Tuesday, February 10, 2015

Economic Effects of Income Inequality

In this post, I'm gonna talk about the issue of income inequality and mainly about the economic consequences of income inequality. Let me preface this post by saying that I do not believe there's anything wrong with some people having more and others having less. On the contrary, I believe it's completely natural and things will end up that way whether we like it or not. Different people have differing skill sets and capabilities, which means that some people will end up having more material things than others. Also note that wealth rarely accrues evenly and almost everything in the world has winner-take-all effects with income/wealth being no different. So my qualms with high levels of inequality ARE NOT moral. The problem that inequality creates isn't a moral problem, but a technical economic problem that can hinder an economy's growth prospects and prevent further economic development.

From here, I'm gonna jump in to the primary technical economic problem: increases in the national savings rate. Remember that savings is defined as income not consumed (S=Y-C) with the savings rate being the portion of your income that's being saved (S/Y). If we make the assumption that the rich save more of their income than the poor or middle class (see (a) below), it becomes obvious to see how increases in inequality would drive up the savings rate. By definition, increase in income inequality means that the proportion of the income held by the rich/wealthy is increasing. Adding in the assumption about the poor/middle class consuming less of their income implies that the savings rate must go higher because the rich have a larger share of the total pie and consume less of it.

Assumption (a): The rich consume a lower proportion of their income than the poor. This assumption should be pretty straight-forward, easy to understand, and is almost always true. Therefore, a rise in income inequality will lead to a rise in the savings rate.

Assumption (b): The purpose of all investment is for future consumption because it makes no sense to create something that will never be used (doing so destroys capital).

So what must the logical consequences of a higher national savings rate be?
1. The first possibility is that the increase in savings is offset by a corresponding increase in productive investment. This is the best case scenario and always generates capital. In this scenario, the inequality causes a rise in the savings rate which coincides with productive investment.
2. The savings can be exported to accumulate foreign assets. In this scenario, investment doesn't go up as much as savings, but the increased savings are used to buy foreign assets. This scenario can create or destroy capital.
3. Consumption drops to accommodate the higher savings rate. The higher savings rate can occur from a rise in savings or from a drop in consumption since S/Y=(Y-C)/Y=1-C/Y. In this case, economic growth can (and usually does) go negative. Even if the growth doesn't go negative, the growth will be concentrated in a few hands with most of the populace being worse off.
4. The final possibility is a rise in unproductive investment. Obviously, this is one of the worst scenarios. In this scenario, the savings get used to fund unproductive projects that provide no value. This scenario leads to capital destruction and makes a country economically worse off.

Scenario 1:
This is the best case scenario. In countries that're low on the development scale, it's relatively easy to find investment projects that're productive and can raise consumption because there is room for development (from the definition of being low on the development scale). In advanced economies, the opportunities for productive investment are much less because they are developed economies. So in advanced economies, this scenario is usually uncommon (the current US economy is an exception).

Another issue is that all investment is for future consumption. If the ability of the populace to consume never goes up, the productive investment opportunities will dry up making this scenario virtually impossible.

Scenario 2:
The savings are exported to other places. Again, the issue here depends on what the savings are used for. It depends on the productivity of the asset over its entire lifespan vs the cost incurred to accumulate it. In other words, exporting savings to countries that create massive asset bubbles and result in capital destruction is not a good scenario. However, using savings to fund/buy assets that do create value will make the country more wealthy (ex. advanced economies exporting savings/capital to less developed economies in order to fund critical/necessary infrastructure projects).

This scenario can be highly limited because if you just try to export all of your excess savings, other countries will be experiencing capital account surpluses which implies a current account deficit. If a country experiences a drop in production large enough from the current account deficit or if there are geopolitical risks, the country may place limits on your ability to accumulate foreign assets. So in reality, this scenario can be heavily constrained.

Scenario 3:
This scenario is almost always bad (I can't think of a single example where it was good)--particularly for advanced economies. Getting a rise in the savings rate while seeing a drop in consumption usually results in negative growth or if the growth is positive, it's almost always concentrated in a few hands. This policy usually not only causes economic stagnation, but can create social and political risks as well.

In this scenario, we usually end up seeing a drop in aggregate demand and a rise in income inequality. This scenario often happens in countries with little social or political capital that don't have the ability of institutions to rule effectively. Over a longer term period, countries stuck in this scenario usually have political systems that're controlled by a few elite families. Often times, these countries are economically backward and are very low on the development scale. It's not surprising to see countries like this be highly natural resource dependent. Politically, they're often very unstable with the lowest classes highly oppressed. In these kinds of scenarios, a few wealthy elites basically buy out/control everything with little social mobility.

Scenario 4:
This scenario IS ALWAYS be bad. Increases in unproductive investment are always bad, unsustainable, and cause capital destruction. It may cause growth in the short term, but assets created will not be able to pay off the real cost incurred by the liabilities. This scenario is inherently unsustainable and will destroy the capital of a country.

Recall from my post on the basics of money and banking how loans create deposits. It's in the same way that investment creates savings. In a closed economy, investment and savings have to move hand in hand with the assets creating the liabilities (investments creating savings). However, less developed countries (capital poor countries) can often times be constrained by a lack of savings.

In the four scenarios I've laid out above, the first scenario allows for capital accumulation while the second could go either way with the third and fourth being almost always destroying capital (particularly if we include social costs). If we add in two more assumptions (see (a) and (b) in purple above), we'll see that developed economies are highly constrained in their ability to find productive investment most of the time (the modern day US is an exception). However, there is one more scenario where the national savings doesn't have to increase from a rise in inequality, but it's not a sustainable or good scenario.

Also note that in the real world, there are often large constraints on the way we behave (both as individuals and as societies). In the two positive scenarios stemming from a rise in the national savings rate, there are major constraints that're placed on countries/economies that often make them unable to take those policies very far. This is a constraint we must understand and operate with.

Scenario 5:
However, there is one scenario I didn't discuss: a consumption boom to prevent the savings rate from rising with higher income inequality. In this scenario, a rise in income inequality doesn't cause a rise in the savings rate because consumption is supported by an increase in debt. Since the debt is being used to fund consumption whereby the future productivity of the economy doesn't improve, we will see a rise in debt/debt servicing capacity ratios and capital destruction. This scenario is unsustainable and will destroy a country's capital when it's all said and done.

Income/Wealth Inequality Can (and Does) Come from Sensible Economic Systems:
As we can clearly see, a rise in inequality can create major downside consequences. However, we must also understand how high levels of inequality can result from an incentive structure that makes sense. People are not equal or the same. Different people are good at different things, which means that it's only natural for some people to become super wealthy. In an entrepreneurial market-based economy, we will see winner-take-all effects where a few people can and will have most of the wealth/income.

A healthy and proper incentive structure will result in a winner-take-all type of system and there's absolutely nothing wrong with that. It's absurd to expect wealth/capital to be accumulated evenly across the population and it never will be accumulated evenly. So a society that wants to accumulate capital will end up having inequality that will result and the benefits to the system will accrue in a winner-take-all manner. However, this accumulation of wealth can create technical economic problems while possibly preventing future wealth accumulation.

I'd like to finish this off with a final comment: there are many ways to deal with these technical problems created. One way to deal with it is to have an economy of high wages to sustain strong internal demand while making sure households have the ability to consume goods/services and make sure productive investment opportunities exist. Another way is to redistribute/transfer resources from the rich to the poor. A third way is to use a social safety net or to have certain groups provide services. There are many other ways to fix this technical problem. Note that the solutions to the problem of higher savings rates stemming from increases in inequality do not have to come from centralized command and control.

Note: I'm defining things differently than how the definitions are traditionally done in an economics. So this is how I've defined everything.
  • Y--national income. S--national savings. I--national investment, C--national consumption
  • C_p--private consumption. C_g--government consumption
  • I_p--private investment. P_g--government investment
  • Y=C+S=C+I+NX
  • C=C_p+C_g and I=I_p+I_g
  • My definition of capital is coming from my post on real wealth creation. See the assumption in red at the middle to the bottom of the page if you wanna know what my assumption is.

1 comment:

  1. I see an underlying commonality to all the scenarios you described: liquidity preference as decision-making under conditions of uncertainty. Severe levels of economic inequality could actually be a toxic symptom of liquidity preference under extreme conditions. Basically, the decision-makers in such a situation would have highly pessimistic expectations, and choose to hoard instead of taking the time to invest (and create new wealth).