Janet Yellen versus the 'unified theory' of what's wrong with America

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Janet Yellen admitted to Congress that, like thousands of other economics fans, she has started Thomas Piketty's Capital in the 21st Century, a 700-page bestseller warning of rising wealth disparities -- but hasn't finished it.

Sen. Angus King, the Maine independent, asked the Fed chairwoman during a Senate hearing if she had “had time to digest” the French economist's work. “It's only a thousand pages,” he joked. Yellen responded, “I can't say I've gotten to the last page of it, but I am certainly familiar with the book.”

King brought up Piketty to raise the concern that rising inequality is depressing aggregate demand, by leaving low-income workers, who are thought to be more likely to spend additional cash, with less.

Aggregate demand is the sum of goods and services demanded economy-wide. Most mainstream economists, Yellen included, attribute the ongoing underperformance of the U.S. economy to a shortfall of aggregate demand.

Yellen's response was approving but noncommittal: "I don't know of any utterly clear evidence on this topic, but it makes sense to assume that ... when income distribution shifts in the direction of those who are wealthier and likely spend at the margin less of their income, that creates a drag on the economy. And a number of economists have certainly made that argument."

Yellen was asked a similar question during a House hearing in February, when Bill Foster, D-Ill., said that low-income people are more likely to spend extra income, and that the wealthy are more likely to spend extra income abroad. Noting that “we're in a demand-limited point in our economy,” he asked if Yellen takes wealth distribution into account when making decisions.

Yellen responded that “the evidence is not crystal clear” and simply stated that “some prominent people have made the argument that you expressed” without endorsing the idea.

The idea that rising inequality is holding back the economic recovery because lower-income people are more likely to spend money and thereby raise demand is what the American Enterprise Institute's James Pethokoukis called the “grand unified theory of what's wrong with America,” and it's been expressed by other key Democrats.

Former Obama economic adviser Larry Summers told the New York Times in April that “income is now more concentrated in the hands of the rich. Those well-off households tend to save and invest higher proportions of their earnings than middle-class or low-income families do. That might mean, on aggregate, less spending and less demand across the economy for a given level of income.”

And current Obama economic adviser Jason Furman said at a January event boosting a minimum wage hike that “increasing the purchasing power of workers in an economy like the one we have today will at least in the short run provide a boost to aggregate demand and potentially help create more jobs.”

Not all Democrats share that view of the economy, though. Jared Bernstein, previously an economic aide to Vice President Joe Biden, wrote in a report on inequality in December that “nor is there evidence, at least not a first blush, linking higher levels of income concentration to reduced consumer spending as theories of marginal propensity to consume or save would predict.”

Paul Krugman, the New York Times columnist and Nobel Prize-winning economist, also dismissed the idea that inequality weakens demand in a post last year. “So am I saying that you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs?” he wrote. “Well, yes. You don’t have to like it, but economics is not a morality play, and I’ve yet to see a macroeconomic argument about why it isn’t possible.”

One reason Yellen has stopped short of weighing in on the debate might be it is the role of the Fed to use monetary policy to stimulate or slow aggregate spending in the short run, regardless of other factors at play in the economy -- and she is in charge of the Fed. In fact, Yellen is associated with a policy, known as optimal control, in which the Fed automatically reacts to a projected shortfall of aggregate demand by promising lower rates, boosting asset prices and consumer spending. Inequality would be irrelevant in that and many other models used by the Fed.

It's also worth noting that consumer spending and confidence are up among all income groups. With the unemployment rate heading back toward the level consistent with no shortfall of aggregate demand, it would be late in the game for Yellen to call for an attack on inequality in the name of aggregate demand.

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