Harness market forces to share prosperity
By Lawrence Summers

When I studied economics in graduate school a generation ago we were taught that it was a “stylised fact” that the US income distribution was very stable. We were shown that the fraction of the population in poverty tracked almost perfectly the performance of median family income over time and that productivity growth and average real wage growth moved together, with both declining sharply after the oil shocks of the 1970s. These observations led naturally to the conclusion that the main way of reducing poverty or increasing the incomes of middle income families was raising the rate of economic growth.

Today, we have another generation’s worth of data including the experience of the information technology-driven re-acceleration of productivity growth in the 1990s. This experience forces a reassessment of the earlier economic orthodoxy. It can no longer plausibly be asserted that the income distribution is relatively static or that average wage growth tracks productivity growth. Indeed, in a recent paper on tax policy prepared for the Hamilton project, my collaborators and I concluded from Congressional Budget Office data that, since 1979, changes in income distribution had raised the pre-tax incomes of the top 1 per cent of the population by $664bn or $600,000 per family – an increase of 43 per cent.

By definition what one group gains from changes in the distribution of income another group must lose. The lower 80 per cent of families are $664bn poorer than they would be with a static income distribution, which works out to $7,000 less in income per family or a 14 per cent loss. To put this in some perspective, the total gain in median family incomes adjusted for inflation between 1979 and 2004 was only 14 per cent. If middle income families had shared fully in the economy’s income growth over the past generation their incomes would have risen twice as rapidly!

While the most recent data available for performing these calculations come from 2004, it appears that the trend towards increased inequality is continuing and may even be accelerating, and will continue even in years when the price of stocks and other assets does not rise abnormally. It also appears that these trends reflect far more than increases in the financial return from education, as the top 1 per cent of the population has pulled away from the rest of the top 10 per cent and the top 0.1 per cent has pulled away from the rest of the top 1 per cent.

Public policy has been successful in cushioning the impact of these trends but in some cases, such as President George W. Bush’s tax cuts, has actually exacerbated them. Of even greater concern is the growing suspicion that gaps in educational access for children and in life expectancy across the population may well be increasing. The observation that trends of the type observed in the US are also observed in other industrialised countries – in particular the English-speaking countries – suggests that something quite fundamental is at work.

What should be done? As is often the case in economic policy the answers are not entirely clear but probably lie between the extreme positions on offer. In the face of the experience of the past generation it is no longer credible, if it ever was, to argue that the goal of economic policy should be only to increase the size of the economy and that addressing questions of its distribution is populist or divisive. Given what has not happened to the pay cheques of average workers over the period of the information technology-induced acceleration in productivity and cyclical expansion, it is not plausible to suppose that policies that focus only on aggregate economic growth are sufficient to meet current challenges.

Equally, arguments that suggest the only way to raise the incomes of middle-class families is through measures to regulate business practices more heavily or to restrict increases in international trade are very dangerous. As much justified concern as we have about increased inequality, we need to recognise that it could be much worse if the economy had not been able to achieve the combination of under 5 per cent unemployment and sub-3 per cent inflation that we have enjoyed for much of the past decade. This surely would not have happened without the US economy benefiting from greater global integration. As western Europe’s long experience with unemployment rates that in some cases are more than double American rates illustrates, we would be taking great risks if, in the name of benefiting workers, we took steps that made production in the US less competitive in the global marketplace.

The right approach is activist but it embraces activism that goes with – rather than against – the grain of the market system. This is not a new idea. The enduring legacy of the New Deal is not the many measures taken to regulate prices or increase public employment. It is the measures such as securities regulation and Social Security that do not seek to oppose but channel market forces and mitigate their consequences.

The challenge for those running for president of the US in 2008 – a challenge very different from that faced by presidential candidates until very recently – will be to develop a mandate for policy approaches that can ensure prosperity is more fully shared without threatening its fundamental basis.