(Warning: Very wonky and lengthy. Proceed at your own peril.)

Last week, Jeff brought our attention to a Congressional Budgetary Office report on income distribution in the United States ranging from 1979-2007. The report details the troubling trend of disparity between the lower and middle economic quintiles and their higher earning counterparts.

For example, as a share of income growth the top 1% of earners saw dramatic increases in their incomes, 275% from 1979-2007. However, the story is a little different for those underneath. Earners in the next 19% saw an increase of 65% in their incomes while there was a 40% boost for the next 60%, and a meager 18% for the bottom 20%. Now…when considering the fact that despite the government’s best efforts high rates of unemployment still persist, the only recoveries taking place seem to be on Wall Street, and past actions such as the litany of bailouts to financial institutions and corporations there shouldn’t be any wonder as to why there is such a high rate of frustration among America’s dwindling middle-class.

Nevertheless, however understandable this attitude is, it only stands to obfuscate real solutions. Furthermore,  it also serves as a straw man argument for politicians seeking ignite economic populist angst in order to guarantee their re-election. With all of this in mind, what I would like to present here is neither an admonishment nor disagreement with Jeff’s position, but to bring these circumstances into focus and provide some bit of clarity.

There should never be any doubt that there exists a huge disproportion in the levels of earnings between the economic quintiles. In terms of equilibrium though, the distributions are relatively balanced until you factor in the very top earners—the one percenters. Another point is that the CBO report that Jeff brought to light represents a static shot of income distribution, it is not dynamic. This leads me into the classic conservative argument against income inequality and that is income mobility. The CBO looked at the distributions as a snapshot of incomes, not who was occupying them and how long they were there.

In normal times, as people get older, more experienced in their craft, better educated, etc. they typically became more valuable to employers in terms of production and this increased their earning potentials. A 2007 study produced by the Treasury Department highlights the argument against judging income inequality using a static measurement.

“To get a broader perspective on these trends, one must look at the opportunity for upward mobility in the United States, which has sometimes been seen as a defining characteristic of the nation’s economy.² Comparisons of snapshots of the income distribution at points in time miss this important dimension and can sometimes be misleading. Research shows that the distribution of lifetime incomes is more equal than a one-time snapshot implies because a household’s relative position in the income distribution often changes over time.”

Treasury also found that during the period from 1996-2005 that there was considerable upward income mobility. Table 3 of the study illustrates the upward and downward track that took place within each quintile. They show that 18.3 % of the lowest earners saw a 50% or less decrease in their earnings. However, the remaining 81.7% saw increases in income ranging from 25% on up. In fact, the largest percentage, 49.4%, actually had a 100% or more increase in their incomes. The middle incomes were a little less dramatic and dynamic. Thirty-one percent saw a decrease of 25% or more in their incomes while 68.5% saw a 25% to over 100% increase in their earnings. Astoundingly the largest decrease in earnings was for the highest income earners. Overall 45.3% of this quintile saw a 25% or more reduction in their incomes. Additionally, the largest loss of income—25% or more—came from the 64.8% of the notorious one-percenters. In other words the economic lifespan of someone existing in the top tiers isn’t very long and is extremely fluid.

Still, there are some problems with citing this report as holy writ. It only explicates pre-recession activity and additionally fails to make clear the rapid growth of income within the top percent of earners.

During times of normal recessionary activity, unemployment always rises and then is followed by a time of considerable economic expansion. This phenomenon is what is known as the business cycle. However, these are less than normal times let alone normal recessionary times. Now, since credit has been so greatly deleveraged, in response, businesses have sidelined inordinate amounts of capital, economic activity has slowed resulting in higher and longer rates of unemployment. Furthermore, those who are maintaining employment are using their post-tax income to pay down debts and purchasing necessities vice consuming what we consider luxury items. This also lowers aggregate demand, which results in lower output, thus higher unemployment. The result from all of this is a rapid decline in peoples’ position within the economic quintiles.

As to why the rich are getting richer there are few key points which you have to bear in mind. The first consideration is the attractiveness of foreign markets. For instance, in 1999 the amount of US direct investments abroad had a cumulative historical total of $1.2 trillion. However, from 2000-10, this number more than tripled to $3.9 trillion, representing a significant increase in foreign investment made by financiers in the United States. Conversely though, private domestic investment within the United States has either been modestly increasing, steadily declining, or stagnating from year-to-year. These facts are illustrated below in a chart (Fig. 1) I compiled using data obtained from the Bureau of Economic Analysis.

Fig. 1

 Source: Bureau of Economic Analysis, Table 5.2.6. Real Gross and Net Domestic Investment by Major Type, Chained Dollars and U.S. Direct Investment Abroad Tables, September 2011

It is important to keep in mind that Gross Domestic Private Investment (GDPI) is still considerably larger annually, measuring in the trillions per year, than US Direct Investments Abroad (USDIA) which is in the hundreds of billions per year. As you can see the chart plots track capital outflows and show that instead of being retained domestically, money is being directed in larger amounts towards foreign advanced and emerging economies. Being that most of the capital directed towards foreign investments was finance, holdings, or banking, there was little if no return in terms of domestic activities.

Furthermore, this chart also indicates that during the last recessionary phase—2007-2009—US foreign investments flat-lined while domestic investments declined dramatically over $700 billion in under two years. This seems to indicate that either outflow of domestic investment capital was lessened because of availability of funds or those investors were hesitant to send more money overseas because of the business climate. On the contrary though, domestic markets which were already dwindling, took a far more substantial hit because of their dependency on the United States economy.

How all this ties to income inequality is quite simple. First, you have an ever growing amount of investment capital being directed towards more attractive foreign markets and a past trend of lessened investments being made back home in the United States. As this capital flows into overseas businesses and markets, new businesses are started or older ones grow significantly. Hence, there is more employment, better jobs, and inevitably higher wages for workers in other countries. If these monies would have been invested domestically, obviously we could have seen a potentially remarkable effect here in the United States. Since this is not the case and domestic investments are depleting, there is continued abatement in the growth of new firms and business, expanding older ones, limiting employment opportunities, and inevitably decreasing wage growth. This is an especially troubling trend normally but during economic contractions like we are going experiencing now it is exacerbated. Certainly though, this is not to say that outpouring of domestic investment potential towards foreign markets alone is the fundamental cause of income inequality, however, there should be no doubt that it is a chronic contributor. Also, there is no getting around that more private domestic investment in the US is one of the keys to business startup and expansion and a great start to reversing income inequality and forwarding economic mobility.

I would also like to add that I will cover the second portion which is also a factor in the growing economic disparities in another post. This is a lengthy topic with many points to cover and cannot be done in one article succinctly.

Related articles

• America’s Growing Income Gap, by the Numbers (propublica.org)
• Meghan McCain on Occupy Wall Street & The End of The American Dream (reason.com)
• Godwin-ing the income inequality debate (hotair.com)
• Mark Perry on Income Differences (cafehayek.com)
• Who Is Getting Richer ? Poorer? ALOT Richer? (ritholtz.com)
• Have and Have Not Nation (Guest Voice) (themoderatevoice.com)