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Econ Book Face Off: The Price of Inequality Vs. House of Debt

In the spirit of my recent diversions from Tech Book Face Offs, I'm going to venture into the domain of economics with an Econ Book Face Off. I don't want to get too far into the field of economics and its ugly cousin, politics, on this blog, but I do think that inequality is one of, if not the major issue of our time, and it's worth spending a post or two talking about it.

We should all be taking a critical look at the state of our economy (this applies to many countries, not only the United States, even thought that is the country I'm focusing on) and how we want it to evolve over the next few decades. Being that our country is a democracy, I truly believe every citizen does have a voice, and together we can make a difference if we raise our voice strongly enough, in spite of all of the corporate money and special interests that are clogging the halls of power. To enact the change that will be most beneficial to all citizens, we need to know what the true issues are, and how to solve them effectively.

Like any software project, reducing inequality requires sharp analysis of context and trade-offs. The evidence is quite clear that inequality has been increasing for decades, and we have reached a point where the top 1% of income earners are bringing in as large of a percentage of total income as they were on the eve of the Great Depression.

Fred the Oyster at commons.wikipedia.org [CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

We've already been through a Great Recession that has caused great hardship for so many people, and the weak recovery has left the bottom 90% of people essentially no better off than they were before the crisis while the wealthy have recovered their losses and then some. To try to better understand what has been happening to the distribution of wealth, what is causing the relentless divergence of income and wealth, and how to make progress in reversing this trend, I did what I always do. I picked out a couple of books to read.

The Price of Inequality front coverVS.House of Debt front cover

The Price of Inequality


Joseph Stiglitz is an excellent writer on economic issues, right up there with the likes of Paul Krugman and Robert Reich in his clear, understandable way of writing about economics so that the average person can easily get everything he's talking about. I thoroughly enjoyed this book because it hits on so many pertinent aspects of the inequality issue we're dealing with in a way that makes sense. In doing so, Stiglitz reveals how complicated inequality is and how there's no silver bullet for fixing it. This book is packed with great analysis and reasoned ideas for making our society more equal and fair without damaging the qualities that define us as a nation of innovators and entrepreneurs.

I can't really do the book justice in one short review, so I'll attempt to hit the most important points that made it resonate so strongly with me. Know that there is a ton more great material than what's represented here. Stiglitz starts off, as all economics books do, by defining the problem we're dealing with, and he puts it in the context of what a desirable economic system should be:
Some individuals will work harder and longer than others, and any well-functioning economic system has to reward them for these efforts. But this book shows that both the magnitude of America's inequality today and the way it is generated actually undermine growth and impair efficiency. Part of the reason for this is that much of America's inequality is the result of market distortions, with incentives directed not at creating new wealth but at taking it from others.
These ideas really set the tone for the book. Fighting inequality is not about trying to redistribute income arbitrarily or waging class warfare. It's about finding ways to eliminate the distortions that are already present in our economy and to make the system more efficient so that everyone who contributes can get their fair share of our national product and technological advancements. If we can do this, then everyone can share in the growth, and better outcomes can be had by all. However, in order to achieve this goal, the wealthy and empowered will have to let go, somewhat. Stiglitz is careful but forthright as he makes his case:
[T]he rich do not exist in a vacuum. They need a functioning society around them to sustain their position and to produce income from their assets. The rich resist taxes, but taxes allow society to make investments that sustain the country's growth. When little money is invested in education, for lack of tax revenues, schools do not produce the bright graduates that companies need to prosper. Taken to its extreme—and this is where we are now—this trend distorts a country and its economy as much as the quick and easy revenues of the extractive industry distort oil- or mineral-rich countries.
In many ways it is in the best interests of the rich to help everyone and make these investments in education to improve the workforce instead of exploiting it for short-term gain. The importance of improving the labor environment in reducing inequality cannot be understated. If there were better support and protections for labor, it would lead to more job loyalty, less churn in employment and the corresponding training costs, and higher productivity, which would create a positive cycle that is beneficial to both the employers and employees. Stiglitz raises the issue of fair treatment of workers numerous times in the book, and he also focuses on the closely related issue of trust:
I have emphasized how the country has to act together, cooperatively, if the country's problems are to be solved. Government is the formal institution through which we act together, collectively, to solve the nation's problems. Inevitably, individuals will differ in their views of what should be done. That's one of the reasons that collective action is so difficult. There needs to be compromise, and compromise has to be based on trust: one group gives in today, in the understanding that another does in another year. There must be trust that all will be treated fairly, and if matters turn out differently from how the proponents of a measure claim it will, there will be change to accommodate the unexpected circumstances.
Here he is talking about trust of the government and democracy, which has been damaged by the catering to special interests and other corrupt practices that permeate our politics. The loss of trust can also be seen in the workforce, reducing worker's loyalty and morale, and it is clearly an issue with how the public now views the financial sector. Banks especially have lost trust by actively destroying it. If any other industry designed products that take advantage of the consumer the way that the banks did, I would imagine those companies would quickly fail, but we seem to be beholden to the banks in ways that don't allow us to let them fail.

People tend to generalize and pick a primary source of failure as either the government or the markets, but the truth is both are susceptible to corruption and failure. Both are also capable of working efficiently and fairly when set up well. The natural reaction when things don't work well, and instead look broken, is to throw up your hands in frustration and throw out the trash, but that doesn't fix anything. Something is going to fill the void left by crippled government or over-regulated corporations, and the public is going to have less control over it than what they have now. Neither the government nor private companies will ever be perfect, but we should always work to make them better instead of blindly trying to make them smaller.

Stiglitz takes a pleasantly rational and balanced approach to the problem of rising inequality, and the ways that we can work to fix it through the channels of our government and private business. He ends with a chapter collecting and summarizing all of the various ways we can attack the problem from his discussions throughout the book. The solutions range from broad economic solutions of market fairness, tax reform, education, and public investment to immediate labor market improvements and household debt relief to political reform in campaign finance, voting, and media coverage. He elegantly addresses a huge, complex economic problem with an appropriately broad, multifaceted set of solutions. I highly recommend The Price of Inequality to get a real sense of what's at stake with this issue of inequality that affects us all.

House of Debt


Whereas The Price of Inequality covered the full gamut of issues surrounding inequality, House of Debt, by Atif Mian and Amir Sufi, takes a different approach. The focus was squarely on the housing crisis of the Great Recession and how the out-of-control lending and run-up of private debt before the crisis resulted in a severe, protracted recession that left our country even more divided than before the recession began. While the Great Recession cannot possibly explain the trend in inequality that has been going on for decades, it is a major contributor to our current predicament and is indicative of the larger issue of how the rich get richer and the poor get poorer.

The authors start out by clearly explaining how the benefits and risks of mortgage debt can be very asymmetric for the lender and borrower. Under most circumstances, the lender has a very safe income stream for the money they lent, backed by an asset that in normal times is very unlikely to lose value. In contrast, the borrower must pay interest on the money they borrowed while taking on most of the risk if the asset loses value. The borrower's equity is the junior share of the investment, so the borrower will lose everything before the lender will lose anything. If the borrower doesn't walk away in the event of going underwater on the mortgage, they end up losing more than they invested while the lender doesn't lose a thing.

The housing bubble was fueled by the lending boom, and the authors did a great job of showing empirically why this was the case. The consequences of this lending are well-known:
Eager to create and sell profitable securities, lenders extended credit to so many marginal borrowers that they reached a point at which they lent to borrowers so credit-unworthy that they defaulted almost immediately after the loan originated. Once the defaults began to rise, the entire game unraveled, and levered losses kicked in.
Much of the sub-prime lending can be explained by rising inequality. As the rich got richer and were looking for more investments for their growing wealth, sub-prime lending increased to meet the demand. The authors remind us that:
We are more than willing to blame "irresponsible home owners" who stretched to buy houses. But the house-buying binge was only possible given the aggressive lending behavior by banks. 
They go through an explanation of how debt is a necessary catalyst for inflating asset price bubbles, using a thought experiment of a set of optimists who will buy assets at a higher price because they believe the assets will increase in value, and a set of pessimists who enable the optimists by lending the money needed to buy the assets at the higher price. Even though the pessimists don't believe the assets are worth the higher price, they lend the money to the optimists because they believe the loans are safe. Without the pessimists lending money, the optimists couldn't inflate the bubble.

When the bubble finally bursts, the optimists lose their equity, but the pessimists still have their loans that they feel they deserve to collect. The pessimists did take some of the risk in loaning money, though, so they should share in some of the downside as well. There is precedent for this idea of lenders sharing the downside risk, and the authors relate some policy choices that occurred in the aftermath of the Great Depression:
When the United States went off the gold standard in 1933, the dollar was worth far less in gold than it had been. As a result, creditors all wanted to be paid the original amount back in gold. But the gold clause in debt contracts was abrogated by Congress. This meant borrowers could pay back in dollars that were worth far less in real terms than what they had borrowed. …

Interestingly, the effects of the gold-clause abrogation were quite positive for both borrowers and lenders. As Kroszner demonstrates, both equity prices and bond prices rose when the Supreme Court upheld the congressional action. In other words, debt forgiveness actually made creditors better off. It is likely that we would have reached a similar outcome during the Great Recession had the government more aggressively facilitated the restructuring of household debt. [emphasis theirs]
They argue convincingly that it is not necessary that wealthy creditors get bailed out while struggling debtors are left under a mountain of debt. They also focus on the best ways to share the downside of a financial crisis equally between creditors and debtors, and why other policies, even fiscal policies, don't work quite as well:
[T]he most effective fiscal stimulus would be one in which the government taxes creditors and provides the funds to debtors. But why do we need fiscal stimulus? Mortgage cram-downs in bankruptcy, for example, would accomplish the same goal without getting taxation involved.

Fiscal policy is an attempt to replicate debt restructuring, but it is particularly problematic in the United States, where government revenue is raised from taxing income, not wealth. The creditors whom the government should tax tend to be the wealthiest people in the economy, which is why they are able to lend to borrowers.
The household debt problem has been a major driving force for rising inequality, and House of Debt is a great book that shows why it's a problem, how it works to enrich creditors at the expense of debtors, and what we can do to make the system more fair, more stable, and more efficient. It's another book on inequality that I highly recommend.

Reducing Inequality


The Price of Inequality is a great book for getting a broad view of inequality, its problems, and possible solutions. It covers most aspects of the issue, and Stiglitz is an effective and eloquent writer. House of Debt takes a more focused look at one major component of inequality, household debt, and what we can do to fix it. Mian and Sufi write clearly and thoroughly about the various arguments and concerns surrounding this sensitive topic. Both books were excellent at what they tried to accomplish.

There are certainly many other books on inequality that I could have read. In particular, why didn't I read Thomas Piketty's Capital in the Twenty-First Century? I would like to, and from what I hear, it's exceptionally well researched and bound to be a classic economic work. But honestly, I'm a bit intimidated by it, and I believe these two books, especially House of Debt, are much more approachable for the casual but concerned reader.

It's important to spread the knowledge about how serious a problem inequality is becoming. It creates a destructive cycle of unemployment and poverty leading to depression and helplessness, which leads to poor education and crime, which leads to more unemployment and poverty. It's a very hard cycle to break once it becomes rooted in a society. I think the public is waking up to these issues and starting to pay attention.

Once enough people are paying attention, we need to decide what we want the future to look like. Do we envision having a desperate underclass that struggles to survive and a disconnected wealthy class that misleads and exploits the masses, or do we want a future where everyone benefits from our technological advancements and leads healthy, happy lives with fulfilling work and enjoyable leisure? I believe the latter is entirely possible, if we decide that's what we want, and we do what it takes to get there.