Why U.S. Debt Must Continue to Rise?
Many Americans are worried about the seemingly
inexorable rise in U.S. debt, whether government debt, household debt, or
business debt. They are right to be concerned. Rapidly rising debt is a problem
not just in the United States but in many other countries too, including China,
parts of Europe, and most of the developing world. In today’s environment, it
seems, reasonable levels of economic growth cannot be achieved unless boosted
by even faster growth in debt.
With so much debt in the world, and with debt
levels rising so quickly, people tend to think that economists have studied
this issue deeply and fully understand it. But there continues to be a great
deal of confusion about debt and about whether and why excessive debt levels
can harm growth prospects. To try to address these issues, this blog post is
divided into two parts. The first part discusses debt and some of the
conditions under which it affects the prospects for economic growth.
The second part argues that at least two of
the reasons that debt has been rising inexorably in the United States for
several years are the country’s rising income inequality and its persistent
trade deficit. Surprising as it may seem at first glance, these two conditions
operate the same way: they distort the level and structure of American savings.
As long as income inequality remains high and the United States runs large
deficits, the resulting savings distortions will continue to mean that U.S.
debt levels have to rise to prevent the economy from slowing and unemployment
from rising.
WHY DEBT MATTERS.
What are productive and
nonproductive debt?
To begin with, broadly speaking, debt can be
divided into two types:
Self-liquidating debt is used to fund investment projects that
increase economic productivity enough (after including all associated positive
and negative externalities) to service the debt fully. In such cases, an
increase in debt is used to create an equal or greater increase in assets.
While this usually leaves the overall economy better off, there could still be
an argument about whether it is best to fund a particular project with debt
(versus equity), about the best (or least risky) way of structuring the
borrowing, and about how the debt and its subsequent repayment affects income
distribution.
All other debt funds household consumption,
nonproductive government activities (such as military spending, welfare
programs, and other kinds of consumption on behalf of households), and
nonproductive investment by either the government or businesses. In some cases,
this debt can have a positive impact on economic welfare, such as when debt is
used to smooth out consumption over a person’s life cycle. In other cases, it
can be positive or negative for economic well-being or for overall economic
growth depending on how it affects the way income is distributed. (Indeed, this
is one of its least understood but most important functions.)
Self-liquidating debt adds to the total debt
in the economy, but rather than heighten the economy’s debt burden it usually
reduces the burden by increasing the wealth or productive capacity created by
the project by more than the cost of the project. The most common form this
debt takes is business investment or government investment in infrastructure. I
say that this type of debt usuallyreduces a country’s debt burden,
rather than saying it alwaysdoes, because this may not be the case
if the debt is badly structured; if, for instance, debt servicing costs are
severely mismatched relative to a project’s net increase in production, such a
project can raise uncertainty in ways that adversely affect the rest of the
economy.
But, except in cases of very badly structured,
highly inverted debt, self-liquidating debt is ultimately sustainable because it
allows economic actors to service the rise in debt by more than the associated
debt-servicing costs. In principle, this means that the debt can be repaid
fully out of the additional value created, leaving everyone better off in the
aggregate. That said, it is possible in some instances that certain sectors of
the economy would benefit disproportionately and other sectors would be worse
off, with the winners exceeding the losers.
Debt that is not self-liquidating increases
the total debt in the economy and, because it doesn’t improve debt-servicing
capacity, usually adds to the economy’s debt burden. Again, I say usuallyrather
than alwaysbecause, in some cases, this second kind of debt leaves
the economy’s debt burden no worse off (if the debt is used for consumption
smoothing, for instance); in other cases, such debt can even reduce the debt
burden if the debt redistributes wealth in ways that increase the economy’s
wealth-producing capacity.
Debt that isn’t self-liquidating is
necessarily serviced only through implicit or explicit transfers from one
economic sector to another. In such cases, the borrower can service the debt by
appropriating income from other projects, including taxes if the borrower is
the government. If the borrower defaults, on the other hand, the debt-servicing
cost is transferred to the creditors.
There are other ways that governments, in
particular, can service such debt by effectively transferring the cost. The
debt can be eroded by inflation, in which case the debt-servicing cost is effectively
forced onto those who are long monetary assets, mainly households that save in
the form of bonds, bank deposits, and other interest-sensitive assets. If wages
are forced down to make it easier for businesses or governments to service
their debts, the debt-servicing cost is forced onto workers. If government debt
is serviced by expropriation, the debt-servicing cost is forced onto the rich
or onto foreigners. One way or another, in other words, this kind of debt is
serviced by explicitly assigning or implicitly allocating the costs by way of a
transfer of wealth.
Is excessive debt bad for
the economy?
Unfortunately, few economists seem able to
explain coherently why a heavy debt burden can be harmful to the economy. This
statement may seem surprising, but ask any economist why an economy would
suffer from having too much debt, and he or she almost always responds that too
much debt is a problem because it might cause a debt crisis or undermine
confidence in the economy. (Not only that, but how much debt is considered too
much seems to be an even harder question to answer.)
But this is clearly a circular argument.
Excessive debt wouldn’t cause a debt crisis unless it undermined economic
growth for some other reason. Saying that too much debt is harmful for an
economy because it might cause a crisis is (at best) a kind of truism, as
intelligible as saying that too much debt is harmful for an economy because it
might be harmful for the economy.
What is more, this sentiment isn’t even
correct as a truism. Admittedly, countries with too much debt can certainly
suffer debt crises, and these events are unquestionably harmful. But as British
economist John Stuart Mill explained in an 1867 paper for the Manchester Statistical Society,
“Panics do not destroy capital; they merely reveal the extent to which it has
been previously destroyed by its betrayal into hopelessly unproductive works.”
While a crisis can magnify an existing problem, the point Mills makes is that a
crisis mostly recognizes the harm that has already been done.
Yet, paradoxically, too much debt doesn’t
always lead to a crisis. Historical precedents clearly demonstrate that what
sets off a debt crisis is not excessive debt but rather severe balance sheet
mismatches. For that reason, countries with too much debt don’t suffer debt
crises if they can successfully manage these balance sheet mismatches through a
forced restructuring of liabilities. China’s balance sheets, for example, may
seem horribly mismatched on paper, but I have long argued that China is
unlikely to suffer a debt crisis, even though Chinese debt has been excessively
high for years and has been rising rapidly, as long as the country’s banking
system is largely closed and its regulators continue to be powerful and highly
credible. With a closed banking system and powerful regulators, Beijing can
restructure liabilities at will.
Contrary to conventional wisdom, however, even
if a country can avoid a crisis, this doesn’t mean that it will manage to avoid
paying the costs of having too much debt. In fact, the cost may be worse:
excessively indebted countries that do not suffer debt crises seem inevitably
to end up suffering from lost decades of economic stagnation; these periods, in
the medium to long term, have much more harmful economic effects than debt
crises do (although such stagnation can be much less politically harmful and
sometimes less socially harmful). Debt crises, in other words, are simply one
way that excessive debt can be resolved; while they are usually more costly in
political and social terms, they tend to be less costly in economic terms.
What are the actual costs
of excessive debt?
So why is excessive debt a bad thing? I am
addressing this topic in a future book. To put it briefly, there are at least
five reasons why too much debt eventually causes economic growth to drop
sharply, through either a debt crisis or lost decades of economic stagnation:
·
First, an increase in
debt that does not generate additional debt-servicing capacity isn’t
sustainable. However, while such debt does not generate real wealth creation
(or productive capacity or debt-servicing capacity, which ultimately amount to
the same thing), it does generate economic activity and the illusion of wealth
creation. Because there are limits to a country’s debt capacity, once the
economy has reached those limits, debt creation and the associated economic
activity both must decline. To the degree that a country relies on an
accelerating debt burden to generate economic activity and GDP growth, in other
words, once it reaches debt capacity limits and credit creation slows, so does
the country’s GDP growth and economic activity.
·
Second, and more
importantly, an excessively indebted economy creates uncertainty about how
debt-servicing costs are to be allocated in the future. As a consequence, all
economic agents must change their behavior in ways that undermine economic
activity and increase balance sheet fragility. This process, which is analogous
to financial distress costs in corporate finance theory, is heavily
self-reinforcing.
·
Some countries—China
is probably the leading example—have a high debt burden that is the result of
the systematic misallocation of investment into nonproductive projects. In
these countries, it is rare for these investment misallocations or the
associated debt to be correctly written down. If such a country did correctly
write down bad debt, it would not be able to report the high GDP growth numbers
that it typically does. As a result, there is a systematic overstatement of GDP
growth and of reported assets: wealth is overstated by the failure to write
down bad debt. Once debt can no longer rise quickly enough to roll over existing
bad debt, the debt is directly or indirectly amortized, and the overstatement
of wealth is explicitly assigned or implicitly allocated to a specific economic
sector. This causes the growth of GDP and economic activity to understate the
real growth in wealth creation by the same amount by which it was previously
overstated.
·
Insofar as the excess
debt is owed to foreigners, its servicing costs represent a real transfer of
resources outside the economy.
·
To the extent that the
excess debt is domestic, its servicing costs usually represent a real transfer
of resources from economic sectors that are more likely to use these resources
for consumption or investment to sectors that are much less likely to use these
resources for consumption or investment. In such cases, the intra-country
transfer of resources represented by debt-servicing will reduce aggregate
demand in the economy and consequently slow economic activity.
Does debt affect demand?
Except for economies in which all
resources—including labor and capital—are fully utilized and for economies that
have no slack (unutilized resources and labor), increases in debt can boost
current domestic demand, although not always sustainably. When households
borrow, for example, they usually do so either to buy homes or to increase
consumption. I am not sure how much of home buying in the United States spurs
new construction and how much represents sales of existing homes, but, in the
latter case, the borrowing creates no new demand for the economy, except to the
extent that the seller uses the proceeds of a home sale to increase
consumption.
Of course, insofar as borrowing for
consumption directly increases aggregate demand by increasing consumption
today, the repayment of such borrowing reduces consumption tomorrow. This is
another area that seems to confuse economists enormously. Standard economic
theory states that borrowing simply transfers spending from the lender to the
borrower, and that repaying debt reverses these transfers. In such instances,
no new demand is created by borrowing nor is it extinguished by repaying.
But this is only true for an economy that is
fully utilizing its labor, capital, and other resources and in which investment
is constrained by high costs of capital. In such cases, borrowers must bid up
the cost of capital to gain access to savings and, in so doing, they prevent
someone else from employing these resources. This is when borrowing has no net
impact on total demand: it simply transfers spending from one part of the
economy to another, and the only thing that matters for the health of the
economy is how efficient any particular use of savings might be and what impact
that use has on long-term growth.
But for an economy with substantial slack
whose investors are reluctant to engage in new investment because of
insufficient demand, borrowing does create additional demand, while future
repayment usually reverses this added demand. Among the three types of
borrowing— household, government, and business—household borrowing is not
self-liquidating and directly increases the country’s debt burden. This is
because aggregate debt rises with no increase in the country’s debt-servicing
capacity or productive capacity, except to the extent that the borrowing
encourages businesses to invest in manufacturing capacity.
Increases in government debt, similarly, do
not result in equivalent increases in debt-servicing or productive capacity,
except insofar as government borrowing is used to fund investment in productive
infrastructure. If used to fund consumption, household transfers, military
spending, and so on, government debt can boost current domestic demand without
boosting debt-servicing capacity or productive capacity, an increase in
domestic demand that must later be reversed.3
Increases in business debt, on the other hand,
do usually fund productive investment, so these increases usually boost
debt-servicing or productive capacity. When businesses borrow capital, however,
for stock buybacks, to pay down other debt, to cover losses, or for
nonproductive investment projects (usually subsidized by governments), this
debt functions just like household borrowing for consumption in the sense that
it is not self-liquidating.
HOW AMERICAN SAVINGS ARE
DISTORTED.
Two reasons for rising
U.S. Debt.
I have no way of calculating the extent to
which recent increases in U.S. debt have funded productive or nonproductive
activity, but a substantial portion of increases in American debt over the past
several years is probably (almost certainly) unsustainable and not self-liquidating.
This is because rising debt is needed to keep growth in economic activity high
enough to prevent a rise in unemployment.
Economists don’t generally distinguish between
growth in economic activity (which is mostly what GDP measures) and growth in
economic wealth or in wealth-producing capacity. They tend simply to equate the
two. While the two may be equal over the long run, however, over shorter
periods they are not necessarily equal, given that the former can exceed the
latter especially as a consequence of an unsustainable increase in debt.
I will not pretend to offer a complete
analysis of debt in the U.S. economy here, but there are at least two reasons
that the United States has no choice but to encourage an increase in debt to
prevent a rise in unemployment. The first reason is the U.S. role in the global
balance-of-payments system and the second one is high levels of U.S. income
inequality. Although these two factors seem like two different things, they
work in the same way and for the same reasons.
Why trade deficits
actually matter.
I have explained many times before that the
United States runs trade deficits mainly because the rest of the world exports
its excess savings there. Standard trade theory suggests that, under normal
conditions, the United States should run persistent trade surpluses, as I will
explain in my next blog post. But because of distortions in income distribution
in the rest of the world, developed economies suffer from excess savings and
insufficient demand.
The way this works is straightforward although
it may seem counterintuitive at first. There are two ways to boost
international competitiveness, which in a highly globalized world can lead
automatically to higher growth. The high road is to boost domestic productivity,
typically by investing in needed infrastructure, education, and technology. The
low road is to reduce relative wages, something that can be done directly or
indirectly. The direct approach is to lower wages or wage growth as, for
example, Germany did during and after the Hartz reforms of 2003–2005. An
indirect way of achieving the same effect is for a country to hold down the
value of its currency by doing things like imposing explicit or hidden tariffs,
subsidizing production factors at the expense of households, or increasing
household transfers to other sectors of the economy.
The low road is, of course, easier to embark
on quickly, and it effectively entails reducing the household share of what a
country produces: directly or indirectly, in other words, households receive
less total compensation for producing a given amount. The problem with this low
road approach is that it reduces total demand. As households receive a lower
share of GDP, they consume a lower share. Unless there is a commensurate rise
in investment, the result is that a country is less likely to be able to absorb
everything it produces.
In a closed economy, or one in which
international trade and capital flows are limited by high frictional costs, a
country that produces more than it can absorb domestically must allow unwanted
inventory to pile up until, once debt limits are reached, it must close down
production facilities and fire workers. In a highly globalized world, however,
where the frictional costs of international trade and capital flows are
extremely low or even nonexistent, it is much easier for such a country to
export both the excess production and the excess savings.
This is the problem. Policies that increase
international competitiveness by lowering the household share of GDP reduce
total demand within such countries, but these policies also allow these
countries to gain a larger share of foreign demand. This is the tradeoff that
makes this arrangement work for the surplus country: while domestic demand
shrinks, the surplus country more than makes up for it by increasing its share
of what is left, at the expense of its trade partners.
Whether this state of affairs benefits or
harms the global economy depends primarily on where the excess savings are
exported. If they are exported to a developing country whose domestic
investment needs are constrained by insufficient domestic savings, they can
cause a boost in productive investment that increases the recipient country’s
domestic demand. In such cases, the net effect on the world is usually
positive. If the increase in investment in the recipient country is greater
than the reduction in consumption in the exporting country, the world is better
off, although there may still be legitimate disputes about distribution
effects.
But if the excess savings are exported to an
advanced economy whose domestic investment needs are not constrained by an
inability to access domestic savings, these savings do not result in an
increase in investment, so the world is left with lower demand. As I will
explain below (see Where Might This Argument Be Wrong?), when
excess savings flow into the United States, these savings do not cause
investment to rise. This is a classic case of beggar-thy-neighbor policies, in
which one country benefits at the greater expense of its trade partners.
Much of the world’s excess savings flow to
rich countries where these funds are not needed, rather than to developing
countries that can use them productively. It is typically the countries with
the most open, most flexible, and best-governed financial markets that end up
on the receiving end, mainly the so-called Anglo-Saxon economies and especially
the United States. The United States runs capital account surpluses, in other
words, not because it is capital short, but because the world has excess
savings and the United States is the leading safe haven into which to hoard
these savings.
Some observers might object to this
interpretation. After all, they might say, doesn’t the United States have a low
savings rate, well below its investment rate? And doesn’t that prove that the
United States needs foreign savings?
Not necessarily. While this was the case in
the nineteenth century, when the United States imported capital because it
lacked sufficient domestic savings to fund its investment needs, it is no
longer true in the twenty-first century. Rather than assuming, as most
economists still do, that the United States imports foreign savings because
U.S. savings are too low, it is vital to recognize that U.S. savings are low because
the United States imports foreign savings.
This is because a country with a capital
account surplus must, by definition, run a current account deficit, and because
investment in that country must, also by definition, exceed savings. Most
economists see this tautology and mistakenly assume an automatic direction of
causality in which foreign capital inflows drive U.S. investment above the
level of U.S. savings. The main reason for this assumption, it turns out, is
because if inflows don’t drive up investment, they must drive down savings, and
people have a difficult time understanding how foreign capital inflows can
drive down savings. But, as I will show later (see What Drives Down
Savings?), there is nothing mysterious or unlikely about this process.
Why income inequality
matters.
It may seem surprising at first that income
inequality has the same economic impact as forced imports of foreign capital.
By itself, income inequality tends to force up the savings rate, simply because
rich households save more than ordinary or poor households. Put differently, if
$100 is transferred from an ordinary American household, which consumes perhaps
80 percent of its income and saves 20 percent, to a rich household, which
consumes around 15 percent of its income and saves 85 percent, the initial
impact of the transfer is to reduce consumption by $65 and increase desired
savings by the same amount.
But that is not the end of the story. In any
economic system, savings can only rise if investment rises. If the United States
cannot invest the additional savings—for reasons which I will discuss below
(again, see Where Might This Argument Be Wrong?)—if rising income
inequality causes U.S. savings in one part of the economy (the rich household
that benefitted from the increase in savings) to rise, this must also cause
savings in some other part of the economy to decline.
Again, the point is fairly simple. Total
savings cannot rise unless these savings are invested. If savings in one part
of the economy rise because of a transfer of wealth from poorer households to
richer households, and if this does not cause investment to rise, this very
transfer must then repress savings in another part of the economy. Notice how
similar this is to the way the trade deficit works: rising savings in one part
of the world are exported to the United States and cause savings in the United
States to decline. In either case, if investment doesn’t rise, savings cannot
rise, so an increase in savings in one sector or country must cause a reduction
of savings in another.
What drives down savings?
There are many ways that the import of foreign
savings or the additional savings of the rich can drive down savings in the
overall economy.
·
Net capital inflows
may strengthen the dollar to a level far higher than it would otherwise be.
Currency appreciation, by increasing the value of household income at the
expense of the tradable goods sector, forces down a country’s savings rate, in
effect increasing the household share of GDP and, with it, usually the consumption
share.
·
U.S. unemployment may
be higher than it otherwise would be because of cheap foreign imports that help
create the U.S. current account deficit or because income inequality drives
down consumer demand (and with it, perhaps, investment). Unemployed workers
have a negative savings rate as they consume out of their savings, so rising
unemployment would drive down the savings rate.
·
If that happens,
unemployment would require more government borrowing to fund larger fiscal
transfers, most of which would cause consumption to rise and savings to
decline.
·
To reduce
unemployment, the U.S. Federal Reserve might expand credit and the money
supply, encouraging additional borrowing.
·
The capital inflows,
or looser monetary policy, may inflate the prices of real estate, stocks, and
other American assets, even setting off asset bubbles, a recurring response
(historically speaking) to substantial capital inflows. Higher asset prices can
make Americans feel richer, creating a wealth effect that drives up consumption.
·
The consequent boost
in real estate prices could set off additional real estate development, some of
which might be economically justified and some that might not be. Technically,
this would not be a reduction in savings but rather an increase in investment,
but it would have the same net impact on the capital account.
·
To the extent that
some real estate development turns out to be economically unjustified, in
future periods it may be written down, with the losses representing a reduction
in the total stock of savings.
·
U.S. banks and shadow
banks, flush with liquidity and needing to create loans, may lower lending
standards and give loans to households that would otherwise be perceived as too
risky. As long as there is a normal distribution of risk-taking and optimism
among American households—and this is the case in every country—whenever banks
lower their consumer lending standards, there are households who take out loans
and spend the proceeds on additional consumption, driving down savings.
·
Credit card companies
and consumer finance companies with abundant liquidity may make consumer credit
more widely available and at cheaper rates than they otherwise would.
Notice that these numerous methods of driving
down the savings rate can be summarized as one of two: either unemployment
rises or debt rises. Because Washington is likely to respond to a rise in
unemployment by increasing the fiscal deficit or loosening credit conditions,
in the end, the result of rising income inequality and trade deficits is almost
always that debt rises faster than it otherwise would.
That shouldn’t be surprising. Another way of
looking at it is that both trade deficits and high income inequality reduce
domestic demand, so returning the economy to its expected growth rate requires
a new source of demand, and this new source is almost always generated by debt.
By the way, this explains in part why economists are generally unable to find a
correlation between the trade deficit and unemployment, or between income
inequality and unemployment. Rather than cause unemployment to rise, these
conditions can simply force an increase in debt.
Where might this argument
be wrong?
This is a purely logical argument, so it would
be wrong only if any of the underlying assumptions are wrong. The main such
assumption is whether investment is not constrained by savings.
The standard argument is that investment is
always constrained by savings and that forcing up savings is positive for
investment because, even in economies with abundant savings and low interest
rates, it lowers the cost of funding, however marginally. If businesses can
borrow at a lower rate than before, the argument goes, there always will be
some productive investment opportunity that only becomes profitable at this
new, lower borrowing cost. This outcome must lead to more investment, which
should lead to more growth over the long run.
This is the basic argument behind supply-side
economics and the implicit justification for President Donald Trump’s recent
tax cuts. Most economists agree that investment levels in the United States are
low (probably too low) and that the United States would grow faster over the
long term if businesses could be encouraged to invest more. Given that one of
the most efficient ways to boost investment is presumably to make more capital
available to businesses at lower costs, tax cuts for the rich would
theoretically benefit the rest of the country eventually, as the additional
wealth generated by higher investment trickled down.
Can policies that result in greater income
inequality nonetheless leave a country better off? It turns out that the
answer, again, depends on the availability of savings in the economy. In a
capital-scare environment, like a typical developing economy, policies that
force up the domestic savings rate can result in a substantial, one-for-one
increase in domestic investment for every unit reduction in consumption. In
such a case, total demand is unchanged (since lower consumption is matched by
higher investment); the economy grows as quickly as ever in the short run while
getting wealthier in the long run.
However, this isn’t necessarily the case in a
capital-rich environment like most advanced economies today. In recent years,
the financial system has been awash with liquidity, interest rates have been at
all-time lows, and U.S. corporations have been sitting on hoards of cash that
they seem unable to put to productive use. In such cases, most economists would
agree that every unit reduction in consumption is likely to be matched by a
smaller increase in investment, so in the short run total demand would decline.
This means that supply-side policies can
reduce short-term growth in the United States because these policies cause a
drop in total demand (assuming that lower consumption is only partially matched
by higher investment). Nonetheless, as long as at least part of the reduction
in consumption is matched by an increase in productive investment, it is still
possible to argue that the country would be better off in the long run because
investment increases productive capacity. In such cases, the rich benefit
immediately from tax cuts for the rich, while the rest of society benefits
eventually.
But, counterintuitively for most economists,
it might be a mistake to assume that, insofar as supply-side policies increase
the availability of capital and lower its cost, conditions that force up the
desired savings rate must always lead to additional investment. There are
conditions under which such policies may actually lead to less investment, and
this outcome is especially likely today in most advanced economies.
All it requires is that, broadly speaking, all
or most investment falls into one of two categories. The first category
consists of projects whose value is not sensitive to marginal changes in
demand, perhaps because they bring about very evident and significant increases
in productivity, or because the economy suffers from significant
underinvestment. The second category consists of projects whose value
ultimately varies as a function of changes in demand.
In the former case, these projects—often in
infrastructure—are typically and for obvious reasons more likely to be found in
developing countries in which capital is scarce than in today’s advanced
economies. In the early 1980s, for example, China reportedly had only a handful
of commercial airports. A country as big as China urgently needed far more than
it had, so it could be argued that whether China was expected to grow at 10
percent annually, 5 percent, or even zero percent, it nonetheless needed
additional airport capacity. In that case, the need to invest is not sensitive
to the expected growth in demand.
At some point, however, once China has filled
the obvious airport gap, whether or not the country needs to build more airports
depends on its growth prospects. A rapidly growing China will need more
additional airport capacity than a slow-growing China, in which case investment
in airports would fall into the second category, which consists of projects
whose profitability is sensitive to demand conditions.
By dividing investment into these two
categories, it becomes clear that policies that aim to force up desired savings
and constrain consumption can have two contradictory effects on total
investment:
·
Forcing up savings
increases investments that aren’t sensitive to marginal changes in demand by
making more capital available at lower costs.
·
Constraining
consumption, however, reduces investments that are sensitive to marginal
changes in demand by lowering the demand that drives the profitability of such
investments.
What matters is simple arithmetic: the
relative size of these two categories. In economies where only some investment
is sensitive to demand fluctuations and most investment isn’t (most developing
economies), conditions like income inequality that boost the savings rate can
lift total investment and, by extension, long-term growth.
But in economies where the profitability of
most investments is a function of changes in demand, income inequality can
result in less total desired investment, rather than more. Greater capital
availability at lower interest rates may cause certain additional marginal
investments to be made, but the resulting increase in investment can easily be
overwhelmed by a reduction in investment set off by slower consumption growth.
Put differently, if U.S. companies are
reluctant to invest not because the cost of capital is high but rather because
expected profitability is low, they are unlikely to respond to the trade-off
between cheaper capital and lower demand by investing more. With less
consumption, businesses that manufacture consumer goods are more likely to
close down factories or postpone investment plans.
The claim that higher desired savings can lead
to less investment may at first sound outlandish, and Marriner Eccles
(1890–1977), a former chairman of the Federal Reserve Board, struggled to make
just this point in the 1930s. This seems to be what happened in Germany after
the Hartz reforms as well. As income was transferred from German workers to
German businesses in the form of soaring profits, income inequality in Germany
worsened. As expected, German savings rose, but (unexpectedly) investment
actually declined, perhaps in partial response to the increase in savings.
The same seems to have happened in the United
States following last year’s $1.5 trillion tax cut by the Trump administration.
As an article this week in Reutersreminds
us:
The White House had predicted that the massive
fiscal stimulus package, marked by the reduction in the corporate tax rate to
21 percent from 35 percent, would boost business spending and job growth. The
tax cuts came into effect in January 2018.
But rather than cause an increase in business
investment, the tax cuts seem to have had no impact, or even a slightly
negative one, which shouldn’t come as a surprise if American businesses already
had access to as much capital as they needed:
The National Association of Business
Economics’ (NABE) quarterly business conditions poll published on Monday found
that while some companies reported accelerating investments because of lower
corporate taxes, 84 percent of respondents said they had not changed plans.
That compares to 81 percent in the previous survey published in October.
…The NABE survey also suggested a further
slowdown in business spending after moderating sharply in the third quarter of
2018. The survey’s measure of capital spending fell in January to its lowest
level since July 2017. Expectations for capital spending for the next three
months also weakened.
What can be done?
Given these facts, the expected effects of
income inequality and capital account surpluses (and the accompanying trade
deficits) on the U.S. economy all depend almost exclusively on what people
assume about investment. If policies or conditions that increase savings cause
U.S. investment to rise, then income inequality and capital account surpluses
(trade deficits) can be positive for American growth. If not, these effects
will necessarily either increase U.S. unemployment or, more likely, U.S. debt.
So assuming that income inequality and capital
account surpluses (trade deficits) are not positive for American growth, what
can the United States do to mitigate these effects?
1.
Limit
foreign capital inflows.
The United States must reduce its trade deficit with the world, but not by
addressing the trade deficit directly through import tariffs or quotas.
Remember that because the U.S. trade deficit is the automatic consequence of
the U.S. capital account surplus, as long as the country is forced to import foreign
capital, it will run a trade deficit, meaning that debt must rise if the
country is to avoid a rise in unemployment. Import tariffs or quotas will only
reduce the U.S. trade deficit to the extent that they reduce foreign capital
inflows. And it is not at all clear that they will do so—in fact, they are at
least as likely to increase inflows. Instead, the United States must address
foreign capital inflows directly, perhaps by taxing them.
2.
Reverse
income inequality. There are many ways
in which the United States can reverse income inequality. Washington could make
the income tax code more progressive, for example, strengthen the country’s
social safety net, raise minimum wages, or increase infrastructure spending.4
3.
Force
up productive investment domestically. If the US decides that it cannot choose but to tolerate high
levels of income inequality and run large capital account surpluses, it can at
least decide to match the resulting increase in savings availability with
higher investment, especially by boosting funding for infrastructure. In this
way keeping unemployment from rising doesn’t require that debt rise. Otherwise,
debt must continue to rise to prevent savings to adjust in the form of high
unemployment.
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