Inequality and debt: the soft bigotry of low expectations

"The poor don't have enough income to save, and can't help going into debt to the rich. Debt is caused by inequality".

That statement is wrong on many levels. It's wrong theoretically. It's wrong empirically. But most of all, it's wrong because it might make inequality worse. It's the soft bigotry of low expectations. Providence is especially important to the poor. Saying that the poor can't help but be improvident is the last thing they need to hear.

(This post will piss some people off. "Nick's blaming the poor; of course they can't help either their poverty or their lack of saving!")

If we want a policy that will promote equality of income we should do it because it's a good policy in its own right; not because of some spurious argument about reducing debt. And the sort of policy that would help attain that objective in the long run is one which encourages a higher savings rate by the poor than by the rich. For example: a policy that increased the after-tax rate of return on savings for the poor, relative to the rich. Canada's Tax Free Savings Account (everybody is allowed to save $5,000 per year tax-free) might be such a policy.

Let's start with theory.

A lot of debt is used to finance investment. In physical capital, houses, education, etc. But let's set that aside, because it's not what I am talking about here. I am talking about the distribution across the population of consumption and savings, not investment. Whether those savings are lent to others or used to finance one's own investment is a separate question.

Economic theory of the consumption/saving decision is based on intertemporal utility maximisation. Milton Friedman's Permanent Income Hypothesis is a simplified version of this. If you consume less today you can consume more tomorrow. You compare the marginal utility of present consumption to the marginal utility of future consumption. You compare your personal subjective rate of time preference (your degree of patience or subjective discount rate) to the market rate of interest at which you can borrow or lend.

This theory says that people who have a low rate of time preference (who are more patient) will tend to save, while those who have a high rate of time preference will dissave (have negative saving).

This theory says that people who have temporarily high income will tend to save, while those who have temporarily low income will dissave. Because if they didn't, and just consumed their current income every period, their marginal utility of consumption in good times would be lower than their marginal utility of consumption in bad times. We save and dissave to smooth consumption over time.

This theory does not say that people who have permanently high income will tend to save, while those who have permanently low income will tend to dissave. Consumption depends on permanent income. But the proportion of your permanent income you consume (and hence the proportion you save) need have no relation with the level of your permanent income. Depending on the particular utility function, the relation could go either way. If the intertemporal preferences simply scale up (which is the standard assumption), then consumption and savings scale up with permanent income, and the savings rate (the percentage of income saved) is independent of permanent income.

Start in one equilibrium. Double both income and consumption both today and tomorrow. If the marginal utility of consumption falls by the same percentage both today and tomorrow when consumption doubles (which it must for example if today's and tomorrow's consumption are equal), then you are still in equilibrium. If the ratio of today's to tomorrow's marginal utility of consumption stays the same, then everything scales, and you save the same fraction of your income regardless of whether income is permanently high or permanently low.

Sure, the poor really need to consume today. But they really need to consume tomorrow too. So their need to save is as strong as the rich.

1. Inequality in permanent income will not affect the level of debt.

2. Inequality of transitory income will affect the level of debt. Those having temporarily low income today will borrow from those with temporarily high income today. And will repay the loans in future when the transitory shock reverses. (And it must reverse, because it wouldn't be transitory if it didn't.)

3. Inequality of rates of time preference will affect the level of debt. Those with high rates of time preference will borrow from those with low rates of time preference, until they are credit constrained and cannot borrow more.

That third inequality is what is driving debt in the Gauti Eggertsson and Paul Krugman paper (pdf). Debt is caused by inequality of patience, not inequality of income.

The second and third inequalities are what are driving debt in Matteo Iacoviello's paper (pdf) (HT goldilocksisableachblond). Despite what it says in the abstract of that paper, it is not income inequality driving debt in his model. Debt is not caused by some people being permanently rich and others being permanently poor. Debt is caused by fluctuations of income over time, where one person's fluctuations are imperfectly correlated with others' fluctuations.

A rich or poor person, having a bad year, will borrow from a poor or rich person, having a good year. An impatient person will borrow from a patient person.

Being poor means having low permanent income. Being rich means having high permanent income. Debt is not caused by inequality in permanent income. Debt is not caused by inequality between rich and poor.

The only way in which a change in permanent income can cause a change in savings is if it causes a change in the pattern of transitory income. For example, as people have become richer over time, the wealth effect on labour supply means they spend a smaller fraction of their lifetimes working, and retire well before dying. Retirement is a time of negative transitory income (current income is below permanent income). So people save for their retirement. And the longer their retirement, the greater the percentage of their income they will save while working.

Here's the nightmare scenario of standard theory (thanks commenter Greg). Take a very simple model with infinitely-lived agents and no investment. Assume all agents have an exogenous flow of income that is constant over time. Assume all agents are identical, except some have low and some have high discount rates. The equilibrium rate of interest will be between the high and low discount rates. The impatient borrow from the patient, for consumption loans. The impatient will initially consume more than their income, and the patient will initially consume less than their income. But over time, the consumption of the impatient will fall and asymptote towards zero (or starvation-level). And the consumption of the patient will rise and asymptote towards their consuming all the labour income of both sets of agents. Debt, and inequality of wealth, rise inexorably over time.

Transfers from rich to poor (i.e. from patient savers to impatient dissavers) will not solve this problem. All they do is reduce the after-tax rate of return to both sets of agents, by an equal amount. The implied tax rate on saving increases the rate of interest, and the patient still save more than the impatient, net of taxes and transfers. It only works if people don't see it coming. But of course they will.

A policy that would help solve this problem is one that gives the poor a greater after-tax return on saving than the rich. That works in two ways. First, it gives those with low savings a greater incentive to save than those with high savings. Second, it means that a given level of saving will accumulate faster if the stock of savings is low than if it is high. One way to implement such a policy would be to put a limit on the amount of saving that could accumulate tax-free. I think that Canada's Tax Free Savings Accounts might do this. They let every person save $5,000 per year without paying tax on the interest earned.

That's what standard theory says.

Does that standard theory make sense? Well, OK, if you are in danger of starvation today it doesn't. Because if you don't consume today the marginal utility of your future consumption is irrelevant. But our ancestors, whose saving and investment created the income we have today, and who were much poorer than we are today, would laugh at us if we gave this excuse for not saving. (Mine, I think, would have been more disgusted than amused).

Does it make sense empirically? Does it fit the facts? I don't know for sure. But the opposite theory, which says that the rich save and the poor dissave, is contradicted by some widely known facts. And big facts at that.

Our grandparents, and great grandparents, despite being massively poorer than us, saved. That's how we have the capital and technology that we have today, that makes us so much richer than them. Real interest rates have not been massively declining, and savings rates have not been massively rising, over the last 200 years as our incomes have massively risen.

China is still much poorer than the rich countries, and yet has a much higher saving rate.

And it's no good just looking at a cross-section of people today and seeing if the savings rate rises with income. Current income is the sum of permanent income plus transitory income. And theory says that transitory income will be saved.

Moreover, current income will be correlated with patience. This is not to say that the poor are impatient. But it is to say that the impatient will tend to become poor. Because the impatient will save and invest less.

The casual assertion that the poor can't afford to save is what bugs me. It bugs me because it ignores theory. It bugs me because it ignores the evidence of our grandparents. But mostly it bugs me because it sends the wrong message.

I understand this only through vague ancestral memories. In the rest of this post I'm talking myth, not history. (I am bad at history).

It doesn't matter that much if rich dissolute celebrities blow their wealth by consuming the lot. (Except they set a bad example for those who can't afford to blow what little wealth they have). In the past, similar rich dissolute aristocrats were the celebrities of the day, and many set a bad example too. But opposing that example was a cultural movement (centred around a religious movement) which promoted a very different set of virtues, and especially for the poor.

Father said that Grandfather paid the farm men's wages on Saturday, to be met by some of their wives on Monday, asking for an advance on next week's wages, because their husbands had already spent the lot on drink. And how the village was split between Tory/Church of England/drinkers and Liberal/Non-Conformist/abstainers.

Commenter Determinant tells me it all changed in the 1930's, for the United Church in Canada anyway, when they shifted from promoting the old virtues towards something more like socialism. I think that was a dead end.

Nowadays the alliances seem to have shifted. The old virtues would now be seen as cultural conservatism, and are more associated with the right than the left of the political spectrum. Which is a pity. It's the poor that need them most.

(This post is not as well argued and evidenced as I want it to be. But I'm aware of the limits of my comparative advantage, so I'm going to stop here and post it as is. And give Frances something to respond to.)

Comments

[Determinant]

Nick, you posted on the previous thread:

There is a difference between: *justifying one's economics* by appealing to morality and religion; appealing to morality and religion: recommending that people follow, and encourage others to follow, certain rules of behaviour. Regardless of my religious beliefs, or lack thereof, I can recognise that in some cases religious movements have created cultural practices that were good ones.

I think providence is a virtue. And if you are a preacher you ought to preach it. Do any preachers preach it nowadays? Or do they just blame the evil capitalists and sing kumbaya?

and you just reiterated that point on this thread.

What, you want the Church to deliver the poor their opium? The masses said they didn't want your economic opium. nods to Marx for riffing on his quote.

In a world where we can't just conquer and annex another country to exploit it or board a ship to homestead somewhere exotic we are stuck with the market we have. When the market turns against you there is no guarantee your savings will be sufficient to see you through to prosperity. Often they are not. This is why we need a safety net.

Second, I believe is is the rich that have access to higher rates of after-tax returns than the poor. Hence why they are rich and stay that way.

[Nick Rowe]

Determinant: I want the Church (or perhaps the "Cathedral" of the academy and media establishment, for the Church is perhaps too weak nowadays) to preach good advice. Or promote good cultural practices. (Ideas that are hard to fit into economic models of course, but ideas that seem to matter).

"When the market turns against you there is no guarantee your savings will be sufficient to see you through to prosperity. Often they are not. This is why we need a safety net."

But it is guaranteed that if you have no savings your savings will not be sufficient to see you through. There is no guarantee my seat belt will save my life. But I still wear it, because it might. But yes, we still need a safety net. Because things can always go wrong worse than we expect. And because people are people, and we all screw up sometimes, or get hit with things we can't do much about.

"Second, I believe is is the rich that have access to higher rates of after-tax returns than the poor. Hence why they are rich and stay that way."

That is at least partly true. It is indeed a central problem. It is one strong argument against inflation, for example. Because for the very poor, cash may be an important savings vehicle.

[Determinant]

I want the Church (or perhaps the "Cathedral" of the academy and media establishment, for the Church is perhaps too weak nowadays) to preach good advice. Or promote good cultural practices. (Ideas that are hard to fit into economic models of course, but ideas that seem to matter).

I don't know about the academy or the media, but the Church won't do that. Mostly because they have this pesky thing called theology and they think it's more important than economics. Furthermore, practising what you preach isn't a blithe statement but a necessity, the converse is also true. Your practices reflect your beliefs.

I really don't want this thread to devolve into theology, just pointing out why the Church won't be led around by the nose by economists or anyone else. Unlike England but more like Scotland, Canadian Churches, the United Church and the Roman Catholic Church especially reject external direction from government. We tell government what to do, not the other way around.

Hmm, I'm not sure devolve is the right term. Theology is the Queen of the Sciences, after all.

[Nick Rowe]

Determinant: OK. I respect that. A Church is supposed to be about religion. They aren't supposed to bend with the winds of economic and political fashion.

But from the social science perspective of comparative theology, do any churches (rightly or wrongly) still preach the old virtues of thrift etc.? Latin American protestants? Black churches in the US?

[edeast]

I think Southern Baptist, evangelicals.
In Canada the crc are pretty good capitalists but they have a social justice kick so I'm not too sure.

[Jane Griscti]

What you've said about the patient saving and the impatient borrowing sounds pretty close to the way people behave; I personally know a number of people who will put vacations on credit cards rather than save up for them.

Earlier generations knew how transitory their incomes was and planned for periods of little or no income. Until this recession hit I think many middle-income earners thought of their income as permanent, not realizing how quickly debts can escalate and income disappear.

[edeast]

Christian & Missionary Alliance.(Harper?)

[edeast]

From my experience in Baptist/evangelical circles this phrase seems to mean something related to economics. Equality of opportunity not equality of outcomes.

[edeast]

Ok, my last bullet comment, you can delete a couple of them. Just a link to a reading list on various church responses to the economic crisis. Also has links to papers on economics and theology, and poverty, etc.

[Bill Woolsey]

When I ran for Mayor, I attended a black church in my town. The pastor had been doing a series of sermons on the need to get out of debt. There was a lot about people not needing fancy clothes and ipods, etc. This was a Presbyterian Church.

[Nick Rowe]

good find edeast. I skimmed a few of them. Mostly anti-market. Couldn't find much on thrift. One baptist seemed to be going there, but veered away a bit. Archbishop of Canterbury was a good read, though I might be biased there.

[Nick Rowe]

Bill: that's the sort of stuff I had in mind. Someone's still preaching it.

What brought it to mind was reading about that controversial pastor of Obama. Strip away all the controversial trappings, and the underlying message seemed to be one that cultural conservatives could look at and say "He's one of us". Am I out to lunch?

[Frances Woolley]

Apparently George W Bush used the phrase the the soft bigotry of low expectation in a speech about the education of disadvantaged children, http://campus.murraystate.edu/academic/faculty/mark.wattier/Purpose.pdf.

[Nick Rowe]

I'm not sure of the history of the phrase. I think it's an example of the right stealing the left's rhetoric?

Like my '"Nick's blaming the poor; of course they can't help either their poverty or their lack of saving!"', which I think is a feminist rhetorical device. (That's where I learned it, anyway).

[RSJ]

It seems kinda backwards.

It's the debt that creates the inequality, not the other way around. Or alternately, excess debt growth creates excess incomes for households, combined with power imbalances that ensure that only a few capture the additional income, which creates the ridiculous savings levels of the wealthy.

In our economy, Robert Rubin saves 150 million in a year, Warren Buffet has saved billions, the Walton family saves billions.

It's not a question of lecturing to the poor to save more, its why are the rich saving so much? How on earth can one man save a billion dollars in a year? Extreme frugality?

Why is labor productivity so disconnected from wages? If the power relations were different, that additional (nominal) income would be distributed across the board to more than the top 1%, there would not be a divergence between labor productivity and wages, and Nick's theory might be relevant.

But then we wouldn't have that kind of inequality in the first place, no one would be talking about a savings glut, and we wouldn't be in a debt crisis now. Then we could worry about trying to get the poor to save more.

[Determinant]

edeast:

I LOVE that list. A perfect fit for this blog, as Tyndale College is part of the Toronto School of Theology, the Faculty of Theology of the U of T.

Before we start down the road of "Black Churches", the term doesn't sit so well in Canada. Canadian churches do divide on racial lines, but not as strongly as in the US. One can say that blacks and whites prefer different churches, but sometimes its the same church too and the later is more common in Canada. Just due to different history.

As a further point of pedantry, Obama's pastor was the minister in the United Church of Christ, the big Congregationalist church in the US and not a "black" or "white" church by any means. They are related to the United Church of Canada but not identical, in fact they are one of few denominations in North America who are more liberal than we are.

Props to RSJ as I agree completely with is post.

[Mike]

Hmmm, my bud used to go to a Sikh temple - they told him to live within his means, hold on to money, etc. Or are we just talking Christianity?

[Nick Rowe]

Mike. Not just Christianity. (Not just religion either, really).

[Cthonic]

Economics and religion don't make good bedfellows

[Greg]

Nick: ….” If the intertemporal preferences simply scale up (which is the standard assumption), then consumption and savings scale up with permanent income, and the savings rate (the percentage of income saved) is independent of permanent income.”

I don’t know, Nick. Unless I am completely reading this sentence wrong, or the data, the several places I’ve looked, it is simply not true. Or rather, since it is a conditional, either the assumption or the implication is false. Or both. I’m afraid I’m not conversant enough with the theory to know whether the theory is dependent on this assumption or not. Savings does not simply scale up with income. (Although one year, 2000, USA, the highest quintile dissaved. Dot.com bubble, I suppose.) Anyway, here’s another:

http://www.brookings.edu/~/media/Files/rc/speeches/2009/1028_personal_saving_dynan/1028_personal_saving_dynan.pdf

and: http://aix1.uottawa.ca/~robinson/english/wp/notredame1.pdf

And I don’t think you want to say that’s because savings rate, or discount rate, has already sorted out according to income. (Or everybody’s where they deserve to be; the poor got that way because they are dissolute, the rich because they are extraordinarily virtuous.)

Nick: “Does it make sense empirically? Does it fit the facts? I don't know for sure. But the opposite theory, which says that the rich save and the poor dissave, is contradicted by some widely known facts. And big facts at that.”

I’m not really talking about this as theory. I’m certainly not talking for all time and everywhere. I’m saying that depending on conditions, some economic, some cultural, some historical, the statistics of who saves and how much they save will change; that under some conditions, as in present day US, it is more difficult for the poor to save, (and easier for the wealthy.)

Like RSJ, I’m rather blaming the rich for much of the present predicament of the poor, and the predicament of the rest of us for that matter. As rulers of our effective Plutocracy, I don’t think they’re behaving responsibly. Should they keep all the money they ‘earn?’ Apparently, you say yes. I say, if they do, we’ll all regret it.

I certainly do not propose to blame the poor for the last 30 years of increased income inequality. Granted they, we, could have tightened our belts in the 1970’s, when wages started falling behind productivity gains, as more and more unions got quashed, and settled for a lower standard of living. And probably furthered the decline. Perhaps an effective boycott could have forced concessions. A refusal to take the poisoned chalice of easy credit? I doubt it. How then would the wealthy have secured their income? What bubble would have blown and burst? But who can guess the counterfactual?

If you are saying what ever discount rate the wealthy assume, the poor, or even the rest of society, with their higher relative expenses, can assume a lower one, I am saying this just isn’t so. Granted, individuals can and do. But it is actually impossible for the whole class to do so. But that’s another posting.

Also note the US government, or the Canadian government, I think, does not have the lowest of discount rates, either.

[Declan]

"But the opposite theory, which says that the rich save and the poor dissave, is contradicted by some widely known facts. And big facts at that.

Our grandparents, and great grandparents, despite being massively poorer than us, saved."

Huh? Because the French revolution never happened when the peasants realized that the king and his court didn't have iphones?

Rich and poor are primarily relative terms, within a given time and place, surely we can all agree on that, no? I liked this Paul Krugman post on the topic.

[Nick Rowe]

Greg: I can't get those links to work. But let me guess: they show that in a given year, those with a higher income in that year saved a higher percentage of that income?

Of course they did. Milton Friedman sorted this one out 40 years ago. Simplest example (ignoring differences in time preference, and the rate of interest):

Savings = 0.1*Permanent Income + Transitory Income

Savings scales with permanent income, and scales with transitory income. But people save only a small fraction of their permanent income, and all their transitory income. Current income (income in any given year) is the sum of permanent plus transitory income. Those with low current income will be more likely to have negative transitory income; and those with high current income will be more likely to have positive transitory income. So when you misspecify the underlying relationship, by looking at the relation between saving and current income, it looks like it doesn't scale.

[Patrick]

Recent book that deals with this issue in the developing world:

http://www.portfoliosofthepoor.com/

I think improvidence of the poor in Canada is entirely rational. Given the marginal tax rates faced by the poor, that we have universal public health care (well, mostly anyway), that food is cheap and abundant, that we have a variety of transfers and income supplements for poor old people, etc. So there is little to no reason to save as a hedge against life threatening disaster. So why not be improvident? What are you providing for? Say you're poor, and believe you are likely to remain so (e.g. never finished high school). Someone in this situation is likely to get bounced around hard by the business cycle, so in some sense they probably view virtually all their income as transitory. It's not surprising to me that they decide to leverage it while they have it. What's the worst that can happen? Bankruptcy. So what. They just go back to being poor. Big deal. It's the default state anyway. So nothing lost. At least they got to enjoy the nice F-150 and the snow machine until the repo man took it away.

Also, if you're poor in Canada, you probably could never save enough to make a big difference in your future consumption given that you're not likely to need your savings to save you from starving (or whatever terrible event). I don't think it implies entirely implausible discounting to end up with the poor deciding that the utility of consumption today is always greater than the utility of consumption of savings + interest tomorrow.

[reason]

I think Patrick is fairly correct here (I have made a similar argument). But isn't there another point here. The permanent income hypothesis doesn't say that the desired saving is a linear function of income. What if richer people save a higher proportion of their income, not in order to spend it, but to build wealth and power? And what if they have no problem riding out shocks to their income (because their wealth is a higher ratio when compared to their income) and so realised net wealth is for them more reliably close to planned net wealth? And what if these musings aren't even particularly surprising?

[Nick Rowe]

Patrick: yep. IIRC (I probably don't) what Frances told me, the Old Age Supplement clawback raises the effective marginal tax rate on savings for retirement to something close to 100%, if you qualify. It's another example of the poor having a lower after-tax marginal return on savings than the rich. So it's not that the poor have inherently less tendency to save. But the tax system gives them a lower incentive and return from doing so. Solution is probably some sort of consumption tax (increased GST) plus guaranteed annual income (negative income tax).

reason: I'm not sure I follow you here. First off, "linear" here can mean S=a+bY, or it can mean S=bY. You presumably mean the second, but strictly, "linear" means the first.

Second off, the permanent income hypothesis *does* say that saving is a constant proportion (approximately) of *permanent* income, and a constant proportion of transitory income. Just that those proportions are very different. 100% of transitory income, and closer to 0% of permanent income (depending on the interest rate and rate of time preference).

[Lord]

I wonder if people's discount rates are not independent of wealth, but that greater wealth (eventually) raises discount rates and lessor wealth lowers them. People would adjust their wealth to levels that are comfortable to them. I am not that fond of permanent income because it seems to assume too much clairvoyance.

[vim]

Nick,

Can you explain something to me (actually more like a couple of things)?

Say that a utility function in one period has the form mu_w = U_W [U_R(X); E], where mu_w is welfare provided by a set of goods, U_R is relative preferences over the set of goods X and E is exogenous factors like health, living near the seaside, getting on with your kids, having access to clean drinking water, not being the victim of political violence, or whatever.

1, Assume that both U_R and U_W are stable across time. What if there were some way that individuals could affect those exogenous factors via their intertemporal consumption decisions? For instance, if by not consuming today they could amass power tomorrow—that might raise their welfare even with the same relative preferences over the same set of goods.

2, Why should U_R and U_W be stable across all states of the world anyway? E.g., “where the total wealth of the people has increased, and equal quantity of utility is represented by a larger quantity of wealth” (Edgeworth)—U_R in period one might be the same as U_R in period two, but a rise in the national income might affect U_W and lower welfare over the same set X.

[RSJ]

"Milton Friedman sorted this one out 40 years ago. "

Hmm, Friedman supplied an incomplete model with additional parameters. How does that qualify as "sorting out"? In order to test the model, you would need to determine:

* How households estimate their future income
* How households estimate future interest rates
* How households are able to borrow and lend freely.

The third point is more important than most people realize, because households carry amortizing debt that must be paid each period, which means that households enter into contractual obligations to save a nominal amount each period. PIH basically says that households smooth consumption at the expense of savings/borrowing, whereas its clear that households try to smooth both, and one comes at the expense of the other. There are other reasons -- e.g. annual retirement contribution laws, that would encourage households to smooth savings at the expense of consumption.

Now at best the data for the PIH is "mixed". We know that

* Consumption is hump shaped over a household's lifetime (peaking when households are near middle age).
* There is both excess sensitivity and excess smoothness problems.
* The income of the wealthy is more volatile in terms of both positive and negative shocks, so there is no reason why the wealthy should save more simply due to PIH.

You can't say that PIH is "settled". It is just another theory in which any present incarnation is difficult to reconcile with the data (e.g. permanent income + ratex, with random walk income deviations can be ruled out), but sufficiently ambiguous that it allows additional elaboration (e.g. permanent income + some more complicated means of estimating future income, with preferably more free parameters, might be reconciled with the data.)

I think it's a bit unfair to dismiss the clear observation that the wealthy save more, proportionally, as a mispecification that was "cleared up" 40 years ago.

[OGT]

Interesting post, though in an odd and kind of cranky way.

So, Nick's contention is that PIH superseded the marginal propensity to spend? Shouldn't savings, at the very least equal something like this:

Savings = (.1 * (Income - Minimum Income)) + Transitory Income

It makes little sense to save while starving, but in addition the conception of Minimum Income may be technologically influenced or culturally influenced (ie signalling). For example, if perceived social status affects one's earning prospects then in some cases not spending, for example, allowing oneself or children to appear in public with 'sub-standard clothing', may be detirmental to one's permanent income.

http://forum.johnson.cornell.edu/faculty/heffetz/papers/consp.pdf

In this simple Veblenesque two-good model, consumers are identical in all but their exogenous, and only privately known, income y. Consumers allocate their income between two types of expenditures: v, which is visible to society, and w, which is not. Since neither an individual’s income y nor consumption of w is visible, the only observable difference between two individuals from the point of view of a third one—or of society as a whole—is their consumption of v.
This setup opens the door for conspicuous consumption behavior: individuals may manipulate their expenditure on v in their attempt to inform (or misinform) society regarding their income type y (or equivalently, regarding their non-visible consumption w). For this
to happen, the public’s perceptions regarding one’s y (or w) should somehow affect one’s utility. Denoting by g (v) society’s beliefs concerning one’s unobservable w based on the observable v, Ireland’s utility function is specified as follows:

U = (1 − a) f (v,w) + af (v, g (v)) . (0 < a < 1)

It is a convex combination (or weighted average) of two terms. The first, f (v,w), denotes fundamental utility: the utility resulting from consumption of v and w. This is just the familiar notion of utility from the standard textbook model. The second term, f (v, g (v)), denotes spectators’ view: what others believe one’s fundamental utility is. The weight a can be thought of as a measure of one’s sensitivity to society’s view, or to social status. With a = 0 the model reduces to the standard model where social effects are assumed away. At the other extreme, with a = 1, consumers consume with the sole purpose of being seen consuming—not too far from Veblen’s (1899) idea of consumption by the Leisure Class. With a in the interval (0, 1), consumers maximize U considering both terms. To the extent that the resulting allocation differs from what it would have been with a = 0, consumption is used as a signal.

[Travis Fast]

Nick, you managed to revive both the Abstinence Theory of Capital and a thrift theory of capitalist development in one post. You do honour to your linguistic cousins and first conquered Sir!

On religion,

Mennonites! It is said only we can buy off the Scots and sell for a profit. It is also true that you can never tell how rich we are by looking at us.

Yep my Grandparents saved more because they consumed less. They built their own house (a nice one too) which is all but illegal today, they fixed their won cars, which is all but impossible today, they had no credit cards or department store accounts (almost impossible today), they grew almost all their vegetables and fruits for the year (2 acres 20 min from down town Seattle), almost impossible today. And all that on one income (sometimes two jobs) almost impossible today. Kinda indicates the productivity gains have been unequally distributed no?

[Mandos]

Oy. This sort of moral logic goes to the root of what annoys me about economists as a group. Are you seriously suggesting that unless the poor exempt themselves from the modern world and return to an agrarian subsistence lifestyle, they have no one to blame but themselves for their debts? Because that is what the entire opening post is suggesting, ultimately.

The poor who want to exist in modern society, on the other hand, should not have to incur debt, temporary or otherwise, to do so.

Wealth is relative. Any other belief is a cruel one.

[Travis Fast]

That is the other thing. It is increasingly illegal to be poor. By which I mean the raft of legislation passed by one or more orders of government (demanded largely by but not exclusively by business associations making pan-handling, wind-shield washing, squatting (the poor man's contribution to urban renewal) and street (park) sleeping illegal.

[Nick Rowe]

Lord: "I wonder if people's discount rates are not independent of wealth, but that greater wealth (eventually) raises discount rates and lessor wealth lowers them. People would adjust their wealth to levels that are comfortable to them."

I wonder about that too. It would be nice if it were true. It would create a stable long-run equilibrium. But I don't know if it is true.

"I am not that fond of permanent income because it seems to assume too much clairvoyance."

It doesn't really assume clairvoyance. It does open the question of how people form their expectations of the future, without answering it. But I don't think we can just ignore it, and say people's saving doesn't depend on what they expect about the future. Life would be a lot easier for macroeconomists if we could just go back to the old Ct=a+bYt. But it doesn't really make sense.

[Nick Rowe]

vim: I'm not quite following what you are saying in that utility function (hard to do math notation in Typepad). I'm going to take a guess:

1. Suppose that by buying (say) a weapon you could increase your power, and you would enjoy power for its own sake, independently of its ability to get you more other goods? At the individual level it's just like any other investment in a consumer durable. At the aggregate level it would be different, if its relative power that matters (rather than power relative to lurking wolves) it's different, because if all invest in weapons nobody is better off.

2. Edgeworth is talking about diminishing marginal utility. He should be talking about diminishing marginal utility of consumption, but he says wealth instead (assuming that greater wealth means greater consumption). I'm not sure what you are asking. But some economists model state-dependent preferences. If it's hot outside I enjoy ice cream. If it's cold I don't. Complicates things a bit, but I don't think it makes a lot of difference.

[Guerilla Economist]

Forgive me for plugging my own blog, but I'm unashamedly trying to drum up some interest. So my thoughts as to why poor save less and rich more, which I would put down to a combination of altruistic parents trying to help out their kids and mean reversion of incomes, are here:
http://guerilla-economics.blogspot.com/2011/01/inequality-and-pt-i.html
Would welcome any comments.

[Nick Rowe]

RSJ: Milton Friedman explained why we see C=a+bY in short run cross-section data, and C=cY in long run time-series data. Yes, he did sort that one out 40 years ago. He also tied the macro theory of consumption/savings back into micro. He also resolved the problem that anyone seeing C=a+bY would immediately see is wrong with that theory (and that I remember seeing when I first saw it as a schoolkid): how can people go on consuming more than their income forever, which this theory says they can? How come whole economies saved negative amounts through almost all of human history?

Does Friedman's simple theory resolve all questions? Of course not. Has theory moved on from there? Of course it has. But too many knuckles have been dragged across the internet saying "C=a+bY and the poor can't afford to save so inequality causes debt". Which is where I came in. Trying to drag this discussion out of the stone age.

By the way, I think Friedman's Theory of the Consumption Function is a beautiful book precisely because it blends theory with so much empirical evidence. He goes through example after example showing how his theory can fit the facts better than the C=a+bY.

Friedman only had adaptive expectations, which is not a very good theory, and not very falsifiable (too many free parameters). Since then, starting with Hall, people have tested the joint hypothesis of Permanent Income plus Rational Expectations. That's very falsifiable. It fails, of course. All theories do, if the test is powerful enough. But no theory has yet replaced it. (And certainly not the old C=a+bY). Borrowing constraints is probably the most important thing that needs adding to the theory. It makes sense, and makes the modified theory work better.

My guess is that the middle-aged "hump" in consumption can be explained by two things: borrowing constraints when young; kids.

And my guess is that the sensitivity stuff may be due to consumer durables and the costs of adjusting quickly and learning new patterns of behaviour.

And maybe, just maybe, the rich are different. And that's why they are rich.

In moments of idle reflection I wonder if the whole thing isn't totally wrong.

But, Oh God, when I hear the knuckle-dragging words "The poor can't afford to save" I reach for my Milton!

[vimothy]

Nick,

I have a micro exam tomorrow (panic!), which may go some way to explaining why I’m not making a great deal of sense. Apologies if I continue in that vein.

I’m trying to give (kind of) an old ordinalist critique of the permanent income hypothesis and the way you’re applying it here.

In the textbook model of intertemporal choice, you want to maximise lifetime utility subject to the market constraint (permanent income or whatevs), i.e. optimal consumption in a two period model is defined by the usual tangency condition where the marginal rate of substitution of the highest indifference curve is equal to the slope of the market opportunity / permanent income curve.

Now the MRS is just the ratio of marginal utilities. Your claim is that the only reason that ratio is different to -1 is the rate of time preference (call it p); different individuals have different values of p, and hence different MRS—some people are more patient than others.

I’m wondering whether this is a great description of reality. My uncertainties relate to the two :

1, Utility derived from consumption isn’t just a function of the consumed bundle; it’s a function of relative preferences over a given set (U(X)), and extraneous factors (E). So a change in the extraneous factors would alter the total welfare you derive from consuming X, even though U(.) is the same and X is the same. But those extraneous factors themselves might not be independent of your saving-consumption decision. If as a consequence of my having a bloody great broadsword, everyone bowed and curtsied and called me “My Lord”, my enjoyment of every good might increase. In fact, I’m already putting money to one side in anticipation.

2, Of course Edgeworth is talking about (diminishing) marginal utility! His point (and mine) is that utility (that is, the satisfaction) derived from consumption depends on the distribution of income, not just relative preferences. Poor people live in a world with people who are not poor, and so the increased wealth of the not poor may reduce the utility the poor derive from a fixed bundle of goods. In order to maintain the same level of utility, the poor need to increase their spending.

That any better?

[Mandos]

"And my guess is that the sensitivity stuff may be due to consumer durables and the costs of adjusting quickly and learning new patterns of behaviour."

By which you mean, willing to live even poorer.

[Nick Rowe]

OGT: "Interesting post, though in an odd and kind of cranky way."

Thanks! That's all I am hoping for. The cranky bit is the only bit that's new in this post. Any semi-competent macroeconomist could have written the rest 30 years or more ago. And the cranky bit is the bit that's hardest for me to think clearly on, and articulate.

I definitely think there is something to the conspicuous consumption or relative status consumption ideas. BUT:

Take the really extreme case. Suppose it's 100% true. Suppose we *only* get utility from our consumption relative to others. How would that affect saving?

At the individual level, it makes no difference at all, as far as I can see. We still face a trade-off between looking cool today and looking cool tomorrow. The incentive to save is unchanged. The response to interest rates and discount rates is unchanged.

The response to an individual-specific shock to transitory income or permanent income is unchanged from standard theory. I want to smooth my coolness over time.

Here's the difference: if I could predict how other people's consumption would vary over time, I would vary my consumption over time too, to follow theirs, even if my income and permanent income never changed.

BUT: Could I predict how their consumption would vary over time? Permanent income, by definition, cannot be predicted that way.

My GUESS, though I haven't worked this out fully, is that this model would have exactly the same predictions about savings as the standard model. EXCEPT, in the presence of borrowing constraints, because those might make it possible to predict other's future consumption.

Changing the model from U(myC) to U(myC/othersC) does not *necessarily* change the results. Too many people are calmly assuming it does, without thinking it through.

[vimothy]

"I’m trying to give (kind of) an old ordinalist critique of the permanent income hypothesis and the way you’re applying it here."

Should read, "old cardinalist critique..."

Doh!

[Nick Rowe]

Travis: What do you mean "revive" those theories? They never went away! Despite Marx's clever invective. Economists just stopped using those words, and used math instead!

It would be a good thing if some people were just a little bit more like your grandparents. One difference is memories of the 1930's (if that timescale works for your grandparents, as it certainly did with mine). Another is it's easier to borrow now. Another is there's more forced savings now. (E.g. we pay CPP contributions and get a mortgage instead of saving that money to buy a house.)

I resist buying a cellphone. The kids, much poorer than me, cannot imagine life without all those gadgets. Eventually it will be impossible for me not to have one. I am holding out as long as I can. And I am fixing my own car as long as I can (one place where modern gadgets like this here internet actually make DIY easier, because I can very quickly get lots of information from other people with the same car).

Yes, it's getting harder and harder to live like your grandparents. And that's a problem. But see what I said above to OGT. We need to keep up today, but we will also need to keep up tomorrow. It doesn't affect the incentive to save. It does, however, affect the incentive/need to work. The kids' Icrap things have put them on a work/leisure treadmill, not a consumption/savings treadmill.

[Nick Rowe]

Mandos: "Oy. This sort of moral logic goes to the root of what annoys me about economists as a group. Are you seriously suggesting that unless the poor exempt themselves from the modern world and return to an agrarian subsistence lifestyle, they have no one to blame but themselves for their debts? Because that is what the entire opening post is suggesting, ultimately."

I find it hard to resist the temptation to say "Yes, that's exactly what I am saying! It's 100% the poor's own fault they are poor. And yes, they should all go back to the land and live on gruel."

Instead I will answer "No".

Dissaving is not a cure for poverty. It cures poverty today, at the expense of even greater poverty tomorrow. So saying it's OK as a cure for poverty is daft. And the paternalistic attitude that assumes only the poor have problems acting with foresight is not good. And the paternalistic attitude which says it's OK for the poor to act without foresight is not good.

I knew my post *would* generate that reaction, which is why I parodied it right at the start. Any discussion of inequality and debt always triggers these responses. Usually it's the "debt is always bad, so everybody ought to always be a lender and nobody should ever be a borrower" reaction.

[Nick Rowe]

vimothy: (I saw your "cardinalist" correction by the way).

I think I've got this bit right:

1. The ordinalist/cardinalist distinction is orthogonal to the question of whether you can make interpersonal comparisons of utility. E.g. I can say A is happier than B, but refuse to say how much happier. And I can say that quadrupling A's consumption will double his utility, but refuse to say that A is happier than B.

2. Saying that U=U(myC/othersC) implies neither cardinality nor interpersonal comparisons of utility.

3. Saying W=U(C1)+BU(C2) implies cardinality. Whereas the Irving Fisher diagram you describe, with intertemporal indifference curves and the implied W=W(C1,C2,B) intertemporal utility function does not imply cardinality. (I'm less sure on that, I hadn't thought about it before).

See my response to OGT on the other stuff.

Good luck on the exam! Now stop reading this stupid blog and go study!

[Nick Rowe]

Guerilla Economist above has a good critique. He argues that the rich will save more over their lifetimes, because they expect their kids to have lower income, due to mean-reversion, so will save for the kids. This is like applying the Permanent Income Hypothesis to dynasties, rather than individuals. See his blog.

[OGT]

Nick- In part my model was to explain why seemingly poorer people, past-xwesterners and Chinese households of today have a higher savings rate. Borrowing constraints are certainly part of that, consumer credit is still tiny and novel in China, for example.

But, I think you miss something with the 'Cool' frame, think of it more as 'Not a Loser.' It is not a continous variable but a dummy variable. You only have to display enough wealth to be certified as 'Not a Loser.' There is actually some research that supports this, and it's certainly not hard to come across negative stereotypes of those who are poor, which would make it worthwhile to counter signal against.

[Kaleberg]

This is an incredibly naive argument. Clearly the author has met more Martians than Americans making the median income or less. Arguing that the poor, which in economics circles these days means 80-90% of all Americans, just aren't saving enough ignores simple reality. Sure, you can live on sorghum boiled in water, or bread, weak tea and treacle, but for most having money saved is much less valuable than having better food to eat, a slightly better place to live, or some other lifestyle upgrade.

Most people have fractal demands on their cash flow. On typical incomes, which, due to inequality, have been stagnant or falling for 30 years, there is no way they can save enough to make any real difference in their vulnerability to financial shocks. Saving money just isn't worth it compared to other basic needs. (One friend of mine has a daughter who may need a heart transplant. Another friend suggested he buy cheaper cuts of meat to help pay for it. Maybe in 1,000 years it might make a difference.)

[Nick Rowe]

Kaleberg: "Sure, you can live on sorghum boiled in water, or bread, weak tea and treacle, but for most having money saved is much less valuable than having better food to eat, a slightly better place to live, or some other lifestyle upgrade."

That's a perfect example of the fallacy I'm criticising. The choice is not between "money saved" vs "having better food to eat, a slightly better place to live, or some other lifestyle upgrade." The choice is between "having better food to eat, a slightly better place to live, or some other lifestyle upgrade." today vs tomorrow.

[Mandos]

1. What Kaleberg said.

2. Um, no:

Dissaving is not a cure for poverty. It cures poverty today, at the expense of even greater poverty tomorrow. So saying it's OK as a cure for poverty is daft. And the paternalistic attitude that assumes only the poor have problems acting with foresight is not good. And the paternalistic attitude which says it's OK for the poor to act without foresight is not good.

First of all, your use of paternalism is a utter reversal of the notion. I don't know who you're talking about, but what I do know is that I believe that all members of our society have the right to partake of an equitable and at least minimal share of the spoils of modern life. And in fact need, as people have pointed out, to have a share in it even to live legally.

Paternalism is to assume that the poor do not know about the conditions of their indebtedness and have not justified it in terms of their own lives.

This is sort of like the people who scorn the homeless because some of them carry such "luxuries" as cell phones. You yourself set the limiting case as the brink of starvation. Guess what, not only do people's "luxuries" give them access to the social infrastructure they need to improve their own lot, they at least allow them and their children to keep up in the Red Queen's race for good health and opportunities. The stress of poverty itself brings ill health.

I suspect that you are comparing apples to oranges when you are talking about your grandparents. In a world in which society as a whole, and particularly business and government, is willing to pursue policies of expansion (building railroads, hospitals, universities, etc), it may appear that fortitude of the poor is resulting in better prosperity. In our modern world, we've reached a point where government proposes continuously to contract, and the wealthy and powerful seek to harvest increasingly pervasive rents from the public. A voluntary choice by the poor to keep themselves in greater discomfort in order to save is not going to make a dent in that.

[Mandos]

That's a perfect example of the fallacy I'm criticising. The choice is not between "money saved" vs "having better food to eat, a slightly better place to live, or some other lifestyle upgrade." The choice is between "having better food to eat, a slightly better place to live, or some other lifestyle upgrade." today vs tomorrow.

So, you should feed your kids cheap unhealthy food today so that you can buy them better food tomorrow? For a good chunk of the current North American public, that is what you are arguing. Yes, your children will live, probably.

Wealth is relative.

[Mandos]

I mean, this is the thing you're missing: that self-denial now, especially in today's politics and social structure, has costs too, costs for which you are not accounting, and costs for self-denial that still leaves you well above the bring of starvation. Such as future foreshortened life-spans.

Then there are the larger social costs of inequality...

[Travis Fast]

Um the abstinence theory is dead. Nobody uses it. The math is motivated by other interesting roundabouts but abstinence is dead as a theory of capital and interest and no one is using thrift as an explanation of the origins or development of capitalism. And that was not just a function of invective from Marx but it is fun that you caught the reference: odd to be at sea in a system of negative dialectics eh! Although I have always harboured a belief that the roundabouts were really just a saving move for the older doctrines so maybe you are right nothing much changes in the face of withering attacks. Outside of war or revolution that is.

On the grandparents the point is that that way of life is closed-off on legal, technological and economic grounds for most of us: the frontier is gone and urbanization and the intensification of the social division of labour mean that, as you would acknowledge, it does not make sense to try to do everything yourself if you have access to paid labour markets and if you do not, you do not have access to credit or its alternative going back to the land. To put it in Steinbeck's terms: No Lennie we can't live off the land in Toronto. There is no analogue. The question over credit is a question over to what ends debt is put. Clearly student loans for the poor or start up grants for poor yet nonetheless entrepreneurial spirits are a good idea. Credit for teenagers from poor families to have cell phones less so. Unless of course they are prostitutes or drug dealers but then that is just case of the latter above:). oh shit that just gave me an idea for a Modest Proposal.

[Mandos]

At the risk of committing an argument from incredulity, moral incontinence as the origin of economic class? Really?

[Determinant]

This is why the United Church of Canada, at least, abandoned the theology of Moral Continence (to borrow Mandos' expression) in the 1930's. In fact I don't know of Canadian church that makes an issue out of that. If they believe it, they don't scream it, or even talk loudly about it.

[Nick Rowe]

Mandos: I feel I am arguing with Nigel Tufnel.

Travis: "Um the abstinence theory is dead. Nobody uses it. The math is motivated by other interesting roundabouts but abstinence is dead as a theory of capital and interest and no one is using thrift as an explanation of the origins or development of capitalism."

Capitalism no. Capital yes. Nobody uses the words "thrift", and especially "abstinence". Nobody uses words at all any more. At least, not words anyone else would recognise. My guess is that people working on long run growth theory would look at you blankly if you asked them if their model of capital accumulation was based on "abstinence". And they would be very unlikely to get the reference.

[Mandos]

I had to look that one up since I never actually saw This is Spinal Tap. My tolerance for rock movies, including mockumentaries, is pretty low.

You referring to my tendency to quadruple-post? I have chronic esprit de l'escalier.

[Nick Rowe]

Mandos: This is really worth seeing. The "goes up to 11" bit at the end

http://www.youtube.com/watch?v=ll7rWiY5obI

[Nick Rowe]

I had to look up "esprit de l'escalier." Will have to try to remember that one.

[Mandos]

It was a bit funny but I mostly don't get it---I mean, that's how I feel about economists (as a group)...

[RSJ]

Are there really people saying "inequality causes debt"? I think the issues and claims are a bit more subtle than that.

Debt is driven by valuation, not income smoothing. From Z.1, consumer credit outstanding was 2.5 Trillion, out of about 35 Trillion in non-financial debt outstanding. The other 32.5 Trillion of debt had nothing to with anyone's intertemporal substitution problem.

When you borrow to buy a house, you are neither saving nor dissaving, and PIH doesn't have anything to say about how much you borrow, and suffers from the same valuation problem as the person buying the house.

Perhaps from a "moral" or "debt is bad" sense, you can argue that someone borrowing to buy a house is being imprudent, and they should save to buy the house instead.

But from a logical or accounting sense, capital transactions are neither saving nor dissaving, and balance sheet expansion for the purpose of acquiring real assets (e.g. 90% of non-financial balance sheet expansion) has nothing to do with instant gratification.

Regardless of what a household's time preference happens to be, if they believe a house will appreciate, then they will buy the house now. They are not going to save to buy the house for more in the future.

Similarly, you cannot argue that *income* inequality has anything to do with prudence or imprudence. You can argue that wealth inequality does, but you still need an explanation for the growing income inequality.

When people make valuation errors and borrow to bid up the price of the in-place capital, that does increase the incomes of others and it contributes to increased savings. This is where the inequality issues kick in. If everyone in the economy owned a house worth X, with X of debt owed, and if everyone bid up the house of their neighbors, borrowing 2X to buy their neighbor's house, and selling their own house for 2X as well, then everyone's income in that period would increase exactly by X. At that point, you can argue that some of them -- the more imprudent ones -- would consume more, while others would save more, but still there would be no change in income distribution.

On the other hand, what you see is different -- not everyone selling their house to each other at the same time, but one person buying the house, followed by 2, followed by 4, etc., in a pyramid-type manner, in which some people's net-worth goes up by more than others, due to issues of market timing, access to credit, etc.

Sam Zell sells equity properties for 39 Billion in 2007 to Blackstone. Right at the peak. Sam's net worth goes up by, say, 1 Billion, but Blackstone does not dissave by 1 billion, as its net worth is unchanged. And this is not evenly distributed across the board.

As Sam was building his real estate empire, he borrowed to buy assets in a period of time in which they were secularly increasing in value and interest rates were in a secular decline. This meant that just as time passed, he gained equity in the property, which was rolled over as collateral to secure additional loans to buy additional properties. On the residential side, he also made a lot of money by kicking out low income tenants, and renovating the residential units, making the neighborhood more desirable, thereby increasing the property values and pushing the former tenants into other neighborhoods (decreasing their property values).

For Sam to save the billion required "entrepreneurial spirit", access to cheap credit, weak or disorganized home-owners associations, excellent legal help, good market timing, a generous tax code, and a long of list of other qualities and circumstances.

But thrift appears nowhere on that list.

Neither does any sort of marginal value product argument.

What you are talking about just isn't relevant to what has been happening here.

Debt is growth is about asset valuation, not thrift.

Savings is the primarily the result of debt growth, the distribution of savings is primarily about power.

Within that broad context, there may be minor variations due idiosyncratic tendencies. Perhaps one person saves a few thousand more than someone else due to increased thriftiness, but whether they earn a hundred thousand more than someone else is more a matter of power relations and debt growth than prudence or imprudence. Prudence isn't important at the macro scale.

[Nick Rowe]

I've had a sudden attack of "esprit de l'escalier"!

Kaleberg: "Clearly the author has met more Martians than Americans making the median income or less. Arguing that the poor, which in economics circles these days means 80-90% of all Americans, just aren't saving enough ignores simple reality. Sure, you can live on sorghum boiled in water, or bread, weak tea and treacle,..."

Who the hell are you to assume I am talking about *Americans*? Jeez! America is not the only country in the world. It is not the only country with poor. It is not the only country with debt.

Ever look at the title of this blog? No. You wandered over the border without ever realising there is a world outside the US.

But, as a matter of fact, I have met loads of Americans earning the median income or less. (And no, "median or less" does not mean 80-90% of the population; it means 50%). I once lived with them for a year. I have probably travelled across more US states than most Americans, for that matter. And when I went to America I was stunned by the quality and variety and cheapness of the food. And, on much less than the median US income, ate better than I had ever eaten in my life. And better than I did again for a long time.

[edeast]

Careful Nick, your sup/inf complex is showing. mmm ihop. Anyway,
I just want to say I'm having a fantastic time still looking through different denominations. Christian reconstructionist, independent babtist, presbyterian etc, basically the reformed denominations and babtist, mennonites, or everything non RC/Anglican. I wonder if there was an Anglican migration north, during the American Revolution, wiki says yes. No wonder the Kennedy Catholic thing was a big deal.

[Travis Fast]

Probably right. Nobody cares about hammers and nails any more. But that is cold comfort to all those who would take shelter under Popper. Not the first time bad Voodoo drove out the good.

It is odd though that you should take such a moralistic (genetic?) tone with respect to the poor. in fact it is od dthat on the hand you laud private markets but on the other give no consideration to the degree to which we are all bombarded by the image industry to consume. So what you are really demanding is that poor are less susceptible to the push to conspicuous consumption than the rest. That sir is soft bigotry. But even so you have not demonstrated that such superior character would be meaningfully rewarded in terms of a change in station. As you have it, if they could achieve this moral superiority they could improve themselves that they can't is evidence they deserve their station?

Ok do the run. Min wage with 10% savings. How many years of frugality is required for a game changer?

Who knew Kalenberg would get your heart pounding. I am starting think this income wealth inequality thing is really not your shtick.

[edeast]

And by reformed, I mean Calvinist, still looking for Lutherans swedes etc. Got something. comparing the three.

Determinant, yep on the Tyndale.

[Contemplationist]

Any theory of poverty that does not even mention behavioral traits like intelligence, conscientiousness and time-preference is worthless (talking about the comments, not your post). Yeah yeah, heartless rightwing stuff. Whatever, if it explains something, its useful and needs to be part of the conversation, whether its heartless rightwing stuff or mushy leftwing stuff.

Some basics

People are different! Hey! Why is this ignored? Intelligence, conscientiousness, and time-preference are all randomly distributed. Yes, luck is also randomly distributed and its a good point that left wingers mention, but you cant ignore how different people are in their abilities and character. The two - luck + human capital must be combined for any satisfying explanation.

And yes, institutions like the old time church can help by using social pressure to dissuade behaviors not in the long-term interest of the person.

[Mandos]

Yes, but people are different in their abilities and character to a great extent due to their environment, which is shaped by inequality and the values implicit in inequality.

Eventually "old time church" becomes co-opted by the rich and powerful...

[Rafael]

Nick,

There's a IMF working paper dealing with the same problems:

Inequality, Leverage and Crises Michael - Kumhof and Romain Rancière

http://www.imf.org/external/pubs/ft/wp/2010/wp10268.pdf

abstract:

The paper studies how high leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of the rich, a large increase in leverage for the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where these features arise endogenously as a result of a shift in bargaining powers over incomes. A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But restoration of the lower income group's bargaining power is more effective.

Sounds a little marxist to me.

[Greg]

Nick: OK I get your point. The short term data is always going to show something like a + bY. But:

http://www.dartmouth.edu/~jskinner/documents/DynanKEDotheRich.pdf

Do the Rich Save More?

Karen E. Dynan
Federal Reserve Board
Jonathan Skinner
Dartmouth College and National Bureau of Economic Research
Stephen P. Zeldes
Columbia University and National Bureau of Economic Research
The question of whether higher–lifetime income households save a
larger fraction of their income was the subject of much debate in the
1950s and 1960s, and while not resolved, it remains central to the
evaluation of tax and macroeconomic policies. We resolve this longstanding
question using new empirical methods applied to the Panel
Study of Income Dynamics, the Survey of Consumer Finances, and
the Consumer Expenditure Survey. We find a strong positive relationship
between saving rates and lifetime income and a weaker but
still positive relationship between the marginal propensity to save and
lifetime income. There is little support for theories that seek to explain
these positive correlations by relying solely on time preference rates,

398 journal of political economy

nonhomothetic preferences, or variations in Social Security benefits.
There is more support for models emphasizing uncertainty with respect
to income and health expenses, bequest motives, and asset-based
means testing or behavioral factors causing minimal saving rates
among low-income households.

Contemplationist has a point, but then the issue is how the rest of us decide to treat the poor. Do we assure them some minimum standard, or not?

My concern is the increase, in the last 30 years, of income inequality. This is the chart that concerns me:

http://paul.kedrosky.com/archives/2009/03/us_total_credit.html

I cannot believe that the situation for the poor is the same now as it was in the 1960’s. Somebody is servicing that debt, and it is not the rich. Somebody is collecting on that debt. And it is not the poor. I don’t know what the graph is for Canada, but I don’t think it’s very different.

(Sorry, Nick, I can’t get these links to work. I don’t know what the problem is.)

[reason]

Nick Rowe
"Second off, the permanent income hypothesis *does* say that saving is a constant proportion (approximately) of *permanent* income, and a constant proportion of transitory income. Just that those proportions are very different. 100% of transitory income, and closer to 0% of permanent income (depending on the interest rate and rate of time preference)."

Maybe the permanent income hypothesis says that, but then it can't explain how wealth is even more skewed than income (unless you play silly games with the definition of transitory income).

[reason]

I suppose besides playing silly games with the definition of permanent and transitory income, you could play silly games with "consumption".

[reason]

P.S. I don't necessarily blame Friedman for this. When he was writing, marginal tax rates on the rich were much higher.

[Nick Rowe]

Edeast: "Careful Nick, your sup/inf complex is showing. mmm ihop. Anyway,"

You lost me there. But it felt good to wrap myself in the flag for once. (Actually, I'm pro-American, and not the Canadian nationalist sort, even though I still think their rebellion was a mistake, and the root source of many ills ;-). They only really rebelled anyway because they didn't like Quebec staying French and Catholic. Look it up!)

Travis: "It is odd though that you should take such a moralistic (genetic?) tone with respect to the poor."

Yes, it feels odd to me too. But my beef is not with the morals of the poor, but with those who would undermine their morals by saying they can't help it. That's what's immoral. And a lot of lefties here (not you, because you are a hard-lefty) are going bat-shit crazy at my accusation. And can only do a knee-jerk response from their hind-brains, by reading me as worshipping all the demons in their demonology, and disrespecting all their sacred cows.

The funniest thing is, Guerilla economist (see comment above) actually has a critique that makes a serious dent in my argument. And they have all ignored it. They just keep on repeating "But the poor can't afford to save!" in outraged tones, ignoring my argument altogether.

"So what you are really demanding is that poor are less susceptible to the push to conspicuous consumption than the rest."

No. Though it would be nice if they were. Because the same amount of susceptibility is more harmful to them.

[Nick Rowe]

Contemplationist is right, of course. Though seeing the knee-jerk reactions of some lefties to this post, which mentions none of that stuff, makes me wonder how they would react. But this post is not about the causes of poverty. It's about what determines saving, and the effect of income on saving.

[Nick Rowe]

Rafael: It might not be Marxist. Depends on the theoretical model. My guess is that it's the same mechanism as in the Iacoviello paper I cited. It's probably transitory income, rather than true inequality. I would read it, but have to sort out too many people here.

Greg: "There is more support for models emphasizing uncertainty with respect to income and health expenses, bequest motives, and asset-based
means testing or behavioral factors causing minimal saving rates
among low-income households."

The "bequest motive" is at the root of Guerilla Economist's critique. The "asset backed means testing" is what I was talking about above, it's what gives the poor a lower after tax rate of return on savings than the rich. It's precisely the sort of perverse government policy that makes the problem worse, by discouraging saving by the poor. To which the left (OK, some on the left) add their patronising excuses.

"Contemplationist has a point, but then the issue is how the rest of us decide to treat the poor. Do we assure them some minimum standard, or not?"

Simple. We do. Assume poverty is 100% determined by genetics. There's a little strand of DNA that determines your relative income. Now assume instead that poverty is 100% determined by luck. It's who you happen to meet at the right time in the right place. What's the difference?

[Nick Rowe]

RSJ: "Are there really people saying "inequality causes debt"? I think the issues and claims are a bit more subtle than that."

Well, all the people mad at me here seem to be saying that.

But you are right, most debt is the result of investment decisions, not saving/dissaving. But I did say at the beginning of the post I was setting that aside, so I could concentrate on the saving/dissaving question.

Reason: "Maybe the permanent income hypothesis says that, but then it can't explain how wealth is even more skewed than income (unless you play silly games with the definition of transitory income)."

Wow, that was a softball. Take a simple lifecycle model, which is a variant/application of the PIH, and you will get that. Non-human wealth rises from zero to a peak when you retire, and down to zero again when you die.

In fact, I'm trying to think of an example where the PIH does not have that property, and can't think of one yet.

Oh, yes I can. People live forever, and half earn $100 in even years and $0 in odd years, while the other half it's the opposite. 0% interest. So half will have $50 in wealth at the beginning of each year, and the other half -$50. Well, it almost works.

[reason]

"Non-human wealth rises from zero to a peak when you retire, and down to zero again when you die."

Well no it doesn't (some people inherest and some people bequest). But this is not the point is it. The same is true I'm CERTAIN for a cross section of the population of a given age (say 55).

[reason]

Oops
inherit some how become inherest (when mated with bequest it seems).

[OGT]

Nick I see you and Contemplationist are out to prove my point. There are some very negative effects of being considered poor both to one's self image and motivation and to the image one is perceived with by others, and both of those perceptions have real long term effects on an individual's earning power. There is a minimum level of visible consumption that is required to earn the 'Not a Loser' badge.*

That level can change with both the level of visibility of everyone in society's consumption(think clothes brands here for example) and the social norms about the level of income as revealed by one's consumption to meet the minimum standards.

But for some reason, without any apparent empirical evidence, you seem determined to claim the PIH intercept goes through zero. Following George Akerlof's 'Identity Economics' I suspect that most people have a self identity in mind that informs a minimum spending level to live up to it, just that the middle classes and wealthier have more freedom in choosing what self identity to pursue. I don't actually think I have much of a problem with your policy recommendations, but you seem to be coming from the perspective of a cranky old guy that fixes his own Dodge Dart or whatever and can't understand why everyone doesn't self identify the same way. That's not necessarily a perfect starting place for good social science.

* A US TV character last week made the joke that "Capitalism is God's way of Determining who is smart and who is poor." Funny but, undoubtedly a bit less so if one is one of God's Dummies.

[reason]

Nick,
I'm not even sure your example has the property (wealth being more skewed than income) that you think it does. If all start from 0 and save at the same rate, then sure some rich will have lots of wealth, but some rich will have harly any wealth, and some poor will have some wealth. How does it help your argument exactly?

[reason]

To avoid confusion by rich and poor above I mean high permanant income and low permanent income. I understand the RANGE from high to low in wealth will be greater than the range of income - if the rate of saving is high enough (10% will do, 5% barely). But the ratio of total savings would then still be proportional to concentration of total permanent income, independent of permanent income. But we don't see that do we?

[reason]

Doing some rough calculations based on wikipedia figures for concentration of wealth and income, I get that the top 20% of households by income have approx 50% of the income and 80% of the wealth. Of course permanent income and household are imperfect substitutes because income changes with age. But wealth distribution by age is nowhere near so skewed.

[reason]

I will admit that the existance of social security biases the figures because expected income from social security could be considered part of household wealth and isn't measured as such.

[Mandos]

Nick,

The objection sounds like a mantra to you because you're starting (as economists usually do) from a different perspective on economic justice. I happen to think that people's basic well-being shouldn't be dependent on small variations in their level of moral continence, and that their basic well-being should include a reasonably large share of the convenience of modern life. From that perspective, the discussion of whether or not "inequality causes debt" contains dangerous presuppositions to me; it is appropriate to compensate for the predilection not to save.

This is the usual problem in discussions between mainstream economists and the present-day left: the former never seem to understand that some of what they think of as means are actually ends for the latter.

[Nick Rowe]

Still reading. Too tired to comment much.

[edeast]

Nick: It's a reference to the wikileaks, paroxisms of moral outrage vs inferiority complex, Andrew Coyne's interpretation. I was agreeing about the food. And I get what you are saying, I think most anglophones are pro-America, it's just that francophones are such strong critics. But I suppose the converse is also true concerning the monarchy.

For 3 years I was educated with a southern US curriculum so I really get the bible belt. And I'd say that I'm more pro-revolution than you. However the reflexive nationalists on comment boards make me wince, not you, more the health-care hockey pointlessness, this image captures how I define Canada, and what I'm proud of. Sort of jingoistic altruists or something.

[Jacques René Giguère]

My grandparents saved of their higly transitory income in the 30's. Did it make any difference short term? Maybe they could buy one more loaf of bread tomorrrow if the starved even more today. Long-term? Could not afford a house anyway.What saved them what the pst-war expansion.
Toda's poor? Can they save enough for the down payment on a house that the middle class is increasingly unable to afford? To pay for a university education ? Try to get a job at a bank with your Hochelaga-Maisonneuve accent.
The Chinese save, like the Japanese and the Koreans did earlier. Growth is so fast you can't adjust your calculation of permanent income. It all looks transitory and your children will adjust their consumption pattern later. Growth leads to savings not the reverse. And it explains why poor but growing countries can save more than rich but stable countries.

For a look at the life of the truly poor, watch the series "Les naufragés des villes" on RDI. In french. Do your bit for national unity...
And even then , it is a fake reality. The middle and upper income volunteers know it is just a show lasting two months after which they go back to paradise. Yesterday,after the first installment (day)they were already out of pocket.

Francos more critical of the Americans? Certainly not. The lower class certainly have what we call an admiring "Elvis Gratton " view. The better educated has the same ( but no more) critical view as other canadians and europeans of the same background. We fought the Americans in 1775 and 1812 because it would have meant even less rights than under the Brits. Other than that , if the U.S. army were to invade Toronto, what could we do? Life is tough isn'it?

[edeast]

I meant francos critical of us anglos, and any imperialistic, or anglosphere ambitions(Boer war, conscription etc) and free market calvinist type policy. While they are also critical of our monarchist childishness and admire the US.

[Ohio Attorney]

Perhaps I am naive but if we had two income earners one with an income of $15000 per year and the other with an income of $150000.00 per year and both decided that they would save 10% of their wages each pay period would it not be much easier for the wealthier to do so, with much less sacrifice and with a much greater confidence that he would enjoy the benefit of his thrift?

The person with a $15000 income would save a mere 1500 a year, his best option for investment would likely be a Certificate of Deposit with a 1.5% annual return which he could purchase once he had $1000 or more, until then he would likely leave the money in a zero interest checking account not having a sufficient balance to obtain a .25% per annum savings account. About 90% of his remaining income would be necessary for food, shelter, clothing and transportation, the remaining 10% would have to cover all other expenses and any emergencies that might arise. If his 10 year old car developed a mechanical problem, or his rented apartment required plumbing repairs not covered by his lease he would either have to dip into his savings, unlikely to cover his emergency needs, or go into debt. With such a modest income and no valuable assets to pledge as security he could at best hope to borrow from a payday lender with a 200%-950% per annum interest rate or to charge it to a credit card with a 25% per annum interest rate. If these extraordinary expenses were not incurred he would effectively give up his income as without regular bathing or reliable transportation he would lose his job. Under these circumstances how much more valuable to him is dollar 261 of his weekly income if consumed than it would be if it were saved?

The person with a $150000 income would save $15000 over a year, he could easily invest in a stock market index fund with a historic return of 11% or better, even with a safer portfolio he could anticipate a return 6-8% a year with some confidence. Perhaps 40-50% of his remaining monthly income would be required to pay for his shelter, food, clothing and transportation, if he really liked to live beyond his means he might choose to devote 60-70% to such necessities with a comfortable margin for other expenditures. His 3 year old car probably won't have too many problems over the course of the year, but if it does he can replace it with a new one without increasing the amount he has to pay for transportation each month significantly. Owning his home does leave him stuck with all required maintenance and repairs, but even if he has a large unexpected expense he can borrow against his home equity at no worse than 4-6% per annum or else he'll have plenty of time to make up the difference from his future income if he does have to tap his savings to pay for such an emergency. How much less valuable to him is dollar 2597 of his weekly income if consumed than if saved?

It seems to me that each percent of income saved by a low income person both costs him more and benefits him less, and that those benefits are much less certain to be realized, than the same percentage of income saved by a high income person.

[RSJ]

Nick,

"Well, all the people mad at me here seem to be saying that."

No, I don't think they are criticizing you for that, but rather for making these types of moral or character arguments to address what is basically an institutional or structural failure. There is just a long history of economics doing this -- e.g. "voluntary unemployment" being the excuse for the 20-40% unemployment rates typical in the non-agricultural sector during the 19th century.

And the economists respond with talk of impatience, people not wanting to work, etc.

Then suddenly we adopted demand management policies and the unemployment rate dropped in half.

Everyone became more hard-working, more prudent?

Did everyone become impatient in the 1990s, or was there an asset valuation problem?

These are structural problems, institutional problems, not character problems; Despite the premise of the Krugman/Gauti paper, debt is not the impatient borrowing from the patient, it is investors valuing the in-place assets as delivering a greater cash-flow, with new money being created as a result, and the new money is distributed disproportionally to the wealthy. Here is a clear connection between debt growth and income inequality not relying on character issues at all.

[Travis Fast]

Nick,

Hard-lefty? Do not get me wrong I like it but...

I will give give you a personal anecdote. Back in my bachelor of arts days I was driving down the road with a hard-nosed blaster (coal miner) who lost his fingers on one hand when the descending cage cut them off (always keep your hands inside the cage) and a pan handler walked up begging for money. He told the guy to fk right-off. I said WTF you are a socialist you can't talk to the poor like that. And he replied "we live in one of the richest cities in NA and thus in the world he should either get organized or just steal what he needs from the rich." To which he added: "being poor is no excuse to accept your poverty."

Often Nietzsche goes further than Marx. Me I keep both close even though each unsettles the other.

[Nathanael]

"Well, OK, if you are in danger of starvation today it doesn't. Because if you don't consume today the marginal utility of your future consumption is irrelevant."

Yep. We actually do have poor people in the US today who are in this position; who are forced to go into debt due to danger of death right here, right now.

In fact, medically-induced bankruptcy is the chief cause of bankruptcy in the US. You can be sure people are not doing this unless their lives are at risk.

Even short of that, there are masses of people who are not earning a "living wage" are in the position of being forced to either take on debt or steal money. Our welfare system really has been ground up that bad. Debt is a lower-risk strategy.

Accordingly, your analysis is simply.... wrong. By "the poor" you seem to mean "the moderately poor", not "the dirt poor".

[Oliver Davey]

This book may be of interest:

The Persistence of Poverty
Why the Economics of the Well-Off Can't Help the Poor

[reason]

I think like Jaques Giguere. I think what he says is just about right.

[Phil Koop]

Nick, I think you might profit by reading the Kumhof and Rancière paper. Maxine Udall's summary was pithier than the paper abstract (http://www.maxineudall.com/2010/12/company-store-redux.html):

"In Kumhof and Ranciere's model, increasing concentration of wealth in a small "investor" class leads to higher demand for investment assets, such as securitized pools of loans made to wage earners who must borrow to maintain consumption as their real income declines."

At a point in time, you could read it as a transitory income effect, but the model has a positive feedback whereby the equilibrium is endogenously shifted. So Marxist then, I suppose.

But note that this model fits certain facts about the sub-prime meltdown, explained in the Levitin & Wachter paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401. The volume of sub-prime mortgage issuance increased even as spreads narrowed, implying an outward shift in the mortgage supply curve. But of course, mortgage supply is the same as investment demand.

[Nick Rowe]

Phil: Thanks. I just read (skimmed) it.

Essentially, it's a variant on the model I sketched above, in the "nightmare scenario". Here's a massively simplified version: some people are more patient than others. Call the patient people "capitalists" and the impatient people "workers". (See, they are the ones assuming poor workers are improvident!). Over time the workers will slowly go into debt to the capitalists. If there's an exogenous shift in the distribution of permanent income from workers to capitalists, the real rate of interest will increase, and this process will happen quicker.

The only real difference between their model and my model (apart from their assumption that it's the workers who are impatient) is that they give the capitalists weird preferences. Capitalists do not save for future consumption. Capitalists are Scrooges, who save for savings sake. This means that my nightmare scenario may or may not happen, depending on the distribution of permanent income.

If I had started out my blog post here by saying "Let's face it guys, the poor are simply less provident than the rich, because poor and rich have different innate preferences", people would have dumped all over me for making that assumption. But if you make that exact same assumption, and use it to say that inequality is a bad thing, all the lefties would be happy! It's all in the framing.

[Patrick]

I dunno ... I'm very leftie (at least where poverty is concerned) and I have no problem saying the poor are improvident compared to the rich. It follows from the definition of poor. Kinda hard to save for tomorrow when you don't have enough today. For the most part, I think the different preferences are a consequence of the poverty, not its cause.

[Oliver Davey]

Well said, Patrick!

Again, I refer you (all) to the book (review) I linked to above. An academic work well worth reading in my opinion.

Another review by Tyler Cowen

[Nick Rowe]

Patrick That's not different *innate* preferences. That paper *is* talking about different innate preferences.

[vimothy]

Nick,

No time for a proper answer now either because I’ve got a godverdomme assignment to write. But quickly,

I think you’ve misunderstood me. I wasn’t bringing up cardinalism because I think that the distinction between cardinal and ordinal utility relates directly to the issue of interpersonal comparisons of utility. It doesn’t—it’s impossible in either case.

The fact that it’s impossible is (close to) what I was trying to get at. The cardinalists were generally more bothered about this than their ordinalist successors. You can see this in the development of neoclassical price index theory. The cardinal-ordinal utility distinction and noncomparability are distinct conceptually but historically the two arrived in the same box, as it were. Perhaps ordinality was a palliative for noncomparability—just define the problem out of existence.

Here’s what one randomly selected textbook says about the issue, in a section entitled “The impossibility of comparing utility between persons”:

“The problems in measuring consumer surplus which we have discussed so far have all been concerned with the ambiguity of this concept when analysing the individual consumer’s situation. We have, however, seen that we may produce an apparently unambiguous monetary measure of an individual’s satisfaction from consuming a particular good if we make the special assumptions set out in the two previous sections of this chapter [total utility is independent from the amount consumed, and constant marginal utility—the subject is Marshallian demand theory and consumer choice]. It must be noted, however, that even making these assumptions provides no basis in economic theory for adding these measures of satisfaction over individuals to produce some global measure of the gain to a community from consuming a particular good. Even if we are willing to postulate the existence of a cardinal utility function for each member of the community, there is no basis for comparing these functions between people and hence no way of adding them up. A pound’s worth of satisfaction to one person and a pound’s worth of satisfaction to another may or may not be the same amount of satisfaction. There is no way of knowing.”

You’re claiming that poor people don’t go into debt because they are poor; they go into debt because they have a high rate of time preference. And you’re claiming that over time, people who have a high rate of time preference become poor. That is, poor people don’t go into debt because they are poor; they are poor because they go into debt.

Well and good. But can you justify your assumptions? They are very restrictive.

Let ‘s say, arguendo, that you can. What are we left with? We know that people go into debt because they have a high rate of time preference. In other words, people go into debt because they are the kinds of people who go into debt, and this property is independent of income (by assumption). So we don’t really know anything. On this basis, you offer some advice: Poor people should be less impatient, and save more—then they will be less poor. No doubt Marx is spinning in his grave. I don’t care about Marx, and your policy prescription seems reasonable, but the inanity of that statement annoys me.

I dunno, this just doesn’t seem like a very fruitful way to proceed. Perhaps I’m missing the larger picture...

[Phil Koop]

Framing always has an effect on us poor, frail mortals. But I think you are attributing too much to framing in this case.

As I read you, "innate" preferences are essentially metaphysical, rather than observable. It is logically possible for rich and poor to have the same innate preferences but markedly different observable ones. This could happen if, say, rank in savings were associated with status, but status had some non-linear intrinsic value. In that case, people would not in fact save for the sake of future expenditure but for status. Everyone would have the same innate propensity to save conditioned on an available amount to save, but they would not have the same empirical propensity to save, given heterogeneous incomes.

Or you could make up some other story. The heart of the matter is that your assumptions about why people save and their propensities to do so are exactly that. The empirical support for them is at best ambiguous. In that respect, your model is just as weird as the alternatives.

[Nick Rowe]

vimothy: "You’re claiming that poor people don’t go into debt because they are poor; they go into debt because they have a high rate of time preference."

No. That's *not* what I am claiming. I see no reason why the poor should have a lower or higher rate of time preference, or be more or less likely to go into debt. It's *everyone else* who is claiming that the poor will be more likely to go into debt. Not me.

(Those who do have a high rate of time preference, and who go into debt because of that, will, of course, tend to become poor over time. But there are plenty of other reasons why people should end up poor, of course.)

Phil: this is not metaphysical. This is about how people will behave in different circumstances.

Here is my basic assumption: everybody has the same preferences (until shown otherwise). If you took a poor person and gave them a rich person's (permanent) income, they would consume and save like a rich person, and vice versa. Everything scales.

But that paper you linked to makes a very different assumption. It says that if you took a poor worker, and gave them a rich person's income, they would behave very differently from a rich person. Look at the paper! The workers and "investors" have totally different utility functions! They are a different species! Given the exact same opportunities, they will behave in totally different ways!