Rising Inequality Explains the Weak Recovery, Not Vice Versa

In this article, I will not passionately try to convince you of the post title. Instead, I will make points on how John B. Taylor's argument on the topic fails under more scrutiny. In his article in the Wall Street Journal, titled "The Weak Recovery Explains Rising Inequality, Not Vice Versa", John B. Taylor makes following use of data to make his point that today's inequality isn't a cause of the type of recovery we are witnessing. First, he explains what the people who he is arguing against say: the slow recovery has been a result of growing inequality. He writes down their argument as follows:

"The key causal factor of the middle-out view is that a wider income distribution slows economic growth by lowering consumption demand. Saving rates rise and consumption falls if the share of income shifts toward the top, according to middle-out reasoning, because people with higher incomes tend to save more than those with lower incomes."

And then he goes on to counteract this view by data he collected and put some make up on. He gives what his data shows:

"The data for the recovery since mid-2009 do not support this view. The 5.4% overall savings rate during this recovery is not high compared with the 8.4% average since 1960. It is relatively low compared to past recoveries, such as the 9.3% savings rate during a comparable period during the recovery in the early 1980s."

In my curiosity, I was able to look at the data he worked on. It is data on personal saving ratio-the ratio of personal saving to disposable personal income. The following graph shows what the saving rate has been.
John Taylor is correct on that the saving rate has been averaging 5.4% since the end of the latest recession. However, when he tried to compare this rate to the 8.4% average rate since the 1960, he makes wrong comparison. Due to the general downward trend of this rate over the last decades, he shouldn't compare this 5.4% average rate of saving during the recovery to the all time average saving rate. But if we compare the 5.4% average rate during the recovery with the average saving rate between the end of 2001 and the start of the recession, which is 3.9%, we can see that the saving rate today is higher than its pre-recession level. Therefore, we have just disproved his claim by using the same argument he tried to use. In other words, with data on how the income inequality has grown, we have further see that the saving rate also increased after the recession.

Hence, we are able to claim that the increase in inequality indeed increased the saving rate; therefore, the total consumption demand has declined, which is exactly what the people he argued against said.

One could argue that  because people might be willing to save more than what it was saving before the crisis to use their saving when another crisis comes during the recovery and uncertainty, the higher saving rate doesn't say that inequality is hindering the recovery. But this surge in the saving rate after a recession has been witnessed only twice, after 2001 and 2007-2009 recessions. Prior recoveries experienced the saving rate which was actually lower than its level before the crises. If we look at the average saving rate between November 1970 and November 1973, it was 12.8% which is higher than the saving rate after the recession, between April 1975 to December 1979, which is 10.8%. The same decrease in the saving rate was seen also during the early 1980's recovery. We can see this trend of decrease in the saving rate following the recession in the above graph except during the latest two recoveries.

In my very first blog post, I compared the income inequality during the pre-recession periods for the Great Depression and the Great Recession and argued the recovery the economy is going through is unhealthy one. One could agree with John Taylor on that the weak recovery is causing the widening inequality and the first problem policymakers should tackle is to boost the recovery by any means. However, the increasing inequality could be the heart of the problem, and the policymakers should prioritize equality to change the speed of the recovery.

The Income Inequality and the Economic Downturns

When we look at the similarities between the Great Depression and the Great Recession, one stark phenomenon that only these two economic downturns saw was the high income inequality in the U.S. that preceded these economic disasters. If we look at the graph showing the historical percent share of income of the top 10%t, this share was at the record high levels right before the Great Depression, in 1928, and the Great Recession, in 2007. In fact, during those times, the income share of the top 10% was almost 50%. As we look from the graph, this high level of income inequality was not seen during the time between the two great crises. This high level of inequality was seen first time at the onset of the Great Depression, and the next one coincided with the beginning of the Great Recession.

Could the increasing income inequality have been a root cause of the greatest economic panics the U.S. economy has faced in the 20th and 21st century? Let me try to see the potential link between the high level of inequality and the economic downturn. When people at top of the income ladder get bigger share of the total income, the folks at the bottom of the ladder would get less share of the total income. However, when, the top, let’s say, 10% get more income, their propensity to consume would decrease. In other words, the money that would have otherwise been spent for the consumption by the bottom 90% wouldn't be spent for the consumption by the top 10%. This leads to a decrease in total consumption in the economy which could have caused the downturns.

The most interesting data we can see is that since the official end of the Great Recession, the income share of the top 10% has only gone up until 2012, in which the latest data is available. Not only did the income share of top 10% go back to the pre-crisis level, but also it is now greater than 50%. In 2012, the top 10%t collected more than a half of the total income for the first time during the time of data. In other words, the income inequality in the U.S. is going to the same direction as it went to before the crisis. In that sense, I doubt the recovery that U.S economy is going through is healthy one. Not only has the income inequality in the U.S. been increasing, but also that in other countries has increased since the 2007-2009 recession. ( Harold James, Project Syndicate) This increase in income inequality in the U.S. has been facilitated by the Fed's non-conventional monetary policy, which has been potentially creating an asset price boom. The Great Recession challenged everyone in the U.S. in some ways, but the top 1% has already recovered what it has lost during the recession. Meanwhile, the increase in the income of the bottom 99% has been very low if there was any.  (Moran Zhang, IB Times)