Commentary on Political Economy

Thursday, 27 July 2023



Income inequal­ity means US debt will con­tinue to increase

While much of the debate about lim­it­ing US gov­ern­ment debt assumes that rising debt is a con­sequence of prof­ligacy on the part of Wash­ing­ton poli­cy­makers, the prob­lem is in fact struc­tural.

Amer­ic­ans are forced to choose between rising debt and higher unem­ploy­ment largely because of the level of income inequal­ity — exacer­bated by their large trade defi­cit — that has sharply reduced the demand for US busi­nesses and man­u­fac­tur­ers.

The rise in US income inequal­ity is the key driver of debt. Because the wealthy save a much lar­ger part of their income than do work­ers or the middle class and use a much smal­ler part for con­sump­tion, rising income inequal­ity reduces over­all con­sump­tion and forces up sav­ings by effect­ively trans­fer­ring income from high con­sumers (ordin­ary Amer­ic­ans) to high savers (the wealthy).

If the higher sav­ings fun­ded higher invest­ment by US busi­nesses, this would be a good thing for the eco­nomy. Lower con­sump­tion would be bal­anced by higher invest­ment, with total demand remain­ing the same in the short term and rising in the longer term as more invest­ment caused growth to accel­er­ate.

But must more sav­ings lead to higher invest­ment? This belief is at the heart of sup­ply-side eco­nom­ics but, while it was true many dec­ades ago when busi­ness invest­ment was mainly con­strained by scarce sav­ings and the high cost of cap­ital, it is no longer true today — when it is con­strained mainly by weak demand.

Busi­ness invest­ment has not risen in line with the sav­ings of the wealthy. This cre­ates a prob­lem for the eco­nomy. If lower con­sump­tion is not bal­anced by higher invest­ment, total demand must decline and in response busi­nesses will cut back on pro­duc­tion and fire work­ers. To pre­vent this hap­pen­ing, Wash­ing­ton typ­ic­ally does one of two things.

First, the US Fed­eral Reserve can imple­ment policies that encour­age house­hold bor­row­ing to fund addi­tional con­sump­tion. In that case, the reduc­tion in the income share of ordin­ary Amer­ic­ans is bal­anced by an increase in their bor­row­ing so the same level of con­sump­tion can be main­tained.

Second, Wash­ing­ton can itself bor­row and use the pro­ceeds to replace the demand lost by the reduc­tion in house­hold con­sump­tion. Bor­row­ing is effect­ively the oppos­ite of sav­ing and, by increas­ing the fiscal defi­cit, the US can undo the adverse con­sequences of rising sav­ings among the wealthy.

There is a third option for many eco­nom­ies. If a coun­try’s sav­ings rise faster than its invest­ment — or if demand declines rel­at­ive to pro­duc­tion — it can export the excess pro­duc­tion in the form of a trade sur­plus.

But the US can­not do this. Because of its open and well-gov­erned fin­an­cial mar­kets, the rest of the world prefers to off­load its excess sav­ings there so the US is a net importer, not a net exporter, of sav­ings.

This will hap­pen as long as for­eign cent­ral banks, busi­nesses, olig­archs and own­ers of fin­an­cial assets can employ their sur­pluses in unfettered access to Amer­ican stocks, bonds, factor­ies and real estate.

These net inflows push up the value of the dol­lar and make US man­u­fac­tur­ing less com­pet­it­ive, so rather than run trade sur­pluses to man­age excess sav­ings, the weak demand cre­ated by income inequal­ity is exacer­bated as Amer­ica runs the trade defi­cits needed to absorb excess for­eign pro­duc­tion.

To stop unem­ploy­ment rising, either the Fed must encour­age even more house­hold debt or Wash­ing­ton must run even lar­ger fiscal defi­cits.

The mis­take law­makers make is to assume that rising debt in the US is the con­sequence of irre­spons­ible beha­viour on the part of Amer­ican house­holds and the gov­ern­ment. In fact, it is a struc­tural prob­lem, and the choice Amer­ic­ans face is not between more debt and less debt but rather between more debt and more unem­ploy­ment.

As long as Amer­ic­ans are will­ing to accept high levels of income inequal­ity and large trade defi­cits, this is the tradeoff the US must con­tinue to suf­fer.

To get debt under con­trol without rais­ing unem­ploy­ment, Amer­ic­ans must elim­in­ate down­ward pres­sure on demand by revers­ing sev­eral dec­ades of policies that favour income inequal­ity or that allow for­eign­ers to dump their excess sav­ings and excess pro­duc­tion into the US.

That is why for all the excited debate, debt ceil­ings won’t limit the rise in US debt. They just allow Con­gress to pre­tend that it is doing something mean­ing­ful about Amer­ica’s sur­ging debt bur­den.

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