Friday, November 25, 2011

The missing productivity puzzle

The Conventional Wisdom is that while productivity has continued to increase, very little of it went to the middle class during recent decades. Since we know inequality was going up contemporaneously, the qualitative-thinking conclusion is that the “the rich” and “corporations” are simply taking the rest.

However, quantitative-thinking shows that no estimates of inequality increase is large enough to account for the mystery of missing output.

This time I start at 1975 since some of the public data doesn’t go back further. Between 1975-2008, real Per Capita GDP increased by 90%. During the same period, real Median Household income increased by merely 17%. The issue is not just with the median, mean household income for the lowest earning 80 percent of the population grows just 21% measured this way. So what’s going on?

Growing inequality is an important part of the story. If we use Pickety and Saez estimates to calculate the share of income that went to the top 10 percent earners, the rest of the population (the “Poorest 90 Percent”) had a real income growth rate of 50%. What about the rest of the gap?

Additional explanations for the disconnect is that the standard inflation measure (CPI-U-RS) may be biased upward, and has at any case increased about 13% faster 1975-2008 than the GDP-deflator used to calculate GDP. Meanwhile average household size decreased by 11%.

Let’s make inflation comparable by using the GDP-deflator also for household income, and hold household size fixed by looking only at 4-person households.

You can see a sizable disconnect between Median Household Income and the “Bottom 90 Percent” growth calculated by combining GDP data with Pickety and Saez distribution numbers. However, once we make two simple (and I hope uncontroversial) adjustments to the Census Median Household Income data the gap vanishes!

While disappointing for such a long period, 50 percent real growth is not quite “stagnation”. The narrative that all productivity increases have been eaten up by the rich is a myth, driven by measurement problem and the unwillingness of many journalists and economists to ruin a good narrative by digging deeper.

Friday, November 18, 2011

Middle Class Income Stagnation is a Myth

The conventional wisdom is that the middle class, 'The Bottom 99 Percent”, has seen stagnating or shrinking income. Thought inequality has unquestionably been rising rapidly, the conventional wisdom is wrong, a result of measurement problems.

The debate has focused on the exact magnitude of income inequality, ignoring that even the highest estimates are too small to eat up all economic growth. The central problem is underestimation of total growth.

Wages, household earnings and earnings of tax units appear to grow slowly. Between 1970-2008 real wages grew 15%, median household income 16%, and according to Pickety&Saez taxable income of "The Bottom 99 Percent" by 12%.

This contrasts with another more reliable and complete measure. Between 1970-2008 Real Per Capita GDP increased by 108%, based on National Accounts data calculated by the Bureau of Economic Analysis.

How can per capita income double, but the income of the middle class barely go up? According to the Conventional Wisdom, the answer is simple: The rich must simply have taken the rest. Indeed according to Pickety&Saez between 1970-2008 the share going to the top one percent increased from 9% to 21%. Mystery solved!

Wrong. Rising inequality alone cannot account for the gap between output growth and middle class stagnation.

Let’s return to Pickety&Saez and their oft-reported figures. They find that real average taxable income grows only 29% between 1970-2008, when including the top one percent (and including capital gains). This is just a quarter of per capita GDP growth. The discrepancy is not a major problem for their original task of estimating relative inequality, but it poses a problem for estimating growth.

There are at least three measurement problems:

1. Taxable income is only part of total income. In 2008 taxable income as reported by Pickety&Saez was only 58 percent of GDP, a decline from 1970. We can’t just ignore the rest of national income. There is a similar income-base problem with BLS wage data.

2. Average Household and Taxable Unit sizes have been shrinking since 1970, both growing at around one and a half time the rate of population.

3. Inflation is systematically miss-measured, as the Boskin-comission found. When calculating GDP a different and less biased inflation measure is used than CPI-U-RS.

The Congressional Budget Office made their own estimates, accounting for the first two problems, though not for inflation. They confirms that the share of post-tax income going to the top one percent increased from 8% to 17% (a bit lower than Pickety&Saez, perhaps because of household size adjustment and a broader income base). Since the CBO estimate of income growth of 62 percent in the shorter period covered is very close to GDP numbers, their estimates of real middle class income growth are also higher, at 46 percent.

A careful new study by Bruce Meyer and James Sullivan corrects for the aforementioned problems. Similar adjustments are done by Burkhauser et al. (2011) and Gordon (2009). Like the CBO, all these studies correspond better with GDP data, and produce higher estimates of middle class income growth (results summarized bellow).

My simple method is combining the best income-distribution estimate (from Pickety&Saez) with the best income-growth estimates (from GDP numbers). This method shows that that between 1970-2008 the real per capita income of the "Bottom 99 Percent" grew by 80%, and the income of the "Bottom 90 Percent" grew by 60%.

The "Top one Percent" took 25 percent of total growth, half of Pickety&Saez estimate. This is bad enough, so why exaggerate? Let me stress once more that I use their distribution numbers, just a different and more realistic figure for aggregate income growth. Underestimating total growth ironically also leads to an underestimation of how much richer the top one percent became (5 times rather than 3 times richer).

To argue for middle class stagnation one must argue that GDP growth numbers are wrong, and estimates based on smaller income bases right (a claim I have never seen, though I am hardly an expert). More on the topic by the always excellent James Pethokoukis.

Real Median Income around 1970-2008:

Not adjusted, Census: +16%

Adjusted for measurement problems:
CBO: +35%
Burkhauser: +37%
Meyer&Sullivan: +50%
Gordon: +52%

Real Average Income of "Bottom 99 Percent" 1970-2008:

Not Adjusted, Pickety and Saez: +12%

Adjusted for measurement problems:
CBO: +46%
Combining Pickety&Saez with GDP: +80%

Wednesday, November 16, 2011

Again with the Krugman

Now Krugman is trying to divert blame for the Euro disaster from his beloved Europeans to the focus of his obsession: The American Right!: “attempt to create a common European currency… was cheered on by American right-wingers… And it was questioned by American liberals, who worried — rightly, I’d say (but then I would, wouldn’t I?) — about what would happen if countries couldn’t use monetary and fiscal policy to fight recessions.”

In 1999, when the Euro was launched, Milton Friedman, the leading right wing economist in America predicted: “The euro will not survive the first major European recession”

The same year Friedman said: “Sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart.”

Friedman had already in 1998 speculated with eerie foresight: “there will be asymmetric shocks hitting the different countries. That will mean that the only adjustment mechanism they have to meet that with is fiscal and unemployment: pressure on wages, pressure on prices. They have no way out…Suppose things go badly and Italy is in trouble, how does Italy get out of the Euro system?”

Milton Friedman was not the only right wing American economist warning about the Euro. Martin Feldstein wrote in 1997: “adverse economic effects of a single currency on unemployment and inflation would outweigh any gains from facilitating trade and capital flows".

Now let’s contrast this to with Paul Krugman's lightweight Euro-optimism in 1999: “For all the seven long years since the signing of the Maastricht treaty started Europe on the road to that unified currency, critics have warned that the plan was an invitation to disaster… Well, here we are, right on the brink of the creation of "euroland", and it is now clear that none of the problems EMU critics have warned about will arise, at least for a while.”

Rather than warning against the overly expansionary policies and cheap debt that would eventually lead to this crises, in 1999 Krugman thought the biggest problem was that European were not being expansionary enough: “Instead of an "asymmetric" economy, in which some countries want tight money while others want a boost, the whole zone is a prime candidate for lower interest rates”.

The same year Krugman wrote another article about how the Euro would impact the U.S, titled “Don't worry about the euro”. Instead of warning about the threat the Euro posed to economic stability as Freidman did, Krugman seems to think the problem was that the eventual success of the Euro would worry irrational Americans about the dominance of the dollar: “it was inevitable that the coming of the euro --the common European currency that seems set to be introduced next year, and that may eventually challenge the dollar's dominance--would inspire irrational fear.”

The point is not to the blame Krugman for the Euro experiment, that would be childish, and overall his record is of mild Euro-spectism. Rather it is comical to see Krugman (without evidence) blaming “American right-wingers” for the Euro disaster when the leading American economist on the right warned about the euro harsher and more presciently than Krugman did.

Saturday, November 12, 2011

Did the Euro kill Italy?

Italy has one of the worst growth records of any country. Between 1990 and 2010 the U.S economy grew by 63 percent, compared to 19 percent for the Italian economy. Had Italy grown as fast as the U.S, their debt would be manageable.

One cause of slow growth is demographic transformation. During this period Italy’s working age population (those aged 15-64) grew by less than 2 percent, compared to 8 percent in the rest of Western Europe.

But aging is not Italy’s only problem. In this graph, I have accounted for demographic change by looking at GDP per working age adult, instead of GDP per capita. Italy is compared with the weighted average of the remaining 14 Western European countries.

There are different ways to read the graph, and I don’t want to oversell this interpretation. The hypothesis, not uncommon among Italians, is that Italy started to lag when it joined the Euro and stopped devaluating the Lira. You see, Italy had developed a habit of periodically devaluating its currency to fix whatever cost problem she get herself into. The devaluations lowered the price of Italian exports and jump-started the economy, working as Italy’s “safety valve” (presumably because an internal devaluation through deflation is too hard). The Euro stopped all of this.

Until the early 1980s, Italy was converging to the rest of Europe, as it had done virtually uninterrupted since World War II, during what is referred to as the Italian “miracle”. In 1970 Italy’s output per working age adult was 90 percent of the rest of Western Europe, and ten years later 98 percent, almost fully converged.

Around this point Italy stops converging, but more or less keeps its relative position. In 1996, the year when the Italian Lira is effectively tied to what would soon become the Euro, Italy had the same relative position, 2 percent below the rest of Western Europe. It is after the Euro prevents Italy from devaluating that serious under-performance starts.

There are of course competing explanations, such as Chinese competition or lack of reform, so perhaps the correlation is spurious. You could also put the start of the decline a couple of years earlier. Still, it would not surprise me if Italian growth would re-bound if they leave the Euro.

Sunday, November 6, 2011

New article in Swedish

Approximately 15 percent of the readers of this blog live in Sweden. They can read this article in Swedish by me and my brother about the roles of norms for the economic and fiscal crises.

Max Weber would not have been surprised by a map showing which countries have the biggest problems.

Wednesday, November 2, 2011

American Mobility is high and increasing

The process we believe created income inequality matters more for the legitimacy of society than the actual level of inequality. Did the rich become rich by producing value or by exploiting the poor? What determined earnings, ability or inheritance/privilege?

The Occupy Wall Street protesters and their sympathizers in the media are angry about four trends they believe characterizes American capitalism.

1. Income inequality has been going up (true).
2. The Middle Class is stagnating (false).
3. Wealth is taken, not created (I believe false).
4. American income mobility is falling (false).

I will write about the middle class stagnation myth and about value creation next time.

The Bureau of Labour Statistics provides the NLSY97 dataset, tracking a large representative number of Americans. In addition to your current earnings, NLSY97 reports the income of your parents when growing up.

Of the Americans whose average income during the last five years put them in the "Top 1 Percent" richest, 7 out of 10 did not have rich parents (defined as the top 10% highest earning parents).

The richest 1 percent do not come from poor homes, they mostly come from upper-middle class homes. Note that because income is measured imperfectly, these numbers likely overestimate mobility.

Nevertheless, you get a similar result from the Forbes 400 list of the richest people in the United States. Forbes magazine lists the source of wealth :

“Two-thirds of the members of the Forbes 400 have fortunes that are entirely self-made.”

The share of billionaires who according to Forbes Magazine are self-made is higher in the United States than in Western Europe.

In addition to mobility between children and parents, mobility across life for the same worker is important. A recent study by Berkley Economist Emmanuel Saez and coauthors confirms that while income inequality has been getting worse, income mobility has not. Instead, driven entirely by women, upward income mobility has actually improved. Saez writes (emphasis in original) “long-term mobility has increased significantly over the last five decades.”

According to Saez, the probability that someone currently in the top one percent will remain in the top one percent five years from now is only around 60%, where it has remained for a very long time. The notion of a permanent elite taking hold of top incomes during the last few years is entirely a myth. There remains a substantial churn among the top one percent, with almost half dropping out every five years.

One common argument is that inter-generational income mobility in Northern Europe is higher than the United States. But even if that were true, it hardly proves that income mobility is low in the U.S, because those studies they cite find extremely high mobility in for example Scandinavia. Also a homogenous country will always appear to be more mobile than one made up of lots of groups. Not surprisingly, inter-generational mobility among Scandinavian-Americans in the NLSY97 is far higher than the U.S average.

Equally important, I believe these results are a statistical artifact. In Scandinavia, the income distribution is highly compressed. This means that even small and meaningless changes in income between parents and children appear as “mobility”.

Even if true mobility is identical, if one country has less income inequality, and if the amount of statistical noise in the income data is the same, the country with the even income distribution will appear to have more mobility as well. This is because measurement error/noise will move people around more in the compressed distribution.

Indeed the OECD finds that income inequality and inter-generational income mobility is highly correlated. If I am right, concluding that Scandinavia has lower inequality and higher mobility is double-counting equality.

Despite what the left claims, the United States is still a country with high income mobility. Another recent study by Pew found that:

"The vast majority of individuals, 71 percent, whose parents were in the bottom half of the income distribution actually improved their rankings relative to their parents."

The study also confirms that to the extent there is lagging mobility in the United States, it is caused by racial disparities, having to do with skill levels. Pew confirms that American children from low income homes with high test scores have extraordinary high income mobility.

There problem is not with American capitalism as an economic system, but with the lingering inability to make capitalism work as well for African Americans and Hispanics as it does for Whites and Asians. This problem is what I and Reihan Salam focus on the latest issue of National Review, which I encourage you to buy.
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