Income and Wealth

Paul Krugman, op-ed writer for the New York Times and economics professor at Princeton University, once boasted about his algebraic understanding. Whereas most political and social commentators speak or write of unquantifiable philosophical notions, coming from an economic background, Krugman is adept at algebraic symbol manipulation. Economists try to model their social science on the physical sciences like physics or chemistry, whose universal language is mathematics. Indeed, Krugman was correct in writing, “There are important ideas in [economics] that can be expressed in plain English, … [b]ut there are also important ideas that are crystal clear if you can stand algebra, and very difficult to grasp if you can’t.” Krugman concedes his impatience with those less precise in thought and presentation than he fancies himself to be. The danger, of course, is that after having postured so, someone will challenge Krugman on his own terms.

Alan Reynolds, of the Libertarian Cato Institute, did not write Income and Wealth as a specific rebuttal to Krugman. However, Krugman has been so argumentative and prolific in writing about the economic demise of the middle class and poor at the expense of the affluent and has done so via the exploitation of sloppy statistics that he provides convenient and oft-mentioned examples of the misuse of statistics. Krugman’s professional background makes it impossible to plausibly plead ignorance to their misuse. None one who seriously wants to understand income and wealth and how it has changed over time in the United States, can be ignorant of the concepts explained by Reynolds in Income and Wealth.

The fundamental problem for Liberal economists is history. In the 1970’s under a regime of high tax rates, the economy suffered high inflation, high interest rates, high unemployment, and low growth. Then President Ronald Reagan arrived and slashed marginal tax rates by half. After a relatively short transition period, the economy radically improved with high growth rates, low inflation, low interest rates, and low unemployment. Clinton marginally increased tax rates but only modestly and, with the help of a Republican Congress, passed the North American Free Trade Agreement (NAFTA). Clinton’s free trade policies were in direct conflict with trade unions, a traditional member of the Democratic electoral coalition. The economy was buoyant in the 1990s. After the short recession caused by the attacks of September 11, Bush’s tax cuts have revived the economy. Moreover, those industrialized countries in Europe that have adhered to a high-tax strategy, the policy advocated by Liberal economists, are burdened with low growth and high unemployment. The Conservative prescriptions for the economy are conspicuously successful.

The response from the Left is to concede the high growth, low unemployment, low inflation, and low interest rates; but to argue a series of “Yes, buts.” Yes, but the real median wages have remained static for the last twenty-five years. Yes, but only the rich have experienced increasing incomes as the expense of the poor. Yes, but the rich have increased their wealth more than others. Yes, but income and wealth inequality have grown.

Unfortunately for the rhetorical convenience of the Left, in order to make such claims, it is necessary to make any number of rather simple errors. Reynolds systematically explains the real nature of the data. For example:

Real wages have only remained static if you use an obsolete measure of inflation. With more modern measures, median wages have risen by over a third.

Median wages only include the wages of those who are employed. In the late 1970’s, the base period often used for comparisons, unemployment was high. The least skilled and the lowest paid were laid off first, ironically increasing median wages for those still employed during that period. However, no one would reasonably want to increase unemployment to increase median wages.

Wages measure only a part of compensation. Medical and retirement benefits have become an increasingly large part of total compensation. Counting only wages neglects this important component. Also ignored are transfer payments to the lower income quintile such as Social Security or in-kind assistance like food stamps.

The Gini index is a broad measure of inequality. People often point to the increase in inequality as measured by the Gini index during the 1990s. Of course, it is often neglected that for technical reasons the Census Department altered the way it computed the index in the early 1990s. This resulted in a one time jump in the Gini index that did not reflect any change in the economy. Without this jump, the Gini index has remained relatively stable.

In measuring the distribution of wealth, many studies only include immediately accessible wealth, i.e., liquid financial instruments. Counting in this ignores the enormous increase in the wealth of the middle class from increasing housing values and increasing asset value of 401(k) or 403(b) retirement plans.

In addition, the demographic composition of the United States has aged dramatically over the last two-and-half decades. Typically, young people are rich in human capital, with the prospect of earning income over many years. Older people have less human capital, but have accumulated a lifetime of assets and savings. By conventional measures, the older people are wealthier than younger ones. Changes in wealth distribution in large measure represent a change in the age distribution rather than a direct economic change.

Reynolds explains that the single biggest discriminator on which households occupy different income quintiles is the number of people who work in the household. Two income households fill the top quintile, while the bottom quintile usually has no worker or only a part-time worker, perhaps a single mother. Family structure is highly correlated with economic success.

The media is too full of glib and incorrect assertions about who has and has not benefited from explosive economic growth of the last two-and-half decades. Reynolds sorts through the errors and the rhetoric in a readable style. And in the end who could disagree with his conclusion:

“No matter what one thinks ought to be done about taxes, spending, unions, immigration, trade, minimum wage laws, and so on, the first thing that needs to be done is to get the facts right. If that happens there will still be plenty of room for lively debates about all sorts of public policies. And they will be honest debates.”

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