Krugman Is Wrong On Inequality

by: Shareholders Unite

Nobel prize winning economist Joseph Stiglitz has forwarded an interesting theory, which argues that rising inequality holds back the recovery and growth in general and leads to a situation known as an underconsumption crisis. Why? Well, the rich tend to save more and spend proportionally less of their money, so rising inequality will lead to less national buyers for our output.

Another Nobel prize winning economist, Paul Krugman has several good arguments against this thesis:

  • Rising inequality since the 1970s has gone hand in hand with falling savings, not rising savings.
  • Rising inequality went hand in hand with robust demand, at least until 2007.
  • A cross-sectional evidence of saving and spending isn't very useful at any particular point in time.

Krugman is right on the first two points, the last needs some explanation:

Consumer spending tends to reflect expected income over an extended period. If you take a sample of people with high incomes, you will disproportionably include people who are having an especially good year, and will therefore be saving a lot; correspondingly, a sample of people with low incomes will include many having a particularly bad year, and hence living off savings. [Krugman]

However, there is plenty of evidence that the rich indeed save more (for instance, here and here). Falling real interest rates is also indicative of a savings glut.

The funny thing is, we advanced an early version of the thesis that rising inequality was an important factor in causing the financial crisis. There has undeniably been a rising gap between labor productivity growth and stagnating median wages since the 1970s.

We think that if there is any single figure summing up American economic problems, this one is it. How has this led to the financial crisis? Well, median wage earners could only keep up consumption by borrowing more.

Most of this borrowing was against rising equity of houses. Banks weren't particularly interested in maintaining credit standards (to put it mildly), because they could repackage the loans into complex derivatives and move them off their balance sheet (the 'smartest' banks even bet against these instruments).

And while the poor were leveraging up to maintain consumption:

In 1983, the bottom 95% had 62 cents of debt for every dollar they earned, according to research by two International Monetary Fund economists. But by 2007, the ratio had soared to $1.48 of debt for every $1 in earnings. [Tami Luhby]

They were effectively borrowing from the rich:

And then there's the top 5%. Their debt-to-income level actually fell during the same period, from 76 cents of debt for every dollar earned in 1983, to just 64 cents in 2007. [Tami Luhby]

So while the poor were leveraging up, the rich were actually leveraging down. This isn't fully captured in the savings data, and it maintained demand for goods and services, answering both of Krugman's objections to the thesis that rising inequality has led to an underconsumption crisis. In a strict sense, it hasn't, but only because consumption was maintained by a huge rise in borrowing by the poor.

After the financial crisis
The problem hasn't gone away, in fact, now also poorer households are deleveraging, not just the rich, and that despite record low interest rates. Demand is maintained by super expansionary monetary policy and large public deficits. But while there is no immediate fiscal crisis looming, this cannot really last forever either.

The simple truth is, to have a viable capitalist economy, supply needs to roughly equal demand, also on a macro-econonmic level. Median wages continue to lag productivity growth. In a disturbing analysis, Emmanuel Saez noted:

In 2010, average real income per family grew by 2.3% (Table 1) but the gains were very uneven. Top 1% incomes grew by 11.6% while bottom 99% incomes grew only by 0.2%. Hence, the top 1% captured 93% of the income gains in the first year of recovery. [Saez]

For shareholders this seems like a bonanza, as the strong stock market recovery indicates. Indeed, wages are stagnating but profits are rising, leading to a decreasing share of wages in the economy:

Funny enough, all this is actually very bullish for shareholders, at least while it lasts. Profits rise as a part of GDP, and demand is maintained by expansionary monetary and fiscal policies.

However, ultimately even shareholders will have to recognize that this is no way to run an economy long term. The shortfall in demand that this causes either has to come either from abroad (net exports have improved a little but the US still has a substantial trade deficit, so this isn't very likely anytime soon) or kept up by very expansive macro policies.

But these are stop-gap measures and come with their own risks and problems (public debt, risk of new asset bubbles). Sooner or later even boardrooms will realize that Ford had important lessens to teach. Employees are not only a cost, they're customers as well.

While this is a collective action problem in the sense that any individual company can reap the full benefits from minimizing labor cost while externalizing much of the social cost of this policy, in the end, everybody will be presented with the bill. Rising inequality and falling labor share cannot go on without consequences for demand forever.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.