Income inequality by Matthew P. Drennan – Book Review
What was missing in the economic
theory that lead to the financial crisis in 2008-09? This was the first
question Drennan want to answer in this book. His thesis is that income
inequality plays a role in the lead-up to the financial crisis by maintaining
consumption through surging household debt. The second question he asks was
‘Why the economist get it wrong?’. Drennan’s answer to the second question is
that the consumption theory of neo-classical economics does not include income
distribution to their economic theory.
To prove his points, Drennan brought
forward econometric evidence to link income inequality with the financial
crisis. He also used various set of data to show that many people resort to
debt to maintain their consumption, meaning that people borrow more money to
buy the necessities to maintain their lifestyle. He also present historical
data as evidence to show that the 2008-09 crisis is not something new and has
happen before.
Drennan also noted that the two
feature that were on the rise leading to financial crash were the stagnant
growth of income and income inequality – although this two do not necessarily
occur together. Although Drennan try to back his argument with data and statistics,
layman reader will not find this useful, understandable, and almost definitely
lost in the process.
What are the possible causes of
rising income inequality? Asked Drennan. Economist pointed out that one of the candidates
is globalization, but he cast doubt to this theory as other countries such as
Japan, Germany, and France were exposed with the same globalization forces but
does not produce higher income inequality. Other candidate favoured by
economist to explain income inequality is skill-biased technological change
(SBTC). This include higher order specialization, for example box mover can learn
to operate forklift easily, but factory worker might have problems changing
their career to higher-order specialization such as a programmer. Some economist
listed SBTC as the cause of the rising income inequality.
But all these candidates do not give
the whole picture. The more compelling cause, is the institutional structure.
Drennan noted that as the economy turn from manufacturing to service economy, the
labor union diminished. This is because the service sector does not have a
strong labor union traditionally. The structure of the law also plays important
roles in containing the labor union force, without them worker have a lower
protection and had to accept lower wages as they don’t have any bargaining
power.
Then there is government
intervention. Contrary to free-market ideology, that income stabilize in its
current level due to rigorous market forces, there are many government
legislation interferences that favors the rich and enlarge the income
inequality gap. Among the law includes treatment to corporate stock option
award, access to bankruptcy, copyright and patent protection, to name a few.
Various conservative think-tanks served as an advocacy lobby to ensure
government keep policies for the benefit of the rich, their objective is
rent-seeking – spending money not on production of product or service but to
take advantage and enlarge their own economic pie at the expense of someone
else’s share.
After presenting his theoretical
background, Drennan continue with the data to back his theory. Although he
emphasized in the introduction that the role of the data presentation is ‘not
to obscure the fact’, he did just that for a layman reader as they lost in the
jargon terms and various graph. Drennan drew from Federal Reserve’s data that
there are a huge build-up of debt-to-income ratio for the bottom 95 percent
whilst consumption remains more or less the same, which means that consumer are
shifting to debt to maintain their consumption, this lead to financial burst
eventually. These consumptions include shelter, health care, and education
which are a necessary expenditure which cannot be postponed, such as taking a
vacation trip.
In the book, Drennan also help explain economic principle such as the Pareto efficiency principle which stated that “any change that make one people better off, without making any other worse off, is an improvement”. This principle is a fundamental tenet of neoclassical economics, which describe the gain of top 1% of the income distribution as Pareto efficient. This is one reason why economist turn away from income inequality.
Other theory, such as Kuznets’s
inverted-U hypothesis, also made economist less worry on the income inequality
and its effect. Drawing from various historical data from numerous countries,
Kuznets argued that the economic shift from agriculture to industrialization
will lead to the rise of income inequality for some time, but as countries
develop, democracy expands and more protection were given to labor causing the
inequality to fall back. He also discussed Arthur Okun’s tradeoff theory
although Okun provided no strong evidence.
In analyzing the data, Drennan also
drew his criticism towards Milton Friedman model for theory of consumption,
noting that the theory does not true for the period 1984-2007 and for the early
twentieth century. He went further to underline the basic flaw of Friedman,
Modigliani, and Brumberg’s model which become the mainstream theory for consumption,
the models devoid of motive and proclivities, whereas in real life human behavior
play an important role in their daily choices and consumption.
In his final chapter Drennan drew attention that this crash has happen before, and in his conclusion, he argue for the need to drop traditional economic theory that did not stood the empirical test from the data. Unless we take into account other element such as ‘behavior’ in our economic theory, we will be chasing unrealistic economic development using unrealistic theory.
