Worldly Philosopher: The Long-Run Consequences of Income Distribution
This week's Worldly Philosopher, Rishabh Kumar, models the asymmetric distribution of income and examines its effect on the growth of the U.S. economy.
In a previous post, I highlighted some demand side limitations stemming from the asymmetric distribution of income and consumption in the United States. This entry examines the effect of this asymmetry on the future of U.S. economic growth and the possibility of secular stagnation.
The first chart measures the ratio of real disposable income (i.e. total income less transfers and taxes) to consumption expenditure, split into four broad groups by income distribution. In essence, it captures the spending (horizontal axis) out of available income (vertical axis). The dashed black line is the level at which this ratio is one, i.e. consumption equals income. This figure can be read by looking at the direction, over time, of each group's consumption propensity. Lines flatter (steeper) than the equality line indicate consumption exceeding (lagging behind) real disposable income.
Income groups were chosen according to distinct spending behaviors between 1987-2009. The bottom fourtieth percentile for example, have a slow income growth but persistently high spending patterns indicating the build-up of debt. A polar opposite scenario can be seen for the top one percentile – high income growth but nearly stagnant consumption spending over time. These patterns are important, because they highlight the concept of aggregate demand and indicate the onset of the paradox of thrift due to income – spending asymmetry in the economy. Groups that contribute highest to aggregate demand (injections) have nearly stagnant earnings while groups that accumulate the bulk of gains from income use most of it to build savings (leakages). Robert Gordon identified inequality as one of the headwinds that herald the end of future economic growth in the United States.
In a simple exercise (see the second chart), I set up an experiment to estimate the possible impacts of the skewed savings propensities in Figure 1. For the top one percentile, I fixed the ratio of consumption to real disposable income at the level for the entire top tenth percentile and derived trends up to 2014. Based on the long run relationship between consumption expenditure and GDP in the National Income and Production Accounts (NIPA), I projected the impact of this 'constant consumption ratio' policy. The dotted black lines in the above chart shows the simulated path while the dashed black line is the trend for actual GDP. Extrapolated to 2014, the simulated trend shows a deviation of close to $2 trillion, from actual current GDP trends. This is a substantially high number, which serves to highlight the outcomes of the paradox of thrift – a century old prophecy, but one which must be confronted by the industrialized world.