economics book-review inequality

Falling Behind: How Rising Inequality Harms the Middle Class

My Thoughts

I think the subject of this book is one of the most important subjects in politics, second only to open boarders. Suppose, for instance, the consumption beyond $20,000 per person provides zero social welfare. Then, in theory, we could all be working half as many hours with consumption-related utility loss - if you really want a dollar value on that it's on the order of $7 trillion per year (35% of GDP).

I think this book acts as a good introduction to the subject, but it has some bias. For instance, it assumes without justification that

  • the marginal tax dollar is spent in a socially valuable way
  • the spending more on education is good when it's not
  • there reducing output with progressive taxation and labor laws will have no negative effect on long-term growth

For these reasons, I can't endorse the book as a neutral, in-depth analysis of the overall subject.

Chapter 1: Introduction

The value derived by some goods is more positional than others. For instance, most people say they'd prefer to have a 3000 sq ft house if everyone else had 2000 than a 4000 sq ft house if everyone else had 6000. However, they also say they'd prefer 4 weeks of vacation if the average person had 6 than 2 weeks if everyone else had one. Likewise, defense spending is almost entirely positional whereas consumption generally is much less so.

Chapter 2: Recent Changes in Income and Wealth Inequality

Income inequality has increased dramatically over the last several decades, with middle class gains coming almost entirely from women entering the labor force.

Chapter 3: Inequality, Happiness, and Health

The are lots of various positive things that correlate positively together including self-reported happiness, indicating that happiness [like IQ or personality] is a statistically valid scientific concept. While everyone agree income makes you happier, how much is an open question. Some evidence indicates not much: Japan saw a 4x increase in income but saw no increase in self-reported happiness. Why, then, do people sacrifice so much for money?

The more nuanced answer is that within rich countries, richer people are significantly happier than poor people, suggesting that as national incomes go up, the proportion of utility from consumption that is positional utility also increases.

This suggests greater income inequality reduces the happiness of the middle class. This claim is supported by the fact that people are happier in more equal states in the US and in Scandinavian countries in Europe, which have notably equal income equality. Also, between 1990 and 2000, the countries with the largest increase in divorce also had the largest increase in income inequality. He also cites lots of other studies.

[Side note: Some experts disagree that income is important because income explains only about 2% of the variance in happiness in snapshots, but this is mostly because the data is noisy.]

Chapter 4: Envy or Context

Because relative consumption is often seen as a form of envy, it’s viewed by some economists as an invalid issue to address. Frank insists, however, that context can influence our interpretations and decisions without envy. He gives several examples, many of which regard anxiety about how others think of you. In addition, he gives these examples:

  1. The size of a bedroom you think of as adequate depends on whether you live in the city or suburbs - a first-world or third-word country.
  2. Advertisers and salesmen will give an expensive option to make a middling element seem cheaper.
  3. If someone with a wheelchair is present, people rate their happiness 2 points higher.
  4. Feeling bad for not being able to provide for your kids things that their classmates have (e.g. braces)

Chapter 5: The Rising Cost of Adequate

Rising top incomes has also raised the cost of what the middle class considers “basic goals”.

This process starts by the very rich building larger mansions, which changes norms (like hosting weddings in your home), which affects the norms of those just below them. These norms trickle down the income ladder causing the median new house size to increase over 30% between 1980 and 2001 despite barely any increase in median income. Since real estate prices are linked closely to school quality and most parents want their children to attend above average schools, this causes parents to buy houses more expensive than they can comfortably afford. He calls this an expenditure cascade.

This increase in the cost of adequate isn't limited to schools. He gives some other examples:

  1. Luxury cars have gotten heavier across the board, because people want to be in cars that aren't tiny compared to other cars, since this makes driving both feel and be riskier.
  2. People spend far too much on suits for job interviews because looking good is purely positional [As far as I can tell this hasn't gotten worse over time].
  3. When some people give larger gifts at special occasions, it pressures the other guests to give more too or risk sending the signal that the relationship is unimportant.

The key point here is that the richest people set a standard and that this standard doesn't directly inform middle class standards, but that it trickles down to the middle class because the top 0.01% influence the top 0.1%, who influence the top 1%, etc. Increasing income inequality increases the distance between us and our standard setters, making it increasingly difficult to meet our own standard for a basically good life.

Chapter 6: Why Do We Care about Rank?

There's a large literature suggesting evolution has hard-coded caring about relative positioning. This makes sense, because the ability to gather resources relative to competitors confers a survival and reproductive advantage, which we can see is still important today. He also cites

  1. children's obsession with fairness, which never really goes away.
  2. a study that found a woman is much more likely to get a job if their sister's husband makes more than their own.

Firms have more compressed compensation than the overall labor, which Frank explains as resulting from some compensation coming from relative status within the company. Less productive workers want to leave the firm they work for to seek higher status elsewhere, but this reduces the status of other workers at the company, so the company subsidizes the less productive workers with additional pay to keep them. For this reason, if you care more about pay, work for a company where you're below average, whereas if you care about status, work for one where you can shine (though you'll probably take a pay cut).

Chapter 7: What Types of Consumption Are Most Sensitive to Context

The Darwinian perspective suggests that consumption will probably be much more positional when it relates to reproduction. One example is leisure. Most people would prefer across-the-board cuts in pay and work by the same percent. Still, they work long hours because income confers positional status. This is why an increase in income inequality should increase hours worked, a correlation we observe in international data.

He also cites a study that found most extra income resulting from the shift from one to two earners was more consumed by spending more on housing.

More generally, we should expect an increasing proportion of consumption to be directed towards positional goods as income inequality increases. [This seems like a strong argument to combat income inequality. ]

Sadly, because of the ubiquity of positional consumption (housing, cars, clothes, education, etc.) another lens to view this whole ordeal is that less-positional goods/services (insurance, leisure, utilities, safety, etc.) will be underconsumed. Society has found various ways to help solve this imbalance:

Churches socially enforce Sabbath days while governments enforce minimum days off.

We provide free education and require those who send their kids to private schools to continue paying taxes for public education. This provides a strong disincentive to send kids to private schools, which heads off a spending arms race.

Regulation to enforce safety standards in the workplace, theme parks, cars, etc.

He also examines savings, observing that (1) the rich save a greater proportion of their income than the poor but (2) as national income goes up, saving rates do not. This "paradox" seems difficult to explain without invoking positional consumption.

Chapter 8: How Can Middle-Class Families Afford to Keep Up?

How does the middle class keep up?

  1. More Labor: Women work 200 hours each year more than in the 1970s. For men, it's 100 hours.
  2. Less Savings: American's savings rate has declined since the 1970s.
  3. More Debt: Significantly more bankruptcies and higher credit-card balances. Also, bankruptcies grew fastest in counties with increasing inequality.

Chapter 9: Smart for One Dumb For All

This chapter doesn't introduce much information. It's purpose is to rephrase this book by showing how this positional consumption is "smart for one, [but] dumb for all". For instance, buying a bigger home is smart for an individual, but bad when we all do it.

Chapter 10: Looking Ahead

Income inequality has been rising for decades and is likely to continue to do so.

One significant reason is that our economy is becoming more winner-take-all, largely due to the internet, exacerbated by globalization making these winners global rather than national winners. This applies to music, fictions, professional sports, CEOs, etc. In fact, income inequality in professions that don't seem like winner-take-alls have also seen dramatic increases in income inequality, professions like dentists. Similarly, income inequality among liberal arts graduates has continued to grow. Other reasons include the increasing returns to a college degree and the increasing labor compensation from abroad.

All the processes are likely to continue.

Chapter 11: Lessons for Public Policy

Broadly speaking, our problems are that we (1) work too much (2) save too little and (3) spend too much on positional goods/services.

Historically, attempts to outlaw particular positional goods have failed terribly, as people just switch their spending to other positional consumption. Similarly, while luxury taxes on (e.g.) yachts do reduce yacht purchases, people will largely switch to other untaxed luxury goods.

One possibly policy is to enforce a fixed minimum savings rate, which is largely equivalent to social security. Another is to implement a progressive consumption tax or (equivalently) allowing the exemption of savings from a progressive income tax. In fact, Frank argues, such an exemption would significantly reduce the distortionary effect of the income tax, which would allow significantly higher top tax rates.

Another benefit of a consumption tax occurs during recessions. Today, when a recession hits, the government temporarily cuts income taxes, which actually encourages savings. Conversely, if the government temporarily cuts a consumption tax, it encourages consumption now.

[ He also makes the book partisan applicable to the real world by discussing Bush's tax cuts and about how spending is good and the consumption of the rich is zero-sum. ]