Monday, March 24, 2014

Pettis On The Economic Consequences Of Income Inequality

From Credit Writedowns:
A lot of things have happened in China since my last entry – in the FX markets, in the banking system, in the announcements of default, and in the continuing lowering of growth expectations – but for all the turmoil, as I see it nothing has happened that was unexpected and that has not been discussed many times on this blog. For that reason I decided to post a rather long essay (sorry) on income inequality and on how I think we can best think about the impact of income inequality on the global economy.

This is a loaded topic, and I suspect I am going to get a lot of responses claiming that my essay is totally brilliant or totally nonsensical based, mainly, on the political orientation of readers. This entry, however, is not intended to be political. Very few things in economics are good or bad in themselves, but rather can be good under certain conditions or bad under others. I want to try to tease out as logically as I can the conditions under which rising income inequality can be good or bad for the economy.

That is all I am trying to do. My logic may be faulty and my assumptions may be wrong, and I invite readers to challenge either, but none of this should be seen as moral or immoral. Income inequality may very well be one or the other for very solid social, political or even religious reasons, but I am interested here only in the logical economic outcomes of income inequality.

Digging deeper into the model I use to understand income inequality also allows me to dig deeper into the sources of global imbalances – the two are tightly interlinked – and how these imbalances have driven much of what has happened around the world in the past decade. This model rests on an understanding of how distortions in the savings rates of different countries have driven the great trade and balance-sheet distortions with which we are wrestling today, just as they have in most previous global crises, including those of the 1870s, the 1930s, and the 1970s. Rising income inequality is key to understanding this model.

It turns out that it is actually not that hard to work through at least one of the major economic consequences of rising income inequality. I would argue that from an economic point of view the income inequality discussion is mainly a discussion about savings, and when you introduce into the economy a systematic tendency to force up the savings rate, the economy must respond in what are only a limited number of ways.
As I will show, some of these responses require an unsustainable increase in debt, and so are temporary. There are, it turns out, two sustainable responses to a forced increase in the savings rate in one part of the economy. The first is an equivalent increase in productive investment (this, I think, is the heart of the supply-side “trickle down” theory). The second is an increase in unemployment.

Much of what I am going to argue is not new, and is merely a revival of the old “underconsumption” debate. Before jumping into the argument I want to start by quoting the remarkable former Fed Chairman (1932-48) Marriner Eccles, who may well have been the most subtle economist of the 20th Century, from his memoir, Beckoning Frontiers (1966):
As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of goods and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations.
But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.
The key point here is that all other things being equal, rising income inequality forces up the savings rate. The reason for this is pretty well understood: rich people consume a smaller share of their income than do the poor. The consequence of income inequality, Eccles argued, is an imbalance between the current supply of and current demand for goods and services, and this imbalance can only be resolved by a surge in credit or, as I will show later, by rising unemployment. Rising income inequality reduces demand. It does so in two ways. ...MUCH MORE
HT: naked capitalism