Michael Pettis — Economic consequences of income inequality

A lot of things have happened in China since my last entry – in the FX markets, in the banking system, in the announcements of default, and in the continuing lowering of growth expectations – but for all the turmoil, as I see it nothing has happened that was unexpected and that has not been discussed many times on this blog. For that reason I decided to post a rather long essay (sorry) on income inequality and on how I think we can best think about the impact of income inequality on the global economy.

This is a loaded topic, and I suspect I am going to get a lot of responses claiming that my essay is totally brilliant or totally nonsensical based, mainly, on the political orientation of readers. This entry, however, is not intended to be political. Very few things in economics are good or bad in themselves, but rather can be good under certain conditions or bad under others. I want to try to tease out as logically as I can the conditions under which rising income inequality can be good or bad for the economy.

That is all I am trying to do. My logic may be faulty and my assumptions may be wrong, and I invite readers to challenge either, but none of this should be seen as moral or immoral. Income inequality may very well be one or the other for very solid social, political or even religious reasons, but I am interested here only in the logical economic outcomes of income inequality.

Digging deeper into the model I use to understand income inequality also allows me to dig deeper into the sources of global imbalances – the two are tightly interlinked – and how these imbalances have driven much of what has happened around the world in the past decade. This model rests on an understanding of how distortions in the savings rates of different countries have driven the great trade and balance-sheet distortions with which we are wrestling today, just as they have in most previous global crises, including those of the 1870s, the 1930s, and the 1970s. Rising income inequality is key to understanding this model.

It turns out that it is actually not that hard to work through at least one of the major economic consequences of rising income inequality. I would argue that from an economic point of view the income inequality discussion is mainly a discussion about savings, and when you introduce into the economy a systematic tendency to force up the savings rate, the economy must respond in what are only a limited number of ways;

As I will show, some of these responses require an unsustainable increase in debt, and so are temporary. There are, it turns out, two sustainable responses to a forced increase in the savings rate in one part of the economy. The first is an equivalent increase in productive investment (this, I think, is the heart of the supply-side “trickle down” theory). The second is an increase in unemployment....

Pettis goes on to quote Marriner Eccles. Worth reading for that alone. Even if you don't regularly follow Pettis, read this one. It's more about the direction of the global economy than China, and it fits in with the both the current debate about inequality and Piketty's "Capital."

Pettis is (still) out of paradigm, however. He claims, "If there is a large amount of productive investment that needs to be funded, and not enough savings to fund this investment, increasing the savings rate can cause an equivalent increase in productive investment, and this increase can create sustainable demand for new jobs." This makes saving the causal factor as input, the saving rate the function or mechanism, and investment the output.

Backwards. But if the causality is reversed, the points he makes are interesting. As the owners' share (profit > equity) increases over the labor share, the saving of wealthy household increases most, since they own the bulk of profit and equity resulting from investment. This happens when capital formation is favored over distribution of productivity gains.

China Financial Markets
Economic consequences of income inequality
Michael Pettis | Professor of Finance at Peking University's Guanghua School of Management