That’s the thesis Mark Thoma puts forth in this article at the Fiscal Times.

There is an equivalent of a Laffer curve for inequality, but the variable of interest is economic growth rather than tax revenue. We know that a society with perfect equality does not grow at the fastest possible rate. When everyone gets an equal share of income, people lose the incentive to try and get ahead of others. We also know that a society where one person has almost everything while everyone else struggles to survive – the most unequal distribution of income imaginable – will not grow at the fastest possible rate either. Thus, the growth-maximizing level of inequality must lie somewhere between these two extremes.

We may be near or even past the level of inequality where growth begins falling. The evidence on this is highly uncertain, so it’s difficult to say. But a few more decades like the last few could make the difference, so why take a chance? I’d prefer to see policies implemented to reduce inequality – given the present, elevated level of inequality, a reduction is unlikely to have much of an impact on incentives. But at a minimum we should resist further increases. This will reduce the chance of crossing over the point where growth starts to diminish rapidly, and it also reduces the chance that we will surpass the point where inequality causes cracks in the social structure.

Thoma concludes that this inequality is a result primarily of what most people call globalization. The basic argument is that competition from cheap labor abroad holds down US wages. The only way to correct this wage stagnation, according to Mr. Thoma, is redistribution. Take the excess income from the wealthy and pass it along to the middle and lower classes where it would have accrued absent the globalization of labor.

If we want to preserve a growing and socially healthy economy, and avoid moving to lower growth points on the inequality curve, then we will need to do much more redistribution of income than we have done over the last several decades. We must ensure that the rising economic tide lifts all boats, not just the yachts. That means the wealthy will no longer get it all, they will be asked to share economic growth with the workers who helped to bring it about, workers who ought to be rewarded for their growing productivity.

I agree with Mr. Thoma that income and wealth inequality has increased since the 1970s but it isn’t the open and shut case it first appears by any means. For instance, it is noteworthy that Mr. Thoma chooses to exclude fringe benefits for if they are included the argument isn’t nearly as persuasive. One could argue that the larger share of compensation that is now dedicated to, for instance health care, is a result of previous government interventions – attempts at redistribution one might call them – that have raised the cost of those fringe benefits. One could also argue that the well being of the average middle class or poor person has improved greatly since the 1970s – the poor have air conditioning, color and cable tv, etc. – and come to the conclusion that quality of life has improved so much that increased inequality was a price well worth paying. Nevertheless, after following this debate for many years, I find these arguments and others offered by those right of center politically – and make no mistake, this is a political debate – tend to come up short. The fact remains that the top 1% have seen their cash incomes increase at a much faster rate than those below that level. They also now capture a much larger percentage of total income than in previous generations and control a greater percentage of total wealth.

I also agree that there are negative economic consequences to increased inequality. Indeed, if anything, I probably believe the economic consequences are more severe than does Mr. Thoma. Economists have long known that existing firms are not generally cheerleaders for free markets and open competition. Incumbent firms have little reason to endorse economic policies that support the creation of new competition. These firms are happy to maximize their own profits and often use their political access and influence to thwart new competitors. For instance, they might embrace relatively harsh regulatory regimes that raise significant barriers to entry for new competitors. Wealth concentration and income inequality give these incumbent firms and the individuals who run them the means to attain political power and influence to protect their position from new competitors. It is easier and cheaper to strangle competition in the crib than to win in the open market. It is advantageous from the viewpoint of upper management to have competition handicapped by costs imposed by political fiat than to sacrifice excessive executive compensation and perks for the good of lower level employees or the bottom line. The preservation of wealth, income and perks becomes more important than new wealth creation.

Wealth inequality reduces the dynamism of the economy as the entrenched incumbent firms and their political cronies act in concert to preserve the status quo rather than encourage the creative destruction that marks highly innovative economies. This can most readily be seen in the recent financial crisis where the large incumbent financial firms were deemed too large to fail while smaller firms were left to market forces. There were many firms that did not participate in the bad lending practices of the mid ’00s – Beal Bank is but one example – that stood to benefit greatly from the failure of less well managed firms, large and small. In this manner, poorly managed firms – Citigroup comes to mind – would have been purged and better managed ones would have acquired their market share. Because this wasn’t allowed to happen, we are left with a financial sector that is more concentrated and less dynamic than it could be. This has consequences across the entire economy. This less dynamic financial sector is now more conservative and less likely to lend to new firms. Some, such as Scott Sumner here, have argued that the financial sector deserves to capture a greater share of profits but having just witnessed this blatant political favoritism of large firms for no reason other than size and political connections, I find these arguments unpersuasive. I suspect the vast majority of Americans do as well.

As Thoma points out, a number of explanations have been offered for the increase in inequality over the last four decades. Education is an obvious one and there is ample evidence that it plays a large role. The unemployment rate for those with at least a bachelor’s degree is just 5.1% while the rate for those with just a high school diploma is almost double that at 10%. Thoma apparently favors the excess labor argument that seems so appealing despite the fact that wages are only one consideration when it comes to where work will be sited and what wage workers will be paid. With much higher productivity and a fairly robust rule of law the US still enjoys some significant advantages in the world. A lower corporate tax rate, which the Obama administration is apparently seriously considering, might make the US even more attractive. Other explanations for the rise in inequality have also been offered, most notably the reduction in top marginal tax rates that started under the Reagan administration.

I don’t disagree with Thoma and so many others that there are multiple explanations for the rise in inequality. I do disagree somewhat about our ability to correct some of them. Thoma says, for instance, that since education has resisted successful reform for so long that it is basically impossible. That seems to be nothing more than a surrender to the teacher’s unions who have been the most obvious obstacle to reforms that have been successful in other countries. Uprooting the status quo in the education industry may be hard but it isn’t impossible. Thoma certainly has a point that it would take time to make a difference but surely we shouldn’t just give up. Top marginal tax rates have also risen since their nadir with the 1986 tax reform act and while I don’t believe we are to the right of the maximum point on the Laffer curve, neither do I perceive that we can expect a significant reduction in inequality by raising them much further than current levels. Rates were much higher when the rise in inequality started in the early to mid 1970s. If higher rates didn’t prevent the rise in inequality why should we expect it to reverse the trend?

I tend to think of factors such as government spending, tax rates and especially globalization as less important issues in the inequality debate. To be sure these factors have an effect on inequality; there is ample research to support that thesis. Education would seem though to be a much more important factor and research – and plain common sense – tends to support this idea. And yet there seems to be something missing; these factors don’t seem to me to fit the time line of rising inequality. Thoma’s article, like almost every other one on the subject, starts with this statement of fact:

From the end of World War II until the 1970s, the growing prosperity in the US was widely shared across income groups. However since the 1970s, households at the lower end of the income distribution have experienced income stagnation – “real average hourly earnings (excluding fringe benefits) now stand roughly at 1974 levels” – while those at the top of the distribution have continued to do quite well. (emphasis added)

How can so many smart economists, from Paul Krugman to Mark Thoma, write that sentence or one very similar and not ask the obvious question? What changed? Was there any major macro economic policy that was in place from the end of WW II until the 1970s and then changed dramatically? Was there a change in some major macro economic policy in the 1970s that could have affected equality of income and wealth in such a dramatic fashion? Why did inequality start rising so rapidly even before the election of Ronald Reagan? Why did it start rising before the top tax rates were reduced and before the adoption of freer trade (globalization)? NAFTA wasn’t enacted until the early 1990s long after the rising inequality trend was well established. Did education change that radically in the mid 1970s that it produced this step change in the rate of redistribution up the income and wealth scale? It seems unlikely.

Of course anyone with even a vague sense of economic history knows what changed. From the end of WW II until 1971 the world worked within the confines of the Bretton Woods currency system where the dollar was pegged to gold and the other major currencies were pegged to the dollar. The result was a very stable system where the currency volatility of today was not allowed. Inflation was low and stable. Commodity prices and interest rates fluctuated within much smaller ranges than today – standard deviation of commodity prices was half what it is today. And, importantly, there is ample empirical evidence that the monetary inflation that followed our abandonment of this stable currency system is a direct cause of the rise in inequality over subsequent decades.

Indeed, the assertion that inflation (the term monetary inflation refers to a rise in the money supply which until the 20th century was the accepted definition of inflation) exacerbates inequality is a very old concept in economics and philosophy. David Hume writing in the 1700s said:

When any quantity of money is imported into a nation, it is not at first dispersed into many hands but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver which they sent to Cadiz. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment. (emphasis added)

The Austrian school of economics is most closely associated with the idea of inflation and inequality with both Ludwig von Mises and Murray Rothbard writing on the subject. In Human Action, von Mises said:

Let’s assume that the government issues an additional quantity of paper money. The government plans either to buy commodities and services or to repay debts incurred or to pay interest on such debts….The prices of some commoditiesviz., of those the government buys-rise immediately, while those of other commodities remain unaltered for the time being. But the process goes on. Those selling the commodities asked for by the government are now themselves in a position to buy more than they used previously…. Thus the boom spreads…. [and] the rise in prices is thus not synchronous for the various commodities and services…. [T]here are people who are in the unhappy situation of selling commodities and services whose prices have not yet risen or not in the same degree as the prices of the goods they must buy for their consumption. (emphasis added)

Rothbard equated the Federal Reserve’s printing of money to counterfeiting and disputes Milton Friedman’s helicopter theory (which Ben Bernanke has echoed):

It would be difficult to see the point of counterfeiting if each person is to receive the new money proportionally. In real life, then, the very point of counterfeiting is to constitute a process, a process of transmitting new money from one pocket to another, and not the result of a magical and equiproportionate expansion of money in everyone’s pocket simultaneously. (emphasis added)

It is relatively simple and intuitive to make the connection between Fed policy and wealth inequality. Whether through open market operations or direct lending through the discount window the first recipients of newly created money are the banks in the Fed system. These banks can then lend out those funds while keeping only fractional reserves. Given that the banks, particularly today, want to limit their risk exposure, this newly created money is first lent to their most creditworthy customers. In addition, the amount one can borrow is obviously a direct function of one’s already existing net worth so it is the “wealthy” who are able to borrow these newly created funds first and at the lowest rate of interest. There are other means by which inflation tends to benefit the wealthy as well but this is the most direct route.

It should also be obvious that the wealthy are better able to cope with the volatility associated with floating exchange rates. Wealthier individuals tend to own assets which benefit first and directly from inflationary and deflationary episodes (defined as periods of a falling or rising currency respectively) while the middle class and especially the poor do not. As real estate prices rose in the early part of last decade (as the dollar fell) the first to benefit were those who already owned this asset, primarily wealthier individuals. The poor were only able to purchase real estate after lending standards were relaxed and prices had already risen substantially. Consider the fate of a relatively poor individual who was coerced by the siren song of rising real estate prices (and a “helpful” mortgage broker) to fudge their personal data on a loan application (liar loan) and purchase a house in 2006. That person today is not only poorer but also likely now has a foreclosure on their credit report. Inequality has risen as a result.

In addition to owning assets which benefit from Fed manipulation of the money supply, thus increasing inequality as their assets rise in value faster than those of the poor, the wealthy are better able to cope with the rising costs associated with inflation. In an inflationary period such as we’ve recently experienced the prices of basics such as food and energy are particularly sensitive to dollar devaluation. The poor spend a much higher percentage of their incomes on these basics than do the wealthy so rising inflation is particularly harmful to the poor. For the middle classes, higher costs for food and energy mean a slower accumulation of the investment capital necessary to build wealth; savings rates are necessarily lower.  As the poor spend their entire incomes on basic living expenses the wealthy continue to accrue wealth through appreciation of assets, such as gold or oil, that nominally benefit from the inflation. Inequality continues to rise.

The price signals that are critical to proper economic reasoning are distorted by monetary inflation so that the average person is unable to make intelligent economic decisions. Those with access to better economic information, such as bankers with access to the Federal Reserve, are able to better navigate this world of floating monetary standards and gain outsize economic rewards. This informational advantage is further enhanced by the political decision to obscure the consequences of inflation by introducing measures such as “core” inflation and hedonic adjustments. Through these changes the political elite has attempted to – and succeeded to some degree – change the public’s perception of inflation and its causes.

Money is the most basic element of an economy and it should not be surprising that changing its very nature has had such a profound effect on our economy. Quite simply, economies cannot properly function without sound, stable money. The consequences of endowing a small elite with the ability to manipulate the value of money are also well documented, unpleasant and unsurprising. Income and wealth inequality are, as Thoma points out, necessary to a point in order to provide the incentives for economic growth. Past a certain point surely the detrimental effects outweigh the benefits. While there is no way to know exactly where that point is, we are well beyond the norms that existed in the decades after WW II and may be approaching or may have already passed the point of diminishing returns. Solving this growing problem is critical to our growth and political harmony. We won’t solve it by ignoring the most obvious explanation for its rise. Sound money must be part of the solution.