GDP, Prosperity, The Wealth Effect, and Marginal Propensity to Consume
Comes to mind: the one about the two British ladies who meet at the Ascot races.
“My dear,” says the first. “What a lovely hat. Where did you get it?”
“Oh darling,” says the second, looking somewhat pained, “don’t you know, we have our hats.”
It comes to mind as I ponder the rather grudging and tepid suggestions that you hear here and there these days — that excessive inequality might actually be a drag on economic growth and prosperity. There are some full-throated assertions of this belief out there, but in the mainstream economics community they are rare and in general quite decidedly mealy-mouthed. (No names, just initials: The Economist.)
The general failure to question the “more inequality is good for growth” mantra has deep roots, even among progressive economists. Viz, this from Paul Krugman back in December, 2008, when the highest inequality since The Great Depression was was in the process of delivering the first (at least potential) depression since…The Great Depression (bold mine):
There’s no obvious reason why consumer demand can’t be sustained by the spending of the upper class — $200 dinners and luxury hotels create jobs, the same way that fast food dinners and Motel 6s do. In fact, the prosperity of New York City in the last decade — largely supported off of super-salaried Wall Street types — is a demonstration that you can have an economy sustained by the big spending of the few rather than the modest spending of large numbers of people.
This seems to completely ignore marginal propensity to consume (MPC) — that poorer people spend a larger percentage of their income than rich people, so a more equal income distribution would result in higher money velocity, hence higher GDP. (I have seen no indication that Krugman’s opinion on this subject has changed since then.)
But I’d like to suggest that the problem runs deeper. Almost all the thinking about MPC seems to obsess about income, and greatly downplay the role of wealth, or net worth. The Wikipedia article on MPC, for instance, includes only one passing mention of wealth.
This failure to consider wealth is important because wealth inequality in this country (and worldwide) utterly dwarfs income inequality.
The Friedman/Modigliani rational-expectations lifecycle-hypothesis school does include wealth in their theories of marginal propensity to consume, but they assume that a great deal of people’s “wealth” actually consists of expected future income. This in turn assumes consumers’ excellent foresight decades into the future, and that people (at all income levels) are able or even likely to engage (accurately) in net-present-value calculations of their future incomes and expenditures.
There’s obviously a large literature on this subject that is ridiculously condensed above. But that aside: for thinking purposes I’d like to propose an admittedly simplified, opposite model that I have not seen discussed, in which current wealth (individual net worth) is the only determinant of (consumption) spending in a given period.
Imagine a world with eleven people in it, where we all have our wealth, and where net worth is broken out as follows.
Person 1: $1,000,000
Persons 2-11: $100,000 each
All spending comes from these stocks of wealth.
Now assume a very simple consumption function — a two-step “curve” — based on MPC (and marginal utility of consumption) thinking: propensity to consume for those holding more than $500,000 is 3% (because that satisfies their desires), while it’s 5% for those holding less than $500K.
Here’s how spending (Y, or GDP) plays out:
.05 x $100K x 10 = $50,000
+ .03 x $1 mil = $30,000
= $80,000
Now change the initial wealth setting: Persons 2-11 have $50,000 each, and Person 1 has $1.5 million.
.05 x $50K x 10 = $25,000
+ .03 x $1.5 mil = $45,000
= $70,000
By transferring half of the poorer people’s money to the richer person, we’ve cut GDP by $10,000, or 12.5%.
Then consider the change in shares of wealth from 2007-2010. Median net worth dropped by 40%, while the net worth of the top 10% went up.
Even if you accept the notion that predicted income constitutes a large portion of people’s perceived “wealth,” the implications are the same. If more of the national income (the $80K or $70K in spending) goes to the poorer people, they will have more wealth in future periods, with the salutary effects on GDP and prosperity shown above. (If they expect that distribution to continue, it will even impact their estimates of their own wealth in this period, increasing their current propensity to spend/consume.)
And this doesn’t even consider declining marginal utility of consumption (or only includes it in a display of circular logic) — that somebody with a $25,000 consumption budget gets more utility from a given (percentage or absolute) budget increase than one with a $50,000 consumption budget. So a small percentage shift in shares of wealth from the rich to the poor, or vice versa, results in quite large shifts in shares of our aggregate utility.
A supporting argument from the personal-anecdote-as-the-singular-of-”data” school of rhetoric: all this holds true for me. I put away a very nice chunk some years back, and am playing the fairly typical “will I run out first or die first?” game. (It’s hard to say which is worse. How many people spend their last dollar on the day they die?) I’ve often joked with my financial advisor that I have one Key Economic Indicator: how much money do I have? That’s what I think about when deciding whether to spend. People nearing or in retirement start paying a lot more attention to wealth than income. (Related but tangential: not surprisingly, as the future gets closer and more predictable, as the kids get up on their own feet, for instance, “the marginal propensity to consume (MPC) out of wealth increases with the age of the consumer.” PDF.) And we have an increasing number of people in or near retirement these days.
If this thinking holds any water — that the distribution/concentration of (perceived) wealth has an important impact on aggregate marginal propensity to consume — there’s a very solid and rather straightforward theoretical basis for the otherwise largely limp-wristed assertions that we’re starting to hear more glimmers of these days in the mainstream media, and in the more influential sectors of the econoblogosphere.
Equity and economic efficiency are not in conflict. Quite the contrary, in fact.
For those who prefer to look at pesky things like facts, the empirical data bears this out: at least in prosperous countries, greater wealth equality correlates with greater long-term prosperity.
For those who care to hear a personal account of how modest, widespread wealth dispersal can encourage innovation, entrepreneurship, and wealth-creation, see here.
Cross-posted at Angry Bear.
Please see “Inequality, Economic Growth, and the Debt Crisis” 1994
http://www.librinlinea.it/search/public/appl/dettaglio.php?bid=TO00342969
well if looking that long ago, Perotti (1993) is better.
See no sign of insufficient demand in unequal countries, but the claim inequality is bad for growth sure is there.
There is actually a large literature. The main focus is on how inequality interferes with schooling because of imperfect capital markets and so relatively poor families need income now. Maybe the main focus should be on how spending on public education reduces inequality and increases growth but that’s not fancy theory enough.
As you note, the raw data are pretty firm on the point that high inequality is correlated with low subsequent growth.
One form of wealth is the ability to influence stuff that you don’t actually own. This is quite hard to measure, if possible at all, but it’s crucial.
So, suppose 10,000 people are living in a favela, have their homes there, jury rigged power supplies, water supplies, etc. They have accumulated “wealth” there, in stuff and community.
One day it is discovered that deposits of allotropium underlying the favela, believed worthless, are essential to some new technology. Predictably, a wealthy investor gets to do two things – mine the allotropium, and destroy the accumulated wealth of those 10,000 people.
The wealthy investor, because of his wealth, actually has “ownership” of resources which he doesn’t have to prepay, store, or even think about until they become worth the bother. Those 10,000 people in the favela, by contrast, don’t own their wealth — they are just allowed to use it till someone else can be bothered to push them aside.
The wealthy guy doesn’t just own his hats, but everyone else’s hats, too.
Noni
@Robert: Right. There are many mechanisms whereby inequality could damage growth and reduce prosperity. This post just looks at a fairly straightforward arithmetic, accounting-based mechanism based on a single aspect of TEC (textbook economic theory) — (MPC, and the marginal utility of consumption).
@Noni: Excellent. This gets into the failure of textbook economics to provide a coherent theory of “capital.”
I like the simple math. I’ll be curious to see how the comments develop here as this is similar to my post noting that monitary policy was just not doing it for me.
I used 100 shares of stock and looked at what would happen if we moved 5 more people into the top that had 81% of the shares. Low and behold, there were now 15 people that could afford to buy a carnation from my shop verse 10 people.
When your an economy that is making it’s money from money, wealth is where it’s at because that is what generates the coin.
Wish more of the “economists” would mention velocity more. Seems everyone believes it’s all drag racing and not endurance racing.
Velocity is absolutely right.
Even a little bit more velocity should be able to make quite a big difference.
If the 2 million for a yacht went to buying 2 million in hamburgers instead (assume at McDonalds), what’s the velocity impact? Assuming the vendor doesn’t get paid until delivery on that yacht, you’re talking 6 months that the builder is borrowing money (or experiencing an opportunity cost if they have the money already) to pay wages etc.
McDonalds is massively liquid in comparison with little drag from borrowing. Maybe it isn’t even the velocity multiplier effect, it’s the effect of the time value of money and borrowing costs.
Thanks for the posting.
Nonni brings it closer to what I think which is that ongoing inheritance has created a small global clutch of folks that own all hats (or banks), so to speak.
Until we can crack that nut they will continue to control all ultimate allocation of capital and the people clawing for it.
The crucial part is “a great deal of people’s “wealth” actually consists of expected future income. ”
How much of that expected future income contributes to future aggregate demand?
For instance, most of the wealth (pension stocks) of retired teachers goes to future aggregate demand. However, it is not the case with top 0.1 percent.
Good points, though unfortunately too true that “full-throated assertions of this belief … are rare and in general quite decidedly mealy-mouthed”.
Your post on this reminds me of one of my own, Debunking the Notion that Inequality Wouldn’t Impact the Economy, although that focused on income rather than wealth. Ultimately, both should probably be considered, though in what ratio is a harder hair to split.