14 December 2013

Reagan and the role of the past in shaping the future

My colleague Ziyi Mai writes that critics of today's slow economic recovery should not look to the policies of the Reagan administration for any explanations. He cites the similar (or better) unemployment and inflation numbers of the late 1970s and early- to mid 1980s, and says that the policies of the second Bush administration have more to do with today's lackluster recovery than those of the Reagan administration. He also claims that consumption inequality, which is lower than income inequality, is a better measure of economic equality.

While it is true, as Mai writes, that unemployment has remained persistently high for a longer period after the 2008-09 recession than after the 1982 recession, much of this persistence is attributable to the different dynamics of recovery from financial panics. Political intransigence has also led to contractionary fiscal policy in direct contradiction to textbook macroeconomics. Had the Congress taken up the monetary 'slack' provided by unconventional monetary policy over the last five years, it is likely that unemployment would be significantly lower today. It is worth noting, as well, that this intransigence has its roots in the political style of Mr Reagan, whose language of class warfare and racially incendiary rhetoric and actions sought to undermine the value of government as an institution, and whose fruits are borne today.

None of this, however, is related to the criticism that Mai seeks to address, which is that income inequality has inhibited this recovery. It is clear that income inequality has skyrocketed since 1980. It doesn't seem as if Mai would disagree with this; but he would rather talk about consumption inequality. That's fine; there are plenty of good reasons to do that. The best reason is that the ultimate purpose of income is to spend it. Various macro models address the utility of bequeathment, and the concept of discounting future consumption is at the heart of any dynamic macro model, but it is safe to say that we seek income so that we (or our heirs) may spend (today, tomorrow, whenever).

So, why not focus on consumption inequality? I think the best reason is that, contrary to Mai's assertion, consumption inequality has risen right alongside income inequality. The argument implicit in the focus on consumption inequality is that "if people can spend, it doesn't matter if they cannot save." This has unfortunate consequences both individually and macroeconomically. Households that are income-constrained, and which therefore must spend to their limits rather than save, face tremendous financial uncertainty. The rise in bankruptcies due to medical emergencies demonstrates this clearly. As Mai cites, the decrease in the national saving rate, while beneficial in the short-run during the recovery, will eventually have dire ramifications in terms of private investment.

There is, of course, a mechanism by which consumption equality could persist in the face of rising income inequality. The trend toward "cash-out refinancing," an equity-draining loan option popular during the housing boom of the early 2000s, allowed the income-constrained to treat their homes like ATMs in order to boost consumption. This was made possible by the outsized demand for collateralized debt obligations, the mortgage bonds whose bubble most directly led to the financial panic of 2007-08.

Mai is right that we cannot look solely to the past to explain our current economic trouble. He is too quick, however, to absolve Mr Reagan and his political descendants of blame for their role in setting the table for the rotten meal we're all staring at now.

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