The Secret Mechanism

by Russ Roberts on August 24, 2006

in Inequality

Coyote Blog has uncovered an article detailing the secret mechanism that is keeping you poor. It’s by Kevin Drum in the Washington Monthly. Drum begins by quoting Ezra Klein at The American Prospect:

The concern [is] that, through mechanisms we’re not entirely sure of,
the very richest are siphoning off the economic growth before it flows
through the middle and lower classes. The worry is about the
distribution of growth, but the suspicion is that the distribution is
being warped by the sheer level of inequality.

I love that phrase, "mechanisms we’re not entirely sure of." Not entirely sure of? That implies that we have a pretty good idea but we’re not completely confident we have it exactly right. When I asked a prominent editorialist at a major American daily how the rich are getting to keep everything for themselves he also confessed that the mechanism isn’t entirely clear. OK, but can you give me the vaguest idea of how this secret cabal is managing to keep everything and leave us with nothing? If you really believe this is true, don’t you want to have the BEGINNINGS of a theory as to how it’s being accomplished?

Drum continues:

I’m not sure this gets the mechanism quite right, though.  There are two basic ways that unequal growth can happen:

  1. The rich suck up vast amounts of income growth, and this
    leaves very little money for the middle class. Thus, wages for the
    middle class are stagnant or, at best, rising slowly.

  2. Middle class wages are kept stagnant, and this frees
    up vast amounts of money from economic growth. The money has to go
    somewhere, and it goes to the rich.

Now, obviously, it doesn’t have to be one or the other. It could be
both. But I suspect there’s a lot more analytic power in #2 than in #1.

So Drum suspects that there is an unspecified mechanism that somehow keeps the wages of millions stagnant freeing up all that growth for the rich to nab. The metaphor is a buffet table where the middle class is cordoned off from the food, leaving the rich to feast at their leisure.

It’s a nice metaphor, but what does it have to do with the economic world you and I live live in, where people go to school, grow up, enter the job market and find work among millions of employers in competition with each other for our services? Yes, you can make the case that some sectors are less competitive than others. But what model or vision or theory of economic reality presumes a mystical mechanism that keeps millions of workers in thrall while somehow creating great wealth for others?

I can think of a few. Most of them have been discredited by time and events. But if you believe otherwise, you have to long for a revolution rather than tinkering with the minimum wage or the tax code.

But to be fair to Drum, he does try and flesh out "the mechanism" a bit:

But — government policies that affect #2 seem far more plausible. For
example: Appoint members to the Federal Reserve who are obsessed with
inflation and act to cool down the economy at the least sign that
average hourly wages are rising. Make it harder to form unions in new
industries, thus reducing the bargaining power of the working class.
Support free trade agreements that put downward wage pressure on
low-income workers. Support tax and deregulation policies that make
middle class jobs less secure.

Let’s take these one at a time:

Appoint members to the Federal Reserve who are obsessed with
inflation and act to cool down the economy at the least sign that
average hourly wages are rising.

I love the reference to hourly wages. They have been stagnant or growing very slowly. They are Exhibit A in the case that the average person is suffering while the fat cats feast. But average wages exclude benefits. Why would you use that measure as a measure of economic well-being? But the real problem with this first example is that if you cool down the economy when the little guy prospers, how do the rich get all the growth? There isn’t any to be had.

Make it harder to form unions in new
industries, thus reducing the bargaining power of the working class.

But the proportion of private employment that is unionized has been falling since the 1950′s. Is that likely to be the mechanism at work over the last 10 or 20 years? During the first part of the post-war era, unionization was declining and average wages were rising. That can’t be the mechanism.

Support free trade agreements that put downward wage pressure on
low-income workers.

Free trade could put downward pressure on wages of some workers. But they also lead to lower prices which lead to a higher standard of living. Besides, I thought we were worrying about all the workers other than the fat cats. If low-income workers are suffer, in the zero-sum game world of Mr. Drum, shouldn’t that benefit the middle class along with the rich?

Support tax and deregulation policies that make
middle class jobs less secure.

Not quite sure what he’s driving at there. Even so, less secure middle class jobs shouldn’t explain how the middle class gets nothing. They should just get something less often.

The real problem with these theories of inequality is that they fail to see that the income distribution is an emergent phenomenon rather than under someone’s nefarious control. Coyote Blog says it well:

What’s bizarre about all of these statements is it treats wealth,
and in this case specifically income growth, like a phenomena that is
independent of individuals and their actions.  They treat income growth
like it is a natural spring bubbling up from the ground, and a few
piggy people have staked out places by the well and take all the water
before the rest of us can get any.

Wealth and income growth comes from individual action.  Most rich
people are getting more rich because they are intelligently investing
and taking risks with their capital, applying the output of their mind
to create new wealth.  There is no (none, zero, 0) economic correlation
that says that if the rich get really rich, then there is less left
over for the poor.

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{ 27 comments }

Mcwop August 24, 2006 at 5:07 pm

Where do I start on this one? My preference is for people making assumptions to back those up with some sort of provable facts, or at least logic that can be followed.

The only way for nothing to flow from one class to another, is for the high class (whatever that is defined as – Drum does not define it) to put it in their mattress, or invest it somewhere outside the country that provides zero economic benefit to US citizens.

Lets follow the money:
- Rich person takes all their “winnings” and builds a new house in Aspen. I assure you, that underwear gnomes are not doing the construction (perhaps illegal aliens are), mining the rock that builds the foundation etc…
- Rich person invests in Government bonds. Those finance all the government programs such as defense, which love it or hate it, provides a ton of jobs (many good ones).
- Rich person invests in stocks, while not direct investment a healthy market helps companies raise capital, to invest and hopefully those companies grow and add jobs.

I could go on, but the mechanism does not seem at all straight forward. In fact the mechanism might be a net positive providing jobs to large numbers of people across income groupings.

jb August 24, 2006 at 9:07 pm

Well, let's see. Why is the middle class stagnating?

a) Because they are too deep in debt. But they chose to buy those $4 coffees and pay the minimum possible on their house to get the "tax break". So that doesn't work as a leftist talking point.
b) Because they are too risk averse.
c) Because they are too conscious and concerned with "group association/status" and feel obligated to keep up with the Joneses. But group association is a key principle of leftist thought.
d) Outsourcing has raised average wages across the world, decreasing global inequality, while increasing American inequality.

I suspect that d) is the one that leftists are going to seize on – it's the only one that doesn't blame the American people for their own situation.

Which means we can look forward to the left becoming the isolationist and trade tarriff party for the next several decades.

nelziq August 24, 2006 at 10:55 pm

There is a very important mechanism by which some groups can prosper economically at the expense of others: it's called rent seeking. Libertarians are rightly critical of widespread rent seeking behavior that is a product of governmental interference in the economy. We correctly complain that it is a major negative influence on the economy. However, most also get sudden amnesia when the conversation turns to income inequality. In the blink of an eye the economy becomes the free maret paradise we wish it was rather than infested by well-heeled parasites sucking away with the governments help.

Kevin August 25, 2006 at 12:03 am

If the middle class is not gaining anything, then who the heck is buying all those 50-inch plasma TVs at Sam's and Costco? No one could afford those a few years ago; and they didn't exist at all a few years before that. Do the few rich people keep buying additional new ones every week?

Frank August 25, 2006 at 8:58 am

Re:

There is no (none, zero, 0) economic correlation that says that if the rich get really rich, then there is less left over for the poor.

Actually there might be a correlation but it would reinforce rather than undermine the point being made. While the comment is correct for market-oriented economies, it might not be true for kleptocracies such as Baby Doc's Haiti. The key is how the rich get really rich–by engaging in mutually beneficial voluntary exchange (a redundancy actually) or via coercion.

Sheldon Richman August 25, 2006 at 9:15 am

All good points, Russell. But something still nags at me. We free-marketeers spend a lot of time railing against corporatist intervention. A slew of policies are more of a burden to individuals, small companies, and yet-to-be-born companies than to giant incumbents. So shouldn't we expect corporatism to have some malign effects somewhere? "Siphoning off economic growth" may not capture what goes on. But there surely is a systemic skewing of growth in the sense that it would be different if the market were allowed to be truly competitive and all privilege were eliminated. To argue otherwise, it seems to me, is to argue that intervention does not change the marketplace at all. If so, why do we complain?

spencer August 25, 2006 at 10:32 am

Since WW II the long run trend growth rate of S&P 500 EPS has been 7% — it is 7.5% for total corporate profits as reported by the government. Moreover, despite strong cyclical swings there is no essentially no evidence of a break in this trend at any point — especially around 1980. Yet since 1980 the compensation of corporate CEOs rose at about double the rate of the growth of corporate profits — previously they had grown at about the same rate.

Apparently this is the major source of the growth in income inequality over the last quarter century.

Since the output of the CEOs — corporate profits — has grown at about the same rate as it use to, why should their compensation
have grown so much more rapidly?

It looks to me as if stock owners have an agent problem.

Radish August 25, 2006 at 10:33 am

Yeah, jb, the first things I thought of were the entertainment and fashion industries. I can never get over how many people who "can't afford" a prescription or gasoline have huge collections of DVDs, video games, shoes, designer jeans, plastic toys, you name it.

I don't believe there's a "siphon" but it seems a lot of low-wage workers willingly give their money over to major corporations and their executives in the form of frivolous purchases instead of saving, purchasing homes, investing in an IRA, etc.

SJ August 25, 2006 at 10:36 am

One such mechanism: immirgation.

Though I don't see the lefties being too eager to embrace that line of argumentation.

Martin Hutchinson August 25, 2006 at 10:42 am

The left are more or less correct; there is a collection of policies over the last deacde or two that have tended to increase inequality sharply. They are:

(i) Uncontrolled illegal immigration and non-existent enforcement of employment laws. These have combined with a low minimum wage to impoverish the high school grads and below, as well as exerting a downward pull on the next layers up. Mike Dukakis is correct that a much higher minimum wage would alleviate the problem — mainly because someone might actually bother to enforce it, whereas they don't enforce employment laws.

(ii) Poor corporate governance, that has allowed management to siphon ever increasing wealth from the stockholders. The stock options scam of 1994-2005 was only the tip of this iceberg.

(iii) Cheap money — very high money supply growth since 1995, with inflation figures fiddled to hide its effect (this is now coming back to bite us.) This has resulted in the creation of endless well-financed get-rich-quick schemes such as hedge funds and private equity funds, and has caused a collapse in ethical standards in the financial services business

(iv) A stock price bubble followed by a housing bubble, caused by (iii) above, which have inflated asset values for the upper middle class and allowed them to stop saving altogether.

The cure is tight money and tight immigration control. This will cause stock and house prices to decline, executive compensation packages to receive intense scrutiny and wages at the bottom end to increase. Inequality will thus be restored to its historic levels, anthough the process of destroying so much unreal bubble wealth will cause howls of pain and may produce the election of a truly unpleasant government.

See "The Bear's Lair" on http://www.prudentbear.com for further details.

The Snob August 25, 2006 at 10:52 am

Just to start, if there were a viable libertarian candidate for president I would probably vote for him…

I think Drum is right on the general issue of rising inequality. Wage growth has considerably lagged the rate of growth in business profits for a couple years now. It's not just offshoring and illegal immigration either–companies today are operating much more leanly than they did 10 years ago, in some cases dramatically so. These three factors could arguably be enough to keep wage growth to a minimum in a wide band of the economy.

Where I break with the lefties on this one is that with a few exceptions I don't want to do anything about it. If corporate profits keep at their current level, wages and employment will eventually follow; if profits are curtailed due to regulation, then they will likely stay at the current level or drop. I do not think profits and wages/employment have been entirely decoupled, it's just that the lag time between a rise in profits and a rise in employment is getting longer. Growth will eventually require more people.

Where I do think a change is needed is in immigration. At the very least, we need strong border enforcement to "lock in" the numbers of illegals we have here now. I live in a hispanic neighborhood and have nothing against them as individual human beings but society is not benefitting from an unlimited pool of minimum-wage labor.

While the middle class tends to own at least some assets and can benefit from growth in their value, the lower class depends almost entirely on wages which at this end of the scale are absolutely pushed down by "undocumented workers."

paul August 25, 2006 at 10:54 am

Look. You can analyze this stupdity until the cows come home, but the real thrust of this is the same ol' socialist, redistributionist bs from decades ago: The left has run out of ideas to justify "progressive" income taxes and other schemes to rob successful people of their earnings. Every theory they've used over the years has proven to be, giving them the benefit of every doubt, idiotic. So, now they come up with some mysterious "mechanism" to justify the same economic garbage that makes their sour little socialist hearts go pitty-pat.

The left really is out of ideas, and they've lost out to reality. It's fantasy time!

AT August 25, 2006 at 11:00 am

Do the rich earn superior returns on investment by being able to invest in unregulated securities? Probably only a small part of the problem, but it couldn't hurt to find out.

Martin Hutchinson August 25, 2006 at 11:03 am

AT: Not in the long run. The superior returns are earned by the managers of the hedge funds, not investors in them. Dodgy accounting and survivorship bias can however be used to hide this fact.

Asset bubbles help people with assets; it's as simple as that.

CB August 25, 2006 at 11:27 am

Replace "rich people" with "government" and apply to government service. It makes for very entertaining reading.

Terry August 25, 2006 at 11:32 am

If you want your opinion of Kevin Drum to deflate even further, read his article on social security at:

http://www.csmonitor.com/2005/0127/p09s01-coop.html

Wherein he argues that the rich of the 1980's made a bargain with the rich of 2040 to gain more wealth at their expense.

Dirk Belligerent August 25, 2006 at 11:49 am

The fundamental problem with socialist agitprop like Drum's is that it flunks the fundamental logic check of: If they're taking the money and no one else gets any, where is it?

Back in 2000, I followed a thread between Bush and Gore supporters in which a Gore fan sneered, "Bush wants to give the rich $30,000 in tax cuts which they'll use to hire another gardener for their mansions." A sane person replied, absolutely brilliantly, "And if you're the person hired to do the gardening, you've got a job."

The appalling level of economic ignorance in the public is no accident. The government education system is totally controlled by socialists (to put it mildly) who indoctrinate their pupils with an anti-capitalist, anti-corporate broth of lies to ensure that ignorance and envy control their thinking. (e.g. They'll pass on tax cuts for themselves if they think Bill Gates is getting soaked.)

The Left pretends that all the money "stolen" by the rich – because they don't actually DO anything; those businesses they start are just legal slave shops, dontchaknow? – ends up in a giant room like Scrooge McDuck has and that the rich go and roll around naked in the mountains of cash, gold and jewels.

Bollocks!!

It's the same (non-)logic that they use to attack anyone who's not a tree hugger. They act as if Republicans have secret underground cities with private air and water supplies that they'll retreat to after they've despoiled the planet for the po' folks. Ludicrous, yet the only way Evil Rich White Republicans could possible survive their policies, right? (Nevermind how we're supposed to be evil when our air pollution sails the jet stream to Europe, yet China and India's Kyoto-exempted pollution coming here is A-OK.)

The Left must have a secret Kool-Aid dispensing mechanism, though how it works is unclear at the moment.

jag August 25, 2006 at 12:33 pm

The comments by Drum and Klien reveal the basis for the resentment of capitalism by the left.

People naturally resent success that they can't understand. If you don't understand how to get wealthy (or stay wealthy) it is very easy to assume wealth and power is attained and maintained by some nefarious, "mysterious", process.

Consider pro athletes, actors and other individual "stars". They make ungodly amounts of money, particularly in today's INTERNATIONAL market, yet few criticize their attainment of wealth. Why not? Isn't it because it is easy to understand that the nature of their success? Just about everyone can imagine being an athlete, singer, actor or writer so there is no "mystery" as to why these people are successful and, consequently, no one RESENTS their OBVIOUS talent (and often attendent hard work) that enables them to attain such wealth. Its easy to respect that which we can understand, no?

Not even liberals knock Oprah's wealth now do they? In fact, look closely at many of these gigantic "star" millionaires and quite a few came from very, very humble beginnings. Certainly no one is going to knock this kind of success.

But if liberals bothered to look hard at successful people in today's business they'd often see the same, up from modest beginnings, they see in these "stars". Forbes publishes lists of the wealthiest people each year. Names appear and disappear with regularity (remember the Hunt Brothers?). Most knowledgable economists understand people move up and down the income quartiles throughout their lives. Few stay at the bottom continuously. The lists of CEOs is also liberally populated with graduates of modest colleges as well as no college attendance at all.

What does this mean? It means if you study the problem of "inequality" it goes away. The "rich" don't always stay rich. Many go broke. The "poor", most often, move up to the middle class (assuming they don't do drugs, don't get drunk, get a reasonable education and get and stay married). Similarly, those in the middle or upper classes who do drugs, get drunk, don't marry, have kids out of wedlock and divorce have a remarkable propensity for becoming "poor" despite their initial advantages.

There isn't any "secret" or mystery to this process. However, liberals are loathe to ask the hard questions of the poor. Are they getting educated, avoiding drugs, drink and promiscuity, getting and staying married? No, to suggest to the poor that maybe their BEHAVIOR is part of their PROBLEM is politically incomprehensible to liberals. The poor, after all, have to be "victims" that liberals, in all their nobility "save". If the poor aren't victims, however, what reason will liberals have to "change the system" into something which will allow them the political license to exercise the power they crave that they can't seem to achieve through being capitalists?

They won't have a reason to be "heros" to the underclass unless the "system" is the problem. Hence, liberals can't be bothered with understanding why capitalism works best (not perfectly, just best). If they understood it, they lose their reason for existence, their hope of being "heros" and would have to forego their love affair of resentment for the "rich" once and for all.

mr.x August 25, 2006 at 12:44 pm

Middle class wages have not stagnated, but they are reported to have stagnated because inflation is overestimated. Discuss.

veryretired August 25, 2006 at 2:07 pm

jag,

Nicely done.

Of course everything's a mystery if one ignores the operation of cause and effect, or denies it altogether.

What's next for the left—conspiracy theories about freemasons, or the Illuminatti?

Sheldon Richman August 25, 2006 at 2:37 pm

Per Nozick, a "distribution" of wealth gets its legitimacy from the historical process that produced it. If it is the result of voluntary exchange, there's nothing more to be said as a matter of public policy. If history is tainted by relevant coercive restrictions or exchanges, there is much to be said. This is an empirical question. I see a long train of corporatist interventions dating back to colonial times. (See Jonathan Hughes's The Governmental Habit.)

Mark August 25, 2006 at 2:45 pm

The average wages where I work are falling: the older (better paid) guys are retiring, leaving the younger (lesser paid) guys. The number of people employed hasn't changed, everyone's salary goes up each year, but the average still drops.
I don't know if that's universally applicable, but the retirement of baby boomers might be a factor here.

Daniel August 25, 2006 at 3:09 pm

The real economy is all about goods and services recieved and rendered, not money. The value of money stems from the fact you can trade it for goods and services.
An ever increasing percentage of the goods and services we purchase is based on computers and other rapidly improving technologies; technologies which rapidly drop in price in the years after they are introduced, and/or get replaced with much better technology for about the same price. Therefore, even with no change in wages the growth in technology allows access to superior goods/services for the same price. Hence the real standards of living of the middle class, and to lesser degrees the poor as well, increase naturally due to technological progress.

Another inobvious observation: while the rich have vastly more money, they do not generally just buy vast quantities of things middle class and poor people buy. Bill Gates is not, for example, going to buy himself thousands of Playstation 3's, thus driving up the price the rest of us face. The extra money Bill has will not generally have an effect on the prices you face, since you will not be in direct competition with him as a buyer in any meaningful way. Instead, the wealthy use their vast wealth for things like 1) luxury items marketed solely to the rich.. 2) investments.. and 3) charity. 1: These things are generally too expensive or customized or whatever to mass produce. Otherwise, companies usually see more profit in streamlining the production and making them by the millions.. see comments on Plasma TVs from an earlier post. Since the rest of us are not going to buy these anyways, we are not harmed by the high prices promoted by the wealth of the rich. 2: investment ultimately leads to even more income inequality, oh no! But it does so by lifting up the poor/middle class through employment, and lifting the investors up at the same time through return on investment. Would we really want to discourage this?
3: charity. This creates the same sort of income redistribution that the left so like to mandate, but if it's done well it can possible avoid replicating some of the moral hazards involved in mandated redistributions. Also, unlike forced redistribution, the donator earns some bragging rights, and maybe even some appreciation. No one ever gives CEOs credit for paying the bulk of our federal tax burden; after all they didn't have a choice so there's nothing to praise.

By contrast, if the average middle class family doubled thier income they would be in competition with each other to buy limited resources such as land (for homes), as well as all the other consumer goods.. leaving the poor to face consequently increased prices.

Aaron Krowne August 26, 2006 at 12:14 am

You're wrong.

The wealthy do grab the money "at the source": it is virtually "printed" continously at a staggering rate and handed off to investment bankers, their favored corporate clients (CEO buddies), and the government. Of course the average joe is somewhat let in on the game, but only in the form of temporary credit. Besides, he makes a convenient "greater fool" when its time to collapse the pyramid scheme du jour. (See http://www.itulip.com/forums/showthread.php?t=292)

The system is so extreme in working in this manner that it is basically incomparable to the more equitable one we had from the end of WWII till the mid 70's, which is why median wages have been flat to falling (by more honest metrics of inflation) since then. Also note the conspicuously larger ranks of the super-wealthy now (higher Gini index, obscene CEO payout ratio, Buffett bequeathing more than all the Gilded Age robber barrons combined…)

Your entire post assumes some sort of laissez faire system, but what we have is interventionist and biased; rotten all the way down to the monetary core. It ain't worth defending.

P.S. – Tell most workers about how they're actually richer because of "benefits". Never mind that pensions are history and health care is getting more expensive faster than we can get compensated extra to keep up with it.

alex August 28, 2006 at 9:36 pm

Ok, lets get some things straight since many of the people here are drinking the kool aid. First, the price of things from food, furniture, manufactures, etc, have all fallen by at least 20% over the past generation, adjusted for inflation. The middle class is being busted by higher health insurance costs, housing (especially those with children), child care(two earner household), basically essentials for the middle class. Secondly, the middle class is being squeezed by a process that has been going on for several decades under federal policies ranging from bs tax cutting to union busting and deregulation. Thats why the middle is going down. Its not an unknown mechanism. Its the federal government being used to redistribute the fruits of the economy to the rich and corporations. You all hate Robin Hood, right? Well you all should love this; its Robin Hood in reverse, against the middle class and poor.

John Dewey August 29, 2006 at 11:29 am

alex: "the middle class is being squeezed by a process that has been going on for several decades under federal policies ranging from bs tax cutting to union busting and deregulation."

How has tax cutting squeezed the middle clas?

How did deregulation squeeze the middle class? I work for a major airline, and I see many more middle class folks taking trips now than before airlines were deregulated. Did telephone deregulation squeeze the middle class? I see children of middle class families walking around with cell phones every day.

If the middle class is being squeezed, who is buying all those middle class homes in the suburbs of every major city? You know, the ones that are twice as large as middle class families owned 40 years ago.

Who is buying all those big televisions that Best Buy sells every day? If it's just the rich, they must have ten sets in every room of their homes.

What about all those trips to Disneyworld? Do all those millions of kids belong to rich families?

Sorry, alex, but I don't see any evidence to support your claim that the middle class is being squeezed.

alex October 18, 2006 at 11:04 am

You didn't read what I said, did you? Be coherent. I said that the prices of most goods has fallen by 20% adjusted for inflation. That includes cell phones, trips to Disney World, and all the other irrelevant points you make. As to deregulation, its basically that of financial corporations and Wall Street. Is private debt soaring? Yes. Are more people in debt? Yes. Is it because of overconsumption? Sorry, but no, unless you believe in Santa Claus, the Easter Bunny, or are overdosing on drugs. This debt increase is being caused by middle class basics rising above the rate of inflation. As to middle class families buying homes in the suburbs, if you bother to read any economic news whatsoever, and clearly you don't, then you would notice that these people are buying homes on adjustable mortgages due to historically low rates, and when the rates rise, oops, they go into forecloture. And you were saying about middle class homes? Tax cutting squeezes the middle class in several ways. One, the taxes that are being reduced are those for inheritances and unearned income, neither of which the middle class has in any sizeable amount. So, they don't get any money from the tax cuts. Also, they get services they need cut, either from the Fed, State or Local governments. Also, taxes that hit them harder, like payroll and sales taxes, are used to make up for revenue losses. Need I say anymore?

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