Putting more eggs in fewer baskets… a risky market failure

There is a bedtime story of a young boy who put all his eggs into one basket and when that basket fell, all the eggs broke. It is risky to put your eggs into one basket. Investors overcome this risk by diversifying their portfolio. Even the colossal derivatives market is said to lower risk through spreading risk.

But at the core of the US economy, we see exactly the opposite happening. The consumption which drives the economy is being put into fewer and fewer hands. There is a greater risk growing.

Consumption depends on income. And income comes from two sources… labor income and capital income. Labor income goes to the hands of many people. Capital income goes to the hands of fewer people. But we have seen labor’s share of national income fall, meaning that capital’s share has risen.

labor share 2

Consumption from capital income has thus grown by leaps and bounds… into fewer hands.

consumption cap & lab

(For easier comparison, the left axis is 10% of the right axis.)

Consumption from labor income used to represent total consumption pretty well. Basically the risks of consumption were spread among many hands. But then around 2002, consumption from capital income began to grow like never before. Consumption from labor income began to separate more and more from total consumption.

The consumption that drives the economy has been put into fewer hands than ever before. And this is risky, because capital income is more discretionary. For example, it depends on asset prices, stock prices, housing prices, and the like. Many times capital income goes capriciously to luxury goods, and not basic needs. The spending by capital income is more mood driven.

The economic growth in real GDP since the crisis has been largely based on increasing consumption by capital income. Yet, look at how the 2008 crisis was preceded by a pull back in consumption by capital income, even as labor income’s consumption grew. And there are signs that capital income is beginning to pull back their consumption now.

What are some causes that increased spending by capital income?

  • Lower taxes on capital income.
  • Lower labor income.
  • and since the crisis… Loose monetary policy without a transmission mechanism to labor income.

You can tell me all day long that loose monetary policy, QE, derivatives and lower taxes on capital income are boosting the economy. And yes they have. I agree with you. Capital income has driven the boost.  But then I look at the graph above… and I hear of middle class malls shutting down, while top-end malls flourish. I hear of $2 billion dollar homes going like hotcakes in California. I see today that Walmart’s profits are down 21% as they serve low-income shoppers.

We can only hope that the rich capitalists keep spending. Because if they start protecting their money, economic growth will come to a halt. Yet, I fear that they will pull back their consumption in 2014 as QE winds down, as China slows down, and as other factors weigh down on business profits.

The result will be an increasing risk of economic contraction, because we acted against the wisdom of a bedtime story… We put too many eggs in too few baskets.