A Discussion of “Market Power, Inequality, and Financial Instability”
Two economists from the Federal Reserve have put out a paper that is exactly what I think economics should look like.
What do I mean?
Cairo and Sim (2020) identify six problematic trends in our macro economy since 1980, trying to determine the common cause. If we can figure out what is causing the problems, that can guide us to policies that address them.
The trends they identify are (p. 1–2)
- Real wages have not grown even as productivity (output per worker) has, meaning the percentage of income that goes to labor has been declining. And to the extent that real wage growth is a measure of living standards, this means stagnation for those dependent on labor income.
- While labor share of income has fallen, before-tax profit share has risen for US corporations. They say these two have a strong, negative correlation suggesting a common cause.
- Income inequality has increased as shown by those in the top 5% of income having a 21% share of income in the early 1980’s rising to a 34% share in 2008 before the Great Recession. This trend is related to the first two trends to the extent that higher income individuals receive more of their income from business profits while lower income individuals are more dependent on labor income.
- Wealth inequality has likewise increased, not because of the growing income inequality but because of rising capital gains. That is, the higher business profits mentioned above lead to a rising stock market, which produces the capital gains and increasing wealth.
- Household debt has increased as a percent of GDP over these years rising from 45% to almost 100%. Other research shows that as income rises, the percentage of income spent on consumption falls (Marginal Propensity to Consume, in econ-speak). The households on the losing end of the rising income and wealth inequality have a higher MPC and are borrowing to fuel it.
- Financial instability (likelihood of a financial crisis) is rising over these years as household debt is increasing.
Not a feel-good article! But I think it is healthy for us to look at the data and see the truth. And before we run to our political corners for solutions, let’s continue with their goal: to identify what could be the common cause behind these trends.
Their inspiration comes from a 20th century economist, Michal Kalecki, who they quote as saying,
The long-run changes in the relative share of wages…are determined by long-run trends in the degree of monopoly…The degree of monopoly has a general tendency to increase in the long run and thus to depress the relative share of wages in income…although this tendency is much stronger in some periods than others. (p. 1)
Cairo and Sim are setting out to explore the impact of an increase in the “degree of monopoly,” which is what they mean when they say an increase in market power.
To accomplish this, they build a model of the economy, calibrate it to the 1980 level for the parameters (like share of labor income, real wages, productivity, etc.), and see what happens when they increase the market power firms have in the output market and the labor market.
Does the result of running this simulation result in a world with our observed trends listed above? To the extent that it does, then rising market power could be the common cause of these unpleasant trends we are experiencing. (p.2)
As they note at the end of their paper though, they are not investigating the source of this growth in market power — that is an issue that would have to be examined in future research. (p. 30) They are focusing on what would be the likely outcome if market power grew in their model. Would those results mirror our observed reality as outlined in the six trends above?
Results
After running their base case of the model, they compare those results to the real world data, finding that
…the increase in market power can go a long way in explaining secular trends on labor/capital shares, income inequality, and financial instability…(p. 12)
They do explore some alternative hypotheses by running the simulation again with some different assumptions as a “validity check” of their baseline specifications. (p.19)
One such check does appear to improve the model’s results. They examine the potential role of households having a “keeping-up-with-the-Joneses” preference in their consumption decisions.
The baseline case predicted a 30% increase in household debt measured by credit as a percentage of GDP compared to the real world 40% increase. (p. 23)
Adding this change in preferences causes the simulation to predict a 50% increase in household debt, which is more than the real world. Thus, they conclude that the desire to keep up with the Jones may play a role in the real world, but it must be in a somewhat weaker form.
Condemnation of our consumerist society has long been a hot topic. Thorstein Veblen was one of the first economists to address this with his theory of conspicuous consumption in 1899.
It sounds plausible since many of us can observe it in others, and likely ourselves at times, so it is interesting that this model shows it could play a role in our world. However, it is not likely a main driver of household debt.
Could Income Redistribution Help?
Finally, they examine if adding income redistribution policies could improve our situation.
Targeted Beats Universal in Developing Countries
The baseline model had one kind of tax: a lump sum tax that was used to pay unemployment insurance. For the redistribution exploration, they add a dividend income tax so that the after-tax income from business profits is lowered, and the proceeds are transferred to those who rely on labor income. (p. 28)
With this tax structure, there is no change in the labor, capital or profit shares before tax because all the tax is doing is redistributing income after it has been earned. Thus, if you look at the original six macro economy trends listed in the beginning, this tax policy does nothing to address the first two, but it is designed to fix the income and wealth inequality.
And it does do that — when they run the simulation, they find the top 5% income earners have much less increase in the share of income over time. It still grows across the time period but only half as much. (p. 28)
Beyond that though they find this policy significantly lowers household debt accumulation which by extension lowers the financial instability for the economy.
Thus, if your goal is to address all six of these trends, you are better off exploring the factors that are driving the increase in firms’ market power.
But if your goal is to address increasing inequality and financial instability, then redistribution of income could be the way to go. It does not get to the root cause of these macro trends, but it could ameliorate the direction we are heading.
Conclusion
I think a paper like this needs to be proclaimed far and wide to aid us in finding solutions. I think most of us would nod our heads in recognition of our reality as we read the list of six trends at the beginning.
What I love about this approach is it focuses on the root cause of our problems and could allow us to apply a real fix. They do show an income redistribution program is successful at fixing some of the negative issues of the trends we are on, but it does not change our path.
Thus, it seems if we could figure out how to stop the increase in firms’ market power, we would have a better, systematic response to the negative trends.
References:
Cairo, Isabel and Jae Sim (2020). “Market Power, Inequality, and Financial Instability.” Finance and Economics Discussion Series 2020–057. Washington: Board Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2020.057
By Ellen Clardy, PhD on .
Exported from Medium on December 15, 2022.
