Inequality and Institutions

In economics circles, MIT economist Frank Levy is associated with the view that rising inequality is largely driven by "skills-biased technical change", but in a new working paper with Peter Temin he develops a much more sophisticated theory of inequality in the United States in the last half of the 20th century that points to a larger set of economic institutions, including collective bargaining, employment standards, and tax policy.

We provide a comprehensive view of widening income inequality in the United States contrasting conditions since 1980 with those in earlier postwar years. We argue that the income distribution in each period was strongly shaped by a set of economic institutions. The early postwar years were dominated by unions, a negotiating framework set in the Treaty of Detroit, progressive taxes, and a high minimum wage - all parts of a general government effort to broadly distribute the gains from growth. More recent years have been characterized by reversals in all these dimensions in an institutional pattern known as the Washington Consensus. Other explanations for income disparities including skill-biased technical change and international trade are seen as factors operating within this broader institutional story.

Levy and Temin summarize their case in a piece at voxeu.org:

....

... we argue that technology and trade’s impacts are embedded in a larger institutional story. We argue that the current trend toward greater inequality in America is primarily the result of a change in economic policy that took place in the late 1970s and early 1980s. The stability in income equality where wages rose with national productivity for a generation after the Second World War was the result of policies that began in the Great Depression with the New Deal and were amplified by both public and private actions after the war. This stability was not the result of a natural economy; it was the result of policies designed to promote it. We have termed this set of policies the Treaty of Detroit, after the most famous labour–management agreement of the postwar years.

This agreement was replaced in the 1980s (and surrounding years) by another set of institutional arrangements which we call the Washinton Consensus. These new policies also originated in a time of economic distress, albeit nowhere near the distress of the 1930s. In a process similar to the experience of the Great Depression, policy-makers – unable to comprehend the macroeconomic causes of distress – instituted microeconomic changes in an attempt to ameliorate the macroeconomic problems. In both cases, the measures taken were only partially successful, and recovery came from diverse influences. The microeconomic changes, however, had durable impacts on the distribution of economic production.

....

The elements of the Washinton Consensus were adopted in the name of improving economic efficiency. But there is growing recognition that the current free-market income distribution – the combination of large inequalities and stagnant wages for many workers – creates its own “soft” inefficiencies as people become disenchanted with existing economic arrangements. People suffering from stagnant incomes —both here and in some similar countries—have begun to protest. Our analysis suggests that the trends in the distribution derive in part from the shift from one complex set of policies to another—from the Treaty of Detroit to the Washinton Concensus. There is no single determinant, whether education, minimum wage, capital or labour mobility, that determines the path of income distribution. Any specific measure therefore can alleviate the distress of some people, but it cannot change the overall distributional trends shown in our graphs.

The last six years of U.S. federal tax history have involved an inhospitable politics in which winners have used their political power to expand their winnings. But political sentiment does shift. Economic distress like that of the 1930s can induce such a shift. Even the smaller economic distress of the 1970s was enough to redirect American economic policy. Only time will tell if more economic distress is needed to change policy yet again.