ALAN REYNOLDS ASSOCIATES-

WHAT PAUL KRUGMAN DOESN'T KNOW CAN HURT YOU

SYNOPSIS: Another Supply-Side attack on Krugman's belief in rising inequality.

"It is easy to imagine a broad public demand that those who have been lucky enough to find gold be required to share a significant fraction of their winnings with those who have not."

-- Paul Krugman, The Washington Monthly, October 1995

Paul Krugman of Stanford appears to have displaced Lester Thurow (and before that, Huey Long) as the media's most reliable source of misinformation about the distribution of income and wealth. His latest article in The Washington Monthly, "What The Public Doesn't Know Can't Hurt Us," draws strong conclusions from weak statistics. Rep. Dick Armey is accused of lying about "the growing gap between the broad public and a small minority possessing astonishing wealth."

Krugman offers a table comparing real income growth from 1973 to 1989. Nobody denies that two episodes of stagflation between 1973 and 1983 had a devastating impact on real income, particularly among low-income families, and also on the real value of family savings. Income growth from 1989 to 1995 has also been quite disappointing, though real wealth has improved (so far) in 1995, after a decline in the previous year.

Krugman's habitual use of 1973 as a base year for long-term income comparisons is misleading. Phase Three of the Nixon Administration's price controls greatly understated the suppressed inflation, making real incomes look higher on paper than they really were. Nobody who actually lived through 1973 could possibly remember the experience as anything but frightening. Using either 1971 or 1974 as the basis for long-term comparisons would be more honest, but then the figures would not show what Mr. Krugman wants to show.

An article by Paul Ryscavage in the Monthly Labor Review (from the Bureau of Labor Statistics) shows average, real household income, in 1993 dollars, from the lowest to highest quintiles. From 1979 to 1989, average income in the bottom fifth rose from $7823 to $8182, while income at the top fifth rose from $84,484 to $99,669. In the middle, the gain was from $32,079 to $33,707. Clearly, all income groups were substantially better off in 1989 than they were in 1979. The improvement would be far more dramatic if we compared 1990 with 1980, rather than 1979, because real income at the bottom end of the income scale fell sharply in 1980. Still, the facts do not support Mr. Krugman's remark that "at the end of the '83 to '89 recovery, the bottom quintile was till worse off than it was in 1979, while the only rally large gains over the decade went to the top quintile."

When we look at 1993, which Mr. Krugman somehow neglects to do, it is also clear that real incomes were still well below those of 1989 in all income groups. In the top fifth, real income fell from $99,669 in 1989 to $98,589 in 1993, in the middle it fell from $33,707 to $31,260, and at the bottom real income dropped from $8,182 to $7,411.

The top two quintiles had higher real incomes in 1993 than in 1979, but lower than in 1989. It is a mistake to attribute these income trends to differences in wages and salaries, much less to "luck." There is a big difference in the average age of those with lower and higher incomes (inexperienced young people earn less than they will later), and there are usually two or more full-time workers in higher-income families. The latest "Population Profile" from the Bureau of the Census notes that in 1993, only 15.3% of poor families had even one member working full time all year: "In poor families maintained by women with no spouse present . . . only 9.2% [worked] year-round, full-time." The changing composition of "families" -- with many more single parents today than in 1973 -- makes comparisons of family income over two decades inherently suspect.

Differences in schooling, age and number of workers explain most of the difference in lifetime incomes, which are substantially more equal than any snapshot picture of annual incomes. Age alone explains much of the difference in wealth. Median net worth among household heads under age 35 was $6,800 in 1989, according to the Federal Reserve survey, while that of households aged 45 to 64 was $91,300.

Mr. Krugman cites Edward Wolff's "mildly liberal" book, Top Heavy (20th Century Fund), as evidence of a supposedly "astonishing" increase in the share of "marketable" wealth held by the top 1%. Wolff does say silly things like that, but his data do not.

Back in April, a front page New York Times "news" story cited Wolff's claim that "the increase in wealth inequality recorded over the 1983-89 period in the United States is almost unprecedented." Unfortunately, that conclusion does not match any of Wolff's own numbers. If we ignore pensions, Wolff shows the share of wealth held by the top 1% rising most sharply from 19.9% in 1976 to 30.9% in 1983, and then to 35.7% in 1989. But we can't ignore pensions. There is no excuse in today's world of tax-favored IRAs, Keogh and 401K plans for pretending that pensions are not wealth, as Mr. Krugman does when he suggests that "the top 1% of families owned 39 percent [sic] of the wealth." Wolff's only semi-relevant estimates are for what he calls "augmented" wealth, meaning it includes pensions.

Ed Wolff's figures were patched together from several sources, some more incredible than others. Only the 1983 and 1989 figures are more-or-less comparable, since they at least came from the same source, Federal Reserve surveys. Of the 14 years for which Wolff has fabricated estimates, all but three from the runaway inflation of 1976-81 show the top 1% holding 19-23% of pension-augmented wealth. The estimate was 23.3% for 1965, for example. Then the share held by the top1% supposedly plummets to 13-15% from 1976 to 1981, before rising back toward the norm as inflation subsided (to 19-21% from 1983 to 1989). What is "astonishing" is not the recent estimate that 21% of wealth was held by the top 1% in 1989, but the seemingly huge losses suffered in for 1976-1981. That is because the snapshot figures on the inflation-adjusted market value of stocks and bonds in, say, 1981 are just so much statistical garbage. The seemingly huge paper losses during the double-digit inflation were only experienced by those with the bad luck or poor judgement to sell at that time. The market value of stocks and bonds held by the top 1% was indeed very depressed in 1979-81, and even more so if you subtract the high inflation in those years. But the most affluent 1% did not all their stocks and bonds at that time, so their statistical share of wealth came back to normal as inflation came down and the markets recovered. The fact that 1% of households owned 19-21% of wealth in 1983-89 was not at all "astonishing." That was below the usual postwar share.

As Wolff observes, "the Great Depression saw a sizable drop in inequality." So too did the mini-Depressions of 1974-75 and 1980-82. From the egalitarian perspective of Wolff and Krugman, those were the good old days. Another big crash in the values of stocks and bonds, combined with a bunch of business failures, could surely create another impressive drop in wealth "inequality." Another Great Depression would flatten things out just fine. How that would help the poor, however, remains to be explained.

What really happened from 1983 to 1989? The 1989 Fed survey, summarized in the Federal Reserve Bulletin of January 1992, showed that 40% of families earning between $20,000 and $50,000 saw their average (mean) real net worth increase by 28% from 1983 to 1989, while the top 20% (earning more than $50,000) had only a 6.6% gain. Median net worth figures (which the Fed says are inferior) show smaller gains in the middle, but a 42% gain among those with incomes of $10-20,000 (e.g., low-income retirees). The biggest wealth gains by far were in the value of family-owned businesses.

It is also enormously misleading to ignore, as all these figures do, the most valuable wealth of all -- human capital (i.e., the present value of future earnings). Young graduate students usually have very little financial capital or real estate, but they have enormously valuable human capital, even if they're studying with Professor Wolff or Krugman. When the same people later approach retirement age, the market value of past schooling and experience drops to zero. By then, however, they will have accumulated other types of wealth, such and pensions and investments, to support them in their old age. It is these other types of wealth that seem to cause Messrs. Wolff and Krugman such unnecessary anxiety.

The reason all this statistical chicanery matters is that it is about to be a major campaign theme for 1996. The Clinton Administration desperately needs an excuse for the fact that all measures of real income at the time of the 1996 election are likely to be lower than they were in 1989. To paraphrase Bob Bartley, we will have been through "Seven Lean Years."

Labor Secretary Robert Reich has an explanation of sorts. He says it is because of "a major shift from earned to unearned income, from paychecks to dividends and capital gains." "Productivity improvements are going into corporate profits," says Mr. Reich, "not workers' pockets." (What productivity improvements?) The Reich story, about a conflict between capitalists and the working class, was reported uncritically by The New York Times, Washington Post, Wall Street Journal, Business Week and others. It is entirely without factual foundation, as I show in a forthcoming survey in Forbes Media Critic. As Paul Krugman points out, "if your doctrine depends on a view of the economy that is flatly contradicted by reality, then the fewer the facts the better." He should know.