Friday, October 24, 2014

Note to Janet Yellen: Income Inequality Isn't Killing the American Dream

Federal Reserve Chairwoman Janet Yellen made a bit of a splash last week during her address last week on income inequality last week when she said that "the extent of and continuing increase of inequality in the United States greatly concern me." After highlighting the income inequality, Yellen highlights what she considers the four blocks of opportunity: education in earlier years, college education, ownership of business, and ownership of wealth. According to Yellen, if America had greater access to education and increased business ownership, the problem of income inequality would be solved. After taking a look at Yellen's address, I thought to myself not only that Yellen's concern for income inequality is overstated (see this fine report by the Manhattan Institute that elucidates upon that point), but even if income inequality is a concern, she should look in different places for solutions. It wouldn't be any fun if I simply left you with that, so I am going to delve into further detail as to my criticism of Yellen's address.

A lot of the issues that I will bring up with her analysis of income inequality are ones that I have brought up in the past both when discussing income inequality and wealth inequality. With that being said, I have to start by taking issue with the data she is using. I understand she wants to use the Survey of Consumer Finances (SCF) because they are data that the Federal Reserve generates, but there are other data sources that go back further than 1989. Capturing only 25 years of data does not tell the whole story, especially if you pointed out to Yellen that wealth inequality is lower now than it was in 1989. Second, she groups households into the top 5 percent, next 45 percent, and bottom 50 percent. The income groupings she uses (see below) are so vague that they really don't provide much substance. Grouping in quintiles, for example, would provide me with more information.

Third, her figures are based on cross-sectional data. This is problematic because when looking at Yellen's charts, it makes the assumption that people remain in certain income groupings, i.e., there is no income mobility whatsoever. While there is less income mobility than there was in the 1950's or 1960's, income mobility still very much exists in America (see Federal Reserve research here as an example). A highly regarded study published earlier this year (Chetty et al., 2014) found that in spite of the increased income inequality, income mobility has not really changed since the 1970's. Fourth, the composition of the household has very much changed since the mid-twentieth century. What do I mean by that? To quote former chief economist of the U.S. Labor Department Diana Furchtgott-Roth, "the size of households has changed since 1980, contributing to perceived inequality. With the increased prevalence of divorce, delayed marriage, and longer life expectancy, there are more households composed of one person, or non-family households. These households tend to be in the bottom quintile." Households with two earners fare better than households with one earner. More households with one wage-earner is going to cause a bigger disparity. Fifth, Yellen's analysis is presumably based on pre-tax income. Looking at after-tax income with government transfers paints a slightly different picture. Sixth, even when adjusting for inflation, measuring income is insufficient in terms of accounting for the increased quality of consumption that we have experienced in recent years, which is why Yellen's accusation that income inequality caused "significant wealth and income gains for those at the very top and stagnant living standards for the majority" is a specious one. We should be looking at how peoples' lives are improving in absolute terms, not in relative terms.

It is peculiar that the head of the Federal Reserve is expressing such concern since Yellen does not have control over education or wealth allocation. The Federal Reserve has issues with fulfilling its dual mandate of controlling inflation and decreasing unemployment, so I don't know what all it can do to help with income inequality. I also think it's peculiar that Yellen is giving such a speech, especially the Federal Reserve has arguably caused income inequality with its quantitative easing, although I would argue that the Federal Reserve completely dismantling from the gold standard has done a bang-up job of devaluing the dollar, as well as keeping interest rates near zero percent.

Even if Yellen is simply using her bully pulpit to advance the issue, I still found the address unsettling. She didn't explicitly give policy recommendations, but given her adherence to Keynesian school of economic thought, it's not unreasonable to assume that she would want the government to do something about these issues. She said in her address that "public funding of education is another way that governments can help offset the advantages some households have in resources available for children." The problem here is that public funding of education hasn't been working too well to help. The government implementing universal preschool has been a debacle, not to mention that keeping interest rates artificially low on college student loans has caused that mean education debt to mean income ratio you mentioned to increase. Speaking of keeping interest rates low, the government pressuring banks to keep interest rates low on housing loans was a major contributor to the bursting of the housing bubble, which would help explain why those in the bottom 50 percent lost their wealth during the Great Recession (i.e., their wealth was tied up in the illiquid asset known as their house). None of this even gets into her assertion that "social safety-net spending is an important form of public funding that helps offset disparities in family resources for children" because that would be too time-consuming right now. I've written on poverty and welfare issues before, so you can look here if you want my two cents on the matter.

If you want to help the American people out of this economic sluggishness, you need to create an environment that inculcates economic opportunity. This means that the government needs to implement policy that encourages, rather than stifles, economic prosperity. I'll give a few examples. If Yellen thinks business ownership is a key to reducing income inequality, she should advocate for reducing barriers to entry such as occupational licensing. The Mercatus Center just published a study showing how employer-based health insurance is causing a huge spike in income inequality, so why not remove this antiquated tax break? Competitive markets incentivize businesses to come up with more innovative ideas than monopolies do, so why not provide public-sector unions or public schools with some competition by encouraging alternatives to the status quo? Unemployment benefits don't help, and neither do high income tax rates or other onerous regulations. These are but a few ideas of what can be done to help the American people. Going after the "income inequality" boogeyman isn't going to solve anything. If you don't bludgeon American businesses with taxes and regulations that hold back entrepreneurship, it will be much easier to live the American dream.

9-10-2016 Addendum: The Cato Institute recently published a paper on five myths about income inequality, particularly with the extent to which it affects poverty.

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