Reforming Capitalism (or Economics?)

There’s a lot of talk about reforming economics/capitalism. The two are different.

Economics is that taught and discussed in academic circles and is the theory.
Capitalism is the socioeconomic realization of the theory and the practical application of it.

There’s no real point of reforming capitalism. If the aim is to reduce inequality or ameliorate its effects, then the only thing reforming capitalism will do will be to change the timeframe over which obscene levels of inequality (and consequent inequity) are observed.

Reforming capitalism is like asking, “How soon do you want to see ugly inequality?”

It isn’t that capitalism has to be reformed, it needs to undergo a radical overhaul. For that to happen though, academic economics needs to let go of its most beloved assumptions and begin working anew. With a different set of assumptions. Most of the research on inequality being carried out now is actually external to economics and the reason is simply that inequality is a factor that has not been directly looked into by most contemporary economics theorists neither is it one of the variables used in macroeconomic models (at least not when I studied macroeconomic theory in university from Romer’s book). The first question to cross any theorist’s mind when including inequality as an explanatory variable in the model will be, “Should it be income or wealth inequality?” Quick answer, wealth inequality. Income inequality, by itself, has little effect on the economy [I do plan, and consider necessary, to elaborate on this one sentence].

It isn’t just income inequality that, itself, is the culprit (even in the studies that found a negative correlation between level of income inequality and economic growth). It’s the break in the flow of resources (money in this case) that halted the growth. The break is caused when the flow builds up at a certain place in the economy. In other words, there is a wealth build-up somewhere*. Extrapolating to cover the population means that income inequality that leads to worsening wealth inequality is what causes economic growth to slow down and not just income inequality itself. Income inequality itself will not cause the flow to get disturbed unless it were to be held up at a certain place when in circulation, in other words, the income gets converted to wealth, leading to increasing wealth inequality. This is not a new idea, introductory macroeconomics taught me that savings had a negative multiplier, so the idea has been around for around half a century at the least. Also, an article from Evonomics1 is quite explicit in why inequality is bad for the economy, though it seems that the confusion of whether income or wealth inequality is the guilty party remains.

Which leads me to ask: If the idea has been around for so long, why didn’t anyone put two and two together?
Rough answer: No one noticed anything wrong with the picture presented in that period.
How could they with consumption patterns not showing any significant divergences based on income? That’s not where one should stop with the questions.
Why were there no significant divergences of consumption patterns based on income? Rough answer: Private debt was growing as a proportion of GDP, and a lot of that debt was for consumption purposes. To get an idea of the situation (in the US for now), I referred to data that I got from the St. Louis Fed website on four series:

  • Household Debt to GDP for United States (HDTGPDUSQ163N)2
  • Shares of gross domestic product: Personal consumption expenditures (DPCERE1Q156NBEA)3
  • Total Credit to Private Non-Financial Sector, Adjusted for Breaks, for United States (QUSPAM770A)4
  • Real Personal Consumption Expenditures (DPCERL1Q225SBEA)5

The resulting graph is below:

Graph showing four annual series: Household Debt as fraction of GDP, Personal Consumption Expenditure as share of GDP, Total credit advanced to private non-financial sector as a fraction of GDP, Percentage change in real personal consumption expenditures
Graph showing four annual series: Household Debt as fraction of GDP (blue from around 2005), Personal Consumption Expenditure as share of GDP (red line), Total credit advanced to private non-financial sector as fraction of GDP (green line), Percentage change in real personal consumption expenditures (purple line)

The share of consumption as a fraction of GDP has remained fairly flat since the mid-1940s to nearly 2015. However, looking at the line for the total credit given to the private sector (green one) is an indication that part of the consumption was being debt-financed. I included the “Household Debt to GDP” trend  (the little tail from around 2005) here as a reference to show that the trend in consumption debt matches the overall trend in debt to the private sector.

The American economy is led largely by domestic consumption, that can be seen from the following graph:

Graph showing Change in real GDP and change in personal consumption
Change in real GDP (blue) and change in personal consumption (purple)

Notice how the trend in the real GDP (blue line) follows the trend in real personal domestic consumption (purple line)? So the American economy is quite dependent on domestic consumption. Additionally, Joseph Stiglitz in “Freefall” pinpointed debt-financed consumption as driving the American economy before the massive real estate asset bubble burst in 20086.

Wages in America have not been rising for everyone. It was actually decreasing for many of the people7, 8. With wages and income decreasing for most consumers, how were they financing their consumption? Mostly by debt finance, or even equity finance, they’re essentially the same thing. The little squiggle at the end of the first graph shows the trend in household debt as a percentage of GDP (data goes back to 2005).

The way to tackle growing inequality cannot be fulfilled by “reforming capitalism”, it will need to be dismantled completely and replaced by a better system that will directly address the matter of growing inequality.


References & Footnotes

* This wealth build-up can happen with or without financial intermediaries. However, with financial intermediaries, there is greater economic activity as the intermediaries often invest in new businesses on behalf of the fund owners.

1 The Science of Flow Says Extreme Inequality Causes Economic Collapse, http://evonomics.com/science-flow-says-extreme-inequality-causes-economic-collapse/, accessed September 10, 2017
2 International Monetary Fund, Household Debt to GDP for United States [HDTGPDUSQ163N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/HDTGPDUSQ163N, accessed October 20, 2017
3 U.S. Bureau of Economic Analysis, Shares of gross domestic product: Personal consumption expenditures [DPCERE1Q156NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DPCERE1Q156NBEA, accessed October 20, 2017
4 Bank for International Settlements, Total Credit to Private Non-Financial Sector, Adjusted for Breaks, for United States [QUSPAM770A], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/QUSPAM770A, October 20, 2017
5 U.S. Bureau of Economic Analysis, Real Personal Consumption Expenditures [DPCERL1Q225SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DPCERL1Q225SBEA, October 20, 2017
6 Pg. 76, Freefall, Joseph E. Stiglitz, W. W. Norton & Company, 2010
7 Wage Stagnation in Nine Charts, EPI, www.epi.org/publication/charting-wage-stagnation/, accessed October 23, 2017
8 For Most Workers, Real Wage have Barely Budged For Decades, Pew Research Center, http://www.pewresearch.org/fact-tank/2014/10/09/for-most-workers-real-wages-have-barely-budged-for-decades/, accessed October 23, 2017

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