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.