Modeling Sunshine and Shadows: Inequality, long hours and crisis

Tom Walker
(aka Sandwichman at Ecological Headstand)

Modeling Sunshine and Shadows: Inequality, long hours and crisis

Alex Harrowell at A Fistful of Euros sees sunshine beaming from the IMF in a working paper by Michael Kumhof and Romain Rancière that identifies income inequality as a potential source of financial crisis. No shit, Sherlock! Outside of the formal modeling, the proposition hardly sounds remarkable.

As goldilocksisableachblonde noted on Mark Thoma’s site, “This finding is consistent with intuition and common sense , meaning – according to mainstream economic theory backed by models and more models – it’s gotta be wrong.” Kumhof and Rancière themselves note that “the link between income inequality, household indebtedness and crises has been recently discussed…” but they object that the authors “do not make a formally consistent case for that argument.” What they mean by not “formally consistent” is presumably not using a dynamic stochastic general equilibrium (DSGE) model such as they employ. I would like to see K&R try that argument in court.

“Your honor, sir, I object, the videotape of my client breaking open the ATM with a sledgehammer is not a DSGE model and thus is not formally consistent as evidence.”

“Objection overruled.”

But it is well that K&R build their formally consistent model to demonstrate that possibility of something happening, which the rest of us can observe with our naked eyes. This will keep other formally-consistent DSGE model builders busy tinkering with assumptions until they can explain the findings away. I betcha Lee Ohanian could come up with a doozy — and it would get more media!

Anyway, where there is sunshine, there are bound to be shadows and the Sandwichman couldn’t resist the temptation of scouring the working paper for some shade. And here it is:

“Finally, the addition of a shock to workers’ labor supply would help to address an important issue raised by Reich (2010), who emphasizes that in the United States households faced with higher income inequality have employed two other important coping mechanism apart from higher borrowing, namely higher female labor force participation and longer hours. This allowed them to replace some of the lost income, and therefore to limit the amount of additional borrowing.”

Now I haven’t read Bob Reich’s new book but I did the next best thing. I saw him talk about it at a book tour event in Point Reyes Station in October. Reich’s argument is that 1. incomes have stagnated since the early 1980s 2. the first response of households was to increase hours supplied to the labor market to maintain purchasing power but when that strategy ran up against its limit, 3. households began to borrow aggressively. I think Reich has the ingredients right but they’re in the wrong chronological order. That can be crucial when you’re baking a cake or explaining history. Long before incomes began to stagnate, hours of work ceased a century long trend of decline, a trend that BLS economist Joseph Zeisel had called “one of the most persistent and significant trends in the American economy in the past century.”

Not to put too blunt a point on it, Americans suddenly stopped taking part of the gains of technology in the form of leisure. It’s not as if they “just decided” to do this, either. There were all sorts of structural changes in the U.S. labor market that broke the trend. Just to name a few, there was the abandonment of the shorter hours employment strategy by organized labor in favor of promoting economic growth fueled by government spending, there was the explosion of per-employee benefits (quasi-fixed costs) as a proportion of total compensation and there was the FLSA provisions themselves which, in effect, were a double-edged sword with regard to the incentive of overtime pay.

From a long-term historical perspective, hours of work stagnated before wages did. I’m well aware of the post hoc propter hoc fallacy. Just because the hours stagnation came first, doesn’t necessarily mean it caused the wage stagnation. On the other hand, there is a sufficient body of theory suggesting that just such a causal chain is likely.

Ira Steward articulated this theory in the 1860s. Marx also presented a theoretical explanation linking technological advance, immiseration of workers and economic crisis. Sydney J. Chapman confirmed the basis of Steward’s and Marx’s theories but within a neo-classical framework. Dorothy W. Douglas reviewed Steward’s theory during the Depression judged it to be rich in explanatory power, institutionally speaking.

More recently Keynes and Luigi Pasinetti advanced theories that none of the formally-consistent model builders have sought to confirm or refute. Instead, the formally-consistent model builders busied themselves refuting a theory that didn’t exist — that “the amount of work to be done was a fixed quantity.” Not surprisingly, they succeeded in refuting that faux fallacy (in a formally-consistent manner, of course) and figured that was all they needed to do. Steward, Marx, Chapman, Keynes and Pasinetti be damned!

Don’t get me wrong. I think formally modeling realistic assumptions is a huge step forward from formally modeling laughable ones. I’m just not sure I (or the unemployed) can wait another sixty years or so for economists to get around to building a formally-consistent model that reflects the powerful explanatory theories the formal modelers have ignored for the last sixty years.