Debunking the Notion that Inequality Wouldn't Impact the Economy

It's been claimed -- incorrectly -- that overall activity would neither be increased nor diminished by how evenly or unevenly money is distributed within our national economy. According to that line, we'd get the same amount of commerce regardless of whether we have a larger share of the pie held by the wealthy or by the lower and middle classes. "Money is money," or so they say.

Except that in reality, lower average propensity to consume (APC) results from significantly increased real income.¹ Who has how much matters because people tend to 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 Warren is a wealthy person and John is a poor person and over time Warren attains a higher share of the available money, total spending -- effective demand -- generated by those two consumers will drop.

If there's $1,000,000 of total income between the two at time T1 and Warren gets $950,000 while John gets $50,000 and Warren spends 33.33%² of income to John's 100% of income, then total spending by these two individuals at time T1 will be:

T1: $316,635 + $50,000 = $366,635.00

When income ratios shift and there's an inflation-adjusted $1,000,000 of total income at time T2 and Warren gets $975,000 while John gets $25,000, Warren's spending ratio (APC) will likely have fallen slightly from the previous propensity, but we'll stick with 33.33% for simplicity and understatement. Meanwhile, John can't spend as much as before because John's available funds have dropped. Even if Warren still spends at the same rate -- which is unlikely -- then total spending would be:

T2: $325,967.50 + $25,000 = $349,967.50

That would be a drop from time T1 to time T2 of $16,667.50 in inflation-adjusted spending. I've picked an arbitrary APC for Warren, but herein we're just showing the rough effect. The dollar values are merely for illustration of the concept. Even if the exact average amount might vary slightly from the $16,667.50 of our illustration, 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 (and thus the overall APC) 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.

Confronted with that reality, the "money is money" crowd rely on APC's flip-side, average propensity to save (APS). They're two sides of the same coin. As APC drops, APS rises. Our hypothetical Warren has a lower propensity to consume but a higher propensity to save. Some try to claim that the 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're 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.

Even if we were a closed economy, we have a variety of investment options beyond just productive business investments alone. For instance, Warren might buy gold ETF shares from Glenn who might then use the proceeds to speculate on the British Pound or perhaps to buy Treasuries.³ A dollar of savings lacks any certainty whatsoever that it would spur even a penny of business investment. 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.

This all matters because we need a certain level of effective demand in order to sustain full employment. Without sufficient consumption, businesses need fewer workers. With less demand for labor, wages fall. Dropping wages and employment both further depress the nation's ability to consume, leading to yet more unemployment and dropping wages. With too much of our wealth concentrated at the top, we can't support as much wealth. That's bad for rich and poor alike. As Franklin D. Roosevelt said, "we all go up, or else we all go down, as one people." We as Americans believe in promoting wealth and affluence. But to do so effectively, we must have enough of a strong base underneath the top to support a growing top. To have steadily growing affluence, we must mitigate the divergence of our most wealthy from our lower and middle classes.

 Notes:

1. When the shift is initially happening, we refer to the marginal propensity to consume (MPC), essentially the rate of change in APC. Herein, we're not concerned with the rate of change but rather just the implications of such a change from one state of APC at one point in time to another state of APC at a second point in time.

2. The 33.33% and 100% value are arbitrary representations of the fact that higher income consumers spend less of their total income than lower income consumers. The actual observed multiplier for various income levels may vary. What's important here is not the specific percentages but rather the impact of the difference in percentages.

3. Treasuries arguably could indirectly contribute to productive domestic investment when the government spends within the economy. Likewise, the gold seller could use the proceeds to invest domestically. However, neither of these have the direct impact on domestic economic activity seen from domestic consumption or direct domestic business investment. They're not a clear proxy for domestic activity. They're a case where savings may or may not translate to investment.

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  http://thoughtstate.blogspot.com/2012/02/debunking-inequality-economy.html and http://www.addictinginfo.org/2012/02/10/debunking-the-notion-that-inequality-wouldnt-impact-the-economy/.

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.

The Second Paradox of Thrift

We generally consider savings good for individuals as a matter of common sense. One would naturally think it would be good for the nation as well. As it was put to me at one point, "But if a household gets ahead by saving, not spending, why don't a million households?" The question requires different answers depending on whether you're concerned with those million households as an aggregate of individual spenders or as a unified spender through a national government.

The traditional answer considering the aggregate of individual spending hails as the paradox of thrift. The typical increase in savings by the average consumer comes via reducing spending rather than from an increased income. Given level income, as one consumer spends less in order to save more, that consumer increases his personal net worth. However, the decrease in spending lowers that individual's contribution to demand. If decreased spending by half the potential spenders is offset by increased spending from the other half, then there's a break even for the overall economy. But if every spender in an economy spends 1% less in an effort to save more, then overall demand for goods and services would be diminished by roughly 1%. When supply and demand happen to be matched, that reduced demand doesn't require as many employees as before to fill the orders. The resulting layoffs mean fewer people can save thus ironically causing reduced aggregate savings from a too aggressive (or panicked) shift towards individual savings.

On the other hand, if we're talking about those million households in the unified sense of a national government, we need to look at a different aspect of the question. At that point, we can shift our focus to that first part about "gets ahead". Almost no household truly ever gets ahead by saving rather than spending in real life. Saving is how households that are already ahead maintain that being ahead. Households get ahead in the first place by spending on tools to increase income (such as job training, education for higher-wage jobs, tools for trades, goods to improve and sell, etc.). Saving foolishly can be far worse than spending wisely.

In that sense that recognizes that certain debts can increase future income by more than the debt, what's good for households can be good for nations. For a nation that's already doing great, saving could do a wonderful job of steadying the already rolling wealth. For a nation that's not doing well, investments in improving the national potential will tend to do much better. In that sense, it's just like an individual. Your high-income CEO would be wise to put enough money into safe investments that he no longer has to have his job to pay the bills and just does it for personal satisfaction. Your broke high-school graduate would be better advised to get an engineering degree on loans than to try to save up from working at a gas station or other low-wage job. A nation in steady growth (or a boom) mirrors the situation of the well-paid CEO or engineer. A nation in low growth (or recession) mirrors the situation of the low-paid laborer who can't quite afford the basic cost of living and will never be able to save up enough to make a difference without taking on debt to achieve a higher income.

Simply put: If you have a high income (strong growth), it is wise to save. If you have a low income (weak or negative growth), it is more wise to spend on increasing your income. The second paradox of thrift: for an individual or nation, you have to already be doing well before thrift makes as much sense as spending wisely.

What Can We Really Learn From Estonia?

S&P Downgrade of U.S. and Upgrade of Estonia Inspires Misguided Admiration

In the wake of a few recent S&P decisions, fans of budget cuts are practically waving the Estonian flag. They point to Estonia's recent austerity measures and it's Q1 2011 growth as some sort of vindication. "Look, look ... we've got a positive example!" Ah, but if only it were that simple. There's more to Estonia's austerity and growth than meets the eye of the starve the beast crowd who would have us emulate their example. Estonia chose "internal devaluation," including wage cuts. So keep in mind what following the Estonian script would mean: big wage-cuts and a lower standard of living. Who really wants to sign up for that?

But more importantly, one should take a closer look at the impact on the Estonian economy before declaring them a model that everyone should copy. I'd swallow some short-term pain if it made the overall situation better for my country in the long run. But in the case of Estonia, the trouble didn't entirely end with the turn-around from the -13.9% plummeting GDP in 2009 to the 1.8% growth in 2010 and varying more-or-less positive growth forecasts for their future. While Estonia has returned to GDP growth, they're doing so on the backs of their neighbors. The one bright-spot in their economy is exports, which were up 43% from a year earlier in June. (Although June's figures showed a drop from the previous month.) Their unemployment remains high. Their retail sales and non-govt construction are both still down significantly. The domestic market isn't looking so good there. But in Sweden, Russia, and Finland demand is rising. All three of Estonia's biggest foreign markets saw significantly higher GDP growth in 2010 than Estonia. The strong growth continues in Sweden in particular ... plenty to explain why Estonian producers have still had a market in the face of lower internal demand. Having growing trading partners is great. But in the long run it's a poor substitute for steady internal demand. Estonia's internal devaluation has made them even more dependent on their neighbors. Should the growth in Sweden, Finland, and Russia cease or even slow down significantly, Estonia could find itself in deep trouble with no fuel for its economy. That sort of dependence on -- and vulnerability to -- foreign trade partners has lots of drawbacks. Sacrificing domestic demand to gain foreign demand means a weakened domestic economy.

So what can we really learn from Estonia? Mainly that it's good to have trading partners who have money to spend on what you're making. That's not a lever we (or anyone else) can control. It's up to our trading partners to keep their economies moving. Aside from maybe lending the occasional wrench, we can only look to get our own engine revving again. But we can also learn that worrying too much about increasing our exports can cause a nation to become export dependent -- at the mercy of the whims of foreign markets. While that may be nice when those markets are thriving, do we really want to count on them completely and make ourselves export dependent? Wouldn't you rather we fixed our domestic shortage of demand instead of sacrificing what's left of it in the vague hope for an uncertain boost to exports?

The Cost of Cuts

To break even on employment, we need around 2 or 3% growth in GDP.

"Putting this in our current context we can see that growth has to do two things. First it has to cover, or absorb, growth in the workforce due to population changes. A good rule of thumb in the US is that GDP needs to rise by about 2.5% for unemployment just to stay even with such changes." from "Sticky unemployment – Okun’s Law" by Peter Radford

Our GDP, the amount of goods and services we produce, comes from the amount that is spent on American goods and services ... the supply rises and falls to meet the demand. Of that spending (or demand), private sources (individuals and corporations) spend only a portion of the total that makes up the GDP. The government also spends, and that spending makes up a portion of the total demand for goods and services.

Supply doesn't discriminate. Supply is blind to the source. It doesn't care whether the demand comes from private or public sources. No matter what portion of the demand comes from each, supply doesn't care about anything other than the total. If the total demand rises, supply will meet it and require more workers to do so. If the total demand falls, supply will meet it and require fewer workers to do so.

Government's share of GDP has mostly risen over the years, although not in an exactly straight line. Some hate this fact; but whether you call it positive, negative, or neutral, there it is. Government's shared of GDP has been estimated at 25% (or even 43.85% by one source) for 2010. For the sake of avoiding any exaggeration of the impact of government spending cuts, let's go with that smaller 25% figure. At 1/4 of GDP, a 10% cut in government spending would mean about a 2.5 % reduction in GDP. Let's simplify the numbers so that is easy to see. Imagine if we had a total GDP of 100 million dollars and 25 million of that were from the government:

100 - (25 * 0.10) = 100 - 2.5 = 97.5

So there you have it, a 10% cut in govt spending would shrink our GDP by 2.5%. Of course, this assumes that what we're cutting is to make up for deficit spending, i.e. govt foreign borrowing. Considering that the main reason there's talk of cutting government spending in the US is to reduce foreign borrowing, that seems a safe assumption. Borrowing brings in money from outside, so a reduction in debt-based spending does not get offset inside the system. If we had a balanced budget and were cutting spending in order to lower taxes, the offset might just be shifted from public to private spending. But that's not where we are. We're looking at cuts to reduce the amount of GDP we cover by bringing in money from outside, which means we'd reduce the total spending in the system, the total demand, the total GDP.

But what does it mean to have a cut in government spending reduce our GDP? This brings us back to that minimum GDP growth of about 2.5% in order to keep employment stable. Estimates vary, but many forecasts for 2011 US GDP growth are around 3%. So if we cut our government budget by about 10%, that'd subtract 2.5% and give us a GDP growth of about 0.5%, which is roughly 2% below the level needed to sustain stable employment. That means we'd have rising unemployment. Of course, rising unemployment lowers payroll tax revenues. Dropping payroll tax revenues increase the deficit. Deficit increases make people think about cutting more from the government spending. See how this could spiral?

To balance the 2011 budget, we'd need to cut government spending by about $1.27 trillion. The total spending for 2011 at this point is estimated around $3.83 trillion. This means that we'd need to cut the budget by around 33% in order to balance revenue with spending.

Assuming the lower 25% share of GDP, thus less impact, a 33% drop in government spending strictly to avoid taking on more debt would slash 8.25% from our GDP.

100 - (25 * 0.33) = 100 - 8.25 = 91.75

Downward spiral

Pulling 8.25% from our GDP growth would leave us with a GDP growth of around -5.25 for 2011, which is a severe contraction. Remember that we need around 2.5% growth to keep unemployment stable and higher than that to see a reduction in unemployment. So with a -5.25% contraction in GDP, unemployment would go up, up, and up some more. That rising unemployment would promptly lower our revenue (and increase our costs for the unemployed) and give us a deficit again. That deficit might make people cut more, which would lower our GDP further and bring more unemployment.

"What you see is that unemployment tends to fall when growth is high, rise when it’s low or negative. You also see that growth has to be fairly fast — more than 2 percent — just to keep the unemployment rate from rising. Why? Well, productivity is rising, so that you can produce any given level of output with fewer workers; so output has to rise to keep employment from falling. And the working-age population is growing, so you need positive employment growth just to keep unemployment from rising." from "Growth and unemployment" by Paul Krugman

Bad recipe. Clearly, we can't cut our way out of this deficit. We have no choice but to find a way to grow. If we had high GDP growth (like 7%), we could to cut meaningful amounts (like maybe 10%, assuming 7% GDP growth), and still have rising employment, reducing unemployment. Rising employment would also mean more payroll tax revenues, thus lowering the deficit directly. Growth such as this is the only way to spiral upwards. During slow growth, cuts force a downward spiral.

We can't afford cuts. We have to find a way to grow.

The Golden Fleece

The drums sound. The town crier roars, "Fleecing the rich! Fleecing the rich!"

But who is fleecing whom? And is the only fleece here just wool for pulling over eyes?

Fleecing the rich is a red herring. We have a demand-driven economy. There aren't enough folks in the very top to take care of all the demand. If the middle and lower classes combined don't have enough money, they can't keep commerce flowing fast enough. That matters, because jobs come from spending. Sure, they come directly from business, but business gets its money from spending at that business. Without enough spending, we can't support as many jobs. There's a minimum level of spending the economy needs for businesses to bring in enough money to need the current workforce to meet the demand. More commerce than that level means more jobs are needed. Less commerce than that level means fewer jobs are needed.

"But wait", the supply-siders say, "the wealthy will buy more Bentleys with their tax cuts or vacation more or something and cover that commerce."

Will they? Let's leave aside the fact that Bentley Motors Limited, like Rolls-Royce, is a British manufacturer and a Bentley purchase may not be as likely to create American jobs as a Fiesta or a Cruze purchase. Even more importantly, each wealthy person only needs so many cars, even if they were purchasing American made cars. The 400ish billionaires in the US can only wear so many clothes, eat so much food, or use so much of anything themselves. Yes, there are more millionaires -- several million of them -- but still, they only need so much each. It's the hundreds of millions of people who are less affluent who will always make up the bulk of need for goods and services. It's not strictly for any lack of patriotism among millionaires; it's just that there aren't enough people at the top to need enough goods and services themselves to keep everyone employed.

With the amount of wealth held by the middle and lower classes declining, we have a serious problem. That's all of us ... not just the middle and lower classes, but the wealthy too. The rich may be more insulated from unemployment and stagnant wages than the rest of us, but if the level of commerce falls too low it can fail to sustain their investments. And the bigger argument for those of us who would like to join the ranks of the wealthy: if commerce is shrinking rather than growing, there's not much chance for new members of the upper class. In order to have rising affluence, you have to have a healthy economy. In order to have a healthy economy, the middle class can't be declining ... because the middle class is the core of spending and the heart of the economy.

"But wait," they defenders of trickle-down say, "if we cut they're taxes, they'll have more money to invest. You're saying that if people have more money to invest then the natural inclination is to NOT invest that money? You're saying that if there's an opportunity for a greater return on that investment, people are less likely to invest that money?"

Sure, they'll invest. Many of them will sink the cash in things that don't create jobs (or at least not in significant numbers) such as buying stocks, foreign bonds, money markets, and commodities like gold. If one billionaire buys a zillion shares of Corporation X from another billionaire, that's generally 0 jobs created ... although it may help maintain a job at a brokerage and then the broker's income may help create or sustain a few other jobs (but still, effectively close enough to no jobs versus what certain other uses for that money could do).

Some few of them might invest in venture capital funds that specialize in US startups or expansions. Some few of them might directly invest in US entrepreneurship. But with raw no-strings-attached tax cuts there's no guarantee that any of them will. If other investments look more profitable, most of them won't invest in such American job-creating investments.

Some might also invest in venture capital or direct entrepreneurship in other countries that compete with our own ... thus destroying American jobs. It is entirely possible that some large amount -- potentially even 100% -- of the tax cuts for the top 1% could end up being invested in foreign companies that will end up killing jobs here. It's not likely that every penny will go abroad, but there's no guarantee that any of it will stay. And it is very likely that at least some of it will go to foreign investments that compete with us. Growth in China is currently high, so odds are good that quite a few of them will risk the possible Chinese housing bubble and such in order to capitalize on their high growth rate. Chinese entrepreneurs are probably thrilled that we're considering borrowing money from China to free up no-strings-attached cash from our wealthy such that some of our wealthy will have more money to invest in China.

Of course, it's probably just a coincidence that this is coming right after Republican wins that saw large chunks of their add money coming from the US Chamber of Commerce that gets large chunks of their money from foreign members such as state-owned Chinese companies. Surely it's entirely unrelated that some of the most lucrative investments around are Chinese companies that compete with American companies. I'm not saying there's any cause and effect there. Probably a coincidence, but a very unpleasant one for our prospects of this tax cut for the wealthy being a good thing for the nation.

Perhaps the most interesting potential: The top bracket could all invest the cuts into Treasuries, so we'd be freeing up money for them to lend back to us at interest to cover the money we gave 'em interest free. Merry Christmas to them, eh?

But the long and short of all this is that while tax cuts for the wealthy will mean more investment, that investment won't necessarily help the American economy and may in fact hurt ... because the bulk of it could be investment in our competitors.