The Output Gap Continues; The Impact Of Deficit-Hawks

The difference between "no longer getting worse" and "actually returning to normal":

We stopped getting worse. We still need a serious boost -- like from reversing the austerity of recent budget years -- to get back to good. Alternatively, a large enough boost to EITC could be another way of doing that while at the same time helping mitigate our ever-rising inequality.

Speaking of the recent austerity, here's that in a picture:

Had we not implemented such budget-cutting, deficit-hawk, austerity from 2010 (by not increasing spending commensurate with population growth) and even worse after (by actually reducing government consumption expenditures and gross investment), that alone would have at least had us significantly closer to potential by now. In other words, we'd have had more of a recovery.

Thoma on Capitalism, Inequality, Social Insurance, and Growth

From Mark Thoma writing in the Fiscal Times,

"Why is rising inequality a matter that our social insurance system should address? The idea behind insurance is to spread the costs of harmful events we cannot control across a large number of people. With fire insurance, for example, participants pool their money into a large sum, and the unlucky few that experience fires draw from the pool of money to cover their losses. In the end there is a redistribution of income from the winners who escape a fire to the unfortunate who don’t, but it would be wrong to view this as a net cost to the winners. The insurance premiums buy protection from fire – a benefit – and presumably the benefit exceeds the cost of the insurance.   

...

At some point, one I believe we’ve passed already, the benefits of inequality in terms of incentives are surpassed by the costs. As Joseph Stiglitz argues, “Inequality leads to lower growth and less efficiency. Lack of opportunity means that its most valuable asset – its people – is not being fully used. Many at the bottom, or even in the middle, are not living up to their potential, because the rich, needing few public services and worried that a strong government might redistribute income, use their political influence to cut taxes and curtail government spending. This leads to underinvestment in infrastructure, education, and technology, impeding the engines of growth.”"

The Progressive Path to Jobs

Steve Roth at Angry Bear yesterday covered similar ground to one of mine from February, "Debunking the Notion that Inequality Wouldn't Impact the Economy". Roth's "GDP, Prosperity, The Wealth Effect, and Marginal Propensity to Consume", took a slightly different track. Whereas I discussed the impact on GDP from inequality of income, Roth looks at inequality of wealth. As of yet, it's hard to say which is the better angle, although as Roth notes, the distinction starts to blur with age, since "people nearing or in retirement start paying a lot more attention to wealth than income." That is, unless you're dealing with folks who have nothing but social security because -- among other possible reasons -- they never had high enough disposable income to put anything aside.

Either way, whether income or wealth is the more important factor, clearly inequality matters. It impacts our commerce, our GDP. At least so long as the people at the middle (let alone the bottom) have wants and needs they can't fulfill for lack of means, a reduction in inequality achieved with the effect of getting more means to those who will use it will increase GDP and general prosperity. Ironically, spreading the wealth around a bit should lead to more potential for our economy to support more wealth. [Caveat: of course, we shouldn't go overboard. Just more equitable ... not perfectly even.]

And by progressive policies leading to more equitable distribution, that would constitute a way that -- contrary to what both candidates said or implied in tonight's debate -- government most certainly can create jobs. What leads to more commerce generally leads to more jobs, and a more equitable distribution would mean more commerce.

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.