Bleg: What’s Wrong with the MPC/Spending-Velocity Argument?
I’ve ground the axe quite a bit over the years for the argument that Kevin Drum makes — and dismisses — here.
In brief: poorer people spend a larger share of their income/wealth than richer people. So if poorer people have more income/wealth — if the distribution is more equal — there will be higher money velocity/more spending/more production/higher GDP.
(Search for “marginal propensity” and follow Related Links to see my stabs at this.)
But Kevin — who certainly has the political inclination to make this argument — says:
This sounds pretty plausible, doesn’t it? Higher inequality should generate less consumption, which in turn produces a weaker economy. Unfortunately, the data says something else. “I wish I could sign on to this thesis,” says Paul Krugman, “and I’d be politically very comfortable if I could. But I can’t see how this works.”
Me neither. I spent a couple of months trying to write a magazine piece based on this thesis, and I finally gave up. By the time I was done, I just didn’t believe it. So I gave up and spiked the idea.
I’ve tweeted him and posted a comment, but haven’t heard: what made him give up on this? What convinced him otherwise?
And in response to a recent post where I ground this axe, Scott Sumner responded:
But you really need to give up on that MPC stuff, it was discredited decades ago. Monetary offset rulz.
This in keeping with his seeming assertion that nothing matters except monetary policy, because monetary policy will (or at least should) always offset it.
But still: Sumner, Drum, and Krugman all seem to think that the distribution/MPC/velocity argument has no legs. They’re quite categorical about this.
SRW took a stab at the subject recently, telling a story that I find quite convincing. But didn’t really explain to me why so many feel so certain that it’s not true.
Can folks (especially those who don’t believe this argument) point me to what might be considered definitive takedowns? I have notions about what they might say, but want to see the best argument(s) out there.
These takedowns should, just for instance, convincingly debunk this paper (sorry, gated), which suggests that rising income inequality ’67-’86 resulted in 12% lower consumption spending in ’86 than would have occurred if inequality had remained the same.
Cross-posted at Asymptosis.
maybe i just don’t know enough. but your article is impossible for me to extract any meaning out of.
if the question is “does inequality of incomes lead to lower growth?” i’d be inclined to guess it does not. the poor can starve in peace without affecting “the” economy.
but if the question is “does an immediate boost in the incomes of the poor result in an immediate boost in “the economy” more than an immediate boost in the incomes (as by a tax cut) of the “rich,” i’d be inclined to guess that it would.
i am, be warned, not a big fan of “studies” or of “economic argument.” they both seem to suffer fatally from the “eye of the beholder.”
or as Roosevelt might have said, “lets try it and see if it works.”
But if the better off spend at the same as the poor doesn’t this also imply that they save as the same as the poor? Consequently, cutting taxes on the wealthy would not lead to more savings and investments? Right.
srw’s post is very thoughtful and seems on the right track.
The question about the sustainability of debt is cogent. With all the caterwauling about federal debt, you seldom see mention of private debt, which is far, far greater.
Isn’t this a variation on the question of whether consumption spending is income based, per Keynes, or wealth based, per the anti-Keynesians?
I had 4 posts on that topic last year, and convinced myself, at least, that Keynes had this one right. Her is one of them.
Another feature I see in just about every data a set I look at is the slow death of the American economy. Just about every parameter has shown declining growth rates since 1980 +/- a few years. This is why the great moderation is really the great stagnation. It is the fruit of low taxation, lax regulation, and the resulting dramatic increase in inequality.
Hope this isn’t too far off topic.
I wonder if it’s an issue of how Krugman et al define consumption? But more importantly as SRW is getting at, the economy has changed.
The deniers see growth and say: See. The rest like you, me and SRW see growth and as how?
My concern for the dismissal is that the economic structure has changed. It’s my issue since first blogging: We make money from money. That is as fundamental a change in the economy as is a warmer temperature of the planet to understanding what one is observing and potentially predicting.
The meteorologists are having problems with predictions of local weather because their science perspective has not incorporated into their basic model a warmer planet that the climatologist have predicted.
The stubbornness of Krugman et al to ignore such a fundamental change is of major risk to getting policy correct. It’s just like the difference in response to a decline in say your available water and a decline in GDP. The natural thing to do when we see a decline of our water is to start taking action to reverse the decline. Unfortunately in economics the response to a decline is to only note the continued growth until the growth is zero or negative. Then the policy change discussion begins. Unfortunately even more so, the zero point is only noted post humorously. It’s too late IOW.
History is replete with economies shifting from an exclusive extractive type (see Why nations Fail) and still growing until they don’t and economies shifting to an inclusive and distributive with sustained growth until the move toward exclusivity. Krugman et al are failing to acknowledge our movement.
And then there is the simple fact that monetary policy is just not getting it done which if I hear Bernanke correctly is seeing this too. It’s like the austerity policy. We see it failing, but hey, they still had growth.
let’s see. i have more money than i need at the moment. you don’t have enough money to buy groceries. the groceries go unsold. i lend you the money to buy groceries.
how much exactly does it matter if you ever pay me back (what is the difference between my lending and not getting paid back, and my being taxed by the government? in either case, you live, the farmer gets paid, and i am out some money i didn’t need. though presumably i will benefit down the road from your work as an employee, your money as a customer, or your contribution as a citizen (including taxes you pay, and possible military service…)
i don’t see how anyone here can “understand” anything as long as they keep on “thinking” in the same well worn political ruts.
Let me just add, that I noted when everyone was all excited about the Gatspy curve presented by Kreuger that the more important point was the $450 billion in consumption activity (per year I believe) he noted was represented in the shift to greater inequality. He noted he was saying that such activity took place, but it was the result of debt spending.
I also posted a research article that showed the great debt spending was not by the consumer to increase their standard of living but to just maintain it.
For Krugman et al to accept the velocity MPC they have to accept that the economy and it’s growth is the smoke and mirrors of making money from money.
This is way over my pay grade and I am certainly not someone who would take a position contrary to Krugman, but I guess I do have a couple of thoughts. Ultimately, what drives the growth of the economy is demand. That demand can be for necessities or more discretionary goods and services. While poorer people might want discretionary goods and services they contribute little to the demand for those items because they exhaust their resources on necessities. If they suddenly had a bigger piece of the pie, they would presumably increase their demand for those discretionary goods and services, but they might also be inclined to start saving a bit (or reducing debt). It takes time to change ones tastes and someone who has run short in the past paying for necessities might well decide that having a few bucks in the bank is a better idea than buying an I phone. Anecdote while a student and when I first started working I usually bought the cheapest beer available. Even after I was making good money and could afford to buy any beer I wanted, I continued to drink the cheap stuff for years and saved money instead. It is only in recent years when my biggest lifetime expenses except retirement have been paid for and I think/hope I have enough saved for retirement, that I have begun purchasing the expensive beer. On the flip side taking money away from the wealthy would rationally mean that they would save less because they do not come close to consuming everything that earn and they already have saved more money than they can possibly consume–and in many cases their children and grandchildren can consume–but I bet that the data shows they actually consume less. Now all of the decrease in consumption occurs in the discretionary category and likely occurs at the very highest end, but instead of buying that new Mercedes every year, maybe they buy every two years. The point is that once you start talking discretionary spending while the poor certainly have a greater MPC than the wealthy, transferring money from the wealthy to the poor might not have any impact on aggregate demand although the nature of the goods and services demanded would surely change. That being said the fact is that the poor –particularly in times of high unemployment do not even cover the necessities and getting them more money would certainly boost demand for them. Case in point is the leveling off of the increase in price of health care. At least some is due to people not seeking medical care because they can not afford it. By definition the wealthy would not cut back on necessities if they had a bit less income.
This issue is really simple. Income flows through the economy as income, whether it is taxed, saved, transferred or spent.
The real issue behind inequality of consumption is how national income is divided between capital and labor. This is what my research on effective demand develops.
Income to capital behaves very differently than income to labor. And remember, even the income of the most rich is included in labor share of income. Capital income includes corporate profits.
Like Krugman said about rising corporate profits, “What’s really out of line with previous experience is the level of corporate profits, which is arguably serving as a kind of sinkhole for purchasing power.”
The rise in capital’s share of national income is weakening aggregate demand, and effective demand, as I frame it.
But then there was the post by Scott Sumner about that “sinkhole of purchasing power”. (By the way, this post has some comments down below that help understand the issue more.)
In that post, Scott said, “The argument that higher earnings by capital will lower the MPC is far more powerful than the argument that redistribution within the corporate sector has an effect on the MPC.”
And now Scott is saying that labor’s share of national income is so important that we might just consider using it as the target for monetary policy. And I would agree with Scott.
I want to post parts of a comment made by Andy Harless on moneyillusion from the link I gave in my other comment above…
“It’s easy enough to look at this in monetarist terms, too. Suppose money demand depends on both Yh and Yc, and M’(Yh) is less than M’(Yc). Then a shift of income toward corporations results in greater money demand for any given level of aggregate income and thus a decline in the velocity of money. “…
“But I think you’re right that the relevant quantity is not actually “corporate income net of dividends” but capital income overall. I suspect that the marginal propensity to consume out of dividends is much lower than the marginal propensity to consume out of labor income. So we really have three categories of income, Yc (undistributed profits), Yd (dividends) and, Yl (labor income). I suspect that the marginal propensity to spend out of the last of these is considerably higher (and the associated marginal demand for money substitutes lower) than both the other two.”
“how much exactly does it matter if you ever pay me back ”
A hell of a lot, I’d say. If I don’t, you can have me sent to jail [in certain eras.] At the least, my ability to continue borrowing – which I need to do to survive – is severely compromised.
Could even lead me to a life of crime.
I think Terry has a very rational narrative.
Krugman calls himself a liberal, but that’s only true relative to right wingers who get basic econ willfully wrong, such as the list of scoundrels he calls out here.
Read the Krugman of the 90’s – conservative side of centrist, all about free trade, etc. etc.
He got politicize about the same time I did, by the GWB regime and its persistent and excessive wrongitude.
That’s why regressives hate him. But in a world that made even the vaguest sort of sense, PK would be seen as a voice of reasoned conservatism, while those other guys would be cast into the outer darkness, where they belong.
i understand your point. I was trying to make a different point.
note, “i have more money than i need.” not “this minute” but pretty reliably for the rest of my life.” the question was what difference does it make to me if i pay a tax, or if i lend the money and don’t get paid back.
i think the difference is entirely psychological, maybe spiritual.
now, that could make a difference to the willingness of the rich to lend, in the short run. but eventually they would have to lend their excess anyway, because it rots in storage.
i believe that historically they have managed to lend their excess to people who couldn’t pay it back, which people then became debt slaves.
something similar may be happening here, but it won’t be obvious to those who can’t think beyond that nickel left on the table.
“And remember, even the income of the most rich is included in labor share of income. ”
Is this a definition, because it is not the way we think about it. Dividends and capital gains are income of the rich, but not included in labor income (as I understand it).
Thanks for all the comments. But I’m still waiting: what’s the slam-dunk argument that has Krugman and especially Drum convinced that the MPC argument doesn’t hold water?
Don’t give me your argument, give me your version of *their* best argument (or, just their best argument).
Kevin Drum doesn’t give an explanation of why the MPC argument doesn’t hold water. The reason is somewhere in the data, but he doesn’t give an explanation. Neither does Krugman.
My view, even though you are not asking for it, you can’t isolate one income group from another in the circular flow of the economy. Households receive income and spend or save. All households interact with firms through product, financial and factor markets. The firms receive revenue and then distribute their revenue according to factors of production, labor and capital. The labor portion goes to households. The capital portion goes to retained earnings, depreciation, dividends, capital investment, reserves and in some instances, overseas investing. So the dividing point is not MPC of household income, because marginally propensity to save is still in the circular flow. The dividing point is the revenues of firms.
Households move money as they work, save and buy things. Firms move capital income where investment is good. Where is investment good? Not where middle and lower US incomes do business. They are losing real income through time. You don’t invest in an industry that is stagnating. The issue more than MPC, it is MPI, marginally propensity to invest. Lower incomes lead to less liquidity, riskier investments, less consumption.
I say that if middle and lower incomes began to rise, you would see investment return to middle America, not because of MPC, but because more liquidity is flowing in their sector of the economy. More liquidity, healthier markets, safer risk. more consumption. We have seen the opposite take place.
Steve, here is a link to marginal propensity to invest, It helps in this issue.
From the multiplier section…
multiplier = 1 / (1 – (MPC + MPI))
A rising MPC from incomes falling or stagnating may be offset by a falling MPI. Do you see it?
It seems obvious to me that the poor spend their money much faster than the rich. If I, as a member of the upper middle class, where to receive a $10,000 windfall tomorrow, I would put $9000 into long term savings and probably wouldn’t spend the money for years. You can argue that my savings (generic stock and bond indexes) represent spending by someone else, but this requires many steps and months or years to play out. When I buy $9000 in index fund shares, no one runs out and buys $9000 in goods and services tomorrow.
In contrast, if my working class brother won $10,000, you can bet your lucky undies that he would head straight to the auto dealer and get rid of his clunker, etc. the money would be spent in a flash.
My understanding is that monetarism didn’t work in 1980, despite being earnestly tried, because the Fed did not know what “money” is, or had become at that time.
maybe things have gotten better. but it seems we are still losing far more money to the bankers than we are to the taxers.
Edward: I’m getting the gist your explanation and your link, will spend more time with it.
What you are suggesting is that Krugman et al dismissing MPC is do to their consideration that income is income? It is the only way Kevin Drum’s statement: “Higher inequality should generate less consumption, which in turn produces a weaker economy. Unfortunately, the data says something else.”
can make sense.
The problem with focusing on MPI is that the drivers seat of income allocation (to labor, capital, dividens) is, or should I say has been returned to those at the top. You can not get a proper allocation of income when labor power in the market is reduced (regardless of method to reduce such power).
The one major issue I have with the idea that capital flows to where the most work can be gotten out of it is that we are not seeing capital do the work of the prior industrial period. We are seeing capital go where it is easiest to produce profits. What is easier than making money in an “emerging” market? No need for anything new, just wash, rinse and repeat in every new market. It’s a lazy economy and only furthers the preception of not being “real” as compared to an industrial or better called producer economy.
I believe this “easy” capital work is part of what came with financialization and the resultant global structure set up by trade agreements. It is the money from money model. It is what explains the concept of United Corporations of Global and it is what explains the decline of western economies in the face of rising “emerging” markets formally known as 3rd and 2nd world nations.
A proper global economy would not be functioning as a closed loop where one side of the membrane’s concentraion is moving toward isotonic relationship to the other. It is what comes of zero sum thinking. Instead a proper global economy would be raising the lows to match the highs only (and to be hippie in thinking) doing it in the face of fixed earthly raw material.
Thus, the issue is not the propensity to spend or invest but the propensity to properly structure the economy both locally through to the global relationships.
Like I suggested, Krugman and Drum et al dismiss MCP because they look at the “data” and say “see it went up”. That’s monetary policy which completely ignores running a flower shop.
Off to the shop. Happy mother’s day to any mom’s reading.
@Daniel, I get what you’re saying, but Edward still makes sense. Most fixed investment (whether on drill presses, freezers, or education) comes from internal funds rather than loans. If a sector — say, lower-income households — is starved for internal funds, external funds in the form of loans can only carry that investment so far, for so long.
And I think it can be predicted that the lower-income household sector is more likely to allocate investment to things that have value to…the lower-income household sector.
Yes Steve, I agree with you and what Ed is saying. However, the question I thought I read from you is why do Krugman et al not see it.
I’ve noted for years the issue of lack of income in the hands of the many. However, if there are those who deny the MPC effect then they are saying that the system is a closed system and the money move regardless.
Ok, yes it does, but is there a movement of money that produces more money (and wealth) as in new not previously existing wealth? I would say yes and it is related to the end user of all that the prior money moving created: the individual consumer.
That Krugman would deny the MPC issue is to understand his position on globalization, Nafta and the rest. It’s all a closed system and it all balances out…expect for those it doesn’t.
Which gets me back to Krugman owning a flower shop, he would then understand the model of double entry accounting in the actual creation of money and wealth. But he doesn’t.
Frankly, it’s the architect who never built a house designing houses. The architect we befriended was the build. It put door in place with no shims.
I can’t tell from what has been said here what Krugman is using to measure “it went up.”
If it is GDP that is too flawed a measure to be useful. At bottom it is begging the question.
At worst, what you are seeing is “the rich” spending more on “toys.” That is not “growth” by any sane reckoning.
As for that door without shims, I live in a house that should have cost 40k when i bought it, but i paid considerably more because a lot of Californians were spending their real estate gains on property in Oregon. As it is, I walked across the street to look at a 300k house being built. My sixty year old house is better built, but I am guessing the 300k house counts as an increase in GDP, as no doubt, does the extra money i paid for mine.
and in none of this do i see living standards for workers going up, or all that much in the way of “investment” (as compared to gambling).
to Steve & Daniel,
First, Steve… you said it absolutely perfectly… when you talked about internal funds for investment in fixed assets. You have a knack for clarification.
Your comment on Financialization is spot on. That is the root cause of inequality and the other economic problems we have. As I see it, financialization created lots of liquidity for capital income, and poor liquidity for labor income. The result was low labor share of income in most advanced countries.
friedman a theory of the consumption function
and you will find more than you want. Including a short first chapter from Milton Friedman’s 1957 “Theory of the consumption function” either as a webpage
or as a pdf
Now… let the dismantling begin.
Yes, more than I want. 😉 Can you encapsulate how that is (can be seen as) a slam-dunk argument against the MPC thinking?
Still readin’ 🙂