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.

Asset Boom vs Low Inflation

Since the Fed announced that it would start trimming it's bond buying program of $85 billion a month to $75 billion in the face of better economic outlook in December, the certain members of the FOMC have been open about their opinion on the Fed's recent QE program.

Being one of the strong critics of the program, Federal Reserve Bank of Dallas President Richard Fisher has been arguing against the whole bond buying program. In his opinion, the bond buying program does nothing much to the recovery, and the Fed should have cut back the amount of monthly bond purchase by $20 billion instead of $10 billion. Moreover, Fisher worries about increasing price of stocks and other assets. He isn't alone to warn about the bond buying programs push on asset price as stock prices are up 30% from a year ago. The worrisome result of the program is that "the boost to wealth and consumer confidence has accrued almost exclusively to the 52% of Americans who own stocks, based on a Gallup survey. It has not flowed through to jobs as the employment-to-population ratio has remained at 58.6% of the working-age population, within tenths of a percent of the recession low", according to RANDALL W. FORSYTH on Barron's. In other words, the bond buying program's main effect has been on the upward movement of the stock and asset prices but not much on the employment. The employment-to-population ratio has been lower than what it was at the "official" end of the recession, namely 59.4%, in June 2009, let alone before the recession ratio 62.7%. But we have to be careful here; to judge the QEs' effect on the economy, we should compare how the economy has been doing to how it would have done without the Fed's bond buying programs. Therefore, the judgement on the unemployment rate should be considered with a research on an "imaginary" economy without the QEs. However, the other point made in the above quote on the distribution of the Fed's high powered money and the beneficiaries of the FED's program, namely asset owners. The Fed's policy, therefore, could be a factor that is widening income inequality. Increasing income inequality should be tackled as soon as possible as it is growing as never before.

On the other hand, some members of FOMC have been big proponents of the Fed's bond buying program. Being one of them, Chicago Fed President Charles Evans has been taking strong stand on the continuation of the program to boost the recovery. He, among others, is worried by not-so-much inflation rate of 1.1% in the last year, which is well below the Fed's targeted level of 2%. To boost it to this targeted level, the Fed should pursue its near zero percent interest rate policy with its bond buying program, according to him. With low inflation, consumers and businesses have low incentive to borrow and spend their money. Therefore, the Fed is targeting high enough inflation to give confidence to consumers and businesses.

In other words, the Fed's policymakers have been divided between a policy against increasing asset prices and a policy against low inflation. Of course, it is not like "black vs white" argument. Fortunately, the monetary policymakers have been critical of each possible effect of the program.