In recent decades, income inequality in the United States has soared. This isn’t the first time. Such high levels of wealth concentration have happened before in U.S. history, most notoriously in the 1920s but also several times in the nineteenth century. Like during these previous periods, the economy today seems to grow only when debt is also growing quickly.
This is no coincidence. In any economy, income inequality tends to reduce consumption and force up the savings rate by effectively transferring income from those who mostly consume to those who mostly save. There are times when this tendency can be positive for growth, but other times it can be negative, depending mainly on whether or not investment in the economy is constrained by low savings and expensive capital.
Specifically, higher savings can boost growth when an economy has less investment than businesses desire because of insufficient savings. In such cases, by saving income that would otherwise have been consumed, the rich create the higher savings that businesses use to boost investment, driving the economy to grow more quickly and wealth eventually to trickle down to even the poorest workers. This was the case for much of U.S. history, when savings were inadequate and investment was constrained mainly by the high cost of capital.
For economies in which investment is constrained not by the lack of savings but mainly by weak demand, however, rising income inequality can actually suppress investment and reduce growth by reducing consumption. This point is very poorly recognized by most economists, but to understand why this is true, it is enough to see that there are basically two kinds of investment:
- Investment that is not sensitive to changes in demand. This kind of investment—typical of underinvested economies (usually developing countries) or underinvested sectors (such as a new technological sector in its early stages) in which there is not enough investment to satisfy existing demand—is limited by the high cost of capital, so when additional savings cause the cost of capital to decline, businesses will increase their investment.
- Investment that is sensitive to changes in demand. In such cases, typical of advanced economies, businesses justify investing in additional productive capacity only when they expect demand for their products to grow.
Much investment in the United States is of the second type,1 meaning that if increases in income inequality in advanced economies reduce expected consumption growth, businesses typically respond by cutting back on investment. This is probably what happened in Germany after the Hartz reforms of 2003–2005 and what has been happening in the United States and other advanced economies over the past several decades. Because of weak growth in demand, business investment has grown more slowly than most economists would have liked, and even then much of it has occurred in the high tech sector (which in its early stages is more like the first kind of investment than the second). Demand growth would have been even weaker if rising household debt and fiscal deficits hadn’t boosted consumption.
The seeming paradox under these conditions is that rising income inequality cannot raise total savings even as it raises the savings of the rich. This is because in a closed economy, like the global economy, savings by definition must equal investment, and if investment does not rise, savings cannot rise.
This dynamic can also apply to open economies, like the United States, in which the capital account is driven mainly by foreign investment decisions. Given the United States’ status as the automatic recipient of nearly half of the world’s excess savings, this condition is even stricter: savings must grow more slowly than investment whenever there is an increase in the current account deficit, which is itself determined largely by the need for the rest of the world to find a safe haven for its excess savings.2 Because most rich countries and some developing countries are unable to find productive use for their savings, they export the excess to countries like the United States, whose deep, flexible, and well-governed financial markets make them the best places to park excess savings.
This is why U.S. investment exceeds U.S. savings, with the gap between the two determined largely by foreign investors.3 To put it another way, the United States must reconcile the tendency of income inequality to drive up the savings of the rich and the tendency of investment growth to decline due to the associated weakness of consumption growth. Because savings cannot rise more quickly than investment—and this is just a basic accounting condition that cannot be violated—more savings among the rich must suppress savings in another sector.
There are broadly two ways an increase in income inequality can suppress savings elsewhere in the economy:
- It can cause unemployment to rise and GDP to contract. In this case, the downward pressure on consumption caused by income inequality can close factories and businesses, which must then lay off workers, who in turn dis-save.
- Or it can facilitate more household or government debt to maintain GDP growth. In this case, to counter rising unemployment, either the Federal Reserve can loosen money conditions, and so encourage private debt, or Washington can increase public debt by expanding the fiscal deficit. Debt is simply negative savings.
Put differently, without rising debt, the United States would suffer rising unemployment and a contracting economy. Understanding this makes it easy to see why much conventional economic thinking fails to make the obvious connection between income inequality, trade imbalances, debt, and unemployment. Economists’ models still implicitly assume that investment is constrained by relatively scarce savings, but—unless perhaps the United States were to implement a major infrastructure spending program—clearly this assumption no longer applies.
This explanation is not new. Amid the extreme wealth concentration of the late nineteenth century, the British economist John Hobson and an American contemporary named Charles Arthur Conant understood and explained the dynamic. The same principle was systematically elaborated nearly four decades later, during another period of extreme wealth concentration, by John Maynard Keynes. At the same time, Friedrich Hayek—whose contempt for rich people did not prevent him from providing the most rigorous argument as to why, given the unequal distribution of business ability, spontaneous accumulations of wealth are a condition of well-functioning markets—justified the accumulation of wealth, not rising wealth concentration, which tends to impede the disruptive nature of markets.4 In a well-functioning market economy, for different reasons, both Keynes and Hayek argued that the income of the poor should grow more quickly than that of the rich, not the other way around, as has been the case for decades.5
Yet the sharpest and most insightful exposition, also made in the 1930s, was by another conservative economist, Marriner Eccles, chair of the Federal Reserve Board. He explained the relationships this way in his memoirs:
By taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital . . . That is what happened to us in the twenties. We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system. This debt was provided by the large growth of business savings as well as savings by individuals, particularly in the upper-income groups where taxes were relatively low.
In the United States of the 1920s, the invention of new forms of consumer lending, powered by soaring gold reserves, drove the economy in the way Eccles described, until debt could no longer grow enough to offset the growth in savings set off by extreme wealth concentration. When this happened, during the three years after the 1929 stock market crash, surging unemployment replaced surging debt as the only way to balance the high savings of the rich.
As Eccles went on to explain in his 1933 Congressional testimony:
It is utterly impossible, as this country has demonstrated again and again, for the rich to save as much as they have been trying to save, and save anything that is worth saving. They can save idle factories and useless railroad coaches; they can save empty office buildings and closed banks; they can save paper evidences of foreign loans; but as a class they cannot save anything that is worth saving, above and beyond the amount that is made profitable by the increase of consumer buying. It is for the interests of the well-to-do—to protect them from the results of their own folly—that we should take from them a sufficient amount of their surplus to enable consumers to consume and business to operate at a profit. This is not soaking the rich; it is saving the rich.
The United States is in the same position today: surging debt is the only way to balance the high savings of the rich without resorting to higher unemployment. While rising concentrations of wealth can create adverse social and political outcomes, they are still justified by some economists on the grounds that, by boosting savings, income inequality leads to higher investment, which in turn leads to the higher growth that eventually benefits even the poor. The point, however, is that this can only happen under economic conditions that no longer apply to the United States (or to other advanced economies).
Today, because it is weak demand, not high costs of capital, that restrains business investment, income inequality does not lead to higher investment. On the contrary, it leads to slower growth, more debt, and perhaps even less investment. If the United States were to reverse the conditions that since the late 1970s have indirectly encouraged rising income inequality, the U.S. economy would grow more soundly with less debt and, as Eccles promised, growth would eventually trickle up even to benefit the rich.
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Notes
1 That is not to say that there is no potential investment of the first type in the United States. U.S. infrastructure is clearly very poor in some respects, and it could use significant upgrading, at the very least. This would be needed investment no matter how quickly or slowly demand grew. The reason much of this investment is not being made is not because the United States is unable to fund the investment at an acceptable cost, but rather because political considerations prevent the country from doing so.
2 The U.S. current account deficit is equal by definition to its capital account surplus, which consists of the net amount of foreign capital inflows into the United States. Because the country acts as the stabilizer that automatically balances global demand for savings with global supply, the United States has little control over its capital account and consequently little control over its savings rate. To see how this stabilizing process works, note that until the 1970s, when the global economy was being rebuilt from the ravages of two world wars, the global demand for savings exceeded the global supply, and as a result the United States exported excess savings while running seemingly permanent current account surpluses. Once this rebuilding was more or less complete, and investment needs among the world’s rich-again developed economies dropped relative to their higher savings, the world suffered from excess savings. As a result, the United States became an importer of foreign excess savings, while the current account swung automatically into seemingly permanent deficits. This almost certainly is not a coincidence, and as long as foreigners place their excess savings into the U.S. economy, its savings rate must be below its investment rate.
3 This is also why an expanding U.S. current account deficit typically raises unemployment or debt, while a contracting U.S. current account deficit typically lowers unemployment or debt. Mainstream economists often have trouble understanding this mainly because, usually without realizing it, they implicitly assume that savings are generally scarce and constrain productive investment.
4 “We ought to be much more aware that if we regard a man as entitled to a high material reward that in itself does not necessarily entitle him to high esteem,” Hayek once explained.
5 At the risk of excessive simplifying, Keynes was interested in understanding the systemic tendencies toward wealth concentration and its impact on demand, while Hayek worried more about how persisting concentrations of wealth might create rent-seeking and lead to legal privileges and government-secured advantages.
Comments(34)
Good Read. This Hayek stuff. Never anticipated that. He just might be an example of someone misused. Thanks
Thank you for this article. “Reversing the conditions that since the late 1970s have indirectly encouraged rising income inequality” 1. Does that imply reversing trade globalization that also started in the late 1970s with the Tokyo Round on terms that didn’t balance external accounts and therefore opened the door to systematic labor cost arbitrage and hence lower labor share / higher profit share as well as duplication of credit worldwide and rising global debt / GDP? 2. If the answer to 1. is yes, then what would be the characteristics of a better international trade system and what would be the most effective / least disruptive way to get there? Can it be done at all without addressing the role of the USD as global reserve currency? 3. If it can’t be done without also addressing the role of the USD as global reserve currency, then what would be a better international monetary system to go together with this better international trade system? 4. Where are the WTO, IMF, G20 on this? Thank you
The answer to your first question should be yes. Efforts to transfer wealth to the working poor in developed countries usually rely on hikes in the minimum wage. Therefore labour-cost arbitrage sabotages those efforts by transferring the jobs to lower-wage economies. An equally important requirement - currently topical - is that the goods then made in the low-wage economies can be transported to the high wage economy and imported into it with tariffs low enough to undercut the domestically made product.
Michael, have you tracked the Household Income as a Percentage of GDP for the US as a whole and for various states? Back of the envelope calculations using rough census numbers gives me 40% or less. If I use median values, I get numbers in the low 10s for some states. Does the Household Income as a Percentage of GDP have the same meaning for the US as it does for China or should there be caveats for the US? Thank You!
You have to combine wages and direct income along with returns on investment, government transfers, and any other source of income. I haven't checked the numbers recently but I think it is in the high 70s or low 80s. Because in the US the government acts mainly as a pass-through, I would guess that the sum of household income and business income is close to 100% of GDP.
That's a fair point. In the US, if Total Household Income + Private Business Income = Vast Majority of GDP and Total Household Income = Wealthy Household Income + Remaining Household Income, off the top of your head do you know what Percent Share of GDP the Remaining Households get a part of? Are we above or below 50%? Putting all this would strengthen the between your lectures and blogs to create a fundamental basis to look back on. Also, since the US based everything on private, what mainly private options is there to increase the Remaining Household Income vs the Private Business Income + Wealthy Household Income that actually worked historically? As a layman, I guess it will probably involve an economic crisis but as you mentioned earlier, not all economic crisis involve a crash of the Remaining Household Income to achieve this (e.g. Japan 80s/90s). But many of the examples I find use strong government involvement. Are there any lighter handed options? Or possibly lighter domestic handed options in exchange for higher foreign handed options? (Which seems to be more politically acceptable in the US). I suppose the last biggest question is, if global supply is increasing and the Remaining Household Income is shrinking, how is the US suppose to absorb this supply if the Remaining Households is typically the consumption part of the economy? I'm not sure if Foreign Savers are giving money to the lower class of the US directly. So how is demand suppose to be financed?
123r2. So "How is the demand supposed to be financed?" This question reveals a fundamental gap in your understanding of money and debt. Sorry, but if you can get this, you will have learned something. The term "lending" is a misleading word when it comes to debt and money. When a bank creates a loan, it does not take the savings deposit of another and give to the recipient. Wrong. When someone like me makes a deposit in a saving account at my bank - it contributes to my banks Reserve Holdings at the Federal Reserve Bank. When my bank makes the loan, it creates a demand deposit available to the recipient at the bank. When the recipient spends the bank money by check, that credit or debt is floated by the bank until the check clears through the Fed, at which time the bank's reserves are drawn down, and if sufficiently enough, they will need to borrow reserves form another bank or the Fed, at the overnight rate, Fed Funds Rate. There is no physical limit to the amount of credit the bank can create - the Fed promises to always be there to provide the reserves required. Money is the expression of a liability, and liabilities are limited by trust.
Hi Yok. I'm a layman on this. I don't know what the correct terminology but what do you call demand that suppliers do not wish to fulfill because they won't pay as much money as the supplier wants? Michael and various others mention that worldwide demand is declining. However, looking at the world, all I can see is infinite potential demand with the financial part in question. The standard of living for the US is much higher then many other countries with greater populations. Many people in the world would like to have an equal standard of living to the US. Countries like Germany, China, Japan can produce goods which can potentially satisfy this demand. They aren't though. Why is this? Venezuela, Congo, Indonesia, Pakistan, etc - are countries with their own monetary system. Each country also has a large portion of the population who desires Central AC & Electricity for it. Why don't most the people there have Central AC everywhere? The layman terminology I use as to why they can't have it is because the people there cannot finance installing & maintaining Central AC in their houses. From my layman prospective Desire for a Good + Ability to Finance this Desire = Demand. The desire in the world for goods equal to the US is close to infinite. But the suppliers of the world do not want to fulfill this demand without some kind of financial component for it. Similar story to a lesser or equal degree with the Appalachian and Midwestern States. There's a desire for many things in these states. But without the financing part, how can demand be created? But I am a layman. Historically, maybe there are many cases where Desire = Demand where financing is 0. I would be interested in learning about these if you could share some. I know USA Aid does this but what other historically are there (outside of agriculture). How did these suppliers service their debt when financing is 0?
123r2. Or is it r2d2. Forget all the talk about financing. It's as simple as this: "ALL OVER THE WORLD THE WEALTHY AND THE POWERFUL AND DRIVING DOWN WAGES, SO THAT THE PEOPLE OF THEIR COUNTRY CAN'T AFFORD TO BUY EVERYTHING THEY PRODUCE. THE WEALTHY AND THE POWERFUL WANT THE SAVINGS SO THAT THEY CAN EXPORT THEM TO ANOTHER COUNTRY AND BUILD UP OWNERSHIP AND CLAIMS AGAINST THE PEOPLE THERE. THE WEALTHY AND THE POWERFUL SEE NO ADVANTAGE TO SHARING.
Hi Mike, Frances Coppola wrote a very interesting post about the hypothesis of the saving glut (Bernanke 2005)to which she opposes the hypothesis of the credit glut, seen as the root cause of the great financial crisis of 2007-2008 . For what it is worth, I share her thesis . It is my opinion that even experts find it hard to tell what the savings glut means in monetary terms. For the sake of simplicity, I will leave out the intermediate steps of the effects of capital inflows into the Usa when a European resident buys T-bonds in the secondary market for the amount of 1000$ and I will indicate only the final results . 1)dollar appreciation 2 )total invariance of the monetary aggregate in the us banking system 3) a long term national debt(T-bond)counterbalanced by a us resident’s credit ( deposit)of the equivalent value of 1.000 dollars in euros into a bank of the European Banking System. The us banking system is able to accommodate any financial need of the market, thanks to its efficiency . Since its monetary aggregate DO NOT CHANGE (2° point), what is the importance of the savings glut ?
What I have tried to show in this and other posts, Gino, is that in a world in which investment isn't constrained by scarce savings, a savings glut must lead either to unemployment or to a "credit glut".
Hi Mike, some time ago you wrote a very thoughtful post titled :"Beijing's three options: unemployment,debt,or wealth transfers ". As a matter of fact a decrease of the balance of the current account should have caused one ( or a mix )of the above options. I wonder how " the saving glut " can cause the same effect ( see your reply to my last post ). In my opinion ,as you wrote many times, an efficient banking system ,and ,I add,an efficient FX, can settle any transaction ,in a developed country. On the contrary ,the saving glut can only influence the rate of Exchange or the solidity of the net financial position of the country.
Hi Mike, some time ago you wrote a very thoughtful post titled :"Beijing's three options: unemployment,debt,or wealth transfers ". As a matter of fact a decrease of the balance of the current account should have caused one ( or a mix )of the above options. I wonder how " the saving glut " can cause the same effect ( see your reply to my last post ). In my opinion ,as you wrote many times, an efficient banking system ,and ,I add,an efficient FX, can settle any transaction ,in a developed country. On the contrary ,the saving glut can only influence the rate of Exchange or the solidity of the net financial position of the country.
In both cases, Gino, the effect works through the change in savings. Current account deficits are the same as capital account surpluses, which can be the results of "savings gluts" elsewhere and which create a gap between savings and investment,
Yok July 30, 20191:06 pm Great post !
Can well imagine how the US establishment will stamp you off as a 'commie liberal intellectual' for proposing to raise their taxes. You might end up in the same camp as another truthteller: Noam Chomsky.
Inequality is not an ethical issue,but an economic one. The economy doesn't work either with too much inequality or with too much debt.
Maybe, Martin, but few "commies" read and learn from Hayek.
Hi, are there any natural non legislative or executive mechanism to automatically reverse the high debt once it reaches to unbearable levels, except for economic crisis
It can be inflated away, Moses, or rolled over at rates below the nominal GDP growth rate, as occurred in China especially in the 2003-2010 period. One or the other is usually what happens.
Also, Newsletter. Can individual sign up for it or is it mainly for institutions?
Sorry, but mainly institutions, and for commercial entities there is a fee. I need it to keep funding the voracious Chinese underground music scene.
Good luck then. Look forward to hearing the results one day. Many of the Japanese & Korean music made it to their video games which is exported around the world. I look forward to the day where I can hear China's take on this.
Hi Mike I promise I will not bother you anymore about BoP and saving glut. In my opinion there is a saving glut which has to do with investments and consumption and a saving glut which has to do with the inflow of capital. The first one causes unemployment or debt,while the second one causes just an improvement in the net foreign position of a country. So any inflow of capital doesn't increase of a dime the balance of the capital account( even that's counterintuitive ).
Why do increase saving cause unemployment?
Il you save you don't consume ( or invest ). If you don't consume ,you don't produce. If you don't produce unumployment increases. So, at the end, either you tolerate unumployment either you are obliged to increase debt.
Gino. Thank You.
Another gem of an article from Prof. Pettis. He is one a few 'experts' who readily admits that some of our most fundamental economic assumptions are no longer working. Otherwise humility is in very short supply among economists, who unlike, say, physicists, almost never pubicly admit that there may be gaps in their knowledge and problems with their assumptions. It's doen't take much intellegince and specialized knowledge to realize ( that most of the economic models developed over centuries, when human polulations were surging and the fundamental problem for economics was to fugure out how to distribute scarce resources among an ever growing population, may not hold in our age where stagnant/declining and ageing populations and overproduction and lack of demand for such production is the new reality across large parts of the globe. (If I, a physicist with no formal training in finance or economics can figure it out, why can't the experts ?) Yet most economists remain adamant, fighting imaginary montsters like inflation, prescribing the wrong medicines for imaginary diseases while entire generations are being gutted by joblessness and hopelessness. So much so, that substantial segments of the populations across the west are now losing faith in liberal democracy. I am afraid, that if the liberal elite can't fix these problems soon, fascists will get another chance.
Excellent take, sir.
Huge Pettis fan, listened to a lot of his videos and read a fair amount of his readings, he is Institution Senior level Critical Thinking, High EQ guaranteed... What I don't seem to understand tho is how Mike believes China will experience a soft landing when it will default well into the hundreds of Billions in USD denominated debt from Eurodollar Markets and Offshore Repo ? Only Chinese Sovereign Bonds are accepted as collateral for offshore money markets since Baoshang haircuts, the writing is on the wall... PBOC is already knee deep in Currency Swaps as well, so is HK. Mortgage To Income ratio surpasses 300 % in all Tier 1's and majority of Tier 2's, how can China's economy ever be Consumption led in such a Inflationary environment along with Deglobilisation taking place ? Mr Pettis is by far the deepest economist I have seen or read on, and I am a freak when it comes to this, so how can a guy so brilliant not see the extreme crisis and mass US denominated defaults coming their way... They had 253 Trillion Yuan in off balance sheet beginning 2017, more then total on balance sheet assets. Please reply Mike, how can China Not have the biggest financial crisis the world has seen in a major economy, giving the very high Inflationary issues, hurting Consumption badly in effect, with Deglobilisation heading into full gear. They have Trillions in USD denominated debt, used Corporate AA or AAA's as Colleteral for those loans to buy assets, then used those assets as Collateral for more loans, what I am missing here ? How can increasing the money supply that drastically in such short periods, with that much Inflation and lower revenues/employment, how is a soft landing possible ? They either allow defaults and reduce money supply, in effect creating deflation at a fast pace, or keep playing whack a mole with yuan denominated landmines, and have 1 Bedroom condo's going for 700K US in Tier 2's within few years, literally creating a Inflation crisis, which they already are in, which turns into a massive recession.
Seff, financial crisis are caused by balance sheet mismatches, and as long as the Chinese banking system is closed and the regulators credible, Beijing can simply restructure liabilities.
Michael, I think we can consolidate the "savings glut" in a flowchart: Capitalist(US)/State Capitalist (China) -> excessive accumulation of capitals -> savings glut -> bubble(US)/missappropriation of capitals (China). Any comment?
Seff, a sovereign power whose debts are in his own currency can never be forced into default in that currency. As long as State has power and uses it there will be no crisis. A long slow decline comes from the erosion of trust.
Eurodollar loans, majority of banks won't be able to refinance due to lack of safe collateral, even sovereign bonds are in question when currency has good odds of depreciating, adding extra hedges that eat away profits... Deglobalisation is happening at a fast pace for reasons Mr Pettis explains very well, considering the very high cost of life in china with much less jobs on the horizon, what am I missing ? I trade for a living, fairly good at it and from a macro I don't get how it's even possible... They are engaged in systemic financial engineering of Corporate Balance sheet, it's all coming apart... My theory is, Inflation is just an increase in money supply ( reducing purchasing power )... If you keep increasing the money supply at a much much faster rate then Wage Growth, it will reach a point of crisis, where things become to expensive to consume, the economy grinds to a halt until deflation happens ( debt gets defaulted, less money in circulation ). Lack of personal Bankruptcy courts will hurt the rebound as well... Thank you for replying Mr Pettis, your aces in my books! I see you look at things from an economist side and not a trader's point of view, still one of the deepest minds I have seen =)
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