Ezra Klein: Income Inequality and Consumption

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January 25, 2007

Income Inequality and Consumption

I'm a bit skeptical of Tyler Cowen's article dismissing the rise in income inequality as a primarily demographic phenomenon, but I'm particularly confused by his conclusion, that "What matters most is how well people are doing in absolute terms."

That is, on its face, true. But it doesn't seem terribly illuminative. Indeed, It'd be easy enough to take that line to justify the opposite of Tyler's intent, arguing that, yes, the measure of a society's economy is the absolute buying power of its median member, or of its bottom 20 percent, or some other arbitrary measure. Such a perspective would make income inequality more, not less, problematic, as you'd then want to engage in some heavy redistribution to make said member or members better off in an absolute fashion. Now, I think that Tyler is actually saying there's some line of "well enough" above which we needn't be so concerned, but then that line needs to be precisely defined so we can decide if that's in fact true.

Elsewhere, Tyler capably argues that you've not seen much change in consumption patterns (though you have seen rapid rises in debt, and second mortgages, etc), but that would appear neither here nor there given his criteria. In absolute terms, the majority of folks could be doing better. The paper he references, after all, says, "we first document that the recent increase in income inequality in the U.S. has not been accompanied by a corresponding rise in consumption inequality. Much of this divergence is due to different trends in within-group inequality, which has increased significantly for income, but little for consumption." So there is more money, it's just not being spent. Assumedly, giving it to folks who would spend it would make them better off. There may be reasons of fairness or efficiency that militate against doing so, but that's sort of a different argument.

It's also worth saying that the authors believe the major reason consumption hasn't tracked inequality is the emergence of more developed credit markets, though I'd be lying if I said I completely understood their discussion of that point.

January 25, 2007 in Inequality | Permalink

Comments

"What matters most is how well people are doing in absolute terms."

That is, on its face, true.

No, it's not, if you follow the research that connects ill-health to being low in relative terms.

I guess the killer study would be one in which society #1 is essentially flat, society #2 is very unequal, the lowest rung in society #2 is as rich as the median in society #1, and society #2 is less happy in toto.

Economists (and businesses) focus on the bottom line because it's easiest to think about and clearest how one might manipulate it (even if the political will isn't always there). But they shouldn't mistake this laziness for a fundamental truth.

Posted by: Allen Knutson | Jan 25, 2007 12:06:32 PM

I'll try to explain Tyler's (and the article's) issue in an example.

Let's suppose you have a society where 18-25 year olds live in their parents' households.

Now the society gets slightly richer and builds some cheap rental apartments. The 18-25 year olds move out of their parent's houses, and live in the cheap rental apartments.

If you measure household inequality, it has greatly increased; however, no one is worse off.

Measuring consumption is one way of attempting to figure out "is anyone worse off?"

Posted by: SamChevre | Jan 25, 2007 12:28:12 PM

Middle-class consumption hasn't decreased possibly because people have been willing to spend the equity in their homes. In the sixties and seventies, people did not refinance their homes nearly as much as today. If they did refinance, it was to lower their interest rate rather than pull equity out. In those days, equity was a good thing. Low interest rates, low loan fees, and rapid housing appreciation (until recently) encouraged many people to use their home's equity to consume more. The interesting question is whether consumption will now moderate along with moderating home appreciation (or depreciation).

Posted by: MarvyT | Jan 25, 2007 12:44:48 PM

I'd like to second Allen at 9:06:32 AM. One's satisfaction with one's state in life is a function of how well one is doing relative to how well one might do. We have some basic desires -- hunger, warmth, sex -- for which our standard of happiness starts in our genes. This is more or less absolute. But even here satisfaction is separate and is based on what one can expect in one's context. Inequality creates unhappiness, however wealthy the society, because it creates unachieved expectations.

Posted by: David Houghton | Jan 25, 2007 1:01:53 PM

If ability to participate in consumption is not linked to income, then financial health is not immediately a primary requisite for consumption. If, as is often likely, bankruptcy follows, bleeding off personal assets stimulates the banking/investment community. Feed the leeches !

Posted by: opit | Jan 25, 2007 2:31:32 PM

Yeah, add me to the list of those seconding Allen Knutson. African Americans in Harlem have a better standard of living in absolute dollar terms than, say, Cubans living in Cuba. Yet the latter has a longer life expectancy and better health during their lives.

And Knutson's exactly right that the emphasis on bottom-line dollars is largely motivated by the false sense of security economists get because, you know, it's really easy to count bottom-line dollars, and not so easy to count other stuff. It's hardly unique to economists---Larry Tribe called it the dwarfing of the soft variable in a law review article some decades ago. But it's an especially important bias in the scholarship to watch out for.

Posted by: Jack Roy | Jan 25, 2007 2:45:51 PM

I've never understood why Democrats don't emphasis the idea of a floor below which society will not let you fall. In other words, make sure every person has the basics and/or the opportunity to get them and more, and then leave everyone else be. That seems to be the operating plan of the party in everything but terminology anyway, and upon first thought, it would seem to satisfy both the desire for fairness and the chance (or dream) to make it big.

Posted by: Brian | Jan 25, 2007 2:47:49 PM

That idea has never flown in Canada - even though federal public healthcare and subsidization of welfare have - because the idea of guaranteed income is seen as too close to communism. If it doesn't go here I don't fancy your chances at all.

Posted by: opit | Jan 25, 2007 2:56:23 PM

Whoops. That was phrased deceptively. The federal government here does not administer either welfare or healthcare insurance, but particpates on a subsidy basis with some resulting influence on policy.

Posted by: opit | Jan 25, 2007 3:03:39 PM

Here's a experiment to illustrate my point about satisfaction and happiness at 10:01:53 AM.

1) Serve yourself a large sundae with hot fudge, whipped cream, and gaudy sprinkles.

2) Find a happy four-year-old child.

3) Sit down in front of this child. Make sure he or she sees you and your sundae. Praise the deliciousness of the sundae. Let the child smell and admire it.

4) Ask the child if he or she would like to eat the sundae. (If the answer is "no", go back to step 2.)

5) Now eat the sundae.

6) See if the child remains happy.

Posted by: David Houghton | Jan 25, 2007 3:08:20 PM

So there is more money, it's just not being spent.

Ergo, its being used to accumulate wealth, and therefore economic power.

But of course, we knew that, since the dominant force in deciding economic policy has been the interests of those with economic power, and that group contains a large fraction of those who utilize their income to gain economic power.

Posted by: BruceMcF | Jan 25, 2007 3:23:00 PM

Here's a experiment to illustrate my point about satisfaction and happiness...

All this comes down to your vision of government. Is it the duty of government to insure your happiness? The poster "Opit" even posits the question of a guaranteed income. Is it also the job of government to guarantee your income?

That about it, there, Comrade?

Posted by: Fred Jones | Jan 25, 2007 3:45:46 PM

Here's a experiment to illustrate my point about satisfaction and happiness...
All this comes down to your vision of government.

No, that's beside the point I'm addressing, which is simpler: is inequality relevant. You argue that all that matters is absolute material wealth. Why does this matter? Because it is a proxy for happiness, which is what we really want to measure. But it is trivial to demonstrate that failure to achieve expected happiness creates unhappiness, and it is a short step from this to the conclusion that inequality creates unhappiness. If what we really want to improve is not wealth per se but happiness, then we cannot ignore inequality.

The short step is not obvious, perhaps. It also is not inevitable. If you perceive the wealthy as qualitatively different from yourself, then perhaps you do not expect wealth and are not disappointed when you do not achieve it. But in the America portrayed by conservative pundits this attitude is anomalous, even un-American. We all can achieve wealth! I leave you to connect or ignore the rest of the dots.

Posted by: David Houghton | Jan 25, 2007 4:39:59 PM

Is the government in the business of insuring your happiness? Or even your financial equality?

Posted by: Fred Jones | Jan 25, 2007 5:12:30 PM

I think that what this means:
It's also worth saying that the authors believe the major reason consumption hasn't tracked inequality is the emergence of more developed credit markets, though I'd be lying if I said I completely understood their discussion of that point.
is that consumers have now greater access to credit which doesn't require collaterals, perhaps things such as credit card debt. I'm not sure how the bankruptcy law and the recent changes in that would play into this, but the basic idea is that if income inequality has risen because workers essentially have less security in their jobs and more year-to-year fluctuations then the ability to borrow money without remortgaging your house, say, allows them to smooth out their consumption over time more than the incomes alone would show.

Posted by: Echidne | Jan 25, 2007 5:34:55 PM

I've never understood why Democrats don't emphasis the idea of a floor below which society will not let you fall.

Because it's a cheap, effective welfare system that's relatively simple to understand.

Posted by: Alon Levy | Jan 25, 2007 5:40:36 PM

Couldn't this also imply that there is something like an s-shaped curve relating consumption and income. Thus, the only people much affected by the greater inequalities are located near the knees of the curve?

Fred, governments are instituted among men to secure our unalienable rights including the pursuit of happiness, while it's said differently in the Constitution the same ideas hold there, so arguing that governments aren't in the business of insuring happiness is rather dubious. i suppose one can make the distinction between pursuing happiness and actually attaining happiness but not everybody wants to be small minded conservatives.

Posted by: BillCross | Jan 25, 2007 7:45:21 PM

Posted by: David Houghton | Jan 25, 2007 1:39:59 PM

No, that's beside the point I'm addressing, which is simpler: is inequality relevant.

And the important point to stress is this: its primarily not about happiness, because the inequality of consumption is less than the inequality of income, and that implies that the inequality of something done with income other than consumption is greater than the inequality of income alone.

And that thing is the accumulation of economic wealth, which is used to exercise economic power.

The question is ultimately whether as a free republic we wish to have see the permanent aristocracy of financial wealth continue to expand and continue to gather a greater share of national political power in its hands.

Posted by: BruceMcF | Jan 26, 2007 2:30:54 AM

There's useful linkage and commentary on the subject of social status and health at this Crooked Timber thread from 2005. The upshot of it is that there are data showing that the overall health of people higher in a hierarchy is better than those lower down. Being subordinate is bad for you, basically. And this is by definition not something that consumption can really compensate for; it can only offset it to varying degrees.

Posted by: Bruce Baugh | Jan 26, 2007 4:25:11 AM

Maybe I'm mired in the old reality-based methods, but whenever people go into debt to finance current consumption it seems to me that they're reducing future consumption by some amount, which has a net present value. If the interest rate they pay on the debt is greater than the sensible discount rate (and it is, for credit cards, and then some) they're reducing their consumption overall.

For people taking equity out of their houses the reduction is less clear (depending on the fees, interests rates and so on). But certainly such folks are increasing their risk of losing the house (or losing a substantial portion of its value in a distress sale). And that risk, too, has a NPV that has to be deducted from current consumption.

As for the rich, even the things we normally consider as assets for investment have a consumption aspect to them. (The imputed rents of mcmansions point at this issue but don't nearly cover it.) The folks with big portfolios get better service from their brokers, better rates on their cards, access to better educational and recreational facilities (even after taking price into account).

Posted by: paul | Jan 26, 2007 10:10:36 AM

The big problem of this conversation is The jealousy and envy aspect that no one wishes to discuss. Brian hit upon the real solution to the poor and that is to have a floor without taking away incentives to do better. But that's not what liberals want. They play upon jealousy and envy of others, just as the commies did.

Posted by: Fred Jones | Jan 26, 2007 10:59:33 AM

Some are jealous of others' physical possessions. Some, apparently, are jealous of others' ability to feel an interest in others' well-being.

Posted by: Bruce Baugh | Jan 26, 2007 11:02:15 AM

"What matters most is how well people are doing in absolute terms."

That, on its face, is false. Wealth translates, directly and indirectly, into political power. Directly, because politicians are bought and sold, via campaign contributions, junkets, and private sector careers. Any billionaire can own a congressman; any multi-millionaire can own a few state senators. If wealth is spread more evenly, coalitions of ordinary people can band together to buy their own politicians. But the way things are going, the very wealthy will make sure that public money goes for stadiums, tax breaks for the rich, sprawl, and military spending, and not for schools, health care, and rises in the EITC. You think all these new Iraq contractor billionaires are going to take their money to Vegas? Or will they buy up their own state and federal legislators and have the fire hose of contract money opened up even wider?

Indirectly, because when income is highly skewed, all sorts of distortions turn up in the distribution of power. Take judges. When the best-educated lawyers can earn $100,000 their first year out of law school, there are two things that can happen to judges: either they will be second-rate hacks who are prone to bribery, or they will be paid like private sector lawyers, and therefore have no understanding of the lives or ordinary people.

Posted by: JR | Jan 27, 2007 1:20:23 AM

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