Q: How do you think about economic inequality and whether it leads to risks in people’s lives? Jacob Hacker:
I think that inequality and risk are very closely related. In this current recession, we’ve seen that growing inequality, with the very top pulling away from the rest of society, has been closely associated with increased risks in the financial markets. Research over the last few years has shown that when you have very large gains at the top, you get a lot of money sloshing around that is used for speculative financial transactions. At the same time, because you didn’t get strong growth in income in the middle, you also saw a lot of extension of credit to middle-class Americans, particularly in the housing market. And those two trends came together in this perfect financial storm in the late 2000s.
Right now the real economy still seems to be trapped under the debris of the financial crisis, but Wall Street is coming back. Corporate profits are back up. Many Americans are looking at this experience and they may not think in terms of risk and inequality, per se, but their lived experience is about the risk they faced over the last generation and especially over the last few years, and the inequality that they see in the aftermath of this downturn.Robert Shiller:
I think that Americans are more concerned with injustice than inequality. I thought that one of the most interesting things in your book, Winner Take All Politics, with Paul Pierson, was how you highlighted elements of injustice that we see in the increasing inequality. Notably you described what you called a “30 Years War,” where the corporate interests were improving their lobbying and efforts to influence Congress and changing a lot of regulations and tax rules and the like to increase their share of the national income. Americans, when they see this, are going to be angry about it, because it seems unfair and unproductive.Hacker:
I think that there is also a very deep connection between what’s happening in this economic crisis and your writings on risk. If you think about the kinds of risk that are hitting people—unemployment risk, the loss of housing wealth, or the loss of housing altogether, medical costs—those are all areas where we’ve seen major problems in the markets to deal with economic risks.
It’s true that a lot of the changes over the last 30 years were pushed for by corporate interests, but they were often justified with a rosy view of the ability of financial markets to innovate and deal with these risks through private means. I know that you have a positive view of private means in dealing with these risks. But when I read Irrational Exuberance and other books, I really get a sense that there are a lot of behavioral biases in financial markets, and there are probably political biases as well, that are going to make it hard to deal with these risks without some major leadership—either public or private.
The real challenge we face now is, how do we get ordinary, middle-class Americans feeling confident again about how the whole system works? People feel like they’re facing a lot of risks while those who helped bring on this crisis are not facing the same consequences—it’s kind of a “heads I win, tails you lose” economy for the financial sector.Shiller:
The Dodd-Frank Wall Street Reform and Consumer Protection Act preamble says that this act is going to end “too big to fail.” There’s already a political movement toward trying to improve that situation. Though it’s not clear how effective Dodd-Frank will be, I think that there is a political groundswell supporting doing something to make our financial institutions more responsible and improve the risk management that we have. I think we have to keep pushing to make more of this happen.Q: What are the risks that really make a difference in people’s lives and how well are they addressed by the political system and the financial system?
I have a team of researchers working with me on a project called the Economic Security Index. We did a survey of a representative sample of Americans in 2009, right in the midst of the downturn. For those surveyed, the most important risk, it seemed, was job insecurity. Unemployment or loss of hours and wages just looms very large in people’s thinking. But there were three other risks that were extremely important: healthcare, specifically the cost of healthcare; retirement, which is a widespread concern, though Americans at the same time feel like it’s the most preventable problem; and the third thing that came up was that people are very concerned about wealth losses, about housing and asset losses. If you boil it down, people worry about those risks that affect their ability to maintain their current standard of living.
Given the way that the downturn has played out, with both historically unprecedented housing market declines and a major spike in unemployment, you can see how this has been devastating to so many people.
This is partly a macroeconomic problem. Unfortunately, we’re stymied about solving that. It’s intertwined with this inequality issue, because the idea of stimulating the economy makes people think that it will be done unfairly. They become very concerned that Congress will funnel projects to favored people. And the sense that the U.S. is building up a national debt in an effort to stimulate the economy has created a huge backlash and that is a very serious problem right now. There’s just a sense of anger at Washington. It’s thought to be captive to special interests. And so there’s just a disinclination to let Washington do anything. So we can’t solve any problems very effectively, right now.Hacker:
One poll sticks in my mind: the Pew Research Center did a poll back in 2010 where they asked people whether the federal government had helped a number of different groups a great deal. When they asked about large banks and Wall Street, 53% of Americans said those groups had been helped by the federal government a great deal. When they asked about large corporations, 44% said they’d been helped a great deal. But when they asked about the middle class, only 2% said that it had been helped a great deal.
One thing that has become very clear to me over the last few years is just how deep this trust problem goes, and how much it corrodes faith in any large-scale institutional or leadership response to the challenges we face. The initial response to the downturn was a fairly comprehensive set of measures to try to deal with some of these risks. We had the passage of financial reform in 2010. We had the passage of a healthcare reform bill. We had the so-called stimulus measure that many believe was inadequate but which was a huge attempt to boost the economy. But, fairly or unfairly, many Americans don’t think that the government actually did a whole lot to help them deal with the economic risks that matter to them. I fear that we’re at a kind of crossroads in dealing with a lot of these challenges, because you really do have to have some shared faith in government—or at least in a kind of minimal role for policy—to deal with these challenges.
We have something like 15 million homeowners underwater on their mortgages, meaning they owe more on their mortgages than their homes are worth. Nothing is being done for them.Hacker:
Clearly the administration’s mortgage modification program has done virtually nothing. What do you think should be done?Shiller:
In 1933, we created the Home Owners’ Loan Corporation, HOLC, and they gave loan modifications to about 20 percent of the nation’s mortgages. And it stopped falling home prices. We could have done something more aggressive.
Q: How does inequality affect the economy more broadly? Does it have an effect on innovation, entrepreneurship, growth?
The way to think about both inequality and risk is that there is a sort of upside-down U-shaped relationship between those phenomena and positive outcomes. A certain level of inequality, a certain level of risk, can have positive effects, motivating people. But at a certain point it becomes counterproductive.
For instance, you mentioned entrepreneurship and growth, and a major reason I am worried about high levels of inequality is that there are a lot of people who do not have the resources necessary to really break into the upper tier and fund new ideas. You also might worry that when inequality is too great, you’re getting hoarding of resources at the top, and credit markets perhaps aren’t working to make sure that the finances are available for the broad economy.
I would just say one last thing about risk. There’s less research here, but my read of what’s been done is that when people face a lot of individual risk that they can’t insure against through the private market or through public means, it can be very debilitating to their ability to make investments necessary for long-term growth, whether in education, whether in small businesses, whether in other opportunity-enhancing interventions. You want to have opportunities and risks in a society that allow people to rise up the income ladder, but you want to make sure that there also are some basic protections in place that mean that people feel comfortable making those investments that have broad benefits.Shiller:
I think it’s worthwhile to think about what kind of inequality we mean. Deng Xiaoping once said, when asked about inequality in China, “Well, somebody has to get rich first.”
In the transition we see in China today, there’s a lot of inequality. But it’s not so much a setback for the rest of China. The rest of China is growing too. And there’s a perception among many Chinese that “We’re getting better, and my children or grandchildren will live like people in advanced countries.” As long as they feel that they have a government that wants them to succeed, that kind of inequality isn’t bad.
But turning back to this country, the problem arises when people sense that wealth was gotten unfairly. For example, people get upset when someone makes money trading, and it doesn’t seem like a productive activity. But I was looking at the Forbes 400 list of the richest people in America, and a lot of the people on there made their money themselves, and not many of them were in hedge funds. They were running some kind of business. They were making toilet paper. They were making shoes or something. And I don’t know that Americans mind so much that there’s somebody out there with a huge shoe company. Let them make money.Maybe there is an optimal level of inequality. I think we should have rich people. I think the guy who devotes his whole life to building a toilet paper manufacturing business and hits it big, and we like his product, it’s okay if that guy has five houses and three yachts. Why else would he do all that?
We know from recent research on income using tax records that about 60 percent of those in the top one-tenth of one percent, so the richest 100,000 taxpayers, are either financial executives or nonfinancial executives. Interestingly, within that group, it’s about a 2-to-1 ratio in favor of nonfinancial executives. These are company CEOs and the most highly paid executives.
Nonetheless, I think that people are worried about the financial world, in part, because they see negative spillover effects. They see negative externalities, to use the economists’ term, in the kind of behavior that seems to have been incentivized in the financial world. And the other side of it, I would say, is that right now we have historically very low levels of average effective taxes for those at the very top. I think the top 400 taxpayers paid an average federal income tax rate in 2007 of around 16%. And that’s down from 30% in 1995 and from around 40% in the 1960s. What are the obligations of people who do well in this system?Shiller:
This is where the sense of injustice comes in.Hacker:
Right. While I agree with you that people might not work as hard to build their shoe companies if they didn’t have the ability to have their five houses or at least four houses…Shiller:
Maybe four is enough.Hacker:
I’m not sure that having a slightly higher marginal tax put on their last dollar would make a huge difference.Shiller:
That’s exactly right.Hacker:
And moreover I think we should all understand that there are enormous basic investments that society needs to finance. How do we have a more entrepreneurial economy, going forward? Well, part of it is making sure that we have kids who are going to college, that we have good math and science education, that we have in place basic infrastructure. Having a society that invests in research and education and infrastructure and good energy models is a huge benefit for everyone. If all the resources are being held by a few people at the top, those investments might not happen.Shiller:
The puzzle to me is, why does anyone disagree with this?Hacker:
If you look at the most conservative part of the Republican Party today that’s often identified with the Tea Party movement, it denies that there is this positive role for government and it really feels that government has a reverse Midas touch, that all spending is wasted. The debates over the economy and the role of government have become deeply polarized, to the point that it’s hard to have a conversation, let alone get anything done.Q: Where does the idea of a reverse Midas Touch come from?
Most people’s thinking about this reverse Midas Touch is probably based on a lot of historical stories. The 20th century was a story of the rise of central planning in communist countries. The communist countries were set up as solving the very problems we just described—no inequality, the public shared in everything, no unfairness. And look what happened. Everyone who lived in those countries was trying to escape. They had to put a wall around them to prevent people from escaping. This story is very vivid.
In the 1940s, Friedrich von Hayek wrote a famous book called The Road to Serfdom, and he argued that there is a collectivist view of the world, embodied not only by the communists but also by the fascists, and this view emphasized the government solving problems. Hayek said this led to a kind of serf mentality. When the government is doing everything, you end up just sucking up to the government. That is a trend that people began to worry about.
The Soviet Union is no longer, but it still spooks us. I think people are right not to just assume that the benevolent government is going to fix everything. But I also think it’s logical for the government to worry about public goods and infrastructure and education and all these important things. And yet people want to dismantle that. I think there’s a deep reaction to historical experience and the rhetoric around the idea of big government.Hacker:
In fact, we’re very far away from that kind of big government. Even at this period of deep downturn, where our government is spending a lot more on unemployment benefits and food stamps than it has in the past, our government spending represents a quarter of our economy, which is well below most other advanced industrial economies.
Again we’re coming to this sense that people have that politics isn’t working. But if you look at the challenges that we face, the solutions to many of them run through American politics. That’s a very rocky road right now.
Q: Can you talk about some of the solutions you see out there?
I’d like to hope we could find common ground in two areas. One is just figuring out a way to get the job market moving again. A lot of that rests on private confidence and behavior, but what distinguishes this recovery from the recovery of the early 2000s isn’t the level of private hiring, it’s actually the fact that there are also big layoffs in the public sector this time. Large layoffs in the public sector seem completely counterproductive, as opposed to, say, restructuring pension or health plans, which is something that may be necessary in many cases to make public sector jobs more affordable. The other area where I think we could really focus our energies in the long term is trying to get our tax code in shape. We have a tax code that is perversely bad at almost everything it tries to do. It’s not particularly investment-friendly in many areas. It seems progressive, but there are so many loopholes and deductions and credits that you have very low effective tax rates on many high-income taxpayers. And there’s a lot of what economists call horizontal inequity—that is, treatment of people with similar incomes quite differently.Q: Bob, can you describe some of the ideas you’ve proposed for a market-based approach to inequality and risk?
Financial theory is about risk management. And risk management ought to reduce inequality. That’s the idea, right? If you effectively pool the risks, then the random shocks that affect people differently will go down.
I’m particularly interested in risk management tools that democratize risk management, that bring it to the ordinary risks that everyone faces, like the risk of a family member dying. That’s a huge financial risk for a family. We have life insurance. And the government has stepped in with survivors insurance and disability insurance. These are really important. We didn’t have them hundreds of years ago. Great personal tragedies have disappeared because of improvements in both private insurance and government social insurance.
But we still have a lot of risks that remain. I think that the next century will see more progress. Among the remaining risks that are not managed is a kind of lifetime well-being index. We have no way of protecting ourselves from the exigencies of the labor market. People get laid off when they reach middle age and then they are washed up for life. They don’t have any way to protect themselves against some turn that made their particular skill set obsolete. We’ve seen homes decline in value and really hurt many people. People leverage themselves up, and then they don’t have any equity at all when their home price falls, and they end up desperate.
In future decades, we could, first of all, have home insurance against home price declines. We could have new kinds of mortgages that would protect homeowners against that kind of exigency, which is not their fault at all. The mortgage could have an automatic workout attached to it. We could also have insurance against occupational income shifts. These would protect people against things that keep them up at night now.Hacker:
You’re right that those hundreds of years of developments in risk management lead one to think that further changes will diversify and democratize risk in important ways. And yet I do think the last 25 years or so have witnessed the shift of a lot of risk onto Americans’ shoulders. I hope that’s just a temporary departure from a longer-term trend.
So, yes, I think we should develop new and flexible responses to risk of the sort you described. I would just add two broad ideas to your list. One is to think about ways to delink so many risks from employment. Having health insurance and retirement pensions closely tied to work has real risks for people. It makes the kind of occupational risk that you talked about even more severe.
My other point, which is really a part of a debate that has been going on for the last 200 years in America about the size and role of government, would be that government has some really unique tools for diversifying and managing risks. Perhaps the most important is the ability of government to compel people to have certain kinds of insurance. One nice thing about home price insurance, and I like the idea very much, is that, if you want to buy a home, the mortgage lender will make it a condition for getting a mortgage. But there are other risks, like disability, for which it’s harder to think of who but government would make you engage in this kind of prudent planning. In many cases, to leverage the full power of private markets, there will have to be the shadow of government behind these insurance policies and products. You’re going to need to have that encouragement for people to have protection against certain basic contingencies that can impinge so deeply on their ability to have productive and happy lives. I know there’s a lot of debate about this. It’s the central issue in the healthcare fight. But it’s something I believe very strongly has to happen.Shiller:
The fundamental problem is that some people are capable of managing their health insurance policies, or whatever kinds of policies, better than others. And some people won’t do the obviously right thing. And then, as a society, we feel responsible for them. This is a difficult problem for financial theorists to work out—how to include everybody in our society.Interview conducted and edited by Jonathan T.F. Weisberg.
[This article has been reproduced with permission from Qn, a publication of the Yale School of Management http://qn.som.yale.edu]