Why is the Fed talking about this? After all, income distribution is not in their policy agenda. Let's wind the calendar of events backwards to get a sense of the where and why of Fed concern.
We start with the November 6 speech by Janet Yellen, President of the San Francisco Fed, on "Income Inequality In The United States"
"However, there are signs that rising inequality is intensifying resistance to globalization, impairing social cohesion, and could, ultimately, undermine American democracy."
Lets go back to October 12, when Governor Mishkin gave a talk at Baruch College entitled "Globalization: A Force For Good?" From that speech:
"I will conclude by saying that those who oppose any and all globalization have it completely backward: Protectionism, not globalization, is the enemy. It is true that, by itself, globalization in both finance and trade is not enough to ensure economic development and that economies must position themselves to handle foreign capital flows. But as I said, to be against globalization as such is most assuredly to be against poor people, and this is presumably not the position antiglobalizers want to take. Developing countries cannot get rich unless they globalize in both trade and finance. Making financial flows truly worldwide and creating robust, efficient financial markets in developing countries is not optional: It needs to be the focus of the next great globalization."
Let's role back to Chairman Bernancke's talk at Jackson Hole, "Global Economic Intergration: What's New and What's Not?" on August 25 From that speech:
"The final item on my list of what is new about the current episode is that international capital markets have become substantially more mature. Although the net capital flows of a century ago, measured relative to global output, are comparable to those of the present, gross flows today are much larger. Moreover, capital flows now take many more forms than in the past . . . Today, international investors hold an array of debt instruments, equities, and derivatives, including claims on a broad range of sectors . . ."
Bernanke concludes with:
"Further progress in global economic integration should not be taken for granted, however. Geopolitical concerns, including international tensions and the risks of terrorism, already constrain the pace of worldwide economic integration and may do so even more in the future. And, as in the past, the social and political opposition to openness can be strong. Although this opposition has many sources, I have suggested that much of it arises because changes in the patterns of production are likely to threaten the livelihoods of some workers and the profits of some firms, even when these changes lead to greater productivity and output overall. . . . The challenge for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared . . . the effort is well worth making, as the potential benefits of increased global economic integration are large indeed."
Where is this interest in the topic coming from? In June of this year, an excellent book was published, "Polarized America: The Dance of Ideology and Unequal Riches" by Nolan McCarty, Keith T. Poole and Howard Rosenthal. It crystallized the political problem of income inequality.
It didn't take much to see, as Yellen did explicitly, that people see globalization as a key factor hollowing out the middle class. At the same time, it didn't take much imagination during these past few months to believe that the Democrats would regain some legislative power and bring the income issue to forefront.
Here is the abstract from the paper that predates the book:
"Since the early 1970s, American society has undergone two important parallel transformations, one political and one economic. Following a period with mild partisan divisions, post-1970s politics is increasingly characterized by an ideologically polarized party system. Similarly, the 1970s mark an end to several decades of increasing economic equality and the beginning of a trend towards greater inequality of wealth and income. While the literature on comparative political economy has focused on the links between economic inequality and political conflict, the relationship between these trends in the United States remains essentially unexplored. We explore the relationship between voter partisanship and income from 1956 to 1996. We find that over this period of time partisanship has become more stratified by income. We argue that this trend is the consequence both of polarization of the parties on economic issues and increased economic inequality"
The Fed is concerned, from my perspective, because any trade legislation that, going forward, has the impact of diminshing global capital flows will be particularly problematic for the U.S. First off, it would be a problem for financing the current account deficit and for financing the rolling over of the accumulated debt. Second, and I believe more important to the Fed, is the financing of social security.
The the social security trust fund has been using its current surplus to fund the current budget deficit by buying non-marketable Treasurys. Once the trust fund has to start paying out from the surplus it has been designed to build (talk to Greenspan, he helped design it), the fund will have to redeem these securities it accumulated to the Treasury in exchange for cash to make the required payments. Where will Treasury get the cash? By issuing debt that would be an addition to any debt raised to finance the budget deficit at that time. Any wonder why Greenspan in the 90s was so focused on maintaining budget surpluses?
If foreign flows aren't flowing at that time, the interest rate adjustment will not be pleasant.
Tomorrow I go back to markets and probabilities and Fed action. I thought today should be about politics and economic policy and the long game.