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PREFACE TO THE 2013 EDITION

Falling Behind was first published in 2007. Its central thesis is that the rapid growth in income and wealth inequality that began in the early 1970s caused substantial economic damage to middle-income families.

I was grateful for the invitation from University of California Press to reflect on the basic message of Falling Behind in the light of events since then. Did the financial crisis and the ensuing Great Recession cast doubt on my thesis?

In a word, no. But it’s a fair question, since those events did upend the inequality trends at issue. Prior to the early 1970s, incomes had been growing at about the same rate for about three decades—slightly less than 3 percent annually—for families at all income levels. Between the early 1970s and 2007, however, almost all significant income gains in the United States were confined to the top quintile of the earnings distribution, and even those gains themselves were heavily concentrated among the top 1 percent.

The salaries of CEOs of large American corporations, for instance, were roughly forty times those of the average worker in 1980, but by 2000 the multiple had risen to more than five hundred.¹ The top 1 percent of U.S. earners garnered 8.9 percent of total income in 1976 but received 23.5 percent by 2007.²

The financial crisis of 2008 and the ensuing Great Recession of course produced significant hardship for almost everyone. But the greatest losses, in proportional terms, were actually to those at the top of the economic pyramid, because of the steep declines they experienced in their financial wealth holdings. Many have described stock ownership as highly diffuse in the United States, and that is true relative to many other countries, but stock ownership in the U.S. remains highly concentrated. In 2007, the top 1 percent owned more than 42 percent of the country’s total financial wealth.³ The Dow Jones Industrial Average declined by 54 percent between October 2007 and March 2009, a blow that the country’s wealthiest households experienced most heavily. People in the bottom quintile of the distribution also took a hit. But although they saw their pretax earnings fall more than 30 percent between 2007 and 2010, their disposable incomes actually did not decline significantly, on average, because of sharply increased government transfer payments during those years.⁴

The immediate aftermath of the financial crisis, then, saw a significant narrowing of the gap separating extreme positions on the income scale. As the economy began to recover, however, the reverses suffered by those at the top quickly faded, while hourly earnings continued to stagnate for those at the bottom. By the spring of 2013, the Dow had exceeded its 2007 peak, and in the first full year after the recession officially ended, the top 1 percent of earners captured a staggering 93 percent of the economy’s total income growth.⁵

That the underlying trend reemerged so quickly should be unsurprising. As I argue in chapter 10, the growth in pretax income inequality between 1970 and 2007 was largely a consequence of technical change and increased competition that increased the economic leverage of the most able performers in every arena. And because those forces still have considerable room to play out, the prospect is for inequality to continue increasing. If it does, the economic background going forward will be little different from the one that made Falling Behind seem so timely in 2007.

As they did then, traditional economic models continue to assume that utility depends only on absolute consumption. Yet compelling evidence suggests that it also depends heavily on the context in which consumption occurs.⁶ Context matters simply because the human brain requires a frame of reference within which to make any evaluative judgment.

Consider, for example, someone who is pondering whether his house is adequate. The answer to that question will almost always depend on the quality and size distributions of houses in the local environment. Decades ago, I spent two years as a Peace Corps volunteer in rural Nepal, during which time I lived in a small two-room house with no plumbing or electricity. Yet because it was more spacious and comfortable than most other houses in the village where I lived, I never experienced it as inadequate. If I lived in the same house in Ithaca, New York, however, I would experience it as distressingly substandard. My children would have felt ashamed for their friends to see where they lived.

By the same token, if my friends and colleagues from Nepal were to see my house in Ithaca, they would think I’d taken leave of my senses. Why, they’d wonder, would anyone need such a huge house with so many bathrooms? Yet my friends here, many of whom live in significantly larger houses than mine, never have that reaction.

Context matters not just in subjective evaluation but also in people’s ability to achieve concrete objectives. If you’re applying for a job, for example, you’re advised to look good when you go for your interview. But looking good is an inescapably relative concept. It is in your interest to compare favorably with other applicants for the same job. If they all spend more on clothing, your best bet may be to spend more as well, even though if you all spend more, none of you will be more likely to land the job.

Likewise, expenditures on housing affect a family’s ability to achieve important goals. Most families, for example, want to send their children to good schools. But a good school is also an inherently relative concept. It is one that is better than most other schools. In almost every local environment, the good schools tend to be those in more expensive neighborhoods. In countries like the United States, that is true in part because local property taxes typically fund school budgets.

Because of powerful peer effects in the classroom, however, the same link exists even when school budgets are completely independent of local property taxes. The children of high-income parents enter kindergarten with many important advantages, so the learning environment in the schools they attend tends to foster strong academic performance. But to send its children to those schools, a family must bid for the relatively expensive housing in the neighborhoods they serve. Thus the best schools in Paris, where per-pupil expenditures are the same citywide, are in the Eighth and Sixteenth Arrondissements, which also have by far the most expensive housing.

In short, absolute income is a highly imperfect measure of a person’s ability not just to enjoy subjectively satisfying consumption experiences but also to achieve many important life goals. That’s the most important message of Falling Behind, and it will be as relevant in the years ahead as it was in 2007.

Despite the incontestable importance of context, the primary index of well-being in economies around the world remains GDP per capita, a measure that completely ignores context. That per-capita GDP is an imperfect index of economic welfare is not news. But recent work suggests that its weaknesses are far more serious than many believe.⁷ Continued focus on per-capita GDP has inevitably distorted economic policy in the direction of promoting growth in this index, even at the expense of other factors known to promote well-being. I’ll conclude this preface with a simple empirical exercise that illustrates the magnitude of this distortion.

I emphasize at the outset that the distortion has nothing to do with negative emotions such as envy or jealousy. There is in fact little evidence that mere knowledge of rapid income growth at the top of the economic pyramid has caused middle-income consumers to experience such emotions. Even so, rising inequality has indirectly affected their well-being, because of a process that Adam Seth Levine, Oege Dijk, and I have called expenditure cascades.⁸ The first step in this process occurred because people at the top have been spending more, which has happened simply because they have so much more money. When the very rich build bigger mansions, they shift the frame of reference that shapes demands for those with slightly smaller incomes, who travel in overlapping social circles. The near-rich respond by building bigger houses as well, which shifts the frame of reference for others just below them, and so on, all the way down the income ladder.

Figure A. Median wages and median house prices (both in constant 2000 dollars), 1950–2010. Sources: Economic Policy Institute, www.epi.org/publication/ib330-productivity-vs-compensation (pre-1975 median wage growth assumed equal to mean pre-1975 wage growth); U.S. Census Data, www.census.gov/const/uspriceann.pdf.

This cascade is the most parsimonious explanation for the striking fact that the median new single-family house in the United States, which stood at 1,570 square feet in 1970, had grown to more than 2,300 square feet by 2007. That growth cannot be explained by growth in the median wage or median family income, which changed by much smaller amounts during those years.

What changed dramatically was the context in which the median family’s housing choice was made. Any family that failed to rent or purchase a house near the median of its local price distribution would have had to send its children to below-average schools. So a family that was determined not to see its children fall behind had little choice but to keep pace with what others were spending on housing.

I’ll describe a simple measure of the cost of keeping up, one that can be calculated easily with existing data. It rests on the positive link between the average price of a house and the quality of its neighborhood school. This link implies that the median family must outbid 50 percent of all parents to avoid sending its children to a school of below-average quality.

Figure B. Monthly hours of work required for the median earner to rent the median house, 1950–2010. Source: Calculated from data in figure A.

Figure A shows the time profiles of median U.S. house prices and median hourly earnings for American workers in the census years from 1950 to 2010. As discussed, the distribution of income was exceptionally stable in the years up to roughly 1970. Median hourly earnings were rising at a relatively rapid clip, slightly exceeding the rise in median house prices, and incomes elsewhere in the distribution were rising at approximately the same rate. In contrast, most income growth after 1970 accrued to top earners, while median hourly wages increased only slightly. And yet median house prices grew much more rapidly during the latter period.

The upshot is that by 2010, the median earner had to work substantially more hours each month than in 1950 to gain access to a house at the midpoint of the housing price distribution (see figure B). For illustrative purposes, I assume that the implicit monthly cost of a given house is 1 percent of its purchase price. During the immediate postwar decades, when the income distribution was stable, the median burden of homeownership varied little and was actually slightly lower in 1970 (41.5 monthly hours of work) than in 1950 (42.5 hours). But the burden began rising sharply in 1970, and by 2010, the median worker had to work 82.9 hours a month—almost twice as many as in 1970—to put his family into a house of median price.

Housing is of course not the only expenditure that is sensitive to context. Increasing concentration of income at the top has also spawned similar expenditure cascades for items such as clothing, gifts, birthday parties, and other celebrations to mark special occasions.⁹ In these domains as well, the median earner must spend more than before or else experience significant adverse consequences of one kind or another.

Of course, not all such spending has been purely wasteful. Although the utility conferred by a diamond ring may depend largely on its relative size and quality, for example, even the lone resident of a desert island might take additional pleasure in the way an absolutely larger stone refracts the light. Yet surely much of the extra spending of recent years has been a relatively inefficient source of extra utility. The average American wedding now costs almost thirty thousand dollars, nearly twice as much as in 1990.¹⁰ Does anyone believe that the extra spending has made couples and their families any happier?

Although additional outlays for many consumption goods—such as houses beyond a certain size—don’t accomplish much, they crowd out other forms of spending that would produce real improvements in the quality of life. If houses grew less rapidly, for example, we could invest in mass transit systems that would yield shorter, less stressful commutes and thereby free up more time to spend with friends and family. Or we could support medical research and safety investments that would reduce premature death. The list goes on.

Figure C. Per-capita GDP, 1960–2010. Source: http://research.stlouisfed.org.

Wasteful “positional arms races” occur because people take too little account of the costs that certain types of consumption impose on others.¹¹ When one job applicant spends more on an interview suit, for example, others must spend more as well or accept lower odds of getting a callback. Yet, as noted, when all spend more, no one’s odds of landing the job are any higher than before.

Existing policy instruments can easily curtail such waste. In a world of perfect information, the ideal remedy would be to tax goods in proportion to the extent to which their use generates negative side effects.¹² In practice, we lack the detailed information necessary to implement this remedy. But in chapter 11,I describe a much simpler instrument that would serve almost as well.

For the past several hundred years, rising per-capita GDP has been interpreted to imply that economic well-being has steadily increased. During the era that figure C depicts, for example, GDP per capita has risen steadily and rapidly, leading many to conclude that there have been significant improvements in economic welfare. This measure of well-being, however, is completely insensitive to the costs imposed by the expenditure cascades just described. From the perspective of the median worker, the contrast between the impressions conveyed by figures B and C could hardly be more striking.

Economic models of human behavior affect how we think about the relationship between income and well-being, which in turn affects the mix of policies we adopt. The current emphasis on maximizing per-capita GDP completely ignores the central role of context in consumption decisions. Alternative welfare measures like the one I have proposed would help focus attention on the economic forces that bear most heavily on well-being. And by so doing, they would strengthen support for policies that would make everyone better off.

NOTES

1. Sarah Anderson, John Cavanagh, Scott Klinger, and Liz Stanton, “Executive Excess 2005,” report for United for a Fair Economy based on annual CEO pay studies conducted by Business Week (1990–2004) and the Wall Street Journal (2005), published August 30, 2005, www.faireconomy.org/files/Executive_Excess_2005.pdf.

2. Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States, 1913–1998,” Quarterly Journal of Economics 118, no. 1 (February 2003): 1–39. Updated to 2010 at http://elsa.berkeley.edu/∼saez/saez-UStopincomes-2010.pdf.

3. Edward Wolff, The Asset Price Meltdown and the Wealth of the Middle Class (New York: New York University, 2012).

4. See, for example, Fabrizio Perri and Joe Steinberg, “Inequality and Redistribution during the Great Recession,” economic policy paper for the Federal Reserve Bank of Minneapolis (February 2012), www.fperri.net/PAPERS/ineq_redistr_latest.pdf.

5. Emmanuel Saez, “Striking It Richer: The Evolution of Top Incomes in the United States” (March 2012), http://elsa.berkeley.edu/∼saez/saez-UStopincomes-2010.pdf.

6. Renewed interest in these issues by economists owes almost entirely to Richard Easterlin’s 1974 paper “Does Economic Growth Improve the Human Lot?,” in Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz, ed. Paul David and Melvin Reder (New York: Academic Press). For a more recent survey of research findings on the determinants of well-being, see Carol Graham’s excellent 2010 book, Happiness around the World: The Paradox of Happy Peasants and Miserable Millionaires (New York: Oxford University Press).

7. For a comprehensive summary, see Joseph E. Stiglitz, Amartya K. Sen, and Jean-Paul Fitoussi, “Report by the Commission on the Measurement of Economic Performance and Social Progress” (2009), www.stiglitz-sen-fitoussi.fr/documents/rapport_anglais.pdf.

8. Robert H. Frank, Adam Seth Levine, and Oege Dijk, “Expenditure Cascades,” Review of Behavioral Economics (forthcoming). See also Marianne Bertrand and Adair Morse, “Trickle-Down Consumption,” University of Chicago Booth School of Business working paper (February 2012), http://isites.harvard.edu/fs/docs/icb.topic964076.files/BertrandMorseTrickleDown_textandtables.pdf.

9. Robert H. Frank, “Post-consumer Prosperity: Finding New Opportunities amid the Economic Wreckage,” American Prospect, March 24, 2009.

10. See Bethany Parker, “Probing Question: How Has the American Wedding Changed?,” Penn State News, September 8, 2008, www.rps.psu.edu/probing/wedding.html.

11. See, for example, my 1999 book, Luxury Fever (New York: Penguin).

12. For a widely cited early proposal along these lines, see Yew-Kwang Ng’s 1987 paper “Diamonds Are a Government’s Best Friend: Burden-Free Taxes on Goods Valued for Their Values,” American Economic Review 77: 186–191.