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.





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.

Much of what I am going to argue is not new, and is merely a revival of the old “underconsumption” debate. Before jumping into the argument I want to start by quoting the remarkable former Fed Chairman (1932-48) Marriner Eccles, who may well have been the most subtle economist of the 20th Century, from his memoir, Beckoning Frontiers (1966):

As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of goods and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations.


The key point here is that all other things being equal, rising income inequality forces up the savings rate. The reason for this is pretty well understood: rich people consume a smaller share of their income than do the poor. The consequence of income inequality, Eccles argued, is an imbalance between the current supply of and current demand for goods and services, and this imbalance can only be resolved by a surge in credit or, as I will show later, by rising unemployment.

Rising income inequality reduces demand. It does so in two ways. First, it directly forces down the consumption share of GDP, and second, it reduces productive investment by reducing, as Eccles says, “the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.”

But – and here is where I will presume to add something new to the historical debate about income inequality and underconsumption – there is another very important form of rising income inequality that also forces up the savings rate in a very similar way, and this has been especially important in the past two decades. A declining household share of GDP has the same net impact as rising income inequality.

We have seen this especially in places like Germany and China during the past decade. In both countries policies were implemented which, in order to spur growth and, with it, employment, effectively transferred income from households to producers of GDP.

The main form of this transfer, in the case of Germany, was an agreement around fifteen years ago to restrain wage growth. By keeping wage growth lower than productivity and GDP growth, unit labor costs declined in Germany and German workers became more “competitive” in the international markets. This forced up the German savings rate and converted Germany’s current account from large deficits in the 1990s to the largest surpluses in the world.

In the case of China there were also restraints on wage growth relative to productivity growth – not so much a policy choice, I would argue, but a consequence of the huge number of underemployed rural workers in China – but there were at least two other very important transfers. First, China has had an undervalued currency ever since 1994, which acts as a spur to growth in the tradable goods sector by effectively taxing foreign imports (and notice, by the way, that something similar happens in Germany, which also has an “undervalued” euro in relationship to the “overvalued” euro of countries like Spain, Italy and France). This reduces the real value of household income as a share of GDP.

Second, and most importantly, interest rates in China have been severely repressed during much of this century, perhaps by as much as five to ten percentage points or more. This has acted as a huge transfer from net savers, who are the household sector for the most part, to net borrowers, who consist mainly of manufacturers, infrastructure developers, real estate developers, state-owned enterprises, and government entities.

In both cases, and this is true of other countries, especially if they have large state sectors, one of the consequences of these hidden transfers is that GDP, which is the total production of goods and services, rose faster than household income for many years, meaning that households retained a smaller and smaller share of the total amount of goods and services they produced. Of course as the total share of GDP they retained contracted, it is not a surprise that they also consumed an ever-declining share of GDP.

The squeezing of the household sector

Notice how this affects total savings. Even if German or Chinese households kept their savings rates steady (i.e. they consumed and saved the same share of their income as before), their consumption as a share of GDP had to decline in line with the household income share of GDP. Most consumption is household consumption, and so as household consumption declines as a share of GDP, total consumption also tends to decline as a share of GDP, which is just another way of saying that total savings rise as a share of GDP.

This is a point that is often missed. Rising income inequality can have the same impact on savings and consumption as a rising state or business share of GDP. In a country in which the state retains a growing share of GDP, the net impact on savings and consumption is almost identical to that of a country in which income inequality is rising. In both cases consumption tends to decline and savings to rise as a share of GDP.

This tendency for rising income inequality, or a rising state share of GDP, to force up the savings rate can be a good thing. 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. Notice that these new jobs force up the total amount of goods and services produced, so that ordinary workers will see their income increase even as income inequality increases. The rich will do very well, but the rest will do pretty well too.

But what happens if there is already enough savings to fund productive investment? In that case the impact of rising income inequality is very different. To understand why, let us assume a closed economy with a moderate amount of unemployment (until we begin interplanetary trading the world is a closed economy). We can define the total amount of goods and services produced, which we usually refer to as GDP, in two ways.

First, everything that we produce must be absorbed, and the two ways we can absorb it is either by consuming the goods and services we produce, or by investing them today for future consumption. GDP, in other words, is the sum of everything we either consume or invest, or to put it arithmetically:

GDP = Total consumption + Total investment

This is true by definition. Second, because our total income is equal by definition to the sum of all the goods and services we produce, and there are only two things we can do with our income, consume it today or save it for future consumption, GDP is also by definition the sum of savings and consumption, or, to put it arithmetically:

GDP = Total consumption + Total savings

From these two equations it is obvious that in any closed economy savings is always equal to investment. This simple truth, which is true by definition, has very powerful implications.

Let us assume now that something has happened that caused a transfer of wealth in our economy from the poor to the rich, or that caused the household share of income to drop. To make things simpler we will assume that this transfer occurred without changing GDP, so that the total amount of goods and services is unchanged, but now ordinary households retain a smaller share. This transfer of wealth must have an impact on both total savings and total consumption.

At first the impact might seem obvious. Total consumption will decline and total savings will rise. But it is not that obvious. In order to maintain the balance expressed in the two equations, mainly the requirement that savings is always exactly equal to investment, something else must happen. There are only two possible things that can maintain the balance:

  1. Investment must rise in line with the increase in savings.
  2. Savings in fact do not rise, which implies that any increase in savings caused by the transfer of wealth was matched by some other event that caused an equivalent reduction in savings.

I apologize if these sound obvious, but I want to keep the flow of the argument as logical as possible, and so I hope each step follows obviously from the prior step.

Let’s take the first condition. Will investment rise? There are, again to be terribly obvious, only three ways investment can rise.

  1. There can be an increase in productive investment.
  2. Unproductive investment can rise in the form of unwanted inventories.
  3. Other forms of unproductive investment can rise.

What causes investment to rise?

Let’s consider each of these three in turn before we consider our second possibility, that savings in fact do not rise.

1. There can be an increase in productive investment.

This is obviously the best-case scenario. The tendency to increase the savings rate is met by an increase in productive investment that exactly matches the reduction in consumption. The combination of an increase in productive investment and a reduction in consumption keeps total demand constant, so that there is no imbalance (in the aggregate, of course) between the total demand for and the total supply of goods and services produced by the economy. Because the increase in investment is productive, however, over time total goods and services will grow, and, presumably, households will be able to increase their consumption in the future.

How likely is this to be happening in the current environment? It is probably not very likely. It is hard to believe that in rich countries, like the US, there are a lot of productive investments that are neglected simply because there is an insufficient amount of savings to fund them.

I am not saying that every productive investment in the US has already been made, but just that if there are productive investments that remain unfunded, it isn’t because of insufficient savings. It might be because of political gridlock, high levels of uncertainty, or something else. Of course it could also be because interest rates are too high, in which case rising income inequality would, presumably by increasing the total amount of savings, cause interest rates to drop. In that case there might indeed be an increase in total productive investment.

But here is where we run into the problem signaled by Eccles. Because the purpose of investment today is to increase consumption tomorrow, if the increase in income inequality is expected to be permanent, the desired amount of productive investment is actually likely to decline. This is because, to quote Eccles again, lower expected consumption would reduce “the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants.”


This, as I understand it, is the process Keynes eventually described after his famous 1930 debate with Ralph Hawtrey. The process is quite easy to explain. As income inequality rises, total consumption tends to decline.

Because there is no equivalent increase in productive investment, the economy finds itself producing more goods and services that it can absorb, and the balance piles up as unwanted inventory, which is a form of unproductive investment. Of course manufacturers are unwilling to pile up infinite inventory levels so this process must eventually stop. Rising inventory levels, in other words, can only be a temporary counterbalance to rising income inequality.

3. Other forms of unproductive investment can rise.

The third way for investment to rise is if the additional savings are used to fund other forms of unproductive investment. Perhaps the tendency for savings to rise without an equivalent increase in productive investment forces down interest rates, with suddenly-cheap capital leading to speculative behavior. Charles Arthur Conant wrote about this extensively at the turn of the last century:

For many years there was an outlet at a high rate of return for all the savings of all the frugal persons in the great civilized countries.  Frightful miscalculations were made and great losses incurred, because experience had not gauged the value or the need of new works under all conditions, but there was room for the legitimate use of all savings without loss, and in the enterprises affording an adequate return.

The conditions of the early part of the century have changed. Capital is no longer needed in the excess of the supply, but it is becoming congested. The benefits of savings have been inculcated with such effect for many decades that savings accumulate beyond new demands for capital which are legitimate, and are becoming a menace to the economic future of the great industrial countries.

Conant’s point was that “congested” capital would end up in speculative investments that were not productive – vast tracts of empty apartment buildings, or spectacular but mostly empty airports, railroad lines, super highways and other infrastructure, or increases in manufacturing capacity even in industries that are experiencing overcapacity, or perhaps in a very expensive sporting event – but would nonetheless seem profitable because of the expectation that asset prices would continue to rise. These investments, whose low productivity will result in debt rising faster than debt-servicing capacity, can go on for many years, to the point where the implicit losses would have to be recognized, but this is clearly not a sustainable solution to excess savings because it requires limitless debt capacity.

Needless to say this seems to have been a pretty good description of recent investments in places as far apart as Arizona housing tracts, Dublin apartments, extravagant but unused Spanish airports, Chinese ghost cities, or Chinese solar manufacturers. We have seen a lot of this before the global crisis of 2007-08, and the seemingly obvious conclusion it that the tendency to increase the savings rate beyond the productive needs of the economy was balanced at least in part by a surge in speculative and unproductive investments.

These three are, logically, the only three ways we can balance the tendency for an increase in savings to be matched with a corresponding increase in investment. Either productive investment rises because productive investment had been constrained by insufficient savings, or unproductive investment rises, either in the form of unwanted inventory or in another form. The first is our best-case scenario, although for the reasons I have noted it is unlikely to describe conditions today, especially in capital-rich countries like the US. The second and third ways are unsustainable because they actually destroy value by increasing debt faster than they increase debt-servicing capacity.

What prevents savings from rising?

I said however that there is a second perfectly obvious way we can maintain the balance between savings and investments even if there is a substantial wealth transfer from ordinary households (either to the rich, or to the state sector). It is possible that total savings in fact do not rise, which implies that any increase in savings caused by the transfer of wealth was matched by some other event that caused an equivalent reduction in savings.

As far as I can work out there are really only three logical ways a transfer of wealth is consistent with no change in the total savings and consumption shares of GDP.

  1. The wealthy or the state consume as much as ordinary households.
  2. Ordinary households increase their consumption rate and reduce their savings rate.
  3. Unemployment rises.

Again, let us consider each of the three so that we can list the possible outcomes.


Clearly this hasn’t happened and is unlikely to happen in the future. Both common sense and all historical precedent suggest that except perhaps over very, very long time periods, consumption does not rise linearly with income and households consume a far greater share of their income than the state sector can. This might not be true of income inequality between countries, by the way, but that shouldn’t matter.


This, which is what happened in the United States and peripheral Europe, is one of those brutally obvious points that so many commentators and economists have failed to grasp. I think the mechanism is fairly easy to understand and has already been much discussed, for example well over 100 years ago by John Hobson who showed how rising income inequality can cause both higher savings and lower opportunities for productive investment. The difference, he argued, poured into speculative stock, bond and real estate markets or was exported abroad to finance foreign demand for home products.

As money poured into stock, bond and real estate markets, either at home or abroad, it caused these markets to soar, making everyone feel richer. The consequence was that although ordinary households saw their share of total GDP decline, rising asset prices nonetheless made them feel wealthier, and encouraged them to maintain or increase their consumption.

Higher savings generated by the rich or the state, in other words, were matched by lower savings (or rising debt, which is the same thing) among ordinary households. Of course this can only be sustained if asset prices rise forever, but assets are locked into a circular process in which rising asset prices cause rising demand and rising demand justifies higher asset prices.

It takes rising debt to combine the two processes, so it is only a question of time before we reach debt capacity constraints, in which the system has to reverse itself, which it did in the developed word as a consequence of the 2007-08 crisis. This process, in other words, is the default reaction to a forced increase in the savings rate in one part of the economy, but it is not sustainable because it requires a permanent rise in consumer debt.

3.      Unemployment rises.

There is another way you can force down the savings rate, and this is by closing down factories and firing workers. As workers are fired, their income drops to zero. Their consumption, however, cannot drop to zero, and so they dip into their savings, borrow from friends and relatives, receive unemployment compensation, or otherwise find ways to maintain at least some minimum level of consumption (crime, perhaps, or remittances).

Of course savings is just GDP minus consumption, and so as their production of goods and services drops relative to their consumption, by definition the national savings rate declines. This balances out the higher savings generated by rising income inequality.

If the savings rate in one part of the economy rises, without an equivalent rise in investment the only way for the economy to balance is for savings elsewhere to decline, and this can happen either in the form of a (usually credit-backed) consumption binge, or in the form of rising unemployment. The first is unsustainable.

Once we understand this it is pretty easy to explain much of what has happened in the global economy over the past decade or two. As an aside, it may seem strange to many to think that excess savings is not a good thing. We are used to thinking of thrift as good for us, and even more thrift as better, and this belief is embedded with so much moral certainty that we react with repugnance to anyone who suggests otherwise. Bernard Mandeville’s Fable of the Bees was famously hated in the early 18th Century for suggesting that if we all saved everything we would all be destitute, and John Hobson, in his “Confessions of an Economic Heretic” tells how his teaching assignment was rejected because of


But excess thrift is a much more serious problem than insufficient thrift. There are two reasons besides moral outrage why we get confused about the value of savings. First, and obviously, because more savings is good for individuals, we assume that it must be good for society. It shouldn’t take long to see why this is simply wrong.

Second, most economic thinking is implicitly about the US or the UK (most economic theory comes from economists trained in one or the other country). Because these countries have had a problem in the past several decades with excessive consumption and insufficient savings, we assume that these are universal problems. We want global savings to rise because we want US savings to rise, because what is good for the US must be good for the world, right?

The global imbalances

Before using this model to examine recent history I think it would be useful to summarize. If the savings rate rises in any part of a closed economic entity, like the global economy, it must be counterbalanced by at least one other change that allows the savings and investment balance to be maintained. Either the investment rate rises, in the form of productive, or unproductive, investment, or the overall savings rate does not rise because it declines in some other part of the economy.

We are left with the table below that shows the six ways that an increase in savings caused by rising income inequality or a rising state share of GDP must be counterbalanced. Each counterbalance is shown to be sustainable or unsustainable.


Counterbalance Condition Sustainability
Increase in productive investment This might happen if total desired investment had been constrained by insufficient savings Sustainable
Rising inventories If factories maintain production even as sales decline, inventories will automatically rise Not sustainable
Increase in speculative investment If there is excess capital beyond productive investment, it will flow into non-productive investments Not sustainable
Linear change in consumption If consumption rises with income, income inequality need not create a demand shortfall Sustainable but a seemingly impossible outcome
Increase in credit-financed consumption If households feel wealthier thanks to rising asset prices, they will embark on a consumption binge funded eventually by debt. Not sustainable
Increase in unemployment If production of goods and services exceeds the demand, factories will fire workers until supply and demand once again balance Sustainable

From this table the problem of income inequality is obvious. There are only two sustainable solutions to the problem of a structural increase in the savings rate. Either we must see an increase in productive investment – which is unlikely except in specific cases in which desired productive investment has been constrained by lack of capital – or we must see an increase in unemployment. Nothing else is sustainable.

There are intermediate steps, but because these require debt to grow faster than debt-servicing capacity, they can only continue until debt levels are so high that the market becomes unwilling to allow them to continue to rise. These intermediate steps are easy to understand. At first, in order to keep unemployment from rising, the excess savings can fund a surge in speculative investment or a surge in consumption, or both, with the latter kicked off by the wealth effect that is often a consequence of a surge in speculative investment.

This is exactly what seems to have happened to the global economy. As savings were force up structurally, whether because of rising income inequality or a declining household share of GDP, the system responded in ways that were sustainable (increases in productive investment) and in ways that were unsustainable (rising inventory in China, increases in speculative investment in the US, China, and Europe, and increases in credit-financed consumption in the US and southern Europe). At some point excessive debt eliminated all the unsustainable ways, and we were forced into accepting the remaining sustainable way, which is an increase in unemployment.

I should add here that this model does not tell us where the increase in unemployment must occur, but history tells us much of what we need to know. In the early stages of the adjustment unemployment usually occurs in the countries that saw the fastest increase in debt, typically the countries with excessively low savings. But as these countries begin to intervene directly or indirectly in trade, the unemployment shifts to the countries with structurally high savings rates – Germany and China, in the current case.

This shouldn’t surprise us. If the global problem is insufficient demand, countries that have excess demand (deficit countries) can increase their share of demand simply by intervening in trade. Countries with excess supply (the surplus countries) have to hope that they are allowed to continue to force their excess savings onto the rest of the world or else supply and demand cannot balance domestically.

It is easiest to see this process in Europe. Following the convention I have used before, I will simplify things by assuming that Europe consists of only two countries, Germany and Spain. Here, as I see it, is the sequence:

  1. Beginning around the turn of the century, and in order to increase German employment, German labor unions, corporations, and the government agreed voluntarily to restrain wage increases in order to make Germany more competitive in the international markets. This had a double effect. First, the household share of income declined. Second, as unit labor costs dropped, German rentiers and business owners saw their share of total income rise. The net effect was that the share of GDP retained by ordinary German households declined partly because non-households (businesses and the state) retained a growing share of total income and partly because within the household sector the rich retained a growing share.
  2. Both effects caused consumption to decline as a share of GDP, or, to put it another way, caused the German savings rate to rise (and notice this had nothing to do with rising thrift among German households). Higher German savings had to be counterbalanced, either within Germany or within Spain.
  3. They were not balanced within Germany. German investment rates did not rise to match the increase in savings (in fact I think investment actually declined), nor did consumption among ordinary German households surge. If Germany had been a closed economy, a rise in unemployment would have been, in that case, inevitable. Instead, Germany exported the excess savings to Spain, which under the conditions of the euro Spain was not able easily to reject (tariffs or currency depreciation). Because capital exports are just the obverse of a current account surplus, this meant that after spending much of the 1990s in deficit, Germany’s excess production, caused not by a surge in production but rather a decline in consumption, was resolved by the country’s running a current account surplus.
  4. This resolved Germany’s problem, but only by forcing the savings imbalance onto Spain. Because savings exceeded investment in Germany, investment had to exceed savings in Spain.This meant either that productive and unproductive investment in Spain had to increase, or that savings had to decline. Martin Wolf makes this point when he argues that the expansion in Germany’s tradable goods sector forced an equivalent contraction in Spain’s tradable goods sector, so that in order to prevent unemployment (temporarily, as it turned out) Spain had to embrace cheap capital which unleashed both a speculative investment boom and a consumption boom.
  5. And both happened. There was some increase in Spain’s productive investment, but the lowering of Germany’s unit labor costs relative to Spain made the Spanish tradable goods sector uncompetitive, reducing desired investment in the tradable goods sector. It was difficult, in other words, for productive investment in Spain to rise enough to account for the surge in German savings.
  6. As asset prices in Spain soared, thanks to the surge in capital inflows, this made Spaniards feel wealthier. There were two obvious consequences of soaring asset prices. Excessively cheap and easily available money poured into non-productive investments – apartment buildings and bloated infrastructure, for the most part. It also funded a consumption binge, and the Spanish savings rate dropped sharply.
  7. But neither of these is sustainable. The debt backing unproductive investment and soaring consumption could only continue if there was unlimited debt capacity. Clearly there was a limit to the debt, and the global crisis in 20007-08 put an end to the party.
  8. This exhausted all the ways an increase in German savings could balance save one – a rise in unemployment. Not surprisingly, unemployment soared almost immediately, but of course it did so in Spain. If Spain leaves the euro, Spanish unemployment will decline sharply, but total unemployment will not, which means that German unemployment will rise.

The Fable of the Bees

Where does this leave us? Until we see a significant downward redistribution of income in Germany we don’t have many options. If Spain were to leave the euro, this would solve its unemployment problem, but only by forcing unemployment back onto Germany.

Many analysts have argued that Spain could have done the same things over the past fifteen years that Germany did and so would not have suffered, but I hope this analysis shows why this solution – so called “austerity” – is completely wrong. If Spain has also taken steps to force up its savings rate by cutting wages, it would only force up the global savings rates even further and, with it, once debt capacity constraints were reached, unemployment – perhaps not in Spain, but elsewhere. The solution to excess savings, in other words, is not for low-saving countries to cut back on consumption. This will only increase global unemployment.

What is very clear from this analysis is that there are really only three sustainable solutions to the global crisis in demand. Either the world has to embark on a surge in productive investment, or we need to reduce the income share of the state and of the rich, or we must accept that unemployment will stay high for many more years.

The first is possible, but with so much excess manufacturing capacity and excess infrastructure in many parts of the world, and with significant debt constraints, we need to be very careful about how we do this. Certainly countries like the United States, India and Brazil lack infrastructure, but they do so largely because of political constraints, and it is unreasonable to assume that any of these countries will soon embark on an infrastructure-building boom.

Even if they do, the amount of excess savings is likely to be huge, and without a significant redistribution of income to the middle classes and the poor, it is hard to see how we can avoid high global unemployment for many more years. Because trade war is the form in which countries assign global unemployment, I would expect trade relations to continue to be very difficult over the next few years, as countries with high unemployment and low savings intervene in trade, thus forcing the savings back into countries with excess savings.

So what are the policy implications? Clearly Europe, the US, China, Japan, and the rest of the world must take steps to reduce income inequality. Just as clearly countries like China and Germany must take steps to force up the household income share of GDP (in fact polices aimed at doing this are at the heart of the Third Plenum reform proposals in China). Because it will be almost impossible to do these quickly, as a stopgap countries with productive investment opportunities must seize the initiative in a global New Deal to keep demand high as the structural distortions that force up the global savings rate are worked out.

But redistributing income downwards is easier said than done in a globalized world, especially one in which countries are competing to drive down wages. The first major economy to attempt to redistribute income will certainly see a surge in consumption, but this surge in consumption will not necessarily result in a commensurate surge in employment and growth. Much of this increased consumption will simply bleed abroad, and with it the increase in employment.

Less global trade, in other words, will create both the domestic traction and the domestic incentives to redistribute income. In a globalized world, it is much safer to “beggar down” the global economy than to raise domestic demand, and so I expect that there will continue to be downward pressure on international trade.

Until we understand this do not expect the global crisis to end anytime soon, except perhaps temporarily with a new surge in credit-fueled consumption in the US (which will cause the trade deficit to worsen) and more wasted investment in China (which, because it is financed with cheap debt, which comes at the expense of the household sector, may simply increase investment at the expense of consumption). These will only make the underlying imbalances worse. To do better we must revive the old underconsumption debate and learn again how policy distortions can force up the savings rate to dangerous levels, and we may have temporarily to reverse the course of globalization.

I will again quote Mariner Eccles, from his 1933 testimony to Congress, in which he was himself quoting with approval an unidentified economist, probably William Trufant Foster. In his testimony he said:




After I sent out the first version of this essay, as I expected, I got some very heated responses, nearly all of which completely ignored the argument and focused on issues that were not relevant. If you disagree with my argument, there are only three ways you can do so. You can prove that my assumptions are wrong. You can prove that my logic is faulty. Finally, you can claim that my argument is irrelevant. You would argue, in that case, that the most important benefits or costs of income inequality do not lie in the realm of economics and have to do with social, political, or religious values or with the structure of incentives in our society.

The latter are all perfectly valid points, but they are separate from my argument. To make it easier for anyone to disagree with me in a way that is relevant or consistent, I will summarize my argument as simply, as possible, listing very specifically the propositions from which I begin and the logical sequence of the argument. The only way anyone can possibly show that I am wrong is by attacking my propositions or by finding an illogical step in my reasoning. Nothing else is valid.

Before starting let me explain some of the responses I have received that were usually irrelevant. People on the “right” focus on either of the following conclusions: 

a)    an increase in the state share of GDP leads to unemployment, in which case they call the argument right,

b)    an increase in income inequality leads to a rise in unemployment, in which case they call the argument wrong,

c)    increase in income inequality leads to a rise in productive investment, in which case they call the argument right (this whole essay, remember, is exactly the same “supply-side” argument provided by Arthur Laffer).

People on the “left” focus either on the following: 

d)    an increase in the state share of GDP leads to unemployment, in which case they call the argument wrong, 

e)    an increase in income inequality leads to a rise in unemployment, in which case they call the argument right,

f)      an increase in income inequality leads to a rise in productive investment, in which case they call the argument wrong.

The problem is that you cannot agree with just the part you like. Either the entire argument is true or it is false. In fact all of these conditions can be true but are likely to be more or less important under different conditions. One of the great follies of contemporary debate, it seems to me, is that certain policies are considered to be intrinsically and always wealth-enhancing, or intrinsically and always wealth-destroying, depending on your political beliefs, whereas I would argue that these policies, and in fact many others (free trade, unionization, free banking, currency regimes, state intervention, deficit financing, etc) can be wealth-enhancing under certain conditions and wealth-destroying under others. Rather than close the door to debate we should try to figure out the conditions under which they are one or the other, and guide policy according to the relevant conditions.

I start with three propositions, from which everything else follows:

  1. The rich in any economy save a greater share of their income than do the poor. This is an assumption that can be proven or disproven empirically. The fact that some countries are rich and others poor may complicate things, but this only means that income inequality inside a country matters, whereas income inequality between countries might or might not matter.
  2. In every closed economy savings is equal to investment. This is true by definition because the demand side of an economy consists of consumption and investment, while the supply side (how we allocate total production of goods and services) consists of consumption and savings. Because demand and supply always balance, savings is always equal to investment.
  3. No one has infinite debt capacity. I don’t know if this is an assumption or if it is true by definition, however no one has ever disputed it.

Here is the argument, which can only be logically true or logically false:

1. From Proposition 1, if income inequality rises, the savings rate must rise.

2. From Proposition 2, if savings in one part of the economy rises, we must see one or both of the following: 

a)  investment must rise, or

b)  savings in another part of the economy must decline.

3.  If investment rises, one or both of the following must be true:

a)    productive investment rises

b)    non-productive investment rises

 4.  If savings in another part of the economy declines, one or both of the following must be true:

a)    the “non-rich” increase their consumption

b)    unemployment rises.

You might question whether there are indeed only two ways for savings in another part of the economy to decline, but these are the only two ways I can think of. If there is another way, it would interesting to see how it would affect the argument.

This leaves us with the following. If income inequality rises, we must see one or more of four possible outcomes, which I list as 3a, 3b, 4a, and 4b. Unless we discover any other possible outcome, these are the only ways to balance an increase in income inequality.

Let us focus on 3a and 3b:

  1. If productive investment rises, we all get wealthier, both rich and poor (this is what the supply-siders mean by “trickle down”). The process is clearly sustainable.
  2. If non-productive investment rises, wealth declines. Once wealth declines to some limit (it could be zero but it could also be, and is likely to be, much higher than zero) the process can be maintained only by rising debt, but from Proposition 3 there is a limit to rising debt, so this process is not sustainable.

Now let us focus on 4a and 4b:

  1. If some of the non-rich increase their consumption, they eventually draw their savings down to their minimum level (which might be zero, but doesn’t have to be), at which point they have to borrow to consume. But again, from Proposition 3 there is a limit to rising debt, so this process is not sustainable.
  2. If unemployment rises, total savings decline, although because it might also cause investment to decline, unemployment might have to rise a great deal, which is what happened in countries like Spain once debt-fueled consumption and debt-fueled non-productive investment came to an end in 2008. This is, unfortunately, sustainable.

The conclusion, which I believe follows inevitably from the three initial propositions, is that a rise in income inequality can lead temporarily to an increase in non-productive investment or to an increase in debt-fueled consumption, but in both cases they are unsustainable. A rise in income inequality can also lead to a rise in productive investment or a rise in unemployment, neither of which is unsustainable (unemployment in the long run might be unsustainable, but of course this does not invalidate the argument).

This means that rising income inequality must eventually lead to more productive investment or to more unemployment. There is no other conclusion. Can this argument be attacked? Of course it can. If you disagree with any one of the three initial propositions, then even if the argument is completely logical, the conclusion may be wrong. Alternatively, if you disagree with any of the logical steps, then even if the three initial propositions are correct, the conclusion can be wrong. These, of course, are the only ways in which the conclusion can be wrong.

Inevitably some one will discover that Keynes and Krugman said many of these things, in which case the essay is the work of the devil and innocent young people should not be allowed to read it, or that it agrees with things that Laffer and Friedman have said, in which case ditto. In fact an awful lot of economists in the past 200 years and on every part of the political spectrum have agreed with some or all of this model, mainly because it is just basic economics. There should be no guilt by association here, please.


 Add your comment
  1. A very interesting in depth article.

    As me being more of a philosopher outside of the realm of economic analysing, after reading this piece I can’t help but wonder how we are going to be able to change the current global economic systems in order to ‘save this planet’ (= save the environment to save current humanity) and accommodate all the new middle class and consuming people. The arguments that Mr. Pettis uses which, if making economic policies in this manner, likely help to keep local economies and the global economy going, would it be sustainable enough? Would as productive investing as possible with new consumers arriving every day from the 7-some billion people on this earth be environmentally sustainable enough?

    I would love to hear more views regarding this from economists, but I know many will claim not being able to do so because they’re not environmental experts and real visionaries. However, I think it is needed because they help shape ideas about future human growth.

    In any case we probably need a lucky invention of a new energy source and new ways to produce food sustainably.

  2. This is totally new perspective to economics – never taught in schools… For me it’ll take 2 days to digest.. thankyou.

  3. Can an increase in ‘unproductive investment’ as you call it, not lead to a redistribution of wealth that corrects (to some extent) the initial income inequality.

    For instance, one unproductive investment is building infrastructure when none is needed. But building this requires paying wages to labour, buying steel/cement from downstream companies etc. It may be that a new construction company (started by an enterprising poor) is financed by ‘rich savers’. The company may go bankrupt, rich people who funded it may go belly-up, but their money essentially went to the poor enterprising founder of this new company who as a ‘new rich’ would have higher propensity to consume. This may correct the initial income inequality.

    • If the losses are borne by the wealthy, Gaurav, bad investment can certainly redistribute income downwards but it is a very inefficient and wasteful way to do so. If the losses accrue to the banking system to an extent such that the banks have to be bailed out, then it actually increases income inequality because households almost always pay to clean up banking messes. The trick is to figure out how the losses are assigned, and basically the bankruptcy process is nothing more than the assignation of losses.

  4. do the rich really save a greater share of income? i think they save a greater amount of money, but not necessarily a greater percentage of their income.

    • Think for 2 seconds before you post ultron….reading your post is 15 seconds of life that we a never going to get back. How many rich people do you know that are in debt?

      • ^^Bob Tong replied: “Think for 2 seconds before you post ultron….reading your post is 15 seconds of life that we a never going to get back. How many rich people do you know that are in debt?”

        Rich-people are not rich because they are not in debt. Rich-people are rich because:
        (1) The worth of their assets vastly exceeds the worth of their debts (i.e. they have high net-worth)
        (2) The return on their assets considerably exceeds the cost of servicing their debts (i.e. they have high net-income)

        Therefore, it is possible for Rich-people to be non-leveraged (no debt at all), moderately-leveraged (moderate debt/net-worth ratio) or highly-leveraged (high debt/net-worth ratio).

        On one end, the Rich-people who have no debt at all have the highest stability (least volatility) and are the least likely to go bankrupt in case of a shock. Conversely, on the other end, the Rich-people who are highly-leveraged have the lowest stability (highest volatility) and the most likely to go bankrupt in case of a shock.

    • This is a fair question, but I think most empirical work suggests very strongly that it does, Ultron. Perhaps the simplest way to think about it is to consider the relationship between changes in income and changes in consumption. If my wealth goes up 10%, I might eat more food and buy more clothing, or more expensive food and clothing, so that my consumption rises by close to that amount, but there is a limit. If my income rises from $100,000 to $10 million, can I really multiply my food consumption by 100? In theory I can, for example by switching to an all-caviar diet, but in fact I rarely do. If I am earning $30,000 a year in New New York, I probably consumer everything I earn. If I am earning $3 million a year, I probably save at least a couple of million dollars.

      • Not sure if the food example is that compelling. If i earn an extra $1 million i am not only going to buy more expensive food, but I am also going to buy a luxury automobile, move to a more expensive neighborhood, travel more extensively, hire a nanny for my kids and send my kids to Harvard rather than Penn State. You multiply that by several thousand wealthy or whatever the number of nouveaux riche coming on board, doesn’t that consumption become significant.

        • The poor often consume 100%, if not more, of their income, year in and year out. Have you even seen rich people do that on a continuous basis ? Yes, rich people do consume marginally more when their income rises, but usually not as much as the poor (typically 100%) in the long run. Have you seen a rich buying a yacht every year ?

    • ^^Ultron said: “Do the rich really save a greater share of income? i think they save a greater amount of money, but not necessarily a greater percentage of their income.”

      In the case of individuals/households, Michael has already made the case that it is empirically true that the rich do save a greater share of their income (i.e. have a higher savings-rate). This is widely-accepted and I don’t think there is any serious debate on this point.

      However, it is interesting to note that what Ultron is saying may be true sometimes for countries as a whole. To see this, let us compare US (the richest large-country in the world) to India (the poorest large-country in the world):

      A) As seen in the linked-graphs, in 1960, it was true that the US (Rich) saved a greater share of its income than India (Poor) did.

      US per capita income in 1960: 15,469$
      India per capita income in 1960: 228$
      Ratio of Incomes US/India: 67:1

      US Savings Rate in 1960: 22.6% of Income
      India Savings Rate in 1960: 12.6% of Income

      B) However, the same graphs indicate that India (Poor) today saves a greater share of income than the US (Rich) does.

      US per capita income in 2013: 45,863$
      India per capita income in 2013: 1,165$
      Ratio of US/India: 39:1

      US Savings Rate in 2013: 15.4% of Income
      India Savings Rate in 2013: 26.4% of Income

      C) However, the AMOUNT of money the US saved was always– and is still is– larger than amount India saved, as seen here:

  5. Terrific! I feel like I have just read the economic equivalent of Spinoza’s Ethics or Euclid’s Elements. Insofar as the tone of the responses you might receive, once again Eccles had hot the nail on the head’……..


    • Yes, remember that Marx said capitalist society must inevitably collapse precisely because of the tendency for an increasing concentration of wealth which, at its limit, must lead to revolution. Keynes (and Eccles and many, many others) countered that this cannot happen in a democracy because of political response that redistributes wealth — intentionally or unintentionally in order to save the wealthy as a class. In the US (as in most countries) we have alternated periods of immense wealth concentration with periods of immense wealth redistribution.

      • and we from the former Soviet block had period of high equality in distribution of poverty (compared to western countries)
        since that time I think there must be possibility of any extra reward for good work or idea (or sometimes just good luck) to keep people motivated = there should be any reasonable level of inequality
        question is how to measure what is over or bellow line and how to act (present French model when you take from the rich the most of their income does not work well at least because in global world they do not need tax their profits in France)
        this is not just single parameter for one article (I enjoyed)

      • If the state is the one that owns the concentration of wealth, will the society collapse ?

        • ^Bill Rich asked: “If the state is the one that owns the concentration of wealth, will the society collapse ?”

          Concentration of wealth is not the primary problem. The primary problem is the concentration of income. Of course, since non-wage income is proportional to wealth (“money makes more money”), concentration of wealth becomes a problem only because of its effect on the concentration of income, which is the primary problem.

          Increasing concentration of income is a problem because it naturally tends to lead to an unsustainable trajectory of ever-rising savings rate (i.e. Savings/GDP) and an implied ever-falling consumption-rate (i.e. Consumption/GDP).

          So the question is not who owns the concentration of wealth, but rather how the income from that concentration of wealth is used or distributed.

          (A) If the State owns most of the wealth and retains most of the income from that wealth in order to add to its existing wealth, the problem ends up being IDENTICAL to the one faced in classical Capitalism (i.e. unsustainably increasing Savings/GDP and falling Consumption/GDP). This is exactly what has been happening in China over the last 10 years, i.e. “guo jin, min tui”.

          (B) If the State owns most of the wealth, but uses or distributes most of the income from that wealth such that the consumption rate is prevented from ever-falling (and by implication the savings rate is prevented from ever-rising), then such a situation is sustainable. At a very minimum, this is exactly what needs to happen in China over the next 10 years, i.e. we need to see “min jin, guo tui” in China going forward.

          Let me know your thoughts.

  6. Prof. Pettis’s article certainly offers a plausible explanation of the economically driven societal changes that have occurred over the last 40 years. As E. K. has pointed out the explanation is limited in scope but were it to attempt to evaluate the wider implications of any change in the current economic situation (such as global sustainability questions arising from proposed responses to ever rising inequality) one might turn away in despair. I would therefore like to limit my comments to the focus of the article.
    It seems we have reached the point where the dominant responses to excess savings (which has been suggested elsewhere as being as high as 10 trillion dollars sitting in cash like instruments) are unemployment and non-productive investment. Even productive investment will be of limited effectiveness unless wages are increased to the level they would have been had they continued to match productivity growth. So I wonder if a combination of increases in minimum wage to a level that matches 40 years of productivity gains, an introduction of a wealth tax above a certain level with a 1 for 1 reduction in the tax for investments in carefully defined profitable investments and the net proceeds of the wealth tax used to offset income tax for everyone up to an actuarially sound level might do the trick. Obviously this is a view from the left and I am sure there are very good reasons why it would be bad policy. I lust can’t think at first glance what those reasons would be.

    • In the unlikely event that anyone cares my advocacy of a “profitable” wealth tax offsetting investment should have read “productive”. One would also hope it would be profitable.

  7. Bingo !

    This post should be the foundation for all macro debate going forward , whether focused on individual countries or the global economy as a whole.

    The “solution” that needs to be considered , and the one I fear may be most likely given human tendencies , is another World War , i.e. , widespread destruction of savings/investments so as to make them scarce again.

    And to the victors go the spoils. In this case , the “victors” may be the radiation-resistant cockroaches.

    • Not necessarily, Marko. War may redistribute wealth, but there are many saner political responses that do the same thing, and they have occurred more often than war. In China, for example, most of the Third Plenum reforms, if implemented, do precisely this.

  8. Would trade obstacles like tariffs, quotas or trade certificates not be another means by which to counterbalance rising savings?

    • Yes. Periods of protection tend to be correlated with periods of declining wealth concentration, but of course not always. Is is possible in principle (although perhaps not in practice) to have a rational discussion outlining the conditions under which trade protection does or does not redistribute wealth downwards. I would propose that tariffs or an appreciating currency tend to increase disposable household income at the expense of the tradable goods sector. I would also proposed that if you use trade protection as Alexander Hamilton suggested — to protect a highly competitive domestic infant industry until it can compete internationally — it might redistribute income downwards, whereas if you use it to protect national champions, it does the opposite. We need, however, to do a lot more work to figure this out more precisely.

  9. Thanks – always insightful.

    While morally I hope you are right that imbalances need to eventually be fixed, I wonder whether it is possible to have unstable system where a disproportionate amount of income ends up with a small number of people year by year, but that if you punctuate the system with massive investment writedowns / debt defaults every few decades (which disproportionally affect the rich and so decrease the “balance sheet” imbalance but not the annual “income” imbalance) then the system rebalances enough to maintain the prior trajectory… which is I suspect what we saw in 2008.

    • It might, Damien, but once agin I would argue that using poor investment decisions to achieve that end is not especially useful because while it might redistribute income, it causes overall wealth to drop.

    • Adding to Pettis’s response, there would also be incentive effects. Once everyone knows that there’s a regular, periodic massive debt write-down / forgiveness and redistribution nobody will invest beyond that time horizon. Thus, investment will fall. However, in this scenario we would expect propensity to consume to shoot higher, especially among high income earners, since they know if they don’t spend it, it will be lost. So that would lead to persistent inflation due to insufficient capital stock and a race to spend.

  10. I don’t think I’ve ever read in a single post like this references to Marriner Eccles, William Trufant Foster, and Charles Arthur Conant. How refreshingly old-fashioned!

    • It’s absurd, isn’t it, that even though brilliant people have been arguing about these issues for nearly three centuries we have decided that we shouldn’t use their great insights to guide our own thinking.

  11. TJG,

    Your view from the “left” is really left of centre. it is actually a good step forward in addressing the serious distortion to the global economy, because if the pendulum continues to swing in that direction of increasing income inequality, then Lawrence Summers’ depiction of a Downton Abbey economy (Financial Times, Feb 15 or 16) will hit it on the nose. I fear it would lead to war and revolution in our time. The difficulty with implementation of your wealth tax with the offset for productive investments is the further question of who is going to decide what is productive or profitable? Bureaucrats? Absolutely not, since that would amount to central planning. Leave it to the free market? Let the entrepreneurs decide what to do with their tax credit? So a Starbucks vs an Apple would make sense to the business owners, and they would both be profitable enterprises. But would Starbucks be more “productive” for the world economy compared to an Apple? We can argue that a superlative coffee shop may not add as much value to the transformation of the world as the ecosystem of an Apple (this is of course a subjective viewpoint). Besides, if the best entrepreneurs take the tax credit and creatively expand their businesses and the economy along the way, their 1 for 1 tax credit will yield them so much profit that the “1” will eventually become a “10”. Then we are back to square 1 on the income inequality problem. I have no better solution than you have and all I wanted to say is that if we leave it to central planners, we know it won’t work, and if we leave it to the market, we are back to square 1 if it works.

    • Mr Yeong,
      Thank you for taking the trouble to think about my suggestions and offering your own thoughts. I understand the difficulty of determining what would be a productive investment suitable for an offset to a wealth tax and have no answer, but there are many smart people in the world and I thought someone would be able to figure it out. I also realized that if such a productive investment also proved profitable the rich would become richer but they would have made effective of cash that was currently doing very little, and put it to work in a way that would have contributed to the public good and probably provided ” good paying jobs”, perhaps even with benefits! I realize the possibility of going back to square one exists but it wouldn’t necessarily have to be that way since income tax would be paid on the profits . It would be nice if such profits were not considered to be carried interest.. At any rate this is just an intellectual exercise that is not going to happen, but the thought process is interesting.

  12. This is brilliant summary, thank you MP!
    Key message is that either we will have high structural unemployment or we will prosper if we reach balanced economy. But balanced economy under central planning or global trade where it is always tempting to beggar the neighbor is difficult. Not sure there is solution out there. May be a country will emerge with minimum central planning and high immunity to global trade frictions, but unlikely such country will be allowed to exist unobstructed for long period of time.

  13. Excellent as always Michael.

    You can lead a horse to water, but if that horse refuses to drink anything but ideological Kool-Aid, he would rather die of thirst.

    Thanks for some of the best analysis going around, there aren’t enough apolitical economists for my liking.

  14. Seems to me that there is another cog, QE.

    This exaggerates the whole cycle by creating a further incentive for those where income is accumulating to save and disincentives to invest in capital and labour as the returns QE cash created were in the form of asset price inflation, which beats traditional investment (involving actual work) hands down.

    So it prolongs the recovery while increasing the distortions.

    The perverse impact of tapering could then be that it actually reverses this cycle, creating a self-sustaining balanced recovery where income inequality narrows again as holders of wealth are forced to sing for their penny. QE will get the credit for this when QE in fact prolonged the recovery.

    • Anyone who has read Hyman Minsky knows the the structure of monetary policy and of balance sheets can either exacerbate trends on both the way up and the way down or can stabilize them. We need to think a lot more carefully about this issue, and the people at the Levy Instituue, with INET, or individual mavericks like Steve Keen, are doing just that.

  15. Mr Pettis,

    The part below this paragraph is a bit confusing for me: I can see that many things consumed are foreign for countries like Belgium and to some extend the benefits of job growth bleed to other countries, but is it not even worse if said country doesn’t redistribute income downwards? I have this thought that with inequality this high, any sort of downward redistribution would be beneficial, despite some of the benefits leaking out. Your comment gave me the thought that more redistribution in current setting might not be so good.


    • Yes, Eric, but I am just thinking about the asymmetry between costs and benefits. If Belgium, to take your example, were to bear the costs of redistributing income — in the form of political costs, higher debt, and perhaps reduced international competitively from higher wages, for example — but were to receive only a part of the benefits, even if it were good for the world overall for Belgium to do so, it might not be good for Belgium to do so. Germany, to take another example, won’t raise wages because their tradable goods sector would suffer while Spain’s would benefit, and Spain cannot raise wages for the same reason, so that even if it is good for Europe to do so, no individual country in Europe will be willing to take the first step.

      • The first step that the periphery has so far been unwilling to take is out of the Euro straitjacket.
        However, IMO this will happen soon, maybe this year. First out gets the best deal… I assume first out will not be Germany, and if that is true German (and French) banks look to be in some difficulty.

        Do you think Chinese leaders will stay the reform course? Will they play the nationalist card to distract the populace as unemployment rises? Will Japanese bashing significantly affect bilateral trade and world growth? Are inflationary pressures causing Chinese profits to fall hard, and if so will the current exodus trickle turn into a flood? Already seeing Chinese buying push up LA real estate, can we expect this to continue? I think you said Chinese growth could dip to 4% on the max side, how low might Chinese growth get to over the next two years?

        Finally, it has been said that if the US catches cold, Euro gets pneumonia… if US goes into recession in 2H14, what would this do to Europe, and what would it do to China?

        Thanks, JK

  16. That’s a whole lotta apologizing for telling a truth that sane people already know. The wealth hoarders, the “it’s all mine and to hell with you” folks are actually fouling their own nests. There will come a time when no one can afford to buy what’s made by the companies they’ve invested in.

    • I think the sad thing is not that the super rich disagree with Pettis. Many of them agree with him completely and want to reduce income inequality. The sad thing is that those who are the staunchest defenders of the rights of the super rich to take an even greater share of wealth are middle and lower middle class tea partiers. I don’t understand why.

      • I think many in the Tea Party are motivated by opposition to government power. They equate higher taxes with more government power and intrusion into people’s lives both in terms of personal and economic freedom. They are highly suspicious of claims that a benevolent government can wisely, efficiently, and fairly redistribute income.

        Also, if we believe the narrative about U.S. oligarchy with only the top of the 1% having influence in Washington, then the super rich would have already bought the legislation to tax themselves more. Instead, we’re told a story of relentless lobbying to maintain the carried interest treatment for hedge funds, big support for lower estate taxes, and opposition to higher marginal income taxes. So you’ve got to give up on one of the stories here, or just live with the glaring contradiction.

  17. I would argue that your model of income inequality is antiquated because savings is now expressed in knowledge and not in stored claims on labor, i.e. fiat money.

    So we would have to entirely recalibrate the basis and rework the model. I don’t have the spare time at the moment to dig into such an endeavor.

    • Sorry Shelby, but the idea that savings can only be something that occurs in the form of cash is not only not necessary for my argument to be true but in fact it cannot be true if my model is correct. Savings is any form of production of goods and services that is not immediately consumed. I know it is very fashionable to think that the recent IT revolution has somehow changed “everything” and created a radical new paradigm of reality, but this is just what we all believe every time these kinds of technology advances happen.

      In my 2001 Foreign Policy article on the coming global crisis I quote an engineer in the 1860s who made exactly the same slightly feverish claims about how the world had changed so dramatically in the past two decades that old the old verities were cancelled. Because he used this to argue that the silly and antiquated conventions about financial crises had been forever revoked, and he said this just a few years before the popping of a technology bubble threw the world into its first truly global (and devastating) crisis, I used the quote to show just how common, and commonly wrong, these kinds of ideas have always been.

      There have been many technological and even IT revolutions in the past, some far more important and dramatic than our own, and some with a far greater impact on changing the value and definition of work and of wealth (like the printing press or the telephone, to name just the most obvious), yet they still must comply with the same old identities. Antiquated idea are often rejected because of fashionable new ideas, but they have a terrible habit of ignoring us and of coming back.

      • Michael thanks for expending the time to explain. I’ve just had this debate, and I think I won the debate. The salient distinction between the prior century example and now, is Metcalfe’s (and Reed’s) Law of the square value scaling of communication and the internet.

  18. Nanostring Founder

    Fantastically illuminating!
    One idea that came to me while reading it. Your outlet #3 (nonproductive, speculative “investments”), usually has corrupting consequences on society. Be it financial mafia “ponzi schemes” or “stimulative” government handouts to cronies. In other words, if you remove the self-corrective feedback loops of the market, where one makes investments to get returns, unsavoury things tend to happen.

    However, the majority of the human population are raised and educated to be virtuous, by default, or otherwise the civilisation would collapse. Therefore, a relatively small fraction of crooks and parasites, which are barely tolerated in normal times, has the required “moral” capacity to benefit from the new conditions, which in turns concentrates the income associated with such nonproductive investment into the hands of a noxious minority (fund managers a la Bernie Madoff are one such sub-strata, and government-affiliated cronies are another).

    So the logical conclusion is that income inequality, among other things, self-feeds on itself, in such a way where the beneficiaries are more and more some odious characters. Certainly, the empirical evidence supports the logic of such model.

    • You may be right. Irving Fischer argued that in the late stages of the bubble it becomes much easier to binge on other people’s money.

  19. The comming Bot revolution is only going to make income inequality worse

    • Perhaps not. This is an old argument, but if workers are more productive to the extent that manufacturing employment collapses, it will be no more transformational than the revolution in agricultural productivity. Once we could all eat cheaply, we decided we needed other goods.

      As people stop making certain kinds of manufactured products, we will all want more in the way of services, intellectual products, and artisanal products. When anyone can buy a Cadillac for $100, instead of displaying wealth and social status by buying Cadillacs, we will find some other way to do so. Once you have met your basic needs for food, shelter, and clothing, you spend money buying social status, and I don’t think we will ever run out of the desire or the means to keep up with the Joneses.

      • Re: “Once you have met your basic needs for food, shelter, and clothing, you spend money buying social status…”

        Sure, that is often true, but it’s only part of the truth. First of all, once you cover the basics you want more of the basics to some extent – both more in volume and more in terms of replacement frequency. Why not have a car *and* and SUV for convenience and pleasure? Why drive a 10 year old car when you can replace every few years? Then you want more quality and features and convenience from existing products. And you want new products and services that in many cases provide more than purely social status services. Nobody needs to know that you bought an indoor air purifier or better wine for it to be valuable to you. And then there’s healthcare: Getting a fancy new stent to save your life isn’t about social status, it’s about just being there for a while longer.

      • Isn’t this a destructive way to look at society. If all we want is exponential growth, don’t we run into a realistic possibility of taking whatever we can from the world around us and destroy it? Won’t ideas like this lead us closer to our self-destruction?

        When we have a society whereby the people associate themselves and determine their value by the amount of material things they have, that’s a real problem. I’m sorry to say that I don’t think that’s civilized.

        This brings me to my next point: there’s a (huge) difference between progress/technology and civilization. Having a society where people sitting at a bar or a table looking at their telephone screens rather than communicating with the people around them isn’t civilized; it’s primitive and dehumanizing. When we spend money to buy $100,000 Caddies without first choosing to develop our minds, our health, our bodies, etc and when our culture or society glorifies this behavior, we’ve got issues. I’m sorry, but that kind of behavior is not what civilization is built on.

    • In the debate I linked upthread, I argued the opposite. The bots will automate the manual labor, which raises the relative value of knowledge capital. Bots can’t automate knowledge production. Bots don’t innovate.

  20. TJG,

    Your intellectual exercise is by no means wistful. I think it is quite executable. What may make it work is that instead of the tax being applied to business, which will bring us back to square one of the income equality problem, we can apply the tax credit to social enterprise, led by the best and the brightest of our entrepreneurs. Let there be a flourishing of the Gates Foundations, the Warren Buffett philanthropic initiatives etc, funded by these tax credits. These social enterprises are no longer a waste of money as in many traditional charities, because they will specifically be required to “make money to redistribute income”, if only for the selfish purpose of preserving the oceans of poor consumers in which the rich sharks (with lower marginal propensity to consume) swim. Some entrepreneurs must be assumed to be noble and altruistic and will do the right thing for the poor. Some will be just ensuring their own survival. It would not take a lot of educating for these clever rich to understand their alignment of interests with the less well off – after all, the risk of a deeply divided society will mean it is their world to lose. And finally, there will be some rich people who will just take advantage of tax credits to advance whatever interests, pecuniary, fame or otherwise, they want to pursue. So the wealth tax with a credit for social enterprise that will redistribute income is an extension of your scheme of things. Obviously, such an systematic organisation of social entrepreneurship is not in existence yet, and we only have ad hoc efforts for the moment. But if it is a choice between forcing the institutionalisation of social enterprises through a tax reform or the alternative of a class revolution, the rich will probably make the right one.

    • Once again Mr Yeong thank you for continuing to give some thought to my suggestion and for offering refinements that make it more practical. I initially thought that a productive investment qualifying for a rebate of wealth tax would have to serve a public good ( such as a think tank to co-ordinate and stimulate efforts to development fusion energy for civilian consumption) but I came to the conclusion that “the wealthy” would need the incentive of being able to achieve a return on their approved investment in order to induce them not to mobilize their resources to ensure an outright defeat of any sort of wealth tax.
      Certainly one would not want to simply fund existing NGOs some of whom make a functional contribution to the areas they serve which represents a pretty thin trickle arising from the flood of contributions they receive. I like your concept that some who would choose to partciipate in this trade-off for wealth tax payments would have more modest pecuniary interest than other participants. I suspect it would be necessary to approve a range of projects to meet the motivation of differing participants.
      I very much agree that smart people should be able to grasp pretty quickly that an initiative that reduces the inequality that could one day threaten their own survival while at the same time earning them kudos from participating in a project boosting a public good, and which offers a return on the money they invest as well as tax relief is a pretty good deal. I think whatever performing investments are chosen they should have a credible plan for achieving the goals of reducing income equality and enhancing a public good.
      Again thank you for your very insightful thoughts on this subject. Unfortunately it is rather difficult to know how to proceed so that this concept could gain some traction. I would suspect someone else has thought of this approach before and abandoned it for reasons that are not immediately obvious to us.

  21. Professor Pettis,

    Another well written article. To this I only wish to add my two cents about income inequality. To me, income inequality in modern times is a reflection of productivity of the people who are above average. Take a guy like Bill Gates, in the old days, he might have become a politician in Rome, or heading a farm in Virginia. In the end of the 20th century, his ability is magnified such that he was able to add value to hundreds of millions of people. Of course one can always point to the bankster trader that failed to add much value to society, but that is a small, though lucrative slice of the job market. The point is that modern infrastructure has enabled talented people to add enormous value to society, and be rewarded by society in turn. On the other hand, the other side of the ability bell curve has been left increasingly behind. To increase their productivity, we resort to increasing automation. If you have shopped at your local Macy’s during the boom years of 2000 in the Silicon Valley, you will see that the level of competence of the clerks in these stores are pretty low and increasingly, we are seeing more automation in the retail industry.

    While I agree that the rich save more money then the poor, the working poor today is making more than a middle class wage compared to, say, the 1920. If a middle class in the 1920s can save a big portion of their earning, the working poor today in theory should be able to do the same. I have had my share of experience with the working poor. In my judgement, a big part of the problem of the working poor today, same as the working poor in the past, is their inability to plan ahead, as well as controlling their impulses.

    What I am trying to point out, is that the rising inequality of earnings is a structural issue that are a bi-products of the relentless drive to increase productivity of the work forces, and the differing ability of the work forces to arise to this challenge. We need to be careful how we “fix” this problem. I think certain amount of wealth transfer from the rich to the poor is OK, but beyond that there is not much that could be done.

    • There have been many innovations that have increased productivity, even more so than our most recent technological advances, and they have been driven by the same ferocious impulse to get rich by increasing worker productivity and firing workers. Just read about the Rockefellers, the Fords, or the Carnegies in their hey day. We have always worried that these processes would lead to permanent higher unemployment but they never do, perhaps because of the reasons I discuss in my response to Rex above.

      • I hate to use this sentance however This time it really is different
        When you can produce products whith no human inervention we have a problem ; Martin Ford and others have written many books about this coming change to manufacturing .

      • I don’t think I have made myself clear on this. My point is that a unit of work force is not the same as the next unit. The higher quality units are paid increasingly more over time as they are able to add more value over time. In Henry Ford’s day, the assembly worker is still a highly valued part of the work force and paid significantly above average wages due purely to the association with the auto industry. Today, a top programmer at Google makes six figures right out of college. While it was possible to substitute one unit of assembly worker with another in Henry Ford’s day, it is not possible to substitute the top programmer with just anyone today. In fact, this guy is a pretty elite group of talents that are very limited in supply. On the other hand, I see people who are house painters, which are dime a dozen here, laid off pounding the pavement . A job in McDonalds is fought over ferociously by hundreds of applicants.

        Increasingly, the talented are adding more value to society while the unskilled are adding less. This has never happened in our history before. In the old days, a guy with a strong back can always find work.Many of those jobs are gone today.

        • John the only reason that a programmer can earn a six figure income straight out of college is that they do not face the same wage competetion as many others do. There are probably more competent programers in India and China, equally as good as those whom you refer to, who make a fraction of what they might in the US. Likley they make less than an American house painter.

          Dean Baker has made this point frequently…….




          • I agree that doctors and lawyers may lobby to restrict job access by other countries. But I have to say that you have it backwards between programmers and house painters and a guy in McDonalds. The former is easily outsourced. Heck, the guy does not have to set foot in this country, he just has to code up the thing and send it over. Where as the latter jobs are never going to be outsourced. What made the top programmer valued more is his/her ability to do this better than the average guy, and to do problem solving.You have to understand the concept that some minds just work better, maybe 10x or 100x better than the average minds. If you disagree on this point, then there is nothing more I can say.

          • John, if we allowed open Iimmigration programmer wages in the US would fall. Furthermore how would explain the fact that U.S. CEOs earn from 400 to 500 times the median salary for workers. For CEOs in the U.K., the ratio is 22; in France, it’s 15; and in Germany it’s 12. Are US companies that much more profitable? BTW if you believe that one can posses a mind that is 100x better than average you are either arrogant or ignorant.

          • Glen,

            I don’t disagree that unfettered access to the U.S. job market by any profession would depress wages, this includes programmers, but I think it is wrong to blame outsourcing for the earning differentials when the example I gave, programming, is one of the most outsourced jobs in this country. I am not saying that I am one of those with 100x productivity, but I have witness in my own profession how some of the best and brightest bring value to a company. They do contribute disproportionately to the bottom line of the company and their pays reflect it. If you don’t believe that there are minds that produce 100x or more value, take a look at a guy like Craig Venter, who pioneer the new method of genetic sequencing. There was a project to sequence the human genome, it was going to take billions by multiple countries over the course of decades. Craig came up with the new method (actually, it was not even his idea, but he saw the potential in this new method) to sequence the human genome for a few hundred million and over the course of a couple of years. Now tell me, how much money should he make compared to the average person for coming up with this?


            I refuted this notion in the debate I linked to upthread (see my reply to Michael). Programmers command higher salaries because the knowledge capital has move closer to the individual, maximum division-of-labor, and away from the vertical integration parasitism.

        • John, Henry Ford paid workers higher wages because he understood that only by paying higher wages could workers afford to buy his cars. He was very explicit about this. Today we call this “Fordism” — assembly line automation plus higher, not lower, wages.
          In a sense Ford was doing exactly what this essay suggests, and not because he was a nice guy. He was redistributing demand downwards not because he didn’t want to get richer, but rather because he knew that with less income inequality he would be even richer than he would with more. It may seem counterintuitive, but in fact it is very logical.

          • Whatever Henry Ford was doing do not detract from my claim that some people are far more productive during this time then they would have been just a couple of hundred years ago and getting paid more for being more productive, where as others are getting less productive and getting lower pay for it. While Henry Ford in the old days can afford to pay his workers more, because largely the auto industry is a much larger slice of the economy then it is today, Today we are seeing firms making rational decisions only concerning the company and how they can attract talent. Everyone from the CEO on down is paid a market price for what they bring to the table, no more, no less. We cannot go to Microsoft and tell them that they should pay their workers 2x the salary because that would be good for the economy and, ultimately, benefit Microsoft. Companies don’t work that way today.I have yet to hear you refute my argument that income inequality is a structural problem due to the differential productivity of the workers.

          • John, I do not think there is any historic evidence that income inequality is purely a function of productivity differentials. Those matter, but the do not explain why we have seen long periods of rising income inequality followed by long periods of declining income inequality.
            You say that income inequality is high today because productivity differentials are greater today than they were 100 years ago, but the period of greatest income inequality in the US was in the 1880s and 1890s, and I think the second was in the 1830s. How do you explain that?
            Income inequality is greater in the US and the UK than it is in Germany, France and Scandinavia and has been since at least the 1940s. Do you really think that productivity differentials have been greater in the US and the UK than in Germany France and Scandinavia during this whole period? Why is Brazil more unequal than Chile?
            Income inequality in the US began rising in the late 1970s and 1980s to reach the point where it is today. Would you say that US productivity differentials began rising then? There is no evidence at all for this. Don’t you think the policies initiated by Carter and Reagan to undermine unions, reduce the top marginal tax rates, lower capital gains taxes, and reduce the social safety network do a far better job of explaining rising income inequality than rising productivity differential.
            By the way you say “Henry Ford in the old days can afford to pay his workers more, because largely the auto industry is a much larger slice of the economy then it is today.” This happened in the early 1910s, when the auto industry was an emerging industry and much, much smaller as a share of the US economy than it is today.

          • Dodgson,

            I did not say that the productivity differential was there historically. It is recent. I tend to think that the English speaking countries tend to have more unobstructed economies where as other parts of Europe has more of a socialist bend. Income inequality in the 1800’s, I was not there so I will take a stab at it with the preface that I don’t know that much about that time. I think in the 1800’s, just after the industrial revolution, capital is relatively scarce while labor was in surplus due to the disruption of the industrial revolution. Those with capital prospered while those who had unskilled labor did not. This gave rise to the poor working conditions and Karl Marx. But today, there is enough capital to employ everyone and we have a different condition.

        • You forget that not everyone has a strong back. There has always been, and will always be, ferocious competition for jobs.

        • I think you forget that not everyone has a strong back! I think you also underestimate the value that education and creativity has added ever since the enlightenment and industrial revolution (maybe more so long ago, when education was not available to the masses). There has always been huge competition for jobs and a huge gap in the ability of different people to do a specific job. That doesn’t explain inequality levels over time.

  22. One possibility is consumption increasing by the “rich”. That is, your postulate is that the “rich” have high savings. An equilibrium could be one where consumption does not increase through the “non-rich” but does increase through the “rich”. The analogy: are slavery or serfdom regimes both economically imbalanced and morally reprehensible?

    • Perhaps, Jesse, but it is hard to imagine that Buffet, the Waltons, or Bill Gates could ever consume anything more than a small fraction of their income. I myself have a comfortable income, but I end up giving away more than half of it every year to support young Beijing artists, and very bright students in China and elsewhere who simply cannot afford the level of education they deserve. I suppose you can call this a kind of consumption, but it seems to me that if I earned a quarter of what I do now, my real consumption would be almost unchanged, which suggests that at least for many of us it is nearly impossible to keep our consumption levels rising as fast as our incomes.

      Serfdom and slavery are certainly unbalanced economic regimes, but the slave owners were a tiny part of overall population, and they tended also to result in very high savings rates among the rich anyway, except that wealth was usually expressed in the form of purchases of “investment goods” (art, jewelry, etc) imported from abroad. I think it would be quite easy to apply this model to societies, like the pre-Ciivil-War American South. Most wealthy slaveowners in fact had very high savings rates, even, funnily enough, the always insolvent Thomas Jefferson, who spent far more than he earned not mainly because of his out-of-control consumption but rather because of his out-of-control investment — in Monticello, for example.

      • Saez and Zucman have a new slidedeck out that shows their estimates of U.S.savings rates by wealth class. The top 1% save at rates of 30-40% thru most of the post-WWII era , and never fall below 20%. The bottom 90% increased their savings up to the mid-1980s ( <10% ) with a subsequent steady decline , turning negative ~1997. ( p. 43-33 ) :

        If the top 1% on average save at those rates , you can imagine what the average savings rates of the billionaires must be. Including the likely unaccounted-for trillions in tax haven wealth would only make the differences more extreme. I think you can safely assume that the MPC of the typical billionaire is essentially zero.

        • Sorry , the page reference above should be “p. 43-44 “.

        • Thanks, Marko. A number of comments have suggested that the more wealthy do not save more than the less wealthy. I think there is a lot of empirical evidence, besides common sense, that says they do.

          • There are some rational reasons floated for higher savings rates, the one that piqued my interest wrt China was insurance. To maintain a std of living with uncertain future income, tax regime, or political revolution, necessitates a sizeable war chest just in case. It is a positive feedback loop: the higher the share of GDP one captures the higher the necessary savings rates as insurance. It is hard to reduce standards of living.

            But also interesting, Prof Pettis, the corollary — the implication that servitude societies are, perhaps, unstable by their inherent structure. Food for thought.

  23. Thank you for bringing much needed clear thinking to the utterly confused economic debate.

    Of course, it might be that the economic debate is only made to appear confused to hide ideological bias (either way) and / or specific interests. In that case, you might simply re-discover, like Maurice Allais before you, that it is indeed impossible “to make the blind see or the deaf hear”.

    Hopefully, your call to analyse the current situation with an open mind and a cool – but rigorous – head will be heard. Nobody can be satisfied with the economic and financial developments of the past few decades.

    Thank you again.

  24. Non-productive investment is indistinguishable from consumption. It does not require a decline in wealth, since investment is financed out of income, assuming constant GDP. Thus that is a sustainable equilibrium as well.

    • I am not sure I agree. If investment is non-productive, it means by definition that the value created is less than the cost, in which case wealth must decline. My example of Thomas Jefferson, above, might show how. He died broke because his investments, while esthetically wonderful, where economically non-productive. That opens up a whole new area of inquiry about the value of cultural investments which I won’t get into, but economically it is certainly the case that non-productive investment, like consumption (as you point out) have the same impact on wealth.

  25. The only value of an economic model – or any scientific model for that matter – is its accordance with the facts. In that respect, your model seems fully consistent with the observed experience of the past 20 years. Which is much more than can be said of alternative models, for instance the wealth effect model dear to the Fed which has been completely contradicted by the facts, not once but twice already, in 2000 and 2007. Which must be why they are at it again for a third time in a row.

    In fact, suffices is to read the Flow of Funds Accounts of the United States published by the Fed, there is a page with the breakdown of National Income between Employee Compensation (labor share) and Corporate Profits, Proprietors Profit, Rental Income and Net Interest (together, capital share). Labor share of national income is at its lowest since the 1950’s. Symmetrically, capital share is at its highest since the 1950’s. Yet, capex share remains at recessionary levels. Instead, the money goes to the equity and high yield credit markets. There, you have it: the Fed own data contradicting their claim that QE supports aggregate demand and validating your claim that it widens the wealth divide even further (hence weakening aggregate demand even further) while facilitating unproductive and speculative investment. But, since Fed officials clearly don’t bother to read their own reports, it is unlikely that they will read your analysis. If we exclude sheer and persistent incompetence, the only other plausible explanation is that there is another agenda.

  26. Mass unemployment has inherent political constraints. It’s not actually sustainable in the short-medium run.

    I mean, devils do love idle hands.

    • I agree, and this is one of the political issues that may override the economic issue.

      • I have great trouble with this part of your post.

        Out of the 3 options you mentioned, I objection might be to call it all irrelevant… or possibly that it is a faulty assumption.

        I can only agree that increasing unemployment will decrease savings rate in the short term. As workers are laid off, they decrease their consumption – just not as much as their income has decreased. So temporarily, I’m totally with you. Unemployment will cause a small downturn in the savings rate. However, I would argue that the people most worse-off are also more likely to be the first ones laid off. If the rich lost their jobs first, the argument would be fairly coherent. But that’s far from the case.

        In your post here, Increasing unemployment is consistently listed as one of the few sustainable responses to the savings rate problem. Perhaps it is slightly more sustainable than the rising inventories, but only marginally so. Workers have finite savings. On a macroeconomic scale, I’m not sure what we should be assuming happens when those run out. They accept lower wages? They join the homeless? Mostly, I just don’t understand the argument. I don’t know what we should picture as the end-game if all the options are unsustainable.

  27. Prof,

    This post is the most insightful on many articles I have read in recent months on the terrifying problem of income inequality. Thank you.

    It is also good to take the politics out of the analysis and see what are the options (or maybe just hope) for solving the problem Your intellectual rigour in inviting alternative outcomes of your hypothesis is most admirable.

    Looking at your propositions in the epilogue, here are some thoughts:

    Assumpton No 1.


    This assumption cannot be too far wrong. It is fundamental in economics. And it is observable (empirical), since we do know that billionaires don’t spend billions in their consumption. Warren Buffet still lives in his modest home of many years rather than a mansion. Even the Indian billionaire who built an entire tower of apartments for his clan wouldn’t have spent a small fraction of his wealth. Most billionaires don’t buy fleets of cars, diamonds, artwork, etc at the rate of their wealth accumulation.

    However, the validity of the above assumption to predict an outcome favored by trickle down economics of productive investment or its obverse that income inequality in raising savings would lead to unemployment after a debt crisis, depends on how we define “rich”. The elegance of the assumption may lose some of its shine, if we expand the definition of the “rich” to include people below, say, the “one percent of one percent” or even the “top ten percent”. What if we argue that the “rich” in the economy is the top twenty or even thirty percent of the population? Or what if we argue that In an economy like China, we classify the “rich” as the minority who live in the cities and the poor as the folk in the rural areas. If we use different analytical nomenclature, then it may not be so obvious that the people will consume less if their income increases. Or that across the economy, consumption falls and savings rise when there are more “rich”, apolitically defined.

    In places like China, the “rich” may also include those in the so-called “grey economy” run by the corrupt, which may, by some estimates, be as large as one third of the formal economy. If their grey income increases, there may be a propensity to spend all, not just part, of it. China’s “rich” would not be unique in that regard. This can be a significant leakage in the elegance of the basic assumption. In other words, if there are these types of “rich” people, then there is a heck of a lot of conspicuous consumption out there.

    In other places like in the US, there are many in the wannabee class, who spend more of their increases in income to “keep up with the Joneses” in demonstrative consumption. Some go over the limit and live on debt. But before they get to debt, they spend more out of income first. As such, if income inequality rises (more wannabees), there may not be the expected decrease in consumption and corresponding increase in savings. Another type of leakage…

    If this is true, then a viable policy option (or maybe just hope…) for governments is to pursue supply side economics where an increasing “rich” class (not the 1 percent or the ten percent, but the top 20-30) will indeed bring economic activity overall to vitality through their increasing consumption. And efforts to increase the wealth of this group (call it “upper middle class” for lack of a better classification or call it “urban-dwellers” in less developed countries like China) through appreciation of home values, stock prices (only the “rich” own stocks and that could be 50 percent of the population in the US), will indeed increase consumption. Empirically, we know this “wealth” effect to be mostly true.

    This alternative assumption will lead to a similar outcome as the analysis where income inequality leads to sustainable and productive investment – a “good” (economically speaking) outcome. However, the other side of the coin is that for a given rise in income inequality, consumption rather than savings increases and as such, it would probably not lead to an increase in unemployment. This sounds politically incorrect in the current mood of the day, but the term “rich” should perhaps be rephrased as “mass affluent” in the context of our apolitical economic analysis. During early stages of economic development, growing the “mass affluent” (or less politically correct, the “rich”) will spur growth and employment. We have seen this happening In many of the Asian economies over the last forty years.

    So while I don’t disagree with your analysis, Prof, I think there may be leakages that will spare us the worst outcomes of rising income inequality. This by no means justify obscene wealth accumulation, but growing the “mass affluent” (still a form of income inequality) is probably not a bad thing, politically or economically speaking.

    • All good points, HY, which is why I prefer not to talk about the rich and the non-rich and instead talk about rising or declining income inequality.

  28. I’m a little troubled by the thrust of “the 3 propositions from which everything else follows” –

    1. The rich are generally older than the poor, and will face greater claims on their income for care as they age, thus increasing consumption. Poor people aren’t exempt from aging and having the same needs, but they are more often cared for in a family setting where the expense of care isn’t captured in dollar based transactions. So you might see increased consumption by the aging wealthy, so there may be more work but it won’t be fun.

    2. What may be an accounting identity as a stock item might not be when flows are considered. Current times aren’t the same as in Keynes’s, where the man who took his trunk of gold sovereigns to Twickenham was reasonably assured of no debauching of the currency as he paid his bills. What is different today is that interest rates are so low that any inflation makes for a negative return on held cash. In the case of the US, say you have personal savings of $1000., suffering real depreciation of ~ 1% per annum. Do this for 20 years and then lay on a 35% estate tax as a coup de grace on exiting this mortal coil, and the flows overwhelm the stock. I see this in real time, where I handle the finances of a 94 year old woman who now earns minimal investment income on savings while her costs of personal care in assisted living rises at a rate in excess of 4% per annum.

    3. If you’re Japan, have super-low interest rates with bonds funded almost entirely by your native population, and have a 50+% inheritance tax at over 5 million yen of assets, you might have nearly infinite debt capacity because the funds go back to the government upon your passing.

    The dissaving that you seek will in part occur naturally, and worldwide, in the wake of baby boomer retirements. Richer boomers will spend down some of their capital in increased need for care, and in some cases the estate tax will help balance things out. Is that productive investment? Depends (I’d guess P&G thinks so).

    So maybe Summers had a point, but where Downton Abbey becomes an assisted living facility – my apologies for that depressing thought…

  29. Michael, another great post. I would love to hear your thoughts on a development that Bloomberg has recently picked up with regards to depositors seeking higher yield on their savings: This development, more so than any proposed deregulation by the PBOC, seems to be putting pressure on the Chinese banks.

    • A very big topic which, fortunately for me, has recently been covered brilliantly by some of my students in the central bank seminar. At some point I might write about it, but I cannot discuss meaningfully in the comments section. We should however be following it as it has very interesting implications.

    • Dear Robert,

      I think this perfectly illustrates the Michael’s point that the ability to incur debt is not infinite.

      Debt is obligation that is remembered. The only way to borrow infinitely is to somehow make, or force the creditors to not remember, or not care. In theory, this is not possible in a “pure market”. In practice, however, this has been the case in China for many years, especially during the boom of early 2000’s, as a result of extra-market intervention.

      Chinese households, being net savers (hence net creditors to the banking sector, which is mostly an arm of the state sector), have been passively accepting the financial repression, namely the artificially surpressed interest rate on bank deposits, which has been described in Michael’s post as a wealth transfer from the poor households to the rich state. This behavior of accepting unfavorable terms, or unfair prices on credit, cannot be explained purely in the name of the market. It exists due to 1) government fiat (interest rate being mandated by authoritarian state), and 2) information asymmetry (only a tiny fraction of the “lay” savers were sophisticated enough to participate in money-market or bond-market mutual funds — you may argue that this is in part a result of the authoritarian state that “dumbs down” the citizens). Both serve to “make/force the creditors to not remember” what should have been due theirs.

      If this were to last, the Chinese state would in principle have been able to borrow almost infinitely at the cost of its household creditors. However, sooner or later there comes a day when the creditors actually remembers and can no longer be forced to not remember. In other words, there comes a moment of “peak financial-repression”. As 1) the state gradually looses its grip on interest rates and 2) booming Internet-firms disseminate financial awareness and knowledge, we see the creditors begin to actively, albeit indirectly, participate in the negotiation of prices, namely interest rates.

      I think we may expect to experience a lot of noise from vested interest regarding this, and the negotiation process may turn unsteady at certain moments. Meanwhile, the trend for the amount of household savings/credit does not change (merely shifted from bank deposits to MMFs), so I don’t think Michael’s basic analysis needs to be altered to take this new development into account. The only consequence I can think of at the moment is the hastening of the exhaustion of cheap credit. Meanwhile, the state has several cards to play in order to continue reaping its creditors, such as debt monetization, defaulting on obligations, forcing the household to reduce its net-creditor position (i.e. savings rate) by forcing or inducing everyone to enter one or more home-mortgates, or even more sophisticated methods of interest rate manipulation, non of which seems very sustainable. I’d also like to hear more on this topic.

  30. In a depressed economy in which unemployment is very high and the value of capital assets collapses then income inequality increases as the 20 to 30 percent who are unemployed, as well as a large proportion of the middle class, see all savings evaporate and earnings collapse. Whilst the remaining owners of capital see their wealth collapse but not to zero. The total savings rate for the depressed economy falls whilst income inequality rises. Hence, your assumption that “if income inequality rises, the savings rate must rise” is wrong.

    • According to Piketty and Saez, the share of income of the top 10% earners in the US was 50% in 2007, dropped to 46% in 2009 and was back to above 50% in 2012 (2012 is still an estimate at this stage). This is including realized capital gains and excluding government transfers. This is because, while many low and average paid workers lose their jobs, highly paid jobs are also lost (eg. banking and finance jobs in 2008-2009) and while ordinary salaries are rather rigid on the downside (as well as on the upside), high bonuses are slashed during recessions. So, perhaps counter-intuitively, income inequality is rather reduced during recessions, albeit for the wrong reasons.

  31. Micheal,

    I think that the argument is correct, but I am far more concerned with the end game. Please note that given: “No one (not even governments!) has infinite debt capacity.” this will end!

    Looking at your essay from the Wicksellian Differential point of view, I think the current situation will go on Ponzi/Japanese style for yet some time, as the real interest rate that the rich debt holders obtain is so low that even though it might be higher than the “natural interest rate”, or, alternatively, the rate of economic growth, there is still a lot of room before we get to the Minsky moment where the cost of servicing the debt is higher than the entire economic output available. Unless there is a strong enough external shock (war, climate change, etc.. ), I am pretty sure that the next couple of decades will go on with the rich getting richer and diminishing returns…


  32. Errrrrr…what? It’s really not that difficult.

    The distribution of wealth reflects the value judgements of consumers. If you want to redistribute wealth then clearly you believe that the value judgements of consumers are impaired. But if you believe that the value judgements of consumers are impaired…then why do you want them to have more dollar votes?

    Pettis: Hey you consumer, you don’t really value shoes that much
    Consumer: I don’t?
    Pettis: Nope! Now here are some more dollar votes. *redistributes wealth*
    Consumer: If you don’t trust my value judgements…then why are you giving me more money?
    Pettis: Because I’m largely confused but largely believe otherwise
    Consumer: Well…I better not look a gift horse in the mouth *externalizes costs*

    Here’s a simple practical exercise. The next time you’re at the grocery store…surreptitiously redistribute the contents of people’s shopping carts. Or, when you’re at a restaurant…go around redistributing people’s dishes. The economy will go vrrooom vroooommmm vrrrrroooommmm. Dui bu dui? Hao bu hao? Jiiiiaaaa you.

    Your value judgement regarding stinky tofu is wrong. Really wrong. Whatever it is…it’s wrong.

    If you want to see what’s wrong with the economy…then go look in the mirror. Or, better yet, try and start a top down forum that thrives. A top down forum that thrives? How can a top down forum thrive? Don’t tell me how it can thrive…PROVE that it can thrive by starting one. If your command/representative forum thrives…if immense value is created…then this will be extremely strong evidence that you actually know what you’re talking about.

    • Consumer judgement is one important part of wealth creation but not the only part. In a world full of labor arbitrage opportunities, it might not even be the main part any more.

      Here is a simple practical exercise you might yourself consider next time you’re at the shop:

      You, as consumer, like very much a brand new, nicely designed and extremely innovative mobile phone that is much more than a mobile phone. It’s called an iPhone. (I know, i’m several years behind). So you buy one iPhone, even though it costs $500 (at the time anyway) and thus make the fortune of Steve Jobs. After all, he fully deserves it: he had the vision, he took all the risks, he financed it during years and years of development to finally make it happen. Consumers liked it, bought it and Steve Jobs’s wealth went through the roof. So far, so good. That’s the demand side of the iPhone and let’s say here that’s the perspective of US consumers.

      Now consider the supply side of the iPhone. There are two scenarios.

      Scenario 1: iPhones are manufactured in the US with US employees paid $45k a year. Apple sells iPhones $500 each to US consumers and makes $62.5 net profit on each (12.5% profit margin).

      Scenario 2: iPhones are manufactured by Foxconn in China with employees paid $7k a year. Apple sells iPhones $500 each to US consumers and makes $125 net profit on each (25% profit margin).

      For an exactly identical consumer judgment on the iPhone, the profit share of the production of iPhones is 200% in scenario 2 versus scenario 1 ($125 vs. $62.5) while labor share is 16% in scenario 2 vs. scenario 1 ($7 vs. $45) assuming Chinese workers are as productive as their US counterparts and that it therefore takes the same number of workers for the same production of iPhones in both scenarios.

      In this very real example, Apple profits and market valuation (hence the wealth of its owners) derives to the same extent from consumer judgement (explaining 12.5% profit margin) and from labor arbitrage (explaining an extra 12.5% profit margin).

      And while it is US consumers buying the iPhones, it is Chinese workers getting paid for producing it. In other words, the $ value of the iPhone market in the US is a huge multiple of the salary income generated by employment with Apple in the US. At the aggregate level of the US economy, it is therefore either financed at the expense of other products that US consumers buy less or not any more (the usual creative destruction process, nothing wrong here) but also very likely by taking on extra debt (which is not sustainable past a certain point).

      In the meantime, the well deserved wealth of Apple owners and shareholders is double what it would have been if iPhones destined to the US market had been made in the US.

      So, here you have it, the growing income and wealth divide. It goes way beyond individual consumers judgement and the just reward that successful entrepreneurs deserve. It has its origin in the WTO global free trade arrangement between countries with salary level ranging from 1 to 10 and the ample opportunities for labor arbitrage it offers to businesses as cross exchange rate don’t compensate for relative differences in salary and productivity levels. Ultimately this system is self-defeating as the gap between the value of financial assets representative of productive assets (eg. Apple share price) and the income available to consumers to buy stuff (eg. iPhones) becomes too stretched. The divergence between inflationary asset values and deflationary labor incomes ultimately backing them up simply can’t go beyond a certain point. If the policy response to deflationary incomes and weak aggregate demand is QE (as it has been in a dominant way), then the wealth divide becomes even worse as these Apple profits get rerated to a higher multiple thanks to a lower cost of capital. The wealth – ordinary income divergence becomes even more stretched. A financial crash is when this divergence suddenly reconverges, as it inevitably does.

      Note I don’t pass judgment on Apple management actions. They dutyfully acted in the best interests of their shareholders, maximizing profits out of their great innovative products within the prevailing institutional WTO framework for global free trade (which is, whether you like it or not, a top-down framework).

      I leave aside any tax arbitrage that Apple may or may not have done on top of labor arbitrage by locating the intellectual property behind the iPhone or the brand or whatever else in the proper jurisdiction where its actual economic activity (the number of iPhones actually sold) is immaterial in the context of the company. One issue at the time.

      Multiply this very real iPhone example across a huge number of industries, products, companies and countries and you understand how global labor share can reach a low enough level so as to force an increase in system debt at first and then eventually, when debt capacity has been saturated, a weakening of global aggregate demand to a point where Apple or other businesses struggle to sell more of the iPhones or whatever product they make and that consumers like so much. The obvious point – which is so often missed – is that in aggregate all consumers in a one country have to be supported by producers generating income in that country (and consumers and producers are one and the same persons for a significant portion of working age population). If you arbitrage them as producers, you can’t sell them as much stuff as consumers.

      So, your value judgment regarding cool iPhones and the wealth of Steve Jobs is correct, but only to some extent, and may be not to the main extent, and may be to a decreasing extent. Which leaves the other aspects to discuss. If possible with a slightly more open mind and cool head if it’s not too much to ask.

    • “If you want to redistribute wealth then clearly you believe that the value judgements of consumers are impaired.” This is a complete non sequiter and certainly neither true nor necessary to the argument. The rest of the comment is a little confused and hard to respond to.

      • “This is a complete non sequiter and certainly neither true nor necessary to the argument.” You either want to redistribute wealth or you don’t. If you don’t…then why did you write so much? If you do…then clearly you believe that the distribution is incorrect. Here’s what you wrote…


        If you think the world must take steps to reduce income inequality…then clearly you believe that the distribution of wealth is incorrect. You think that some people are getting paid too much and/or some people are getting paid too little.

        But you fail to address the basic and blatant fact that American CEOs are getting paid so much because they bothered to employ some of the poorest people in the world. Global inequality is rapidly decreasing because of the profit seeking behavior of CEOs. How can you be oblivious to the rapidly rising wages in China and other parts of the world?

        Global inequality is decreasing and it’s decreasing despite the efforts of people like you. Global inequality is decreasing because of greedy corporations. The number of people lifted out of poverty in the past 50 years is unprecedented and unparalleled. And it’s not because of liberal economists or governments or NGOs…it’s because of profit seeking individuals competing for cheap labor.

        And rather than facilitate the flow of capital to countries that have the cheapest labor (poorest people)…you want to take steps to solve this “problem”. It’s outlandish and extremely harmful to the millions of truly poor people around the world that you and your ilk have never made and will never make the effort to employ.

        For goodness sake, please think your position through. And maybe have somebody send you the memo about mercantilism.

        • I am pretty sure that Pettis knows a lot more about mercantilism than anyone else but let me explain why he (and I) find your argument to be pretty confused. Income inequality is not about consumer choices. Consumers choose when they spend their income, but the amount of income they have, and the share of GDP they have, which is what is important here, depends on lots of things but not on consumer choice. I think you are trying to argue about something which seems to confuse you as lot. If I decide to buy Nike shoes instead of Reebok shoes, this has no impact on income inequality. If the government decides to increase the marginal tax rate, this does.
          When you say global inequality is decreasing, you are talking about inequality between countries. Pettis has made it pretty clear that he is discussing inequality within countries and this is not decreasing at all. It is increasing. Being rude does not reduce the confusion in your thinking.

          • “Income inequality is not about consumer choices.”


            “If I decide to buy Nike shoes instead of Reebok shoes, this has no impact on income inequality.”


            If you decide to give your money to Nike instead of to a poor person…this has no impact on income inequality? If you decide to give your money to a rich person rather than to a poor person…this has no impact on income inequality?

            There’s a logic to how you distribute your money. There’s a logic to how consumers distribute their money. Do I seriously need to help you understand this logic? Do I really need to help you grasp the logical consequences of this logic?

            If I ask you for $500…it would be extremely logical for you to ask me what you would get in return. If I told you that I would give you $200 in return…then I’m pretty sure that you wouldn’t give me your money. What about if I offered you $500 in return? Well…then what would the point be? How about if I offered $1,000 in return? Or maybe $10,000 in return? Deal or no deal?

            Society has limited resources. People do different things with society’s limited resources. Some things that people do with society’s limited resources are more valuable than other things. In a market…the distribution of wealth reflects the basic fact that some people do more valuable things with society’s limited resources than other people.

            Now, maybe I’m being super rude. But do you want to listen to Pettis instead? On one hand…maybe he’s super nice. But on the other hand…here I am having to teach you some super basic economics. Why hasn’t Pettis taught you super basic economics?

          • Epiphyte says: “Why hasn’t Pettis taught you super basic economics?”
            Well, let’s see, maybe because what you call super basic economics is total nonsense?
            Let’s look at the evidence.
            From his Wikipedia article and other sources what do we know about Pettis? He has had senior positions on Wall Street, he teaches or has taught economics at Columbia and Peking University, his books have been published by Oxford University Press, Princeton University Press, and the Carnegie Foundation, he is one of the most admired and widely cited economists in the world, he has advised many governments, including both Republicans and Democrats in the US, he is all over the Financial Times, the Wall Street Journal, and dozens of other newspapers, magazines, and academic journals, this blog is cited over and over again as one of the most influential economics blogs in the world, etc. etc.
            What do we know about you? Well, you write anonymous and bad mannered comments on other people’s blogs accusing them of stupidity.
            So there are two possibilities:
            1. Pettis, as you say, knows nothing about basic economics and nearly everyone in the world is too stupid to have noticed.
            2. You know nothing about basic economics.
            So which is it? before you answer, pause, take a deep breath, and try to think about it logically.

        • Ha ha Pettis complains that few people are capable of judging any argument on income inequality on its merits and instead become horribly indignant, and the less they get it the more indignant they become, and Epiphyte kindly provides an example. I think the phrase “you and your ilk” is moralese for “I am indignant but I can’t explain why.”
          Can you try to explain why redistributing income means impairing consumer choices? Redistributing income, as is made very clear in this piece, means increasing the consumption share of GDP. How does this mean that consumer choices are wrong? I think you have gotten yourself into a total muddle, Epiphyte.
          And global income inequality is not declining. It is rising. Inequality between countries is declining. That is a very different thing.
          If this sounds a little rude, professor, I am sorry but as you know the more confused people get the more they resort to bad manners in their argument, and I am sure this part of the comments section will only deteriorate.

          • Whenever, I see Ha Ha,i know it to be an immature commentator from certain perspectives, often more used to narrated dialogues on associated topics, and more often driven by the narrow frames of an ideology.

            So, whomever, the simplicity of Pettis’ model is refreshing, and for those intrigues by complex adaptive systems, really insightful. For many of us, it should have been, on reflecting on it, “Yes, exactly, of course, that’s what I have been thinking.”

            For any that knows the use and limitations of theory and models, can recognize the utility in his perspectives. Take a step back and just think about it.

            Camps of thought, might not get it, but only to their cost of non-paranoid, rational, non-ideological take on a complex matter. Some need to simplify to another cause, it seems to me the model is brilliant, because it is common sense. As are all useful theory.

        • Ok folks, this has been a fascinating and brilliant thread but I wonder if we haven’t managed already to squeeze out every possible gram of intelligence from it. No more along these lines, please. I won’t approve further comments.

  33. Count me in the camp of BRAVO MICHAEL! and let me highligth these to paragraphs at the end of the post:



    Now my comment:

    The ruling class in the EU has somehow realised that forcing down consumption in periphery countries too heavily is counterproductive, so they have relaxed the public debt reduction requirements. Nevertheless this does not mean that consumption is increasing or will soon increase in countries like Spain. On the contrary, wages are declining and will do so in the foreseeable future. Additional tax hikes (particularly VAT) are in the agenda which means more income transferred to the state and increased saving rates (to repay debt, you know) in the aggregate. Nevertheless, the ruling class claims this is a success story, recovery in on its way, and “confidence” is returning and will create a lot of jobs and blah, blah, blah….In the real world, this “success” is reduced to a marginal increase in (cheap) employment while most unemployed have already exhausted their subsidies and now exclusively depend on the mercy of their relatives, or on robbery.

  34. Interesting piece of theoretical economics.

    But, extremely difficult for countries/world economies to carry out as your model would suggest — politics (regardless of left, centre, right-wing governments).

    The general rule of thumb is that a government objective is to enhance oneself (whether it’s leader, political parties or its own citizens). This enhancement doesn’t necessary mean long-term benefits. With benefit of hindsight, short-term benefits (even if unsustainable) has always welcome. Asking any government to look at the long-term is dangerous for the initiator, that can lead to leader being forced down; political parties losing votes; or at extreme, civil wars.

  35. Thank you for this — logical, clear and well advanced. I wish it was you lecturing when I was struggling with IS-LM curves ;-)

  36. Petis makes a lot of sense but the reality is, like the bumper sticker said, “whoever dies with the most toys wins.” The economy is basically game theory which means its a death cage match. We’re all driven to own everything and push everyone else out into the sea. Of course the game ends before that ever happens. Society collapses when rampant disease and famine approach biblical levels as a result of all the unequal distribution and inequality.

    Even though most people favor this winner take all approach (whether they know it or not) and deserve the outcome because they’re contemptible, us enlightened people should do all we can to save society lest we perish along with the multitude of modern day barbarians. By hook or by crook, find a way to diffuse purchasing power: spread it out.

    • It’s interesting, so many things rest upon assumptions, in the Axial age, where the assumptions of Axial Religions obtained, there was no such thing as a society. people were necessarily in the realm of a God, where necessary power relations obtained. Although the prerogatives of Kings are discussed in some quarters, as Society against the King, there was actually a situation, in feudalism, for most of history globally, where small groups fo elites conflicted against themselves, with the rise of cities, the dispersion of power led to growth in power of Kings, or sovereigns, in respect to local warlords or landed gentry,

      At this, pre-king time, under the interpreted principles of Axial Age religions, power relations necessarily obtained, of par and course relative to a hierarchy stemming to God, where people had no conception of a society, or nation, or culture, all enlightenment, and post-enlightenment ideals, that have come to be second nature in our thought and structures of belief. But, insofar as the commentator I respond to, notions still obtain, to the conflicts between warlords, even before the rise of Kings, as a natural element of current order of things. With a sentimental desire for a return to a notion, Society, which is an assumption, and an assumption, that is far more modern, then the more ancient structures, of economic relations, and what these portend, if economic structures and relations have evolved incredibly as well.

      But to income inequality, i tend to see most things moving from extreme to extreme, de-monopolization, and de-regulation, of telecommunications led to innovation and a re-monopolization, which will lead to a de-monopolization, etc… Almost, a slow motion, magnetic, attraction, repulsion, attraction mechanism. So, yes, the holders of great masses of excess wealth, will eventually realize that the only thing that rationalizes, and supports that wealth, are structures of wealth, as links in a network, or as legs to a table, as foundation blocks below, where all might just get blown away, in a strong wind, unless they consider the supports below.

      As to Society, this is a recent modern evolution, and for areas where this obtains, others globally would realize, while they fight over enlightenment, ideals, one or another, one to another, that much need to be done to move this thing forward. And what seems right or ideal, might just mask, or portend to very different outcomes, then the foundations of their belief systems, might imply.

  37. Professor, as I am reading, I am wondering about the following. Your analysis is great, I am no economist, so please bear with me if I am inaccurate.

    On the first part of the analysis

    Ghost city is really just piled up inventory of houses, is it not? Unused rail, airport, infrastructure is really just pile up inventory of public projects, is it not? If so, other unproductive project(3) is really part of unproductive investment can rise in the form of unwanted inventories. (2)

    I thought the reason for people not willing to pile up inventory is that inventory impairs with time. Goods such as houses deteriorate, technology obsolete, services expire if unused. It becomes consumption (or should I say, waste?). So the equation, I think is like

    GDP = investment + consumption = investment + (meaningful consumption + waste from the stockpile) = (saving + waste from stockpile) + meaningful consumption

    As countries pushes the string for saving to increase and the meaningful consumption string is not pull because of inequality, the “slack” is wasted.

    For the second part,

    Why can’t state consume for the household? Country can become welfare state, tax the rich and pay the poor? For example, the unemployment compensation in (3)? In a democratic world and inequality, the poor are numerous, this is bound to happen. It seems to me, rising unemployment leading to rising consumption (if state does not let them suffer in poverty), in a sense, is only a special case of linear increase of consumption.

    In undemocratic world, the poor are numerous, the choice is welfare or riot? Well, until we have advance weapon which make riot less of a problem for the state. In a global scale between countries, we are inherently undemocratic.

    Therefore it would seems to me there are not that many counter measure, they are

    Increase in productive investment (Increasing investment, sustainable)

    Rising inventories with a special case of increase in speculative investment or increase in credit-financed consumption (Pumping into waste, as you said, not sustainable)

    Linear change in consumption with a special case of increase in unemployment (Increasing meaningful consumption, sustainable)

    I certainly hope I am not one of those “irreverent”. I think your medicine is correct even though I find the analysis rather strange.

    In closing, I offer an analogy. Suppose the world decide to (or made by the government to) build roads to nowhere.

    People would “save” and “invest” more to build the empty roads. People would not find themselves consuming more as they run out of food and die, for example. The resources are lost even if the numbers (in financial term) may still be in the GDP. The rest is just how the remaining resources is divided.

    In more realistic world, the same people would even speculate on the roads and ate their store of food (their resource saving). Until one day they either ran out, or they finally admit the project is a waste (write down?).

    The medicine is to either
    1) Build roads that lead to somewhere that people wish to go (productive investment) It would require a bit of wisdom and intelligence because we would need to predict where people wish to go.

    2) Live around the road and use the built road (increase meaningful consumption and used up the slack). It is a great re-balancing of building roads and doing other stuff to stop the lost of resources from wastage. In real world, it would be using up overcapacity and pile of inventory by redirecting efforts into providing for the household.

    The moral of the story is saving is only good if we are capable of (1), otherwise we are kidding ourselves.

    • Sorry prof, unpon reading again I think I err. What you called “unproductive investment” is what constitute “waste” to me. I think

      GDP = (productive investment + unproductive investment) + consumption

      Ideally, we can minimize the second term by either absorbing it to the first or the last term. Realistically, we would inevitably write off part of the middle term, recognize the loss and lower the GDP as we are doing the above.

    • Aggregate spending will naturally pick up once the demand side of the economy – mainly households – has restored its self-financing capacity in a sustainable way (ie. not by government transfers financed out of taxation which is already too high in many countries). This will only happen when systematic labor arbitrage on a global scale cease and when global labor share of production stop declining.

      So, before we start building roads to nowhere financed by debt or freshly printed money as counter-measure, perhaps we could consider the following solution:

      Convene an international financial conference. Decide that from now on, cross exchange rates will be fixed at levels that compensate for relative differences in salary and productivity across countries and would be adjustable from time to time to keep up with how these relative differences evolve. This simple step, while maintaining global free trade, ie. no tarrifs or equivalent protectionist measures, will eliminate systematic labor arbitrage across the world and reveal true competitive advantages arising from know-how and expertise (a la Ricardo) instead of competitive advantage arising from undervalued currency given labor cost and productivity. From that point, the growth engine of global debt will be desactivated. Aggregate demand will be able to recover gradually as labor share recovers globally. Incremental consumption will be financed by incremental current income rather than by debt. Debt-settled trade imbalances between regions / countries will gradually recede. Excess industrial and real estate capacities will be gradually absorbed, allowing businesses to pay down the debt incurred in the previous investment cycle. Relative deleveraging will happen in a non-deflationary way. Wealth will again reflect primarily the judgement of consumers (who are also producers) and wealth will still be inequally divided based on inequal capabilities / hard work / risk-taking / luck but it won’t be inequitably divided as it is now with excess wealth accruing to the few indexed on the profits of large global companies and excess debt accruing to everyone else. Supply and demand will again be synchronized. Money printing, bank bailouts, deposits confiscation, debt ceiling political fights and all the rest won’t be necessary any more.

      The theory that market forces will naturally make freely floating exchange rates converge towards equilibrium levels whereby large an persistent surplus or deficits would be impossible has been empirically proven wrong since 1971. At the other end of the spectrum, completely fixed exchange rate without adjustment possibilities – the Euro – have also not prevented imbalances (as the Germany – Spain example of the article shows all too well) and have made their resolution only through a sharp decrease in unit labor costs or a sharp increase in unemployment unecessarily costly socially. That´s why a globally managed exchange rate system could prove the best (or least bad) solution. In any case, it is the necessary complement to the global free trade arrangement currently in place with the WTO. International trade and exchange rate can’t be treated separately. They are one and the same thing.

      This solution has the merit of having already been implemented not so long ago (in historical terms) and of having produced strong economic performance for 27 years (with the help of post WWII reconstruction initially).

      That was in Bretton Woods in 1944.

      • Volcker suggests a new Bretton Woods.

        Asks “has the absence of a well-functioning international monetary system been an enabling (or instigating) condition [of financial crises]? Did the absence of international oversight, of discipline in financing, of exchange rate management permit – even encourage – unsustainable imbalances of international payments … to persist for too long? […] Where was an effective adjustment mechanism?”

        Says “The creation of the G20 … The agreed changes in IMF governing structure … means little without substantive agreement on the need for monetary reform.”

        Concludes “We can and should consider ways and means of encouraging – even insisting upon – needed balance of payments equilibrium.”

  38. Dear Professor Pettis,

    when I read your book The Great Rebalancing, I thought that there was another aspect that complements international imbalances and that was income inequality. I hoped you would publish a book that clarifies the mechanisms by which income inequality travels through the system as much as you did with national policies regarding trade and general household income. Now you have done that in this excellent post. Thank you very much!

    • Thnaks, Pigeon. =In fact my publisher told me that they have sold enough copies of the book to merit a paperback reprint, to which I plan to add a version of this essay as an appendix.

  39. Pettis should be kudo’ed for taking the trouble to explain Keynes, Eccles, Krugman, et. al. He doesn’t like to mention that the most extreme income inequality in US (1929 and 2005-6) led to Great Depression and Recession, because of excessive speculation of the rentiers–those excessive savers who couldn’t spend all of their excess income. That it why it took the New Deal (and WWII) to redistribute incomes and create the Middle Class. But T Piketty says that may have been a transitory phonomenon in his “Capitalism in the 21st Century” that Krugman, et. al., are talking about. Historically capital has always had the greater return, so who should own that capital, was Marx’s question? If shareholders of corporations with their millions of stock holders could really ‘own’ the capital, for instance, if laws didn’t tilt compensation in CEOs’ favor, and give corporations’ monopoly power, then capital returns would be more equitably distributed.

    • Why do you say “He doesn’t like to mention that the most extreme income inequality in US (1929 and 2005-6) led to Great Depression and Recession”?
      I thought that is exactly what he did. Isn’t this the obvious conclusion from his essay?

  40. Very interesting article, as usual.
    I have just one question: why does increasing the share of the sate in GDP necessarily increase savings? Unless it is for paying down debt (which countries rarely do), all state income will be ether consumed or invested in the economy.

    • “Investment” is what you do on the demand side. “Saving” is on the supply side. You must compare savings plus consumption with investment plus consumption.

      • Ok, so increased state income decreases income for other participants in the economy, but since the state saves more than others participants, savings in the economy as a whole must increase because of the different consumption-savings mix.
        It was just a bit counter-intuitive for me to regard the government as somebody who saves, this is because usually all government savings go into investment (productive or not) but that is on the other side of the equation.
        So a tax on investment, the revenues of which are channeled into consumption is needed (although is sounds a bit unnerving). But this actually occurs naturally in a stagnant economy because interest rates and return on investment fall to zero.

        • I don’t think Pettis says you need to tax investment. He says increasing productive investment is the good outcome of income inequality, so you shouldn’t want to reduce it. There are many other, better ways to reduce income inequality, the most obvious being to raise marginal tax rates and strengthen the social safety net. We can argue about how to strengthen the social safety net, but I guess most people would agree that improving education is a great way to do so. Another way might be to make it easier for small businesses to survive, maybe by reducing their taxes and improving the infrastructure they need.


    This may be “well understood” but it may also be wrong. NIPA data, for example, suggest that the rich do indeed spend as much, if not more, of their income.

    • See above. This is pretty well-established by the data. I don’t know which data you are referring too but I suspect you are misreading it.

  42. Some of the discussion has become a little heated, with one side insulting the other. Please do not take the trouble to write long comments if they include insults as these will not be approved for posting.

  43. Great analysis, and I agree with the findings 100%.
    I have worked and lived for 5+ years in China, with half of my family still there, whilst I grew up and live in a western nation. I can both see and have experienced the effects first-hand from both sides of this equation.
    The situation in China is further exacerbated by the fact that tight capital border controls and the lack of internationalization of Chinese banks means all those saving from Chinese citizens and companies have nowhere to go except slosh around dangerously inside China fuelling one speculative boom(and bust) after another, be it housing/stocks or credit/shadow lending. It’s inability to get out of the country means it can not reach the west as meaningful forms of productive investment such as a Chinese bank lending to western companies for needed projects that may help rebalance the consumption/saving scales between nations around the globe.

    As a point of contention, to make (stupid) people better understand your argument and not jump to pre-concluded ideas based on their political/whatever beliefs, you might want to rename “Savings” to “Investments” or even “Speculative Savings”(which is what savings in China end up becoming), or something else.
    There is a certain psychological effect on readers whenever the suggestion of “Savings = bad” is made, and even though you may be doing your best to dispel such simplistic equations, that is how the human mind works. Even for economists, they will still draw that “He’s aruging savings = bad!” conclusion in their head and immediately put up a mental block and jump into “denounce the heretic” mode.

    As a relative newcomer to your blog, I have not read many of your entries but I certainly like what I’ve read so far. I have long been tired of reading the ilk of Krugman still flogging his dead horses(that Nobel prize is a terrible curse btw) in the media and wondering where have all the sane economists gone. It’s good to know there is one here.

    • I don’t think you can rename Savings to Investment, VL. Savings is what you do with income received. Investment is what generates income.

    • Also the argument is not that savings is bad. The argument is that if savings funds unproductive investment, it destroys wealth. If it funds productive investment, it creates wealth.

  44. Apologies, haven’t had a chance to read the whole thread, just tossing in some thinking I’ve done that might be useful:

    1. The economic “undersoncumption” effect is arithmetically inexorable. It’s only one of many interacting economic effects, but it seems an extraordinarily powerful one.

    2. Despite libertarian theorizing, no modern, prosperous, high-productivity country has ever emerged without massive quantities of redistribution. Not one. Ever. If libertarian notions were so economically efficient, one would expect at least one such country to have emerged, and surged ahead of all the rest. Han’t happened. Makes a fellow wonder.


      Despite liberal theorizing, no modern, prosperous, high-productivity forum has ever emerged that has massive quantities of redistribution. Not one. Ever. If liberal notions were so economically efficient, one would expect at least one forum to have emerged, and surged ahead of all the rest. Hasn’t happened. Makes a fellow wonder.

      Oh, actually, I don’t wonder at all. Nobody would voluntarily participate on a forum that didn’t give them the freedom to choose which threads they allocated their time to. I could be wrong though. It sure would be so super easy to prove me wrong. How about Pettis? Want to prove me wrong? Want to prove Samuelson right? Want to prove yourself right? LOL…of course you don’t.

      • Germany, France, England, the Scandinavian countries, the US, Canada, Holland, Belgium, etc. etc. I suppose these are not considered “modern, prosperous, high-productivity”?

        • Harry, those countries are all prosperous because of, or despite, the visible hand? I’m skeptical, to say the least, that the visible hand contributes to the creation of value. But it’s easy enough for you to rid me of my skepticism. All you have to do is create a top down forum that thrives.

          As it stands, all forums are bottom up. For example… is bottom up. You can go there and create a new product (thread) and members can choose whether or not they allocate their time/replies to your product. This is the invisible hand…it’s up to consumers to decide which products they put in their shopping carts.

          Do you think it’s a coincidence that every forum is a market? I really don’t. Which is why I challenge you, and any other liberal, to create a forum that operates just like our government does. Elected representatives would choose the threads that members allocated their time/replies to. This is the visible hand…it wouldn’t be up to consumers to decide which products they put in their shopping carts.

          The Nobel Prize winning liberal economist who provided the best (most widely cited) economic justification for our government is the same guy who said, “the Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.”

          Yeah, I’m still seriously skeptical. Clearly you aren’t. Therefore, you should have absolutely no problem starting a forum that operates exactly like our government does. Let me know when you do so.

          • Huh? Did you address my objection? I am totally confused now.
            At least my confusion is starting to match yours, so I guess we are coming closer to an agreement.

          • Epiphyte:

            Does what you seem tend to Anarchy.
            You realize, that there is not a developed evolved stable society without a tax base, and a government, anywhere. That there is not a country, who has managed to transit the middle income curse, that has not evolved non-market mechanisms,and streams of taxation. that in an era where expectations can be influenced, each era in history, ever more enabled by the dispersion of technology, where not simply skill, hard work and intelligence obtain to influence the thoughts, beliefs, sentiments and experiences of actors; while I stress Liberty as a condition of man, and assume equality in my relations as spiritually important. for self and even society, I do not assume that people who might have to cut the lawn, or change diapers, or fix the transmission in the cars, or whatever, are less hard-working, nor that each, living in society need to be engaged in competing in a market as the goal of their life, and in liberty have a right to influence the nature of their society.

            In the enlightenment, when theorists were discussing the invisible hand, a notion that pre-dated Smith, the invisible hand was the mysterious complexity of God, nature, the order, that represented, and expressed the majesty and complexity of how so many peoples actions, toward, away, up, down, left, right, faster, slower, jumping, falling, etc….etc….came together in mysterious ways.

            It wasn’t merely, that there is and has to be a certain something, but that all these come together in a mysterious way, and in the manner of a complex adaptive system, those things can move “society” to a new homeostasis, after old, perpetually. The forces of the invisible hand can raise, or lower the state of the system. Even with the preponderance of a force, the invisible hand still obtains, because, all is but an amalgam. of interactions and forces, between and of elements, with impacts, each to another, and returning, magnifying, disassembling, dis-empowering, reinforcing. The notion that the visible hand is merely a sovereign, or to preclude the actions of sovereigns, especially considering how sovereign power, in current power in its current manifestation results in an untenable obfuscation of what enlightenment philosophers had in mind, prior, during and after, Smith used the term, which has been expropriated by some Economic philosophers, to drive very different ends.

            Now, of course, globally, should countries want to continue advance the global system that has advanced global development, which is what most diaper-changers, and fence-post painters want, for the development of their families, societies, etc….should countries want the global system to continue, they will have to use their governments less in driving economic matters, on the other hand their is not an advanced society that does not have a tax base, and non-market institutions, and finally, the invisible hand, while expropriated by some, has a much broader pedigree then economics, and certainly than in interfering in markets by sovereign actors, as any predominate influence would, and should be criticized by any who support the invisible hand. As much for the titans of finance, for union leaders, technocrats, global institutions, and libertarians who want to open their own bank, to be included in the potential culprits to be criticized int his “invisible hand” matter.

            Aura Medicritas = All truth is found in the middle.

    • I am a libertarian and I am very much opposed to the implications of the argument Professor Pettis has laid out. However let me state clearly that unlike Epiphyte I do not think the argument is stupid or wrong. On the contrary, the argument is logical, intelligent, and perhaps even brilliant. I think any real libertarian must deal with it if he is serious about his beliefs, and I do not think Epiphyte represents libertarian thinking at all. If I had a conspiratorial cast of mind I would even argue that he is a socialist pretending to libertarianism in order to make us look foolish and irrational, but rational thinking is the essence of libertarianism.
      Pettis says there are only three ways we can dismiss this argument. He is correct. First, we can dismiss his three propositions, and this I cannot do because they seem pretty obviously true to me. Second, we can prove his logic is faulty, and as a hard-core logician (most libertarians are) I think I can say very confidently that if there is a flaw in his logic it is very difficult to find it except, maybe, where he points out the potential flaw in Point 4. But even is there is a flaw here it is not obvious to me that it will invalidate his conclusions.
      Finally he says the only other way to counter the implications of his argument is to show that it is irrelevant. I think this is correct (and I love the cold logic of his pointing it out) and my instinct is that this is exactly where his argument fails. I need to consider his argument more carefully but it seems to me that the real problem with redistribution is that even if it leads to lower unemployment, as Pettis claims, only does so in a static system. Income redistribution changes the incentive structures in a way that is harmful for productivity in the long run.
      The difference between advanced economies and backwards ones, as Pettis pointed out on his other, to my mind brilliant, blog entry on social capital, is that advanced economies have institutions that promote creativity and productivity growth. Mechanisms that redistribute wealth undermine those institutions, so in a dynamic system income redistribution is worse for employment and wealth in the long run.
      I hope to think about this a lot more and maybe write about it at some point in the future, but I did want to add to this debate by insisting that even those who disagree with Professor Pettis have no choice but to acknowledge that he has put together a very strong argument. My congratulations.

      • Thanks for your very rational critique, John. I edited your piece by changing “better” for “worse” in the second-to-the-last paragraph. I am pretty sure you meant the former, but if I am wrong please let me know.
        We do not disagree at all. My instinct, like yours, is that if this argument does not prove the case for income redistribution in wealthy countries with sufficient savings, it is because of the impact of redistribution on incentive structures. It is pretty clear to me that this is the main potential flaw in the argument, although it might only mean that redistribution must take special care in dealing with incentives.
        I will add this point when I revise, in the next two weeks, the essay for inclusion in the republication of my book. I would greatly appreciate any further ideas from you or others on this topic.

        • Your change was correct. Thank you.
          Let me make a small recommendation. Change your Point 4 into Proposition 4 (“The only two ways in which savings in another part of the economy can decline are…”). This will make your logic completely unassailable, and will focus potential disagreement on your four propositions, where it belongs.
          That leaves the point about dynamic systems versus static systems. Many foolish people will still respond with indignation and fury, but you will have nonetheless completely clarified the debate.

          • So we agree on this: In a static system, the argument above is correct, but in a dynamic system, policies can affect incentives, and incentives can affect wealth creation, and wealth creation can affect employment, so it is not necessarily the case that rising income inequality (absent the savings constraint on productive investment) must lead to rising unemployment.

        • Michael, it would be hard to make the argument that income redistribution would be disruptive enough on incentive structures to negate your argument. First, it would have to follow that the current inequalities are the sole result rewards. For example the tax treatment of different forms of income can, and does, contribute to the inequalities. So to can differences in opportunity. Peter Theil, a libertarian of some note, sheds some light on this …… ” “If Harvard were really the best education, if it makes that much of a difference, why not franchise it so more people can attend? Why not create 100 Harvard affiliates?” he says. “It’s something about the scarcity and the status. In education your value depends on other people failing. Whenever Darwinism is invoked it’s usually a justification for doing something mean. It’s a way to ignore that people are falling through the cracks, because you pretend that if they could just go to Harvard, they’d be fine. Maybe that’s not true.” ……. “Thiel is the first to admit some of this promised security is true. He himself grew up in a comfortable upper-middle-class household and went to Stanford and Stanford Law School. He certainly reaped advantages, like friendships with frequent collaborators and co-investors Keith Rabois and Reid Hoffman. Today he ranks on Forbes billionaire list and has a huge house in San Francisco with a butler. How much of that was him and how much of that was Stanford? He doesn’t know. No one does.” ………snip

          The argument would also need to ignore that for many, there are non monetary rewards that are even more valued. Not to flatter you with false platitudes, but you yourself off proof of these arguments. I am sure you would be able to earn more money, either by teaching elsewhere or by doing something other than teaching. Yet, as you have mentioned that is not what motivates you.

        • I can’t believe you are buying the idea that ” Income redistribution changes the incentive structures in a way that is harmful for productivity in the long run”. Where is the proof?

          It seems to me that if it can harm it can also be adjusted to help. Think of a hammer that missed the nail and crushes your finger. Ouch! But if you move the impact zone over a little bit, the nail is sunk and that could be part of something productive like framing the wall of a new house.

          I think what libertarians are saying is if you don’t receive an earned income tax credit you should just quit what your doing not out of protest but because the EITC is just so thoroughy disincentivizing.

        • Glen and Borch, I am not saying that income inequality is justified by their impacts on incentive structures. I am making a much simpler and purely logical point: Income inequality must lead either to higher productive investment or higher unemployment unless it can be shown that income inequality is a prerequisite for an incentive structure that maximizes growth over the long term. Those arguing in favor of income inequality still have to prove the point.

          • I am a big fan of prof Pettis, but frankly, this last post fails to impress… To me, the major flaw is lack of differentiation between income inequality under state dominated economies like China or Russia, which do introduce tremendous distortions into global economy vs income inequality in free market economies. Clearly, the fact that Buffett can not consume his income on his own has no direct bearing on level of unemployment, while the fact that communist party nomenclatura controls Chinese economy does. While I also believe that suppressed consumption is to blame for the recent crisis/liquidity explosion, to me, the main culprits are not free markets, but rather state-dominated economies.

          • Leos, perhaps you only proving Pettis’ claim that most people agree or disagree based not on the logic of the argument or on empirical evidence supporting the assumptions but rather because of a priori political beliefs. If you agree that higher savings caused by state concentration of wealth leads to higher unemployment, why do you reject the claim that higher savings caused by income inequality also leads to higher unemployment? It’s exactly the same argument.

            You might find that the former claim reinforces conservative ideologies and the latter offends them (and my own beliefs are usually conservative), but this cannot be the reason Pettis is wrong.

            I am not trying to be truculent or offensive. I am genuinely curious and would love you to be right, but I don’t see how. Where is the flaw in Pettis’s argument that suggests that he is partly right, and in the direction we both might prefer?

            You say “Clearly, the fact that Buffett can not consume his income on his own has no direct bearing on level of unemployment, while the fact that communist party nomenclatura controls Chinese economy does.” What is so clear about that, besides wishful thinking?

          • JeremyChan, to answer your questions, in my view, you totally miss the key point, which is the incentives of actors. That’s why, to you there is no difference (in impact on employment) whether capital allocation is done by totalitarian state or Buffett.
            As to the logic of prof. Pettis argument, frankly, I do not see any. Accounting identities do not show that income inequality leads to unemployment, only that it MAY lead to unemployment, and only IF it does not lead to increase in productive investment (ie, INCREASE in employment).
            If anything, prof Pettis seem to make a luddite argument that capital concentration, irrespective of details, automatically decreases investment opportunities and leads to unemployment. I do not see how one can agree that this argument is supported by logic, economic history, or accounting identities.
            If to talk about empirical evidence, in the past, in long term, capital concentration in the hands of profit seeking free market actors led to prosperity, while capital concentration in the hands of totalitarian state nomenclatura led to poverty.
            So, again, focus on incentives, not vacuous math. That’s why, instead of lumping China with Silicon Valley, I would focus on China et al policies as principal destabilising factor.

        • Very thoughtful debate. What if we differentiate between Paris Hilton’s and Larry Page’s wealth? As one example, Bush cut estate taxes, but estate taxes have essentially no impact on incentives for innovative entrepreneurs. Income inequality is due increasingly due to rentier behavior, or increasing wealth going to Paris Hilton, Lloyd Blankfein, and Bernie Madoff types, and less due to creating wealth by building innovative new businesses. As one data point, look at the Forbes list and consider how many got their money through inheritance (e.g. Waltons) or government relations (e.g. Slim, Adelson) versus creating new businesses (e.g. Gates, Ellison, Persson).

      • You have an interesting point on the incentives but I think that your view about how those work is quite slanted when you assert that wealth redistribution undermine institutions that promote growth. My opinion is that while incentives, as you suggest, play an important role in growth, their effects do not depend on a simple way on wealth redistribution but on many other factors. Some of these factors (interest rates, taxes, subsidies, quantitative easing etc.) may have different effects on incentives and redistribution but I think you cannot assume that the effects are parallel. For instance, I think that quantitative easing redistributes wealth upwards (increased inequality) while at the same time creates incentives that I deem perverse. For instance It helps corporations to accumulate wealth that is not invested in productive activities but used in speculative investments like propping up stock values with buybacks. The argument provided by Michael explain those perverse incentives. Why invest in productive activities when consumption is diminishing? Thus, increasing inequality can create perverse incentives by itself. On the other hand, almost certainly, an extensive redistribution policy could create other perverse incentives if money is just poured non-sensically in the hands on the lower income deciles. As I see it incentives play in a parallel context that does not invalidate the logic behind Pettis’ take on the effects of income inequality but force to think twice what kind of redistributive policies should be taken in this particular context.

        • So perhaps the trick is not so much to redistribute wealth downwards, Ignacio, but rather to eliminate polices that do the opposite. I think this is something on which both liberals and libertarians can agree.
          Beyond that we have to think seriously about why most countries that became sustainably rich followed the pre-1840s polices in Britain, in which state intervention — in the form of protection, infrastructure investment, expansion in education — fostered rapid growth as well as implicit income redistribution. These policies were called “the American System” in the US at the time, and were subsequently followed by Germany and continental Europe (Friedrich List learned his economics while in exile in the US in the 1830s), and by Japan after 1870 (Japan was tutored by an “American System” proponent).
          True “free market” economies in the 19th Century (Chile and Colombia being the most obvious examples), or countries in which the elite were absolutely protected (mainly commodity exporters) never became sustainably rich.
          This can be coincidence, of course, or it might be that developing countries benefit from redistribution policies and state intervention in ways that advanced countries don’t. Most political economists seem to think that high levels of income inequality are associated with high levels of political and social inflexibility, in which case maybe liberal democracies are different from other forms of government, and so suffer less from the employment impact of income inequality.
          All of this is interesting stuff, but it digresses from the original point of the essay. For now nearly everyone on this forum seems to agree that if rising income inequality does not lead to higher productive investment, in a static system it must lead to higher unemployment.

          • Have you read Fukuyama’s, Origins of Political Order, seems that there might be some nuggets in there in relation to evolution’s of a Society and enabling mechanisms.

      • Dear Prof. Pettis,
        as always, thank you for the very clear arguments and interesting “food for thought”.
        I and some fellow physicists had a discussion about this topic a while ago, after watching the TED talk about a social effect of income inequality by Richard Wilkinson ( ). While our discussion might have been moderated by two good bottles from the Priorat, it focused on some side effects and I would like to add two comments that came from there:

        We ran into a similar problem as raised by John Person: how to judge the incentives provided by the inequality. The point I would like to add to the discussion – even though I am a bit late – is that one main issue might be the “freeze” of the inequality over the generations. While an entrepreneur might enhance the wealth of a society while generating inequality, its offspring often does not provide the same value. So it might be reasonable to “reset” the inequality for each generation. However, this is more an addition to John´s comment, but not to the logical arguments.

        The second point I would like to add is the impact of financial inequality on other aspects of society, as presented by Wilkinson in the TED talk linked above: if social factors such as crime rate (and number of prisoners per capita), rate of child death and numbers of psychological illnesses (per capita) inside a society depend on the inequality, inequality should lower the social capital by itself and thus reduces the effectiveness of investment.

        Please do excuse if they are not economical arguments, but I hope they are still interesting for the discussion. By the way, is there any chance you might think of recording a TED talk or something similar yourself?

  45. If we consider the situation that China is unifying previously disintegrated factor distribution systems ( as many resources e.g. labor, land, etc were locked in old planning system and now are being introduced to a more market-driven system), will it give any change to this income inequality analysis?

    I think the framework still works and with that considered we can see more possible ways to deal with the rebalancing.

  46. I followed your article with great interest. I would like to note that many productive investments are currently un-funded, under-funded. For example, clean energy seems like a productive investment that is very under-funded. Similarly, most science research is productive in the long term but under funded. In fact, I am pretty sure in real terms, the research funding has been dropping.

    However, its not like the labs can borrow to fund their research, since most of the profit accrues to someone else (not the labs). Would your theory imply that the govt should borrow a lot of money to fund research?

    • Wenyan, Alexander Gershenkron (and others) argued that if the private sector is not able to fund certain productive projects, perhaps because they are unable to capture the full externalities, the state should take the lead in promoting the investment. This was one of the three pillars of the “American System” that evolved in the 1810-20s (and probably earlier from Alexander Hamilton’s two main “Reports to the Congress…”) and was followed by the US for most of the 19th Century. I discuss this in greater detail in an earlier blog entry called “A brief history of the Chinese growth model”.

  47. While it’s an interesting work and quoting Eccles makes a great start, it would be much improved by referencing some grounds for claiming that spending by the state tends to not serve as consumption. Considering that there’s much empirical evidence for fiscal multipliers greater than 1 when an economy is not operating at capacity, this doesn’t seem like a claim that can reasonably be made … especially not without much more explanation than given herein.

    Further, what about inflation & deflation? What about perceived or ephemeral values? How does your closed system premise where goods and services produced (GDP) always equals consumption + savings stand up to the following scenarios?

    A) Mr. Smith loses a briefcase containing $1million in cash after accidentally dropping it in an incinerator. Doesn’t this violate the idea that it is a closed system by reducing savings (stored in the cash) without increasing consumption (not spent on anything) or changing the amount of goods and services produced (GDP)?

    B) Mr. Smith takes out a loan for factory expansion from a bank that issues the loan out of reserves credited to it by the central bank. Doesn’t this violate the idea that it is a closed system by granting funds to Mr. Smith for capital investment that do not derive from goods & services?

    • A) No it wouldn’t. You are suffering from what economists call “money illusion”. Burning cash does not affect the savings/investment balance at all. US wealth is not the amount of cash in the system. It is the value of the sum of goods and services produced in the US. Burning cash does not change this. It merely transfers wealth from the person who burned the cash to those who are net long monetary assets. Your savings would drop by $1 million and their savings would rise by exactly the same amount.

      B) There is a big debate about whether granting credit increases demand. Orthodox economists say it does not. Others (including me) insist that it does, except in the case (only theoretical since it never exists in reality) in which all resources, including labor, are fully utilized.

      But there is no debate about whether it alters the savings/investment imbalance because it doesn’t. Why do you think it does? Remember that “creating” money out of thin air does not create additional goods and services. If it did, the US should just create infinite amounts of money and everyone would be rich.

      There is a difference of opinion on what would happen. One school of thought would argue that creating money transfers demand from those who are long monetary assets to the lender. The other school says that the transaction increases both savings and investment by the same amount. Neither believe it violates the savings/investment balance which is, by the way, an accounting identity and so it can never be violated, and more than can the accounting identity 2 + 3 = 5.

      • If the value of cash actually equals the total of goods and services available to be sold, then does the purchase of each digital copy of an MP3 or digital movie reduce the value of cash by “creating” goods & services out of thin air (or more literally, by changing the pattern of stored electrons)?

        If nobody else knows that some counterfeiter cheated the system and created an illegitimate but indistinguishable from legitimate $100, would the creation and entry into circulation of that fake $100 have a practical difference on the value of all of the legitimate money different from the effect of finding a lost legitimate $100 bill in a desk drawer? If so, how? If not, are you saying that forgetting a $100 bill in a desk draw increases the value of all other money temporarily until that $100 is found again?

      • But those musings on the theoretical nature of money and it’s substance or illusion were tangents — in my opinion — to the other part: the question of your grounds for claiming that spending by the state tends to not serve as consumption despite the empirical evidence for fiscal multipliers greater than 1 when an economy is not operating at capacity. That’s the meatier question.

        • I don’t know what the multiplier has to do with it, but the state does consume. I bet Pettis doesn’t focus on it is because it tends to be a very small part of consumption, even in low-consuming countries like China. Most consumption is household consumption and changes in household consumption reflect nearly all change in total consumption.

          I guess if we allowed the state to buy our shoes for us and pay for our restaurant meals and suits their consumption would rise substantially, but they would need to pay for it, mostly with income taxes which would then reduce household consumption, so it doesn’t really change the dynamics because it simply transfers income and consumption from one entity to another. But it would certainly result in a strange Soviet world in which the state simply assigns each household its consumer goods. In most economies I don’t think higher state consumption is a realistic alternative to lower household consumption, and it would be a lot less efficient.

          • > … it would be a lot less efficient.

            For what? That’s important.

            If we’re talking about socks or bread, yes. For that, state consumption is less efficient.

            If we’re talking about road construction (which requires consumption of industrial materials, many privately fabricated goods, and so on), no. For that, state consumption is much more efficient.

            Pettis claims that, “Rising income inequality can have the same impact on savings and consumption as a rising state or business share of GDP.”

            Yes, state consumption is a smaller portion of the economy than household consumption. That doesn’t make it savings. Nor does it explain thinking the state would have a higher rate of savings than households. The state may occasionally engage in saving by buying resources, but most of state’s share of GDP immediately goes into transfer payments (which means right back to households … and usually transfers from households with a low propensity to consume to households with a high propensity to consume) or else it goes into consumption.

            As such, the state generally has a far higher propensity to consume than the average household.

          • StaeOfThought, you are confusing consumption and investment and also savings. When the state builds a road, this is investment, not consumption and not savings. The state “saves” by paying down debt and “dis-saves” by borrowing. It consumes by buying goods and services for immediate consumption or by paying military expenditures, and it invests by building infrastructure

            Remember that states, companies, households, etc, create goods and services by consuming or investment (demand side). These goods and services they produce then become their income, which they allocate either to consumption or savings (supply side). Total supply of goods and services is equal to total demand for goods and services by definition, which is why savings = investment.

        • I think most people accept that the fiscal multiplier can exceed one and sure, all state spending is consumption or investment, but why does the fact that the multiplier is greater than one matter? I don’t get it.
          And did Pettis say that the state cannot consume? I don’t see that anywhere and would be surprised if he said it. He has mentioned many times in other blogs that both state and household consume. I think is main point is that the demand from consumption and investment demand must add up to the supply of goods and services which is divided into consumption and investment. Burning money doesn’t change this.

          • That consumption or investment, if multiplier greater than one, would lead to further consumption and investment by others in society, who would pay taxes on the income and profit of that consumption and investment, and then again, and again and again; I guess the key to that is to have a positive multiplier, far greater than one, and the closer it gets to one, or less than one, the more inefficient it becomes, or arguments, might be it is wealth destroying if there are other investments that would be more productive and thus more beneficial.

          • Pettis didn’t so much say that the state cannot consume as suggest that the state has a lower propensity to consume.


            Rising income inequality reduces propensity to consume, i.e increases savings and lowers consumption.

            When the state engages in transfer payments, for the most part the transfer is from those with lower propensity to consume to those with higher propensity to consume. As far as transfer payments, rising state share of GDP should have the opposite impact from rising inequality on savings and consumption.

            Aside from transfer payments, most of the rest of state’s share of GDP would typically be consumption. Which also means having the opposite impact from rising inequality on savings and consumption.

      • Banknotes are on the liability side of the central bank balance sheet. Burning or burying 1 million in cash until the end of times wouldn’t change anything to the central bank balance sheet. From the point of view of the central bank, this million would continue to exist. Then, savings would still the same.

        Also, State of Thought seems to make confusion between savings (a stock) an saving (a flow, or income minus consumption). If you decide to hold your salary in cash, say 3000 dollars, and then decide to burn it (that’s probably illegal, by the way), you just decide to save 3000 dollars (you don’t spend any part of your income).

  48. Seems to me that, over recent decades, inequality between countries has reduced while inequality within countries and between capital owners and employees has increased within many countries and globally, and that these two trends may in fact be related.

    1) Average living standards have converged across the globe at the benefit of poor people

    According to the International Labor Organization, there were 1.56bn people working in industry and services in the world in 2000 (i leave agricultural employement aside voluntarily as it is not mainly wage based). In 2013, they were 2.14bn people employed globally. Source: ILO, Global Employment Trends.

    Of the 1.56bn global workers in 2000, 424m were in developed countries and 1.13bn in developing countries.
    World population was 6.1bn in 2000 so 26% employment to population ratio.
    Say the 424m workers in developed countries earned an annual wage of $35k on average in 2000. That’s an annual income of $14.8 Tr.
    Say the 1.13bn workers in developing countries earned an annual wage of $5.5k on average in 2000. That’s an annual income of $6.2 Tr.
    That’s a global wage income of $21 Tr.

    Of the 2.14bn global workers in 2013, 458m were in developed countries and 1.68bn in developing countries.
    World population is estimated at 7.1bn in 2013 so 30% employment / population ratio, higher than in 2000, with all the gains in developing countries.
    Say the 458m workers in developed countries earned an annual wage of $45.3k on average in 2013 (+2% p.a. since 2000). That’s an annual income of $20.7 Tr.
    Say the 1.68bn workers in developing countries earned an annual wage of $11.7k on average in 2013 (+6% p.a. since 2000). That’s an annual income of $19.7 Tr.
    That’s a global wage income of $40.5 Tr.

    Note i don’t have exact statistics for median wage in all countries, i’m simply using realistic orders of magnitude derived from individual countries wage level for illustration purposes (for most individual country wage level, source is ILO, Global Wage Report).

    So, global purchasing power has been rising at an annual nominal pace in excess of +5% over the last 13 years, from $21 Tr in 2000 to $40.5 Tr in 2013, so may be something like +2% in real terms, with all the growth in real terms accruing to developing countries workers.

    The salary gap between workers of developing countries and workers of developped countries has reduced from 1 to 6.4 in 2000 ($5.5 to $35) to 1 to 3.9 ($11.7 to $45.3) in 2013. In that sense, global inequality has decreased.


    2) But, this is not at all incompatible with the fact that there is indeed a global shortfall of demand relative to supply

    In 2000, global wage income of $21 Tr compared to global nonimal GDP of $32.9 Tr, so labor share of production of 64%

    In 2013, global wage income of $40.5 Tr compared to world nominal GDP of $75 Tr, ie. a labor share of 54%

    Over this period, one thing has enabled production to grow faster and finally diverge from labor income and consumption: global debt.

    Indeed, global debt has risen exponentially relative to income. It has financed partly consumption and partly investments, as the flow of capital to countries with the cheapest labor has actually been greatly facilitated. The problem is that a material portion of these investments is now at risk of becoming wasted as the actual demand falls short of the projections on which they were based. If these investments are wasted, then a corresponding amount of the debt that financed them will default. Fractional reserve credit systems are highly vulnerable to defaults as the multiplier effect works both ways. The impact of a credit crunch on economic activity and on asset values have been clearly displayed in 2008.

    During that same period, the reciprocal of falling labor share has been increasing profit share as companies engaged in labor arbitrage (relocating production from high cost to low cost countries, partly to export back to high cost countries) and pocketed the difference in their bottom line. This created more wealth for capial owners. In that sense, global inequality has increased: more wealth for capital owners, more debt for everybody else.

    Not great!

    This is the point of the dicussion: How to avoid a situation where continued decline in global labor share keeps feeding the global debt snowball and global overcapacities in productive or non-productive assets, which are ultimately wealth destructive?

    Net worth is simply the net present value of income after debt has been deducted. Wealth can’t increase if debt continues to grow much faster than income. Even from the point of view of profit-maximizing capitalists, there is an optimal labor / capital split: the one which maximizes their wealth. And below a certain critical level of labor share, there is wealth destruction. Perhaps we are already there and that’s why we need expedients like QE to support wealth. Through QE, wealth is now effectively supported by top-down institutions in the form of central banks, though not too many wealthy bottom-up lovers have complained about that one…

    Actually, many CEOs show a clear awareness of the situation when you discuss their investments decisions with them, for instance where to locate their new facilities to serve the US market (in the US? in China? in Costa Rica?) or the European market (Germany? China? Spain? Hungary?) or whatever market. They are very aware that, while it makes sense at their individual company level to profitably exploit the arbitrages available to them, at the global level the system doesn’t balance. But, as CEOs, they are incentivized to run their individual company in the best interests of its owners, not to fix the world. The only difference between current CEOs and Henry Ford one century ago might simply be that current CEOs have many more arbitrage opportunities available to them and their companies.

    So, there could potentially be a tension between taking policy steps to reduce inequality within countries, on the one hand, and continuing the trend of decreasing inequality between countries on the other hand.

    • I think there certainly is a tension, DvD, and the trick is to work out why.

      • Equality and Inequality

        Convergence between and Divergence within
        2000’s great growth, growing financial integration globally,
        heightened asset values,
        competition to lower wages,
        lessening income shares of GDP,
        everything predicated on Global competition,
        technology facilitating processes,
        material sciences making better use of materials,
        more entrants hoping to modernize and industrialize,
        open markets, global focus, competition, wage arbitration, overcapacity,

        Thoughts, Beliefs, Ideas that there is an open Global Market, that countries and Governments do not interfere, or if they do, that all interference is equal, that mere interference, in the post-modern trend of equalization make any interference of equal degree, kind and impact

        Belief that this is they way it is, and has to be, being a force in rationalizing the structures that support growth in inequality.

        Alternatively, the opposite notion that there should be enforced equality, in spiritual and material terms, such that people have equality in things, rather than toward opportunity. Where such would necessarily imply a level of force in society that scares some people, such that inequality seems to be a better alternative.

        Alternatively, notions that structures as they are, are as they should be, and that equality of opportunity exists, and that what has evolved is natural, designed of God by providence, etc….

        Or, some thoughts that it is all just a structure, driven by hands of nefarious intent, and the things are as they are do to the powerful interests of small groups of global players (this group or that group)…..thus dis-empowering more rational discussion, as the small group uses money, is in league with the Devil, etc…etc…etc…

        Those who hope for global development, are critical of income inequality but note the role that open markets have played in advancing the standards of living of people globally, however unequally, and are afraid that responses would require much more interference in markets, and limit the potential of development to serve the advancement of standards

        Those that note the above, from political and social perspectives and note the necessity of development, even with growing income inequality in supporting greater peace and security than might exist otherwise, and inequality might be a better course than greater global instability, that will be costly in terms of treasure and lives.

        And then the mix of all that just mentioned, and the fact that, whether one criticizes case of liberalism, or neo-liberalism, and crisis or otherwise, or Keynesian, whatever, however, perhaps, against all odds, the system for all its faults, has advanced the lives of people, at all stages of incomes,a dn technologies, and human capital, however unequally, as the world has evolved, in greater stability and wealth from the latter half of the 20th century to today, than might have not been the case otherwise, so, don’t fool with it, as it has been doing pretty well.

        It seems pretty clear to me, that open markets, financial liberalization, lower tariffs, as seen a process, for the advanced world, that has resulted in greater income inequality, as it has enabled rationalization for growth and investment in developing countries, as it has enabled, liberal and illiberal elements in developing world societies to gain greater shares of income and wealth, even a firmer hand of control in those societies, and that as these converge, advanced world demand, becomes less of an impact, as more hope to develop, and that over-capacity, will force the hands of some, to alter previous ideological frames, toward reversing inequality dynamics, and such will require policy. The tension are all the drivers of trends and beliefs I listed above, and the complex interplay between them, but ultimately, the dynamics will have to reverse, the tension is due to leakage, and dissimilar interests in this process,and the inability to have other sovereigns cooperate as completely as they must to maximize outcomes, while the inevitable movements will come as countries move toward expectations of stability, after the GFC.

  49. Professor,

    Thanks for the great article and interesting model. I just have one question. In the comment section you have briefly discussed how technological change does not seem to lead to long term higher unemployment. I believe the term is creative destruction. As some industries are destroyed through technological progress, others are created by this same progress.

    So do you believe this will always be the case, or at least for the foreseeable future? The rate of automation appears to be staggering and with the rate of technological progress seemingly increasing, do you think we may see a day when these assumptions will no longer hold and workers will be permanently displaced?

    Obviously predicting too far in the future can be problematic (and usually is) but I just wanted to see what you thought.

    • No, Matt, because there is no limit to our consumption. Remember that after we have satisfied our basic needs, most of our consumption is aimed at status.

      There was a time when most of what we consumed was food. Once we produced enough food to meet our needs, and very cheaply, we didn’t stop consuming. We just switch our consumption to basic manufactured goods. As these needs were met, we switched to prestige goods and services.

      As I said above, once everyone can buy a Cadillac for $100 we won’t stop purchasing prestige cars. We will just redefine prestige. Unlike goods and services required for living, the goods and services required for status are infinite. Whatever prestige object I acquire, in other words, once everyone acquires it it is no longer a prestige object, and I will need to redirect my buying to something else. Automation just lowers the cost of prestige objects, making them necessities, and we will then turn to something else to signal status.


        While I understand what you’re saying, I think you’re denying a reality — declining marginal propensity to spend/consume out of income and particularly wealth. In aggregate, this is an undeniable reality, because the marginal utility of consumption is also a declining function. The last dollar spent delivers less utility than the first.

        I would say, rather, that there is no limit to some people’s propensity to accumulate financial assets (and the associated stagnation/low turnover velocity that inevitably results; see MPC, above).

        And while status is a quite correct explanation for that accumulative urge, I find Steve Randy Waldman’s insurance-against-drowning description of that urge — using the Titanic as a metaphor — to provide a more intuitively satisfying explanation. It does not preclude the status explanation, but it certainly complements or illuminates it, associating it with powerful incentives and motives that arguably dwarf the undeniable psychological allure of “status.”

        • I don’t think the fact that “the marginal utility of consumption is also a declining function” (which by the way is about consuming the same thing, not consuming in general) contradicts anything that Pettis said about why we will never run out of things to consume. At best this just might explain why the rich consume a smaller share of income than the poor, which is the whole point of his blog. What is the insurance-against-drowning explanation?

          • @Harry: ““the marginal utility of consumption is also a declining function” (which by the way is about consuming the same thing, not consuming in general)”

            Sez who? I understand that’s how it’s often formulated, but nothing says it can’t be (and isn’t, frequently) formulated otherwise — and usefully.

            “What is the insurance-against-drowning explanation?”

            See the link.

          • It seems pretty obvious that with overcapacity existent, that many, even lessor developed societies, in the present and future, with the advance of ICT’s, are quasi-post-industrial societies in terms of societal characteristics, and even eco structure.

            While status is a driver for many, it would also seem that services need rise as a component of GDP and globally, and that there are, at present, still a near infinite number of potential goods for facilitating life; to a machine that can prune my fruit trees, and test the soil around particular plants and deliver plant specific, relative to weather and soil conditions, interventions, to production that can clean water, air, provide energy, make my clothes, shoes, etc….etc….etc….

            The advance of technology, might make feasible a more natural capitalism.

      • “Remember that after we have satisfied our basic needs, most of our consumption is aimed at status.” I agree with your underlying point though I think it might be more accurate to say “status or community.” People consume to belong.

        I think there’s an interesting development in the “free culture” and “free software” communities — think YouTube video creators and the developers of Linux — where status (and community) are achieved on the basis of what you produce/create. I don’t think that’s even a new thing, historically. Artistic production has always been like that. But what is new, I think, is the scale of the “produce to belong” community.

        In any event, I think there’s interesting future work about such an economy, which already exists to some extent and may grow.

        And thanks for a very illuminating post.

  50. Just a brief note to congratulate Michael on a truly excellent piece. If I had his ability to present these matters as “logically” and clearly as he does, I would! In my own little blog I have sought to suggest a more philosophical approach to these matters – it is difficult reading, I fear (as ‘The Blorch’ above once put it, “Belbruno is heavy”), but I thought the more philosophically-inclined and literate followers of Michael’s blog may wish to hazard a visit to it.

    • Belbruno is too polite to post the address so I will:

      And while it is not beach-side reading, he exaggerates the difficulty. I strongly recommend it to readers who want to understand economics in the context of the history of economic thought (it has all been said before, and usually much more intelligently). His is one of the best blogs out there.

      • Thank you, Michael, for perhaps the highest compliment I have ever been paid by an intellectual I hold in the highest esteem! Destitute as I am of any literary talent to compose an adequate reply, I can only summon to my aid the lyrical skills of Jackson Browne (Late for the Sky): “But when you know you’ve got a real friend somewhere,/ suddenly the others are so much easier to bear”. I will try to make good use of your kind encouragement. Ciao.

  51. Excellent refreshingly different from the mumbo jumbo and irrelevant stuff one invariably reads in mainstream press-you know rogoff-rinehart, etc.
    The cardinal crime was friedman’s. i think he coined the term ‘positive economics’ to describe economics totally abstracted from real life!
    We need to ‘demarketise’ and ‘ definancialise’ large swathes of modern economies.
    They only create rentier incomes and rising inequalities.
    A question to m p and readers. Does the ‘mainstream’ economist crowd not getting the hang of the issue of excess saving and overproduction staring in the face deliberate or innocence?
    Either way unforgiveable.
    The tragedy is that they dominate all economic debate.

  52. Thank you for this piece I cannot stop thinking about it. There are few questions that sprang to my mind:
    (Caveat, I am not an economist and i have not read all the comments, but i did read quite a few):
    1. What about the LM part of the equation. I would imagine that higher savings would lower rates, which would 1) increase amount of productive investment so the best case scenario is more likely and 2) reduce income to wealth owners, so they would save less. I presume that these effects would just imply a smaller magnitude of the forces you describe.
    2. What would be the role of central banks in this model? and, in particular, what does this imply about appropriate rate of inflation?

    Once again, thank you for this amazing piece.

    • 1) 1) At first, there is no way to tell the difference between productive and unproductive investments. It usually takes a couple of years to become clear. The theory is that lowering long term interest rates below their natural level, ie. below the nominal growth rate of the economy (a situation that prevails in the US since 1997 …), either by the forces of a “savings glut” of by central bank intervention, will lift investment and hopefully the majority of these investments will turn out productive. However, the real life experience of the past 15 years has been crytal clear in that respect: whether the TMT equity bubble of 1999-2000 or the real estate bubble of 2005-2006 in the US, whether ghost cities or speculative metals inventories in China in recent years, whether empty appartment blocks in Spain in 2006, unproductive investments are the by-product of too low for too long interest rates. Low interest rates trigger the credit cycle which finances many projects and makes all asset values initially go up (as well as debt), which becomes self-reinforcing as rising asset values make lending criteria more flexible thus allowing more shaky projects to be financed, etc. until the credit cycle becomes truly exuberant. When debt capacity becomes constrained, the flow of new credit slows, asset values stop rising and the process reverses and becomes self-reinforcing on the way down as falling asset values means the debt is called, the asset repossessed and sold, which means asset values fall more, etc. Because it is long, painful and often self-defeating to repay the debt out of income, it is much easier to reiterate this all process one more time, ie. lower interest rates further to start the next, usually bigger, asset bubble. This is the reason for the repetition of the boom – bust pattern of the past 17 years: 1997 Asian crisis / 1998 LTCM and Russian default => liquidity injections => TMT equity bubble => financial crash => liquidity injections ^2 => real estate bubble => crash => liquidity injections ^3 => collective financial asset bubbles => ??? When interest rates have hit 0% and can’t be lower anymore, print money to monetize the debt. Sounds familiar? In other words, interest rates going ever lower makes the total amount of unproductive investments ever bigger. While central banks hope to pull us out of the debt hole, they are simply helping us to dig deeper.

      1) 2) Lower interest rates lift the wealth of asset owners, it doesnt reduce it. Bond price go up on lower interest rates. Equity price also. Real estate price also. The magnitude of the instant price appreciation is much larger than the impact of lower income over time.

      2) Central banks orchestrate this system and bring it to the next level with each iteration. Note that in a world full of labor arbitrage where consumers income are repressed, monetary inflation doesn’t really flow to Consumer Price Inflation (CPI, the common definition of inflation), the channel is more inflation as in Asset Price Inflation. Everybody (except the central banks of course) sees that clearly.

    • Keynes called this the liquidity trap and we are seeing it in action right now in the u s.
      Zero rates needn’t stimulate investment when there’s oversaving and overproduction.
      Ben bernanke was pretty frank. Low rates cause asset prices to rise and hopefully make the rich invest and create jobs.
      The costs and risks of this as opposed to fiscal action is a separate story by itself.

  53. I used to quote Eccles on a lot of websites … I’m glad his thinking is getting more attention.

    It’s a shame that this was understood so long ago, and has been totally forgotten or disparaged by ‘mainstream’ neoliberal economics. The financial crisis has exposed these theories as nonsense, but they don’t seem to die anyway. How they have the nerve to mock Keynes after what we have been through and are going through is astounding. Today we have even more flexibility to deal with the business cycle through fiat currencies.

    Of course that does not really address inequality. It sometimes seems now that inequality is the natural state, which in the US, only the period after the Depression and Second World War interrupted (a brief period where the working class received a good share of the wealth they produced). The wealthy use their wealth to influence the political system to write rules that favor their interests. A self-propagating system, that only a major event seems to change.

  54. Your argument today doubles down on fallacy.

    Proposition 1 is false. Therefore, your entire argument is false.

    Savings is mere rhetoric. There is no such thing as savings. Interest-bearing deposits are a share of bank profits.

    As well, Proposition 2 is false. There are no such things as a “demand side of an economy” and a “supply side.” There are only purchases and sales of what is on offer. What gets put on offer arises from efficiency and not savings as savings is illusory.

    To help Pettis disabuse himself and all who have fallen under Pettis’ spell, check out the fast read:


    As well, Pettis ought to read


  55. Nice! Gini coefficient is higher in less democracy country yet!? In my opinion, China is good at business competition perspective, but politically not so good. so it must be big impact to create bigger imbalances or inequality of do it happen in my country Indonesia. Bad democracy is the father of corruption, collution, nepotism.

  56. I haven’t commented in a while on this bog (although I read it religiously) but this is too much fun to pass up. Someone certainly is under a spell, but not the one Smack is thinking about.

    First, savings is not “mere rhetoric”, whatever that means. It is whatever goods and services are produced that are not consumed. If a factory makes a pair of shoes which someone immediately buys and wears,consumption rises. If a factory makes a machine that makes shoes, or if it makes a bunch of leather that is stored somewhere to make shoes next year, savings rise. Confusing savings with the money you put in your savings account is a mistake that even someone with high-school economics shouldn’t make. Even your man Shidlock agrees with that.

    As for Shidlock’s “rebuttals”, they aren’t rebuttals at all, and don’t even really come close. It took me a while to read them because they are long and very mixed up, darting from one point to another without really saying anything about the argument except that he hates it, but here is what I read:

    First, he disagrees with Pettis because he thinks Pettis’s argument is immoral. Pettis explains (very politely — kudos to him because I would have had a hard time being so polite) why his arguments have nothing to do with the point he makes about immorality. Pettis then simplifies his argument further to make it easier for Shidlock grapple with.

    But it doesn’t work. Shidlock comes back and more or less acknowledges that his first disagreements are irrelevant, or at least he makes no more references to them. Now, he says, he has proven Pettis wrong by ranting about the evils of a fractional reserve system. Fractional banking systems are the most evil thing ever invented, he says, and so that [proves that income inequality doesn’t lead either to higher productive investment or higher unemployment as Pettis says.

    Huh?! There is a serious debate over the pros and cons of a fractional reserve system (but not in Shidlock’s piece), but this argument has nothing to do with Pettis on inequality. There has been income inequality in economies with fractional reserve banking systems and in economies without. In fact Pettis mentions “The Fable of the Bees”, which is a 17th or 18th Century version of Pettis’s argument long before the concept of fractional reserves even existed. Shidlock does not address any of the propositions or arguments Pettis makes. Fractional reserves have nothing at all to do with this argument, and whether or not t is as evil as Shidlock says matters not one whit.

    In both cases Shidlock has simply said that Pettis is wrong because he hates the implications of his argument. Sorry Smack, but this doesn’t even begin to disabuse any “follower” of Pettis (i.e. person with common sense). It just proves what Pettis said in his appendix, which is that very few people can read this argument without going postal for purely political reasons. So far the only serious refutation, which Pettis acknowledges, might be the one from the libertarian guy, who makes a distinction between static and dynamic systems. All the rest if just Tea-Party rage.

    • As I understand Shedlock’s argument, he is saying (after agreeing with most of Pettis’ argument) that Pettis’ argument fails to account for a feature of dynamic economic systems with fiat money, namely that over time inflation and interest rates can and almost certainly will cause the values of savings and investments to diverge and thus cause the accounting identity savings = investments to be true only for the moment at which the money is allocated to one or the other.

      If we take an instantaneous snapshot of a closed economy, then savings = investment. However, over time, interest rates and inflation will erode the value of savings, while the investments will vary depending on any number of market factors and conditions. So by manipulating interest rates and inflation, central banks can create a situation where high inflation and low interest rates “soak up” the excess savings created when one part of the economy increases its savings, without investment necessarily having to increase to match it.

      I don’t see any flaws in this argument. Does anyone else see one?

      • If the real value of fixed income assets is eroded by negative real interest rates (so called “financial repression”), the value is transferred from savers to borrowers. To the extent these borrowers (for instance corporations or government) have a lower propension to consume than these savers (for instance households), excess savings are only perpetuated. This has been covered many times in this discussion and in previous ones.

      • I think DvD is right, JasonL. The fact that wealth can be transferred, whether fairly or not, from one agent to another does not in any way alter the need that savings equal investment. After all no one would suggest that this identity is only true in a system with no direct or indirect taxes, especially given that it is almost impossible to conceive of such a system, and I think all you are saying is that Shedlock has identified one such hidden tax.

    • LOL. “It is whatever goods and services are produced that are not consumed.” Goods produced but not sold is known as INVENTORY, and not the illusory “savings.”

      It’s impossible to produce services that are not consumed. Blueprints drawn on spec are services rendered. Imaginary haircuts yet to be cut are not services.

      There is zip point in reading the rest of your expression as your premises are false, thus your conclusions must be by the titanium hammer of logic.

      • Blueprints drawn on spec are NOT services rendered. Imaginary haircuts yet to be cut are not services.

      • Never-sold inventory on outlays is A LOSS. It is not your illusory savings. Savings don’t exist.

        When lingering inventory gets sold eventually beyond an expected time, the return to capital ends up being lower than expected. That capital might have been deployed elsewhere gaining a higher return.

        I could go on and on, but forget it. Your mind seems unwilling to learn at this point in your life.

      • You are confusing final sales with consumption: a good can be produced, sold but not consumed. For instance a capital good. For instance, company X produces a bottling equipment and sells it to Coca Cola to install in one of its plant to increase capacity and / or efficiency. The transaction takes place and is definitely recorded as a sale by company X. But it goes into the asset base of Coca Cola,
        not in cost of goods sold as it would if it had been consumed. This is because Coca Cola will be able to process more volume for years to come thanks to this new machine and derive value from this in excess of the purchase price it paid for the machine. If you are a shareholder of Coca Cola, you are richer. Your wealth has increased and is actually partly stored in that new machine which is all but illusory. Warren Buffet will confirm that as he buys the business (ie. the plants) rather than the stock ticker (which could have an illusory feel to it). Coca Cola net asset value has gone up, except if nobody buys more Coke because everybody is so broke that nobody can afford to buy any extra bottle. The investment is predicated on there being more demand for Coke. Final sales is consumption + capex. Final production is final sales + variation of inventory. Capital goods are valuable well after their date of purchase. Consumables are not valuable well after their date of purchase. In that sense, capital goods are an investment, they have been paid by Coca Cola savings if financed by retained cashflow or by bank depositors savings if financed by a loan.

        • I have not confused anything. Rather it is you who suffers from a slew of false beliefs.

          [1] YOU: “Your wealth has increased and is actually partly stored in that new machine which is all but illusory.”

          ME: The machine is not wealth for Coca-Cola. Property in the machine is capital. If Coca-Cola execs need to sell it, property in the machine becomes wealth. If those same execs need to borrow, pledging the machine, property in the machine becomes collateral.

          The entirety of trade, or commerce, or real economics ties up with two words — property and profit. Though most think of property as things possessed, property always has meant the right of ownership and never the thing owned. Only when property gets created, can trade arise between two persons.

          The name for property put to making stuff is called capital. The name for property put to purchase and sale for cash and credit is wealth. The name for property that can be sold to satisfy debts is asset. The name for property pledged against a debt is collateral.

          The bottling machine made by the machine maker is wealth and in a purchase and sale, the machine maker trades its property in wealth (the bottling machine) for property in wealth (credit as cash or pure credit). In the same purchase and sale, Coca-cola execs sell property in wealth as credit or cash and buy property in capital, the machine, as they do not plan to re-sell the machine but to use it.

          If something is produced and never sold, it’s a waste of work, of effort and materials. It’s a loss. It’s not “savings.”

          [2] YOU: “If you are a shareholder of Coca Cola, you are richer.”

          You commit a non-sequitur when you make that claim. Simply, it doesn’t follow that Coca-Cola is richer through property in the machine.

          To become richer, Coca-Cola execs would need to gain more profit. Coca-cola execs would need to increase sales on the same costs or decrease costs on the same sales.

          [3] Economics is fake. The substrate basis of economics is the false doctrine of the Physiocrats who held the silly belief that only producers from the land were productive and since retailers and artisans weren’t they should be the ones who should bear the burden of taxes.

          From the silliness of the Physiocrats comes all of the silly language of “production, distribution and consumption.” It was Turgot, Quesnay and Le Trosne who claimed that exchange was incomplete until the one who received money selling something, in turn bought something with the that money. They called it consommation. It was these same Physiocrats who defined wealth as only material products from the earth, that products consumed as biens, meaning goods, and that products traded away as ‘richesses.’ The Physiocrats denied that credit and labor were wealth.

          And then the marginalists doubled-down on the silliness of the Physiocrats by introducing the faux concepts of utility and scarcity as the source or cause of value.

          [4] To disabuse yourself, you can read this fast read of mine, WHY IS THE ECONOMY SO HORRIBLE? BECAUSE ACADEMIA ECONOMICS IS FAKE.

          • First, there is no need to be rude. Just make your point, hopefully in good faith. People will agree or disagree with you, hopefully in good faith. And that’s it, whether you are polite or impolite. So you may as well be polite.

            Second, vocabulary here is unimportant. What matters is to establish relationships between well specified aggregate values, whatever the name you want to give them. Definitions are anyway a matter of convention, so you might want to use your convention rather than others, that’s fine and again it is not the interesting part, fighting on words is useless. What is interesting and useful is to try to understand in a rigorous way the various flows and stocks of the economy.

            Third, please note that at this stage, we are not at all doing academia economics. For that, one would need to to go much deeper in the structure of individual and collective preferences and motives and to establish dynamic causes and effects relationships. At our stage, we are simply doing basic accounting, summing up values from the accounts of each economic entity to get to the consolidated accounts of the overall economy. And we agree that this task involves a certain dose of simplification of the complex reality. It’s fine and the only thing is to make it explicit so that it is clear what we are talking about.

            Fourth, by doing this accounting consolidation exercise, i get to the following expressions for the aggregate economic flows under discussion:

            Final Sales = Total Sales – InterCompany Sales = Consumption + Gross Investment in Fixed Assets

            Final Production = Final Sales + Variation of Inventory

            Gross Savings = Final Production – Consumption = Gross Investment in Fixed Assets + Variation of Inventory

            Net Savings = Gross Savings – Depreciation of Fixed Assets = Gross Investment in Fixed Assets – Depreciation of Fixed Assets + Variation of Inventory = Variation in Total Capital

            Value Added = Salary + Net Interest + Profit = Salary + Net Interest + Distributed Profit + Retained Profit = Distributed Income + Retained Profit = Consumption + Household Savings + Retained Profit (Business Savings) = Consumption + Net Savings = Consumption + Variation in Total Capital = National Income

            Wealth = Net Worth = Total Capital – Net Debt

            Fifth, vocabulary is not important here, what matters is the substance of the economic concepts thus defined so that we can understand each other with some precision what we are talking about. The ones above are simply derived from the consolidation of the accounts of economic agents. They exclude the Government for the sake of simplicity and also exclude Exports and Imports, which is correct if we consider the worldwide economy, but not if we consider the economy of individual countries. You are welcome to disagree with the concepts above. In that case, please provide your own relationships between the global quantities that you will have defined.
            Then we can have a more fruitful discussion instead of vain verbalism.

          • I get it — all of this name calling is merely aimed at getting people who read an intelligent blog to read a blog that no one wants to read.
            There is a long history of economic cranks in the US. Sometimes, Ezra Pound, for example, the economics is nutsy but the writer is so brilliant that he is worth reading anyway, if only for his critiques. Usually the economics is just nutsy and reading it a waste of time. Of course sometimes it is also amusing. I remember seeing a little man who whittled pliers out of wood on the Groucho Marx show whose economics were similar to that of Smack, but he was charming and didn’t mind having his leg pulled.

          • By the way I know that on the Yahoo comments section, writing in all-caps is a sign of seriousness, but in other more intelligent sites it is usually considered a sign of intellectual feebleness, EXCEPT OF COURSE WHEN I DO IT!

          • I think, Smack. that you are too impressed by being the least dumb among your dumber habitual debate companions, but to say that savings is an illusion is the kind of nonsense that might impress them as insightful, but it is meaningless. This is a definition, and is defined as postponed consumption. If produce two tomatoes and eat one today and postpone eating the other one until tomorrow, the first tomato is defined as consumption and the second as savings. It is no more complicated than that.

            Of course the second tomato can also be invested, by the way, which does not negate that it has been saved, and this is an idea that seems completely to evade you no matter how often explained. In a closed system, all goods and services produced that are not immediately consumed are, by definition, saved, and everything saved that is not stored and consumed later is investment. Again, this is true by definition, so when anyone hollers excitedly that these are all vicious lies he is simply showing that he desperately wants to make a point that he himself is unable to understand.

            Why is this so hard to understand?

          • Speaking of the comments section on Yahoo, at some point an argument just becomes deaf people yelling at each other. Let us agree that some people believe there is such a things as “savings” and others don’t. Any disagreement between them is perhaps more of a religious disagreement than one of logic, and so cannot really be resolved except by burnings at the stake, which of course I encourage. Otherwise categorical denials are not especially helpful, except on television and radio talk shows.

  57. Wealth and People

    Finding a technicial and ideological solution for wealth redistribution is not possible. Because it’s trying to get from someone who has to someone who don’t have.

    The solution is work on the mind of those who have the money. Ask them to give billions to spicific human problems. Really give to food, education and health of those who need a minimal universal human care for the basic needs.

    We prais those who work for the benefits of billion people but not the ones who care only to make billions of money.

    Money is a mind creation and any unbalanced money situation should focus on unbalanced mind individually and collectively.


  58. With all the respect that is due to an economics professor from a simple internet reader well outside of its domain, I am going to raise two logical issues with your argument. While they don’t invalidate its conclusions, the second one seems to slightly alter it, by offering an alternate solution. Both of them relate to the equations :

    GDP = Total consumption + Total investment


    GDP = Total consumption + Total savings.

    Let’s start with the first. Although never stated, these equations apply to a chosen period, ie the second one should be read as :

    GDP during the period = Total consumption during the period + Total savings during the period.

    Similarly, the first one should read :

    GDP during the period = Total consumption during the period + Total investment during the period.

    Of course, GDP and consumption are always computed within a given period, thus this gives us :

    GDP = Total consumption + Total new savings.
    GDP = Total consumption + Total new investment.

    From this, we can clearly get

    Total new savings = Total new investment.

    However, I see no way to get from this to the equation

    savings = investment.

    That’s because doing so would require proving that, when investment equals 0, savings also equals 0. Not only is there no proof of this, but I would even argue that this can be convincingly shown as false.

    Let’s consider a society of hunter-gatherers that use sea shells as their currency. Their society never performs any investment, thus investment=0. But this doesn’t precludes some people from saving some sea shells, thus savings != 0. This, in my opinion, strongly indicates that there is a constant value that separates investment from savings. (I think this is what economists call the monetary base.)

    The second issue I have also relates to these two equations. Looking at them, it is obvious that they only cover the economic parts of their members. For example, if I go into the forest, find a comestible mushroom, and eat it, the consumption of society has just increased by one mushroom, but I’m not sure GDP has changed; and economic GDP certainly hasn’t. Similarly, if I go in my garden and plant a fruit tree, society’s total investment has increased by one tree, with no change in savings, and if I find a currency-seashell or mine some gold and turn it into a gold coin, society’s savings has increased with no effect on investment.

    Now you might say I’m nitpicking, and that the non-economic portions of consumption, investment and savings are negligible today. As for the first two, I would agree, as for the third, I would like discuss the point.

    Indeed, one of the actors, the state, has the ability to print as much money as it wants, thus increasing its own savings. Since the equation we have is simply :

    new economic savings = new economic investment,

    and we also have :

    new savings = new economic savings + new artificial savings,

    and the problem we are facing is simply an increase in savings, it seems to me that an alternate solution is a simple rise in the monetary printing of the state.

    Thet being said, I’m not even a student in economics, so I may be the one that made a logical error in my reasonment. Is there one? If so, where is it?

    • When new money is created ex-nihilo by the central bank, it goes:

      1) either to the government if the central bank directly buys bonds issued by the government, in which case the government spends the proceeds directly (ie. buys products and services from the business sector) or pays salaries to civil servants who either consume (ie. buys products and services from the business sector) or save it

      2) or it goes to the commercial banks if the central bank buys bonds held by banks, in which case the banks might lend the proceeds a) to the government as per 1) above or b) lend it to the business sector, typically to finance investment or c) lend it to the household sector who use the proceeds to either consume or invest or d) the banks might use the proceeds to buy secondary assets in the capital markets, bidding up their prices

      As new money ultimately flows either to financial assets or to business sector profit (we include commercial banks in the business sector), only a portion of which are distributed (and in general distributed to wealthy people who typically save / reinvest a portion), it seems to me that, far from being the solution, money printing ulimately makes the problem worse by widening the wealth divide even further and by increasing the pool of savings with no worthwile outlets to go to. This is the clear lesson of recent years where the massive malinvestments we have seen can be attributed to excessive money creation either by the commercial banks or directly by the central bank when the appetite for regular lending / borrowing vanished. I believe malinvestment is the main reason why the wealth effect theory has empirically failed twice already, in 2000 and 2007. Central banks lower the cost of capital to encourage investment in the real sphere (creating some exuberance in the financial sphere at the same time) but, in the absence of end demand, a portion of these investments turn out wastful, which triggers a collapse in asset value, which triggers another round of money injection to stabilize asset markets / banking systems and so on and so forth. Money printing is just a way of going further down the hole, not of pulling out.

      Just take the data for the US for the past 15 years (from year-end 1998 to year-end 2013): M2 Money Supply has grown by 2.55x, CPI by 1.43x, Nominal GDP by 1.83x, Population by 1.14x, Jobs by 1.09x, Full-Time Jobs by 1.07x, Wage & Salaries by 1.67x, Debt by 2.58x, Net Worth by 2.11x and Corporate Profit by 2.75x. These data neatly answer the question of where excess money creation goes. It goes to asset values and profits, not to jobs and incomes, hence debt needs to rise for the system to balance. Unsurprisingly, income and wealth inequality has soared during that period. Excessive money creation is clearly pushing imbalances further, not reducing them. For obvious reasons, this is never admitted and lip service is actually paid to the contrary. But the evidence is crystal clear. By the way, the source for these data is the Flow of Funds Accounts of the United States published by the Fed. Which raises an intringuing question: why money creation was so enthusiastically chosen as the preferred solution to the crisis and no alternative was even discussed or considered?

    • I think this is just money illusion, P. The sea shells aren’t savings. They are merely a claim on goods and services that we might or might not agree to honor, but savings are the part of the goods and services produced that we have not consumed (or wasted), and in your theoretical society, in which there is no excess production and everyone consumes everything he produces, there is nothing that isn’t immediately consumed. In fact there never would be seashell money because it would always be worthless — no one would sell you anything because he (and you) consumed everything he produced.

      If the Fed creates a billion dollars (or seashells), it doesn’t create savings or wealth or anything else. It transfers to itself a portion of the total amount of goods and services produced from those who are long monetary assets.

      Please remember that money isn’t wealth. It can be a claim on wealth, but if there is no wealth, there cannot meaningfully be any claim on it.

      • Do real economist still talk like that in the 21st century? The interaction of symbolic and tangible wealth is a reality that has been pretty convincingly demonstrated. Economics is not strictly about an “objective” reality but rather laced with cognitive/symbolic/cultural interpretation and action. It is ultimately a social science studying a social phenomena, not an engineering discipline of machines exchanging inputs and outputs. To ignore money totally is to have a poverty of economic thought.

    • First of all the sea shell example is rather contrived. But if you must, holding on to sea shells not used is holding on to a surplus. If you prefer the term surplus and stockpile to savings and investment go ahead. But nothing has changed from the original point. Secondly, obviously you have never had a really bad year with zero savings, because believe me there will be zero investment, and if there are, it wasn’t a really bad year (and by definition there were investments).

      You introduce the role of currency, which is fair game. I believe the original article pretty much applied to fundamentals, the author being an economist, not a financier. On the other hand, it is banks that create the vast bulk of money and that is why we have a bubble economy. True they do this with government permission but it is the instability inherent in the “private” market (private profits, public debt) that skews the equation. Taking note of manipulation of the money supply is fair game to note (both Keynesians and Monetarist have an obsession with it) and the basis of much “fiscal policy”, so it is fair to note the factor is there. Your challenge is to show the factor is big enough to matter much in the end. Meaning of “money” is the slipperiest notion in all of economics.

  59. There is only one limitless supply, and it is not land, labor or capital, but rather greed, the desire for more to continue the addiction for yet even more. No one is poorer than a miser for whom no amount of money can rescue them from their condition. Nobody can fulfill the urge to take more than they need when the rich are well past having every personal need catered to. All that is left is a pathological need to pile up bigger numbers no matter what it does to a society or the carrying capacity of the earth. Don’t worry about killing incentive. Those with the most will always want more and it has nothing to with necessity or reward, it is pure craving. You cannot tax it out of existence, it was never rational in the first place.

  60. Your great article on the economic consequences of income inequality could be usefully completed by a discussion of:

    a) The causes. What exactly are these unspecified “structural and policy forces that push up global savings” and why have they been able to develop to such an extent all around the world?

    b) The remedies. What form could take the unspecified “temporary reversal of the course of globalisation”?

    With these additions, your article could acquire a practical value for policy implementation that is currently lacking.

    I know it will increase your exposure but it probably can’t be avoided if this pressing issue is to be peacefully resolved.

    Thank you.

    • I will try then.

      As for the causes,

      I believe the origin of the leakage that causes labor share to drop to the point where global wage income is no longer able to buy global production, forcing global debt to increase faster than production, is the systematic labor arbitrage (labor cost / labor productivity * exchange rate) allowed by the current global free trade / floating exchange rate organisation whereby international trade takes place at exchange rates that don’t compensate for relative differences in wage level and workforce productivity. This allows companies to capture such labor arbitrage opportunities, hence profit share is increasing and labor share is decreasing. Over time, the impact is cumulative as it repeats itself at each iteration of the economic process. This explains the growing income inequalities between those few who are indexed on the profits of the top ~ 3000 global companies (shareholders, management, senior staff, financial markets, etc) and those many that are ordinary employees and of course those that increasingly fall out of employment and sometimes out of the workforce. In this WTO / floating exchange rate institutional framework, only the most competitive countries are able to avoid unacceptable level of under-employment, the corollary being that they generate trade surplus. Hence, the incentive for each country to implement economic reforms forcing down labor share (under the more marketable label of “structural reforms”) to improve competitiveness. Hence also the need to have an undervalued currency, which explains why – right now – everybody is simultaneously trying to devalue against everybody else in a global currency war. When all countries pursue these same economic policies at the same time, which is the only rational thing to do for individual countries in the current global free trade / floating exchange rate system, we get to the present impossibility whereby global supply is constantly running ahead of global demand (hence the constant danger of having to lower production, which is the definition of a recession) except if global debt keeps growing faster than global production, which only mean an even bigger recession (depression?) later on.

      As for the remedies,

      I can only see two variations of the same remedy:

      Either we can find and implement a system of fixed but adjustable exchange rates set at levels that compensate – on average – relative differences of salary and productivity between countries so as to avoid the possibility of large and persistent deficits for some and surpluses for others that are settled by debt, the debt of deficit countries being the monetary reserves of surplus countries, forming the base of their own domestic fractional reserve credit system in the double credit spiral – correctly identified by French economist Jacques Rueff in the late 1960’s – which is the precise mechanism that turbo charges the growth of global debt ever since the early 1970’s.


      Free trade is only allowed between countries and regions of similar living standards so as to reduce the opportunities for labor arbitrage. These regional free trade zones will still be large enough so as to ensure effective competition in all markets, which is the only justification for free trade in the first place. This was the conclusion reached by French economist Maurice Allais (which foresaw everything and issued numerous warnings) almost 25 years ago already.

      Debt financed stimulus programs, quantitative easing and fiscal austerity all have in common that they are only trying to address the symptoms. Which will, at best, only have a temporary effect and, at worst, make things worse.

      What we need to do instead is to address the causes. While it’s still time, meaning urgently.

      • “I will try then….As for the causes……”

        (A) Some structural CAUSES of rising income-inequality in the US:

        In the US, rising income-inequality is caused by globalization. This includes globalization of labor (immigration), globalization of production (offshoring) and globalization of trade in goods, services & capital (surpluses, deficits, debts etcetera).

        (i) Low-skill immigration puts downward pressure on the wages of lower-end blue-collar US workers. (Has happened for all of US history, which is why the Robber-Barons loved the arrival of Huddled Masses during the Gilded Age)
        (ii) Offshoring of goods-production puts downward pressure on the wages of higher-end blue-collar US workers. (Started with socks & shoes in the 1950s, but accelerated sharply from 1980s after Deng Xiaoping brought China into the East-Asian export-to-US system)
        (iii) Offshoring of services puts downward pressure on the wages of lower-end white-collar workers. (Took-off during 1990s with rise of information age and the global communication revolution)

        (I) Cumulatively, (i), (ii) & (iii) caused the wages of the US “middle-class” to be capped by global competition, whether by physical immigration or by trade-carried import of labor from the Third World. In effect, the wages of such US workers tends to rise slower than their productivity, or, in other words, such US workers get to keep a smaller fraction of what they produce because of their reduced “bargaining power”.

        (II) The only people in the US who are immune to this effect are people whose skills are rare to find in the Third World, and such people tend to be at the higher-end of US wage-income. The wages of such workers rise fast enough that they keep up with their productivity, because they have higher “bargaining power”. Note that I am including the salary-equivalents of people like Buffet & Gates in this category, regardless of whether they receive actual “wages” or not.

        (I) & (II) cause rising basic-wage inequality, which is one component of rising income inequality.

        After accounting for this basic wage inequality, we note that the workers at the top wage range (see (II)) tend to have a higher marginal propensity to save (401-k etcetera). This leads to higher additional non-wage income for such workers. This non-wage income also rises faster because the other workers (see (I)) are keeping a smaller share of what they produce due to global wage-competition for their type of labor. Adding rising basic wage inequality to rising non-wage income inequality, we get rising overall-income inequality in the US.

        (B) Some structural CAUSES of rising income-inequality the Third World

        In the Third World, rising income inequality is a natural phenomenon associated with incipient capitalism. This happens because the mass migration of unwanted labor from the agricultural economy in the country-side to the urban industrial economy keeps wages from rising relative to production (due to wage competition from the labor surplus). This implies that non-wage incomes rises faster than wage-income and there is upwards pressure on total income-inequality.

        For poor countries where investments are savings constrained (like India), this is not a bad thing, as rising inequality leads to higher savings-rates, which can then be productively-invested to raise production and bring the country out of poverty (“supply side” or “trickle down” approach). On the other hand, for countries like China, where investment is NOT savings constrained (China runs a surplus), rising savings rates generated by the rising inequality would lead to either overinvestment or excessive surpluses– which is exactly as we are seeing in China today.

        Finally, we note that this labor-surplus wage-competition in the Third World mentioned in (B) is the same phenomenon that acts as a downward pressure on certain types of US wages due to globalization, as explained in (A) above.

  61. I apologise for late comment. I think this essay is excellent. It follows the logic of National Income accounting impeccably.
    It is hard to see what can be added. I would observe that one issue perhaps could have been taken a bit further. What are the limits of increased government spending to make up for deficiency in demand caused by a higher propensity to save? The calculations of De Long and Summers suggest that with multiplier effects even public consumption need not lead to unsustainable debt. On the other hand Kalecki in his classic Political Aspects of Full Employment suggest the rich will obstruct such policies.
    Could I also comment that this fascinating discussion is calling out for further development to link it to Piketty’s work.
    And finally, may I say that as a great admirer of your work I bought the hardback of The Great Rebalancing and recommended it to numerous students and colleagues so whilst I think it’s a great idea to reissue with this added essay, I am jealous of those people who will get the cheaper fuller paperback edition!

  62. Really interesting. A few thoughts:
    1. I think you’re holding GDP constant? What happens if you don’t?
    2. Savings=investment by definition – but how useful are the definitions? E.g. if a person buys gold he’d think of that as saving but does it count as such in this argument? Are there transactions that affect the economy that sit outside of this argument?
    3. How does fractional reserve banking sit in these equations? Money created is immediately deposited and is defined as savings, perhaps?

    I am no economist so dismiss these questions if they are stupid!

    Many thanks


  63. Dear Professor Pettis,

    I´m not yet convinced, whether the economic data for Germany really confirm your tale of two countries. Of course the external surplus of Germany has developped the way you describe it. It rose from less than 1% of GDP in 1999 to more than 6,3% of GDP in 2013. But in some contrast to your story, the share of consumption did not decline accordingly. Rather it stayed flat at 77% of GDP if you take private and government consumption together. Private consumption alone maintained its 58% share of GDP. In fact the rise of the share of the external surplus was entirely matched by a decrease in gross investment, the share which went down from nearly 22% in 1999 to less than 17% in 2013. It seems, that the undeniable increase of inequality in Germany was transmitted only via the indirect path you mentioned – the decrease of investment. But since this lack of internal demand was perfectly matched by the rise of external demand, which focusses also on investment goods there are, at least till now, no signs of the internal imbalances you show as the heart of the problem. So far the problem Germany was facing over the last years, was to replace overindebted customers abroad by new ones who were still able (or at least willing) to pay for more german exports. China has proven to be the perfect adress so far. So maybe the real problems for Germany will start the day China finally starts to solve its own problems.

  64. Erik,


    There was a long and fascinating thread on this Germany/Spain issue on Michael’s site in May last year (“Excess German savings, not thrift, caused the European crisis”). It got lost in the computer problems but happily I had saved the file.

    Much of the discussion then revolved around the same in principle issue you’ve raised; namely, the extent and direction of causality.

    I posted some figures that suggest Spain’s part in the whole macroeconomic dance seemed to be considerable, and which also tie into your investment thesis:

    “By the late 90s, Spain was already running persistent and substantial current account deficits at a time when Germany was still running deficits itself.

    In the 10 years from 1999-2008, credit growth in Spain averaged 15.4% against 2% in Germany.

    Much of the difference in their current account performance is tied to a radical divergence in their relative rates of investment. Despite being roughly equal at 21% of GDP in 1996, during those 10 years (1999-2008) Germany’s average gross investment as a percentage of GDP was 19.2% whilst Spain’s was 28.1%.”

  65. Found it brilliant. The current debates over inequality are somehow sadly welcomed… This would have been a non sense a decade ago, although income inequality was already there. What I would add to the proposed solution is the big need of having a high level policy debate on the issue, that urges. I have not seen this, for instance, at the Group of Twenty, forum that global leaders have picked to discuss and coordinate exits from the crisis. Going over the communiques, there’re just mere mentions about unemployment, but a few in depth proposed measures to tackle it and none of them considering the problem of the workers’ income.

  66. Thank you for this post. I have been saying that for a long time. You are brilliant economist. I have read some comments here and I must reply to the one in which you mention “Fordism”. Sorry but it is not logical for me. Why do you expect that the single bussinessman will care about increasing demand in a system in which there are dozens of other bussinessmen? Isn´t that an analogy with Spain and Germany? You said that is is logical for Germany to take care of themselves more than they care about whole eurozone and I aggree… Is is not logical for one producer in an open system to raise wages because he wants to raise demand. One solution is that part of the wage will have to be spend for the company (or partners company) product. But overall I do not see Fordism as a sustainable idea…

  67. I know this threat is old, but because I think the equitations are wrong, I post nevertheless:

    Your assumption:
    GDP = Total consumption + Total investment
    GDP = Total consumption + Total savings
    Total saving = Total investment

    What should these equitation mean? Money flow? Then we have to take the fiat-money system serious. The fiat-money system creates money out of nothing. So there are these sources and uses of money:

    Sources of money
    – wages
    – profits
    – new credits
    – earning interest

    Uses of money:
    – buying consumer goods
    – buying investment goods
    – buying assets
    – hoarding money
    – money at bank account
    – paying interest

    So we get this equitation:

    wages + profits + new credits + interest
    consumer goods + investment goods + assets + hoarding + bank account + interest

    What means „saving“? In your equitation saving is everything but consumtion.
    So saving = investment goods + assets + hoarding + bank account + paying interest

    There is no identity saving = investment in a fiat-money system.
    The identity saving = investment derives from neoclassical economy, an economy without money, the „veil of money“ assumption, which is pure nonsense.

    • a mistake:

      Sources of money
      – wages
      – profits
      – new credits
      – earning interest
      – selling assets (!)

      • You just added “selling assets”.

        But you already had, presumably, “buying assets” on the RHS of your equation as a “use of money” in your original comment.

        This is similar to your showing interest (presumably received) on the LHS and then interest (presumably paid) on the RHS of your original equation.

        Perhaps, what you are really trying to say is NET interest and NET assets.

        You could do this with other things as well.

        For example, have you given thought to the fact that SALE of previously purchased “investment goods” could be a SOURCE of money?

        How about when we sell our used appliances (consumer goods)? Could the sale of (used) consumer goods be a SOURCE of money?

        Given that you have listed “hoarding” as a use of money? What happens when we de-hoard? Or liquidate inventory? Would that also be a SOURCE of money for current fiscal?

        Again, as you can see, you need to deal with NET items. After netting, is it a source or a use of money? This is the question you need to ask yourself.

        Do you disagree? Please let me know your thoughts.

    • Michael was speaking of the accounting identities over the global economy (which is, by definition, a closed economy).

      (I) You write that: wages + profits + new credits + interest =

      (II) By definition, summed over the global (i.e. closed) economy, Interest paid = Interest earned

      Therefore, summed over the global economy, we can re-write your equation as:
      wages + profits + new credits =
      consumer goods + investment goods + assets + hoarding + bank account

      (III) We note that investment goods, hoarding, bank account are all example of “assets”. Therefore, we can re-write as:
      wages + profits + new credits =
      consumer goods + assets

      (III) Now consider that Wages + Profit = Aggregate DEMAND &
      Consumer goods + Assets = Aggregate SUPPLY

      Therefore, your equation can be further be re-written as:
      Aggregate DEMAND + New credits = Aggregate SUPPLY

      The prices at which Aggregate SUPPLY = Aggregate DEMAND are called the market-clearing equilibrium price level.

      (V) Therefore, all that “New credits” can do is change the equilibrium price levels at which the markets clear. In other words, “New credits” can cause one of these two things:
      (a) Cause general price levels to rise (i.e. cause inflation in during under-capacity).
      (b) Prevent general price levels from falling (i.e. prevent deflation during over-capacity)

      (VI) At the market-clearing equilibrium price level, therefore, “new credits” = ZERO, and Aggregate SUPPLY = Aggregate DEMAND

      (VII) None of this changes the basic accounting identity that Michael correctly stated, that in a closed economy (the global economy is, by definition, a closed economy) SAVINGS = INVESTMENT at equilibrium. This is true regardless of whether the economy runs on commodity money, on fiduciary money or on fiat money.

      To see why, consider this from (III) above:
      wages + profits + new credits = consumer goods + assets

      We can re-write this as:
      Consumed wages + saved wages + profits + new credits = consumer goods + assets

      We know that:
      Consumed wages = consumer goods = CONSUMPTION

      We also know that
      (i) Saved wages + Profits = SAVINGS, and,
      (ii) Assets = INVESTMENT.

      So we can re-write as:

      Simplifying this, we get:
      SAVINGS + New credits = INVESTMENT

      Using (VI), we get:

      Which is exactly what Michael wrote.

      Do you disagree? What are you thoughts on this?

    • It’s not just fiat money whereby money gets created out of thin air. Loans ALWAYS create deposits. Money’s always created out of thin air. The only difference between a fiat monetary system and the monetary system we’ve had in most places over the past 200 years (excluding free banking) is that the government targets the short term money market rate of interest instead of the rate of exchange. By the way, loans create deposits in free banking as well.

      Here’s some stuff that might help you understand our monetary system a bit better.

      By the way, the S=I doesn’t derive from a neoclassical economy (or an economy without money). It’s always true for any closed economy. Y=C+I=C+S for the world which implies S=I. S=I is an ACCOUNTING IDENTITY! It’s always true.

  68. Excuse my awful posting. I wrote complete nonsense. I have had a very bad day.

    Thousand thanks to Vinezi Karim and Suvy to have patience with a stupid Comment.

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