Monday, February 6, 2012

Debunking the Notion that Inequality Wouldn't Impact the Economy

Update: A newer revision of this piece is available than the one below. While this version is still OK, the newer version is recommended as both more complete and I think a better read. The newer version is available at and

It's been claimed that, "Money is money: demand is made by those who have it to spend. If it is unequally spread, the amount of consumption remains the same if saving remains the same."

Except that in reality, lower average propensity to consume (APC) results from significantly increased real income. Who has how much matters because people spend different portions of their income at different levels of wealth. Wealth and income distributions make a significant difference to effective demand. We're not concerned with what people would like to have if they had enough money; we're concerned with what people will spend with the money they're getting. If X is a wealthy person and Y is a poor person and over time X attains a higher share of the available money, total spending -- effective demand -- will drop.

If there's $1,000,000 of total income at time T1 and X gets $950,000 while Y gets $50,000 and X spends 33.33% of income to Y's 100% of income, then total spending at time T1 will be $316,635 + $50,000 = $366,635.00.

If there's an inflation-adjusted $1,000,000 of total income at time T2 and X gets $975,000 while Y gets $25,000, X's spending will likely have fallen from the previous propensity but we'll go with 33.33% for understatement. Meanwhile, Y can't spend as much as before because Y's available funds have dropped. Even if X still spends at the same rate -- which is unlikely -- then total spending would be $325,967.50 + $25,000 = $349,967.50. Admittedly, I've picked an arbitrary APC for X, but the point is to show the effect. Even if the exact average amount might vary slightly from a drop of $16,667.50 in spending between T1 and T2, the point remains that there would be a shortfall. With more of the money shifted to those with a lower APC, you get lower consumption which is to say lower effective demand.

Even if total income increases, with enough shift from those who will spend higher percentages of their income to those who will spend lower percentages of their income, total spending can fall. More total wealth does not necessarily translate to more total spending. More total wealth will only increase total spending when distribution among varying APCs remains sufficiently stable. Having wealthy people is useful; but we need enough money in the hands of average consumers to support that wealth. Concentrate too much of the available wealth into too few hands and you get less ability to consume which means less effective demand.

Note on totals versus individuals: the figures above are not intended as a complete representation of our entire economy. They're just looking at two selected hypothetical consumers within that economy and the total between those two. In order to represent the total economy, we'd need to involve such factors as the ratio of upper incomes to lower incomes with many Y-type consumers existing for each X-type consumer. However, representing the entire economy is thoroughly unnecessary for illustrating the main point. We're not looking to calculate out the exact total dollar amount shifted out of the domestic economy by shifting income shares from lower-income individuals to higher-income individuals. The point is simply to explain the fact that there is some amount being shifted out of the domestic economy.

Note on the impact of increasing APS: It's been argued that this reduction in APC would be balanced out in terms of economic activity by the corresponding increase in APS. Unfortunately, that would only hold true in a closed economy with no outlets for investment other than productive investments (such as business start-ups and expansions). We are not a closed economy, so even when increasing APS does translate the savings into productive investment, those investments need not necessarily be domestic. For the United States, given that foreign returns are out-pacing domestic returns from such investments, much of the savings naturally translates into foreign investment which does absolutely nothing to balance out the reduction of consumption in our domestic economy. Further, even if we were a closed economy, we have a variety of investment options beyond just productive investments alone. There is absolutely no certainty whatsoever that a dollar of savings will necessarily even spur a penny of business expansion. Particularly when many businesses are avoiding expansion because they already have more than enough capacity to meet projected demand for their goods and services for  the next several years, we find ourselves in a situation where there is both a shortage of effective demand from consumption and a shortage of available productive investment options due to insufficient need to expand caused by that same shortage of effective demand.

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