the first four years of the Bush administration, you get an increase of 4%, a dramatically slower rate of increase than in the previous two decades.

The bottom line is that how the incomes of the top 1% move around is a complex phenomenon. it is foolish to look at one year and conclude that a small elite is keeping all the economic growth. I would also note that even if you wanted to change the distribution of income, it’s hard to know which policy levers would be effective other than improving the educational system, a solution that Krugman seems to think is absurd.

Perhaps, but for absurdity, turn to Krugman’s first recommendation for improving the problem he perceives of the richest of the rich getting all the growth. Krugman wants to RAISE THE MINIMUM WAGE. I’m not making this up:

Can anything be done to spread the benefits of a growing economy more
widely? Of course. A good start would be to increase the minimum wage,
which in real terms is at its lowest level in half a century.

Earlier in the article, he wrote:

There are a couple of additional revelations in the 2004 data. One is
that growth didn’t just bypass the poor and the lower middle class, it
bypassed the upper middle class too. Even people at the 95th percentile
of the income distribution — that is, people richer than 19 out of 20
Americans — gained only modestly. The big increases went only to people
who were already in the economic stratosphere.

And the first thing to solve the problem is an increase in the minimum wage?  No, if you really think that somehow the American economic system has been rigged to reward the rich then the first step to take is to double the marginal tax rate on the rich and use the money to increase the earned income tax credit or expand welfare programs. But increase the minimum wage? What was he thinking?

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{ 5 comments }

happyjuggler0 July 21, 2006 at 7:14 pm

Just out of curiousity, how does the accounting go for deciding which percentile you are in?

For example, when one looks at the top 1% for 1980-1990, do the numbers represent those who average earnings for those years was the top 1%? Or do they look at the top 1% of earners in the single year 1990 and compare them to the top 1% in the single year 1980?

If it is the latter, then I strongly suspect that those in the top 1% are mostly different each year due to multiyear stock options being realized. It would be nice to see some data on year to year longevity in the top 1% or earners. It wouldn't surprise me to see most of the top 1% in one year earning "only" in the 89th percentile in the next year.

If it is the former I wouldn't be surprised at all to see older Americans in the top 1% and younger Americans in the bottom 1%. How many people do you know are earning less than a decade ago, or 30 years ago for that matter, which is when this trend supposedly started? If the bulk of individuals are increasing their earnings decade after decade, then it is disingenuous to say the bulk of people are falling behind or have meager gains is in reality they have substantial wage gains after all their job experience. The real culprit in that case would be something like the percentage of Americans who are Hispanic going from 5.2% in 1973 to 14.3% of the US population in 2004.

The more immigrants we have in this country who become citizens and have low skills will by definition drag down the averages for all deciles.

Bruce Hall July 22, 2006 at 9:27 am

I suspect you've never been to Michigan.

* companies going belly-up
* foreclosures increasing
* unemployment DOWN because PEOPLE ARE LEAVING THE STATE
* housing market shot

Okay, the weather is nice now.

liberty July 22, 2006 at 1:09 pm

I am late in joining this debate here, but I commented over at Delong's site on the post for his response to Mankiw's response to Lazear's response to this Krugman article – I think.

http://delong.typepad.com/sdj/2006/07/incomplete_and_.html

Anyway, my comments were similar to yours. I said:

The problem that I see with your analysis is that you assume a static state. The income of the top 1% is not the absolute income of those persons and their educational status for life, just as the income and education of those earning within the bottom quintile are not their income and educational status' (stati?) for life.

In fact, most people in America start out in the bottom quintile and end up in the top quintile – or stay there briefly and slide back down during retirement. Most 40-50 year olds are in the fourth or top quintile. Most people don't make it into the top 1%, but the fact that the incomes of the top 1% are much higher and growing much faster than the incomes of the bottom 20% means something different when you recognize that it is a highly dynamic system: productivity growth
of the most productive during their most productive periods is growing faster than productivity of the least productive during their least productive periods.

Isaac Crawford July 23, 2006 at 2:30 pm

"I suspect you've never been to Michigan.

* companies going belly-up
* foreclosures increasing
* unemployment DOWN because PEOPLE ARE LEAVING THE STATE
* housing market shot"

Umm, it sounds like things are happening the way they're supposed to. Noncompetitive companies close, people move to find jobs elsewhere, and the oversupply of vacant houses causes the price of homes to fall. But if they move to find a new job and they cause that market's housing to rise in price, what's the problem? All of these things are a benefit of a free society. Would you prefer other people paying residents of Michigan to stay there when they could be working in businesses that people actually want to support?

Isaac

Chris July 23, 2006 at 6:12 pm

How can you complain that everyone is doing better, but some (few) are doing better than everyone else? Isn't the fact that wages are growing faster than inflation (rather than at inflation) a huge success?

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