Basic Macroeconomics of Income Distribution Cannot Explain Today’s Rising Inequality

inequality

I was recently looking over the debates surrounding the Pasinetti theorem and I thought it might be worth writing a few words on it. Pasinetti formulated his theorem — which is dealt with in detail in a fantastically thorough Wikipedia article — in 1962 in response to Nicholas Kaldor’s seminal paper Alternative Theories of Distribution.

What Pasinetti’s theorem showed was that while propensity to save by workers has no long-run effect on the share of profits in the national income, it does have a long-run effect on the manner in which these profits were shared between workers and capitalists.

The Pasinetti theorem actually has very interesting implications for how we should approach really existing capitalist economies. In his equations Pasinetti assumes that workers savings earn the interest rate — which is assumed to be equal to the rate of profit. Given the assumptions of the entire model I think that this is quite reasonable. Now, if workers can manage to save more then more of the profits will accrue to them.

If we apply this logic to really existing capitalism it yields something interesting: in really existing capitalism we have different layers of income distribution that save at different rates. At the top end are those that save copious amounts of their income — now colloquially known as the 1%. While at the bottom we have people who probably net dis-save — i.e. go into debt — a good deal of the time. By Pasinetti’s logic the more savings become concentrated at the top of the pyramid the more income distribution will diverge due to a higher share of the profits going to those that save greater amounts.

Before I go on to criticise this a little bit let us first turn to the neo-Keynesian response from Paul Samuelson and Franco Modigliani. They tweaked the model a bit with some extremely unrealistic assumptions so that it showed that income would eventually become evenly distributed. While Pasinetti patiently criticised the assumptions that Samuelson and Modigliani employed, Kaldor undertook what I think to be the more relevant critique: he analysed the empirical data and showed just how widely savings propensities in different groups diverged. He concluded,

[U]nless they [Samuelson and Modigliani] make a more imaginative effort to reconcile their theoretical framework with the known facts of experience, their economic theory is bound to remain a barren exercise.

Whether it was politics or the soothing fairy-tales told by marginalist economics that motivated Samuelson and Modigliani, I do not know — although I suspect it was some measure of both (their idea that the conclusions of the British economists required the assumption of ‘hereditary barons’ indicates extreme political immaturity and an almost cartoon-cultural American view of the British economy on their part) — regardless, however, they won the day, as they so typically did. Anyway, that particular debate — which goes round and round and ends up in the infamous Capital Controversies — is somewhat stagnant; and so I want to raise some slightly different and more pressing points here.

From the extensive empirical work done by James Galbraith and his co-authors we now know that income inequality is strongly positively correlated with the size of the financial sector. Intuitively, of course, this is not surprising and the Occupy Wall Street movement certainly figured it out without needing the extensive empirical work done by Galbraith and company.

Now, this can be interpreted in two ways. The first is that savings of the rich built up to such an extent that an entire financial sector rose up to accommodate it. The second is that the financial sector was an autonomous creation — the result of certain historically contingent policies — and that the savings/profits that accrued to the higher income tiers came from the rise of finance.

Here’s the problem with the first interpretation: the financial sector can generate savings/profits with no reference to the real economy. If stock prices rise of their own accord then the savings/profits of those that hold them also rise.

Now, following Pasinetti we might respond: “Sure, that is true, but you need a prior level of unequal income distribution otherwise workers will receive the gains of the upswing in the stock market”. There is certainly some truth in this view. But I just don’t believe that it is the crux of the issue. Rather I think that runaway financial markets actively engage in income redistribution through the building of hoards via rising asset prices that then generate reinvestment in those assets which then in turn produces a growth in the hoards. And so on and so on… round and round we go. While I cannot really substantiate this here, I think that this is what most of the data points to.

None of this, of course, actually undermines Pasinetti’s work. After all, his work never really says anything about how the rate of profit — and, in the long-run, the rate of interest — is actually generated. If we include rising asset prices in Pasinetti’s framework and assume a given unequal distribution of income then we can easily come to the conclusion that asset prices will generate worsening income inequality. But to me this sidesteps the issue.

If the true causal variable is the rise in asset prices — and again, I think that this is what all the data suggests — then it is this aspect of the problem that should be at the forefront of the analysis. That leads to the question: what causes asset prices to rise? And unfortunately the answer to that is institutional and, to a very large degree, psychological. It is deregulation and swings in psychology — not to mention accommodative monetary policies — that leads to growth in the financial sector and massive upswings in the price of financial assets.

This is where the neat, formalised Keynesian models break down: they cannot explain the key determinants of the problems we face today. Yes, we can build countless models — of lesser or greater merit — to show that unequal income distribution can hurt economic growth (frankly, that should be obvious by simply assuming different marginal propensities to consume across different income groups), but we cannot really say anything about the cause of the problem.

Actually, we should be clear: economic theory has very little to say about this problem. But the economics of institutions — particularly of political and financial institutions — has rather a lot to say about this problem. So too do empirical economic studies showing clear correlations between the financial sector and income inequality.

But basic macroeconomics comes to a halt, as it did in the famous passages in the General Theory on financial markets and expectations all those years ago, against the rock of finance. And any descent deeper into the crevices of the finance industry and the political institutions that facilitate it requires altogether different tools.

Addendum: I am pulling a comment that I made to Neil Wilson in the comments on this blog because I think it is of general interest to consider when thinking about the above discussion.

If you hold a stock worth £1000 and I feel super-confident in the market and offer you £2000 and this leads others to then think that this particular stock is valued at £2000 I’ve just increased the net worth of every holder of that stock by (£1000 x amount of stock held). If, say, 5000 of those stocks exist in the economy I have just increased the net worth of the economy by £5,000,000!

Now assume that the economy had a total net worth of £100,000,000 prior to my optimistic bid. And that income is distributed in such a way that the top 10% hold £50m while the bottom 90% hold £50m. Now assume that all of this particular stock was owned by the top 10% of the population.

Well, after my little optimistic bid the top 10% now have £55m in net worth while the bottom 90% still have £50m. We’ve gone from an economy where the top 10% of the population by income distribution hold 50% of the wealth to an economy where the top 10% of the population by income distribution hold 52% of the total wealth! And this was done simply by changing the prices of assets with one bid!

Obviously this is an extreme example. But it highlights the dynamics that I’m talking about very clearly.

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About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
This entry was posted in Economic History, Economic Policy, Economic Theory, Toward a General Theory of Pricing. Bookmark the permalink.

37 Responses to Basic Macroeconomics of Income Distribution Cannot Explain Today’s Rising Inequality

  1. NeilW says:

    Isn’t the financial sector required to increase the velocity of money sufficiently so that small skims from turnover amount to something – helping to maintain profit levels.

    It’s very difficult to make things go faster in the real economy – haircuts from even the fastest hairdresser take time. Even advertising and legal papers take time to draw up.

    However financial transactions can operate ever faster approaching the speed of light, and each cycle is a ‘turn’ from which you can skim a little income.

    • For rising asset prices you don’t even need “speed”. If you hold a stock worth £1000 and I feel super-confident in the market and offer you £2000 and this leads others to then think that this particular stock is valued at £2000 I’ve just increased the net worth of every holder of that stock by (£1000 x amount of stock held). If, say, 5000 of those stocks exist in the economy I have just increased the net worth of the economy by £5,000,000!

      Now assume that the economy had a total net worth of £100,000,000 prior to my optimistic bid. And that income is distributed in such a way that the top 10% hold £50m while the bottom 90% hold £50m. Now assume that all of this particular stock was owned by the top 10% of the population.

      Well, after my little optimistic bid the top 10% now have £55m in net worth while the bottom 90% still have £50m. We’ve gone from an economy where the top 10% of the population by income distribution hold 50% of the wealth to an economy where the top 10% of the population by income distribution hold 52% of the total wealth! And this was done simply by changing the prices of assets with one bid!

      Obviously this is an extreme example. But it highlights the dynamics that I’m talking about very clearly.

      • NeilW says:

        That’s fine for bragging rights, but it doesn’t create any actual income. For that to happen somebody has to act on the ‘wealth effect’ caused by the casino culture.

        Which means borrowing, and means banks believing in the asset price increases so that they trim their ‘haircut’, etc.

      • It does create wealth. It just doesn’t create income. But it does create wealth. And it is wealth inequality that is the key problem today.

        Take the example of a CEO. Where does he get most of his salary? From his income? No! From his stock portfolio! That’s what Galbraith’s work shows so clearly.

        The wealth is continuously created and recreated through credit expansion, through share issuance, through accounting tricks and so forth. Standard measures of income — that is, wages and salaries — are totally misleading in this world.

      • NeilW says:

        But isn’t it largely illusionary? You can’t cash in this ‘wealth’ and use it for anything other than to pretend to be the BSD on the park.

        In that way it is very much as Mosler puts it – a scorecard. So if they want ‘points’ why not let them have ‘points’.

        I can see that the obsession with the ‘points’ system has caused the normal economy where the rest of us live to be neglected, but we know how to patch that up and make it work.

        So why not do that and just let the ‘points’ game continue?

      • Of course they can cash it in. They cash it in and then spend it on luxury yachts etc.

        They can cash it in because the pool of money keeps expanding via the mechanisms of credit and the central bank.

        Hell, even if the market tanks they can sell this garbage to the Fed for newly issued cash!

      • NeilW says:

        Isn’t that what I said?

        “Which means borrowing, and means banks believing in asset price increases so that they trim their ‘haircut’ etc”

        You have to have a liquidating mechanism or you’re just changing the ownership tags on existing assets.

        And that would stop with the appropriate type of narrow banking.

      • Yes. But you see how the truth of the matter can easily lead people astray into thinking that 100pc reserves or some crap is the answer? That’s what makes the narrative so difficult to communicate…

  2. “If the true causal variable is the rise in asset prices — and again, I think that this is what all the data suggests — then it is this aspect of the problem that should be at the forefront of the analysis…And unfortunately the answer to that is institutional and, to a very large degree, psychological. It is deregulation and swings in psychology — not to mention accommodative monetary policies — that leads to growth in the financial sector and massive upswings in the price of financial assets…Actually, we should be clear: economic theory has very little to say about this problem.”

    As once said Schumpeter:”…when we succeed in finding a definite causal relation between two phenomena, our problem is resolved if the one which plays the “causal” role is non-economic. We have then accomplished what we, as economists, are capable of in the case in question and we must give place to other disciplines. If, on the other hand, the causal factor is itself economic in nature, we must continue our explanatory efforts until we ground on non-economic bottom”.(The theory of economic development)

  3. paul davidson says:

    The trouble is that the Passinetti et al was a discussion of a closed economy. In an open economy, as described within true Post Keynesian Economics — like my textbook POST KEYNESIAN MACROECONOMIC THEORY and in the JOURNAL OF POST KEYNESIANECONOMICS we can demonstrate that trade can affect national income distribution — e.g., outsourcing to find cheaper sources of labor to produce the same product can result in a reduction of domestic wage share relative to capitalist share. Another cause of reduced wage share is automation which removes labor from the production process to enhance capitalist income. For all this see my THE EDITOR’S CORNER in the Winter 2013-2024 issue of the JOURNAL OF POST KEYNESIAN ECONOMICS.

    Finally I wish people would stop calling the Cambridge analysis of Income distribution via Passinetti, Kaldor, etc. Post Keynesian. It is not under my definition of the term Post Keynesian as developed by Sidney Weintraub and myself in the 1960s.

    • I agree, Paul, that trade etc. can affect worker compensation. But the main driving force behind inequality is changes in asset prices.

      • paul davidson says:

        I think you are having a confusion here. Changes in asset prices involve a change in wealth — NOT INCOME. Income is a flow and it arises, by definition, only with payment the flow production of goods and services that are sold in the market under monetary contracts.

      • paul davidson says:

        Trade can not only affect wages paid — but it can also affect the number of domestic jobs for which people are hired — if offshoring outsourcing occurs. This offshoring raises the share of profits per unit produced and therefore can improve the price of the equities of the corporations. So the increasing inequality due to trade lowering both domestic jobs and wages can cause an increase in asset prices — and not a n increase in asset prices causing greater inequality. Looking at the correlation between change in asset prices and changes in inequality does not prove that asset price changes causes increasing inequality.

      • Yes Paul. And the empirical evidence shows that WEALTH inequality is more important than income inequality today. Economists are trapped by their focus on what they define income to be; which is very different from what CEOs consider income to be.

      • paul davidson says:

        If you want to discuss wealth inequality OK — but do not confuse it with income inequality
        The ability to spend Wealth on currently produced goods and services (which generates income) depends on the liquidity of the assets that make up that wealth— as owners of mortgage back derivatives found out in the financial crisis of 2007-8.— Liquidity can quickly disappear )

        In other words, changes in asset prices can affect the distribution of wealth — which can affect your balance sheet — which can make you feel more comfortable (or uncomfortable) depending how the change in the asset prices in your balance sheet is going.

        Think about a sudden drop of say 20 per cent in the Dow Jones — people with equity assets (or mutual funs that invest in these equity assets) will find their net worth (wealth) decline — but suppose their income they earn from their contribution to the production of goods and services do not change — and the government takes quick action to prevent any decline in GDP. what then?

        Compared to a case where the Dow Jones increases by 20% and the national GDP is permitted to decline in real terms by say 10% — as Apple, and other US corporations move their production overseas to cheap foreign labor facilities. What then??

      • The evidence shows that inequality tracks the stock market. It is the key determinate of inequality if you believe the data.

  4. paul davidson says:

    Also what empirical evidence are you using to say wealth inequality is more important? And who cares what CEO’s think is more important– I think it might be wonderful if the CEOs took their entire payment from their companies in the form of newly issued stock and not from the cash inflow from sales of products of the firm.
    What do you think?
    And note that CEOs are often not only using corporate cash flows to pay the large sums in “salaries” but then also use cash inflows to buy back outstanding equities after they have obtained sock options as additions to their salaries.

    • Yes liquidity is important. But when markets become illiquid the central banks step in and reflate them. So the process can go on and on via credit-cum-central bank liquidity cycles.

      Evidnce comes from the enormous study done by James Galbraith and the University of Texas. See: “Inequality and Instability”.

      • paul davidson says:

        I know about Jamie Galtraith’s study but regression analysis does not prove cause and effect.

        If one switches independent variable and dependent variable in any study one will still provide a significant statistical relation between the variables but this does not tell you which variable is cause and which is effect.

      • Yes Paul, I considered that possibility in the above post. It seems unlikely. When countries shut down finance inequality goes down. We know which way the causality runs.

      • paul davidson says:

        but when you shut down finance you are depressing the economy — and the first thing to get hit in a downward moving economy is capital income called profits! so it is still the problem of ross income changes not wealth chanes as the main cause of changes in INCOME inequality.

      • I don’t think that Brazil depressed its economy when it cut its financial sector… Nor did Argentina.

        Maybe shutting down overgrown financial services leads to downward pressure on the currency. But I don’t think it has any other effects outside of redistributing income — at least, so long as it is offset by good economic policy.

      • paul davidson says:

        well you may “rthink” what you want — but in both cases of Brazil and Argentina the economies took a dive after that.

        Paul

  5. deusdarkjaws says:

    Philip, you might remember that in the classical economists the surplus came from profits and rents…and sraffian and related traditions that delineate a social surplus and circular production (not Pasinetti) have the theoretical tools to model such a dynamic.

    • We’re dealing with rising asset prices. Not rents. Comparing ground rents based on marginal productivity of land to modern asset markets only shows how far behind the empirics the theory currently is unfortunately.

      • Deus-DJ says:

        Rent was defined in a variety of ways, and I think it is sufficiently malleable to incorporate asset pricing as long as some other assumptions are made (which need not be ad hoc and can be historical/analytical). And if you want to either talk about wealth or income distribution, then I see no reason why you would want to ignore using this powerful method of bringing together these ideas.

        With that said, I realize your focus is a little more narrow, but this post of yours is broader and that is why I brought in the benefits of using a surplus approach.

      • Yes, as I said in the piece: the Pasenetti theorem can incorporate rising asset prices as part of profits. But it can’t explain this phenomenon. And if this phenomenon is that which is causing the wealth inequality then it seems silly to have a theory of wealth inequality that cannot tackle the cause of wealth inequality. That’s the problem.

  6. Marko says:

    Debt can contribute to gdp and income growth via investment in productive activities. It can also contribute to rising asset prices , especially if you have a hyperactive financial sector , as we do today. Debt and gdp grew at roughly the same rate until about the mid 1970s , around the same time that wages started stagnating and financial liberalization accelerated. I suggest these are not merely coincidental events. This graph shows debt growth ( two flavors – domestic nonfinancial and total ) and gdp growth on the left , in logs. On the right scale is the net worth to gdp ratio ( orange plot ):

    https://research.stlouisfed.org/fred2/graph/?graph_id=163740&category_id=9418#

    Debt growth substituted for missing wages , supporting consumption , but decreasingly supporting new investment. Instead , asset prices got the juice. Today’s version of this process has companies borrowing to buy back stock and pay dividends , almost all to the benefit of the top few percent.

    Richard Werner has described this process well , and I suspect Piketty does so as well in his new book.

    Frankly , I don’t see any mysteries here. We’ve been , and continue to be , gang-raped , and mostly , without objection.

    • Debt doesn’t cause asset price rises any more than money drives GDP and inflation.

      • Marko says:

        Really ?

        Wow. Too bad you weren’t around in the 1940s to tell Minsky that , you could have saved him 50 years of wasted time developing his theory. Similarly with Irving Fisher.

      • If you think that’s Minsky’s theory then you obviously have no idea of Minsky’s theory whatsoever and are basing your opinion on some caricature you found on the internet.

        Debt is a passive entity. Like the money supply. Debt doesn’t walk out of the bank and start causing asset bubbles in the economy… Duh! I hate when people try to turn Minsky into a neo-monetarist. Such ignorance…

      • Marko says:

        From the horse’s mouth :

        “…In the deal-making that goes on between banks, invest­ment bankers, and busi­ness­men, the accept­able amount of debt to use in financ­ing var­i­ous types of activ­ity and posi­tions increases. This increase in the weight of debt financ­ing raises the mar­ket price of capital-assets and increases invest­ment. As this con­tin­ues the econ­omy is trans­formed into a boom econ­omy. ”

        http://www.debtdeflation.com/blogs/2008/03/10/time-to-read-some-minsky/

        OK , so it’s too late for you to straighten-out Minsky , but you can save the EU regulators some grief by informing them like you have me. They also think debt causes asset price increases :

        “Excessive credit growth has been identified as a key driver of asset price bubbles and subsequent financial crises, with leverage acting as an amplifying channel.”

        p.7 of “Flagship Report on Macro-prudential Policy in the Banking Sector”

        http://www.esrb.europa.eu/pub/pdf/other/140303_flagship_report.pdf?eccb199f2a077dc5e411fdca1f0c67ee

        This was just published , so there’s probably still time to get them back on the right track. Give them a call , I’m sure they’d be grateful.

      • Looks like the causal variable is a decision made by banks to increase investment in assets via increased leverage, bro. The debt incurred is a residual of that decision. Try not to play smartass when you fail at basic reading comprehension, genius.

      • Marko says:

        I think I’ve made my point sufficiently , so I’ll refrain from replying. Your readers will do their own fact-checking and reach their own conclusions. At least , I hope so.

      • If the point was that you lack basic reading comprehension skills and seem unable to interpret the causal argument at the heart of a sentence or series of sentences then you have amply demonstrated your pint.

        For those interested in Minsky’s actual views on what determines asset prices try pages 200-205 in his ‘Stabilizing an Unstable Economy’. Hint: it has to do with expected yield (i.e. animal spirits) and perceived liquidity. It has nothing to do with debt which is merely the vehicle through which assets are sometimes purchased.

        Marko, you might pick up the book from your local library or pick it up off the shelf and open it for the first time.

  7. Robert says:

    I have explained a variant of Kaldor’s model with finance here: http://robertvienneau.blogspot.com/2013/07/rate-of-profits-and-value-of-stock.html. In this model, one can solve for the ratio of share prices to the value of the underlying capital goods.

    I think Ian Steedman has done some work with balanced growth paths and foreign investment. I doubt that Paul Davidson would consider that approach “Post Keynesian”, as he means the term.

    One should be careful in interpreting causality in models of balanced growth. I am probably not careful enough in the above link.

    Also these models could be said to be very long run insofar as all classes grow at the same rate. If one class is gradually declining, with another class gradually growing, the economy is not moving about a warranted rate of growth. So one should also be careful in applying these models directly to empirical economies.

    I think of models of warranted growth as showing what must be the case for smooth growth. They are maybe useful for identifying issues that are arising in actually existing capitalism, even if they are not directly applicable.

    • Two points.

      (1) This model does not EXPLAIN rising inequality which is caused by rising asset prices. This is because you are assuming that asset prices converge on some sort of “real” rate of return in the long-run. So there is no chance that arbitrary increases in asset prices can have real redistribution effects. I.e. redistriburionary effects of changes in asset prices will disappear in the long-run.

      (2) Tied to the above, what your model actually assumes is a long-run EMH (or CAPM, if you prefer, they both contain the same ‘efficiency’ assumption). You can see this when you write:

      The ratio of the market value of stock to the value of the capital goods owned by the corporations is called the valuation ratio, v. The valuation ratio is assumed constant along a warranted growth path. Variations in the valuation ratio reflect short-term speculation.

      By assuming the long-run EMH — which Kaldor largely also assumed in his 1939 paper on speculation — you are basically saying that the market will clear out any inequalities based purely on rising asset prices. Empirically, I find this argument dubious and, frankly, pretty mainstream.

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