Inequality really does matter!

Fortune magazine recently came out with an article about a report by S&P that says inequality is harming the economy. So did the OECD.

So economists need to see empirical evidence before having an opinion about something? Whatever happened to good ol’ intuition and logical reasoning?

In my very first macroeconomic course, I was taught Y=C+I+G+NX, that is, part of the output is domestic consumption of production in the economy. In an economy like the United States, domestic consumption has been found to be ~70% of total output. That means a policy by the US government targeting the investment (I), government expenditures (G) or net exports (NX) to improve the US GDP will have a much smaller impact than a policy that will drive consumption. That was exhibit 1.

In the first microeconomics course, there was a whispering of a “marginal propensity of saving” (MPS) and “marginal propensity of consumption” (MPC). In simple language, how much of your next dollar (5, 100 or even more) are you going to spend. It was well-established that MPC is negatively correlated to income, that is, the more one earns a progressively smaller portion of it gets consumed by that person(1).

So if one is already rich, they are going to spend less of it, i.e. consume less of it, leading to lower economic output. Isn’t that what the OECD and S&P reports say? That income inequality led to lower output? Why need empirical studies by PhDs to answer something that a first year “kid” in college could do? If economics has been argued to have become a religion, this is why. The task of “understanding” economics has been delegated to a highly specialized orthodoxy who can make sense of “numbers”.

I’m reading Asimov’s “Foundation” again. The new planet, Foundation, was surrounded by militarily stronger planets and had to use what advantages it had to be safe. Their advantage was that they had knowledge that the other planets did not have access to. Specifically, knowledge of nuclear power and devices. To preserve this “power”, Foundation disguised the workings of nuclear energy as a “religion” that can be known by only a select few “priests” (Foundation born and educated), technicians (born outside the Foundation) trained at the Foundation were like the fathers at local churches while priests headed up an entire denomination (planet).

Economics is much the same today. Only those who have been “trained” in the “proper manner” (of statistical empiricism) can make the “correct and valid” conclusions.

Reminder: Kuznets came out with his hypothesis, increasing inequality as a capitalist society matures then decreases afterward, during the 1950s and 1960s. No one really bothered much with inequality after then it seems, 50 years later there are empirical studies coming out proving that inequality is harming the economy (also upsetting the social order: Occupy [2011], anti-austerity protests in Greece and Spain [2011-2012]; but no one’s paying much attention there).
The two basic assumptions from micro and macro were there for a long time before then.

It was known for two years that income gains are extremely skewed, all that was needed was to use the idea of the MPC to figure that the wealthy would not spend much and the economy would then suffer because of a lack of demand (that was the problem during the Great Depression in the 1930s). There were warnings as far back as 2009 when the bank bailouts and QE measures were announced by the Fed.

Now that there have been empirical studies showing that inequality actually harms the economy, maybe the economists will actually do something about inequality [I’ll place bets on not, mainly because it is the people who do not want to do anything about it and expect the government to magically solve the problem].

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