Saturday, February 20, 2016

Increasing inequity impeeds growth and causes deflation

Much has been written and commented on about inequity in recent years.  From the Occupy movement to the current campaign of Bernie Sanders.  Inequity has become a rallying call for many Americans who see the system as not benefiting them, while a few appear to reap all the gains of a growing economy.  Interestingly, no one that I've seen seems to have connected the growth in inequity to slow growth and deflation.  I would be interested in finding others that have examined this issue.

First a few definitions so we agree on what we're discussing.  Growth is the total change rate in real value of production in the economy, and is usually expressed as the change in GDP.  The measure of growth is thus truly economic as the effect of inflation (or deflation) is removed from the value.  Inflation (or deflation) is the change rate in the nominal price of a set basket of goods and services.  So, that the actual goods and services received are the same and the change in the total price is measured.

The increasing nature of inequity that is a driver of slow growth and deflation.  This is tied to long term debt that people have incurred over the previous decades.  This primarily includes mortgages and student loans, but some other debt like auto loans may also contribute.  When these debts were incurred decades ago the distribution of incomes was skewed more toward what we call the middle-class.  Workers in the economy brought home a greater percentage of the GDP compared to the highest earners in the economy.  These are the so called "1%" who's share of GDP has grown significantly over the last few decades as has been documented in many places.

The effect of a higher relative income in past decades is that people took on long term debts with the expectation that their incomes would continue to grow as they had for the previous decades.  When incomes failed to keep rising as they had in the past, i.e. inequity increased, people thought is temporary and took on yet more debt to maintain the life styles to which they had become accustomed.  Eventually, the lack of rising incomes and growing inequity led to an inability to pay the monthly payments on those large debts, and crisis ensued. 

This phenomena of growing inequity continues today with wages growing slowly relative to the economy and long terms debts slowly being paid down to levels that can be supported by the new expectation of future incomes.  These effects are deflationary for two reasons: first, the basket of goods and services that is used to measure inflation are mainly comprised of the very items that these middle-class members consume.  So, perhaps at better label would be "middle-class inflation" for what is measured.  Second, people are paying down their long term debt and have little additional money to spend on these goods and services, so their is little demand pricing pressure to push prices up.  Perhaps if the measures of inflation included more high luxury goods then the reported inflation would be rising at a faster rate that is more inline with the desires of policy makers.  In this case goods such as trendy art, super yachts, and mega-mansions would need to be included in the rate.

Growth suffers for similar reasons.  The distribution of goods and services planned for production still reflects the demands of the middle-class from years ago.  So, with the inability of this class to consume at a higher level with their constrained incomes growth stagnates.  To remedy this situation manufacturers can shift quicker away from producing middle-class goods and services to those that are consumed by the "1%".  Or we can simply wait for deflation to reduce the price of goods for the middle-class to a level where their incomes will allow them to consume more.  The economy is shifting toward a new steady state of lower relative incomes.  Until that new state is achieved the effects will be observed as low growth and deflation (or low inflation).

In any case, it is the lack of demand from middle-class consumers that is limiting both growth and causing deflation (or low inflation).  A shift in incomes from the "1%" back to the middle-class, as was the condition decades ago, will allow the middle-class to consume more.  This will have the twofold effect of raising prices as consumers compete to buy goods and services, thus eliminating deflation, and increasing growth as the increase in demand and subsequently prices will spur manufactures to increase production to satisfy that increasing demand.  This will contribute to a virtuous cycle of increased employment as manufactures hire to increase production which will in turn increase incomes which will in turn increase demand.

Tackling inequity is central to fixing the economy.  Fixing the economy is central to fixing the financial problems.  Changes to Federal government policies is central to both.

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