"The poor don't have enough income to save, and can't help going into debt to the rich. Debt is caused by inequality".
That statement is wrong on many levels. It's wrong theoretically. It's wrong empirically. But most of all, it's wrong because it might make inequality worse. It's the soft bigotry of low expectations. Providence is especially important to the poor. Saying that the poor can't help but be improvident is the last thing they need to hear.
(This post will piss some people off. "Nick's blaming the poor; of course they can't help either their poverty or their lack of saving!")
If we want a policy that will promote equality of income we should do it because it's a good policy in its own right; not because of some spurious argument about reducing debt. And the sort of policy that would help attain that objective in the long run is one which encourages a higher savings rate by the poor than by the rich. For example: a policy that increased the after-tax rate of return on savings for the poor, relative to the rich. Canada's Tax Free Savings Account (everybody is allowed to save $5,000 per year tax-free) might be such a policy.
Let's start with theory.
A lot of debt is used to finance investment. In physical capital, houses, education, etc. But let's set that aside, because it's not what I am talking about here. I am talking about the distribution across the population of consumption and savings, not investment. Whether those savings are lent to others or used to finance one's own investment is a separate question.
Economic theory of the consumption/saving decision is based on intertemporal utility maximisation. Milton Friedman's Permanent Income Hypothesis is a simplified version of this. If you consume less today you can consume more tomorrow. You compare the marginal utility of present consumption to the marginal utility of future consumption. You compare your personal subjective rate of time preference (your degree of patience or subjective discount rate) to the market rate of interest at which you can borrow or lend.
This theory says that people who have a low rate of time preference (who are more patient) will tend to save, while those who have a high rate of time preference will dissave (have negative saving).
This theory says that people who have temporarily high income will tend to save, while those who have temporarily low income will dissave. Because if they didn't, and just consumed their current income every period, their marginal utility of consumption in good times would be lower than their marginal utility of consumption in bad times. We save and dissave to smooth consumption over time.
This theory does not say that people who have permanently high income will tend to save, while those who have permanently low income will tend to dissave. Consumption depends on permanent income. But the proportion of your permanent income you consume (and hence the proportion you save) need have no relation with the level of your permanent income. Depending on the particular utility function, the relation could go either way. If the intertemporal preferences simply scale up (which is the standard assumption), then consumption and savings scale up with permanent income, and the savings rate (the percentage of income saved) is independent of permanent income.
Start in one equilibrium. Double both income and consumption both today and tomorrow. If the marginal utility of consumption falls by the same percentage both today and tomorrow when consumption doubles (which it must for example if today's and tomorrow's consumption are equal), then you are still in equilibrium. If the ratio of today's to tomorrow's marginal utility of consumption stays the same, then everything scales, and you save the same fraction of your income regardless of whether income is permanently high or permanently low.
Sure, the poor really need to consume today. But they really need to consume tomorrow too. So their need to save is as strong as the rich.
1. Inequality in permanent income will not affect the level of debt.
2. Inequality of transitory income will affect the level of debt. Those having temporarily low income today will borrow from those with temporarily high income today. And will repay the loans in future when the transitory shock reverses. (And it must reverse, because it wouldn't be transitory if it didn't.)
3. Inequality of rates of time preference will affect the level of debt. Those with high rates of time preference will borrow from those with low rates of time preference, until they are credit constrained and cannot borrow more.
That third inequality is what is driving debt in the Gauti Eggertsson and Paul Krugman paper (pdf). Debt is caused by inequality of patience, not inequality of income.
The second and third inequalities are what are driving debt in Matteo Iacoviello's paper (pdf) (HT goldilocksisableachblond). Despite what it says in the abstract of that paper, it is not income inequality driving debt in his model. Debt is not caused by some people being permanently rich and others being permanently poor. Debt is caused by fluctuations of income over time, where one person's fluctuations are imperfectly correlated with others' fluctuations.
A rich or poor person, having a bad year, will borrow from a poor or rich person, having a good year. An impatient person will borrow from a patient person.
Being poor means having low permanent income. Being rich means having high permanent income. Debt is not caused by inequality in permanent income. Debt is not caused by inequality between rich and poor.
The only way in which a change in permanent income can cause a change in savings is if it causes a change in the pattern of transitory income. For example, as people have become richer over time, the wealth effect on labour supply means they spend a smaller fraction of their lifetimes working, and retire well before dying. Retirement is a time of negative transitory income (current income is below permanent income). So people save for their retirement. And the longer their retirement, the greater the percentage of their income they will save while working.
Here's the nightmare scenario of standard theory (thanks commenter Greg). Take a very simple model with infinitely-lived agents and no investment. Assume all agents have an exogenous flow of income that is constant over time. Assume all agents are identical, except some have low and some have high discount rates. The equilibrium rate of interest will be between the high and low discount rates. The impatient borrow from the patient, for consumption loans. The impatient will initially consume more than their income, and the patient will initially consume less than their income. But over time, the consumption of the impatient will fall and asymptote towards zero (or starvation-level). And the consumption of the patient will rise and asymptote towards their consuming all the labour income of both sets of agents. Debt, and inequality of wealth, rise inexorably over time.
Transfers from rich to poor (i.e. from patient savers to impatient dissavers) will not solve this problem. All they do is reduce the after-tax rate of return to both sets of agents, by an equal amount. The implied tax rate on saving increases the rate of interest, and the patient still save more than the impatient, net of taxes and transfers. It only works if people don't see it coming. But of course they will.
A policy that would help solve this problem is one that gives the poor a greater after-tax return on saving than the rich. That works in two ways. First, it gives those with low savings a greater incentive to save than those with high savings. Second, it means that a given level of saving will accumulate faster if the stock of savings is low than if it is high. One way to implement such a policy would be to put a limit on the amount of saving that could accumulate tax-free. I think that Canada's Tax Free Savings Accounts might do this. They let every person save $5,000 per year without paying tax on the interest earned.
That's what standard theory says.
Does that standard theory make sense? Well, OK, if you are in danger of starvation today it doesn't. Because if you don't consume today the marginal utility of your future consumption is irrelevant. But our ancestors, whose saving and investment created the income we have today, and who were much poorer than we are today, would laugh at us if we gave this excuse for not saving. (Mine, I think, would have been more disgusted than amused).
Does it make sense empirically? Does it fit the facts? I don't know for sure. But the opposite theory, which says that the rich save and the poor dissave, is contradicted by some widely known facts. And big facts at that.
Our grandparents, and great grandparents, despite being massively poorer than us, saved. That's how we have the capital and technology that we have today, that makes us so much richer than them. Real interest rates have not been massively declining, and savings rates have not been massively rising, over the last 200 years as our incomes have massively risen.
China is still much poorer than the rich countries, and yet has a much higher saving rate.
And it's no good just looking at a cross-section of people today and seeing if the savings rate rises with income. Current income is the sum of permanent income plus transitory income. And theory says that transitory income will be saved.
Moreover, current income will be correlated with patience. This is not to say that the poor are impatient. But it is to say that the impatient will tend to become poor. Because the impatient will save and invest less.
The casual assertion that the poor can't afford to save is what bugs me. It bugs me because it ignores theory. It bugs me because it ignores the evidence of our grandparents. But mostly it bugs me because it sends the wrong message.
I understand this only through vague ancestral memories. In the rest of this post I'm talking myth, not history. (I am bad at history).
It doesn't matter that much if rich dissolute celebrities blow their wealth by consuming the lot. (Except they set a bad example for those who can't afford to blow what little wealth they have). In the past, similar rich dissolute aristocrats were the celebrities of the day, and many set a bad example too. But opposing that example was a cultural movement (centred around a religious movement) which promoted a very different set of virtues, and especially for the poor.
Father said that Grandfather paid the farm men's wages on Saturday, to be met by some of their wives on Monday, asking for an advance on next week's wages, because their husbands had already spent the lot on drink. And how the village was split between Tory/Church of England/drinkers and Liberal/Non-Conformist/abstainers.
Commenter Determinant tells me it all changed in the 1930's, for the United Church in Canada anyway, when they shifted from promoting the old virtues towards something more like socialism. I think that was a dead end.
Nowadays the alliances seem to have shifted. The old virtues would now be seen as cultural conservatism, and are more associated with the right than the left of the political spectrum. Which is a pity. It's the poor that need them most.
(This post is not as well argued and evidenced as I want it to be. But I'm aware of the limits of my comparative advantage, so I'm going to stop here and post it as is. And give Frances something to respond to.)
Worthwhile Canadian Initiative 
Nick, you posted on the previous thread:
There is a difference between: justifying one’s economics by appealing to morality and religion; appealing to morality and religion: recommending that people follow, and encourage others to follow, certain rules of behaviour. Regardless of my religious beliefs, or lack thereof, I can recognise that in some cases religious movements have created cultural practices that were good ones.
I think providence is a virtue. And if you are a preacher you ought to preach it. Do any preachers preach it nowadays? Or do they just blame the evil capitalists and sing kumbaya?
and you just reiterated that point on this thread.
What, you want the Church to deliver the poor their opium? The masses said they didn’t want your economic opium. nods to Marx for riffing on his quote.
In a world where we can’t just conquer and annex another country to exploit it or board a ship to homestead somewhere exotic we are stuck with the market we have. When the market turns against you there is no guarantee your savings will be sufficient to see you through to prosperity. Often they are not. This is why we need a safety net.
Second, I believe is is the rich that have access to higher rates of after-tax returns than the poor. Hence why they are rich and stay that way.
Determinant: I want the Church (or perhaps the “Cathedral” of the academy and media establishment, for the Church is perhaps too weak nowadays) to preach good advice. Or promote good cultural practices. (Ideas that are hard to fit into economic models of course, but ideas that seem to matter).
“When the market turns against you there is no guarantee your savings will be sufficient to see you through to prosperity. Often they are not. This is why we need a safety net.”
But it is guaranteed that if you have no savings your savings will not be sufficient to see you through. There is no guarantee my seat belt will save my life. But I still wear it, because it might. But yes, we still need a safety net. Because things can always go wrong worse than we expect. And because people are people, and we all screw up sometimes, or get hit with things we can’t do much about.
“Second, I believe is is the rich that have access to higher rates of after-tax returns than the poor. Hence why they are rich and stay that way.”
That is at least partly true. It is indeed a central problem. It is one strong argument against inflation, for example. Because for the very poor, cash may be an important savings vehicle.
I want the Church (or perhaps the “Cathedral” of the academy and media establishment, for the Church is perhaps too weak nowadays) to preach good advice. Or promote good cultural practices. (Ideas that are hard to fit into economic models of course, but ideas that seem to matter).
I don’t know about the academy or the media, but the Church won’t do that. Mostly because they have this pesky thing called theology and they think it’s more important than economics. Furthermore, practising what you preach isn’t a blithe statement but a necessity, the converse is also true. Your practices reflect your beliefs.
I really don’t want this thread to devolve into theology, just pointing out why the Church won’t be led around by the nose by economists or anyone else. Unlike England but more like Scotland, Canadian Churches, the United Church and the Roman Catholic Church especially reject external direction from government. We tell government what to do, not the other way around.
Hmm, I’m not sure devolve is the right term. Theology is the Queen of the Sciences, after all.
Determinant: OK. I respect that. A Church is supposed to be about religion. They aren’t supposed to bend with the winds of economic and political fashion.
But from the social science perspective of comparative theology, do any churches (rightly or wrongly) still preach the old virtues of thrift etc.? Latin American protestants? Black churches in the US?
I think Southern Baptist, evangelicals.
In Canada the crc are pretty good capitalists but they have a social justice kick so I’m not too sure.
What you’ve said about the patient saving and the impatient borrowing sounds pretty close to the way people behave; I personally know a number of people who will put vacations on credit cards rather than save up for them.
Earlier generations knew how transitory their incomes was and planned for periods of little or no income. Until this recession hit I think many middle-income earners thought of their income as permanent, not realizing how quickly debts can escalate and income disappear.
Christian & Missionary Alliance.(Harper?)
From my experience in Baptist/evangelical circles this phrase seems to mean something related to economics. Equality of opportunity not equality of outcomes.
Ok, my last bullet comment, you can delete a couple of them. Just a link to a reading list on various church responses to the economic crisis. Also has links to papers on economics and theology, and poverty, etc.
When I ran for Mayor, I attended a black church in my town. The pastor had been doing a series of sermons on the need to get out of debt. There was a lot about people not needing fancy clothes and ipods, etc. This was a Presbyterian Church.
good find edeast. I skimmed a few of them. Mostly anti-market. Couldn’t find much on thrift. One baptist seemed to be going there, but veered away a bit. Archbishop of Canterbury was a good read, though I might be biased there.
Bill: that’s the sort of stuff I had in mind. Someone’s still preaching it.
What brought it to mind was reading about that controversial pastor of Obama. Strip away all the controversial trappings, and the underlying message seemed to be one that cultural conservatives could look at and say “He’s one of us”. Am I out to lunch?
Apparently George W Bush used the phrase the the soft bigotry of low expectation in a speech about the education of disadvantaged children, http://campus.murraystate.edu/academic/faculty/mark.wattier/Purpose.pdf.
I’m not sure of the history of the phrase. I think it’s an example of the right stealing the left’s rhetoric?
Like my ‘”Nick’s blaming the poor; of course they can’t help either their poverty or their lack of saving!”‘, which I think is a feminist rhetorical device. (That’s where I learned it, anyway).
It seems kinda backwards.
It’s the debt that creates the inequality, not the other way around. Or alternately, excess debt growth creates excess incomes for households, combined with power imbalances that ensure that only a few capture the additional income, which creates the ridiculous savings levels of the wealthy.
In our economy, Robert Rubin saves 150 million in a year, Warren Buffet has saved billions, the Walton family saves billions.
It’s not a question of lecturing to the poor to save more, its why are the rich saving so much? How on earth can one man save a billion dollars in a year? Extreme frugality?
Why is labor productivity so disconnected from wages? If the power relations were different, that additional (nominal) income would be distributed across the board to more than the top 1%, there would not be a divergence between labor productivity and wages, and Nick’s theory might be relevant.
But then we wouldn’t have that kind of inequality in the first place, no one would be talking about a savings glut, and we wouldn’t be in a debt crisis now. Then we could worry about trying to get the poor to save more.
edeast:
I LOVE that list. A perfect fit for this blog, as Tyndale College is part of the Toronto School of Theology, the Faculty of Theology of the U of T.
Before we start down the road of “Black Churches”, the term doesn’t sit so well in Canada. Canadian churches do divide on racial lines, but not as strongly as in the US. One can say that blacks and whites prefer different churches, but sometimes its the same church too and the later is more common in Canada. Just due to different history.
As a further point of pedantry, Obama’s pastor was the minister in the United Church of Christ, the big Congregationalist church in the US and not a “black” or “white” church by any means. They are related to the United Church of Canada but not identical, in fact they are one of few denominations in North America who are more liberal than we are.
Props to RSJ as I agree completely with is post.
Hmmm, my bud used to go to a Sikh temple – they told him to live within his means, hold on to money, etc. Or are we just talking Christianity?
Mike. Not just Christianity. (Not just religion either, really).
Economics and religion don’t make good bedfellows
Nick: ….” If the intertemporal preferences simply scale up (which is the standard assumption), then consumption and savings scale up with permanent income, and the savings rate (the percentage of income saved) is independent of permanent income.”
I don’t know, Nick. Unless I am completely reading this sentence wrong, or the data, the several places I’ve looked, it is simply not true. Or rather, since it is a conditional, either the assumption or the implication is false. Or both. I’m afraid I’m not conversant enough with the theory to know whether the theory is dependent on this assumption or not. Savings does not simply scale up with income. (Although one year, 2000, USA, the highest quintile dissaved. Dot.com bubble, I suppose.) Anyway, here’s another:
http://www.brookings.edu/~/media/Files/rc/speeches/2009/1028_personal_saving_dynan/1028_personal_saving_dynan.pdf</a hrref>
and: http://aix1.uottawa.ca/~robinson/english/wp/notredame1.pdf</a href>
And I don’t think you want to say that’s because savings rate, or discount rate, has already sorted out according to income. (Or everybody’s where they deserve to be; the poor got that way because they are dissolute, the rich because they are extraordinarily virtuous.)
Nick: “Does it make sense empirically? Does it fit the facts? I don’t know for sure. But the opposite theory, which says that the rich save and the poor dissave, is contradicted by some widely known facts. And big facts at that.”
I’m not really talking about this as theory. I’m certainly not talking for all time and everywhere. I’m saying that depending on conditions, some economic, some cultural, some historical, the statistics of who saves and how much they save will change; that under some conditions, as in present day US, it is more difficult for the poor to save, (and easier for the wealthy.)
Like RSJ, I’m rather blaming the rich for much of the present predicament of the poor, and the predicament of the rest of us for that matter. As rulers of our effective Plutocracy, I don’t think they’re behaving responsibly. Should they keep all the money they ‘earn?’ Apparently, you say yes. I say, if they do, we’ll all regret it.
I certainly do not propose to blame the poor for the last 30 years of increased income inequality. Granted they, we, could have tightened our belts in the 1970’s, when wages started falling behind productivity gains, as more and more unions got quashed, and settled for a lower standard of living. And probably furthered the decline. Perhaps an effective boycott could have forced concessions. A refusal to take the poisoned chalice of easy credit? I doubt it. How then would the wealthy have secured their income? What bubble would have blown and burst? But who can guess the counterfactual?
If you are saying what ever discount rate the wealthy assume, the poor, or even the rest of society, with their higher relative expenses, can assume a lower one, I am saying this just isn’t so. Granted, individuals can and do. But it is actually impossible for the whole class to do so. But that’s another posting.
Also note the US government, or the Canadian government, I think, does not have the lowest of discount rates, either.
“But the opposite theory, which says that the rich save and the poor dissave, is contradicted by some widely known facts. And big facts at that.
Our grandparents, and great grandparents, despite being massively poorer than us, saved.”
Huh? Because the French revolution never happened when the peasants realized that the king and his court didn’t have iphones?
Rich and poor are primarily relative terms, within a given time and place, surely we can all agree on that, no? I liked this Paul Krugman post on the topic.
Greg: I can’t get those links to work. But let me guess: they show that in a given year, those with a higher income in that year saved a higher percentage of that income?
Of course they did. Milton Friedman sorted this one out 40 years ago. Simplest example (ignoring differences in time preference, and the rate of interest):
Savings = 0.1*Permanent Income + Transitory Income
Savings scales with permanent income, and scales with transitory income. But people save only a small fraction of their permanent income, and all their transitory income. Current income (income in any given year) is the sum of permanent plus transitory income. Those with low current income will be more likely to have negative transitory income; and those with high current income will be more likely to have positive transitory income. So when you misspecify the underlying relationship, by looking at the relation between saving and current income, it looks like it doesn’t scale.
Recent book that deals with this issue in the developing world:
http://www.portfoliosofthepoor.com/
I think improvidence of the poor in Canada is entirely rational. Given the marginal tax rates faced by the poor, that we have universal public health care (well, mostly anyway), that food is cheap and abundant, that we have a variety of transfers and income supplements for poor old people, etc. So there is little to no reason to save as a hedge against life threatening disaster. So why not be improvident? What are you providing for? Say you’re poor, and believe you are likely to remain so (e.g. never finished high school). Someone in this situation is likely to get bounced around hard by the business cycle, so in some sense they probably view virtually all their income as transitory. It’s not surprising to me that they decide to leverage it while they have it. What’s the worst that can happen? Bankruptcy. So what. They just go back to being poor. Big deal. It’s the default state anyway. So nothing lost. At least they got to enjoy the nice F-150 and the snow machine until the repo man took it away.
Also, if you’re poor in Canada, you probably could never save enough to make a big difference in your future consumption given that you’re not likely to need your savings to save you from starving (or whatever terrible event). I don’t think it implies entirely implausible discounting to end up with the poor deciding that the utility of consumption today is always greater than the utility of consumption of savings + interest tomorrow.
I think Patrick is fairly correct here (I have made a similar argument). But isn’t there another point here. The permanent income hypothesis doesn’t say that the desired saving is a linear function of income. What if richer people save a higher proportion of their income, not in order to spend it, but to build wealth and power? And what if they have no problem riding out shocks to their income (because their wealth is a higher ratio when compared to their income) and so realised net wealth is for them more reliably close to planned net wealth? And what if these musings aren’t even particularly surprising?
Patrick: yep. IIRC (I probably don’t) what Frances told me, the Old Age Supplement clawback raises the effective marginal tax rate on savings for retirement to something close to 100%, if you qualify. It’s another example of the poor having a lower after-tax marginal return on savings than the rich. So it’s not that the poor have inherently less tendency to save. But the tax system gives them a lower incentive and return from doing so. Solution is probably some sort of consumption tax (increased GST) plus guaranteed annual income (negative income tax).
reason: I’m not sure I follow you here. First off, “linear” here can mean S=a+bY, or it can mean S=bY. You presumably mean the second, but strictly, “linear” means the first.
Second off, the permanent income hypothesis does say that saving is a constant proportion (approximately) of permanent income, and a constant proportion of transitory income. Just that those proportions are very different. 100% of transitory income, and closer to 0% of permanent income (depending on the interest rate and rate of time preference).
I wonder if people’s discount rates are not independent of wealth, but that greater wealth (eventually) raises discount rates and lessor wealth lowers them. People would adjust their wealth to levels that are comfortable to them. I am not that fond of permanent income because it seems to assume too much clairvoyance.
Nick,
Can you explain something to me (actually more like a couple of things)?
Say that a utility function in one period has the form mu_w = U_W [U_R(X); E], where mu_w is welfare provided by a set of goods, U_R is relative preferences over the set of goods X and E is exogenous factors like health, living near the seaside, getting on with your kids, having access to clean drinking water, not being the victim of political violence, or whatever.
1, Assume that both U_R and U_W are stable across time. What if there were some way that individuals could affect those exogenous factors via their intertemporal consumption decisions? For instance, if by not consuming today they could amass power tomorrow—that might raise their welfare even with the same relative preferences over the same set of goods.
2, Why should U_R and U_W be stable across all states of the world anyway? E.g., “where the total wealth of the people has increased, and equal quantity of utility is represented by a larger quantity of wealth” (Edgeworth)—U_R in period one might be the same as U_R in period two, but a rise in the national income might affect U_W and lower welfare over the same set X.
“Milton Friedman sorted this one out 40 years ago. ”
Hmm, Friedman supplied an incomplete model with additional parameters. How does that qualify as “sorting out”? In order to test the model, you would need to determine:
* How households estimate their future income
* How households estimate future interest rates
* How households are able to borrow and lend freely.
The third point is more important than most people realize, because households carry amortizing debt that must be paid each period, which means that households enter into contractual obligations to save a nominal amount each period. PIH basically says that households smooth consumption at the expense of savings/borrowing, whereas its clear that households try to smooth both, and one comes at the expense of the other. There are other reasons — e.g. annual retirement contribution laws, that would encourage households to smooth savings at the expense of consumption.
Now at best the data for the PIH is “mixed”. We know that
* Consumption is hump shaped over a household’s lifetime (peaking when households are near middle age).
* There is both excess sensitivity and excess smoothness problems.
* The income of the wealthy is more volatile in terms of both positive and negative shocks, so there is no reason why the wealthy should save more simply due to PIH.
You can’t say that PIH is “settled”. It is just another theory in which any present incarnation is difficult to reconcile with the data (e.g. permanent income + ratex, with random walk income deviations can be ruled out), but sufficiently ambiguous that it allows additional elaboration (e.g. permanent income + some more complicated means of estimating future income, with preferably more free parameters, might be reconciled with the data.)
I think it’s a bit unfair to dismiss the clear observation that the wealthy save more, proportionally, as a mispecification that was “cleared up” 40 years ago.
Interesting post, though in an odd and kind of cranky way.
So, Nick’s contention is that PIH superseded the marginal propensity to spend? Shouldn’t savings, at the very least equal something like this:
Savings = (.1 * (Income – Minimum Income)) + Transitory Income
It makes little sense to save while starving, but in addition the conception of Minimum Income may be technologically influenced or culturally influenced (ie signalling). For example, if perceived social status affects one’s earning prospects then in some cases not spending, for example, allowing oneself or children to appear in public with ‘sub-standard clothing’, may be detirmental to one’s permanent income.
Click to access consp.pdf
In this simple Veblenesque two-good model, consumers are identical in all but their exogenous, and only privately known, income y. Consumers allocate their income between two types of expenditures: v, which is visible to society, and w, which is not. Since neither an individual’s income y nor consumption of w is visible, the only observable difference between two individuals from the point of view of a third one—or of society as a whole—is their consumption of v.
This setup opens the door for conspicuous consumption behavior: individuals may manipulate their expenditure on v in their attempt to inform (or misinform) society regarding their income type y (or equivalently, regarding their non-visible consumption w). For this
to happen, the public’s perceptions regarding one’s y (or w) should somehow affect one’s utility. Denoting by g (v) society’s beliefs concerning one’s unobservable w based on the observable v, Ireland’s utility function is specified as follows:
U = (1 − a) f (v,w) + af (v, g (v)) . (0 < a < 1)
It is a convex combination (or weighted average) of two terms. The first, f (v,w), denotes fundamental utility: the utility resulting from consumption of v and w. This is just the familiar notion of utility from the standard textbook model. The second term, f (v, g (v)), denotes spectators’ view: what others believe one’s fundamental utility is. The weight a can be thought of as a measure of one’s sensitivity to society’s view, or to social status. With a = 0 the model reduces to the standard model where social effects are assumed away. At the other extreme, with a = 1, consumers consume with the sole purpose of being seen consuming—not too far from Veblen’s (1899) idea of consumption by the Leisure Class. With a in the interval (0, 1), consumers maximize U considering both terms. To the extent that the resulting allocation differs from what it would have been with a = 0, consumption is used as a signal.
Nick, you managed to revive both the Abstinence Theory of Capital and a thrift theory of capitalist development in one post. You do honour to your linguistic cousins and first conquered Sir!
On religion,
Mennonites! It is said only we can buy off the Scots and sell for a profit. It is also true that you can never tell how rich we are by looking at us.
Yep my Grandparents saved more because they consumed less. They built their own house (a nice one too) which is all but illegal today, they fixed their won cars, which is all but impossible today, they had no credit cards or department store accounts (almost impossible today), they grew almost all their vegetables and fruits for the year (2 acres 20 min from down town Seattle), almost impossible today. And all that on one income (sometimes two jobs) almost impossible today. Kinda indicates the productivity gains have been unequally distributed no?
Oy. This sort of moral logic goes to the root of what annoys me about economists as a group. Are you seriously suggesting that unless the poor exempt themselves from the modern world and return to an agrarian subsistence lifestyle, they have no one to blame but themselves for their debts? Because that is what the entire opening post is suggesting, ultimately.
The poor who want to exist in modern society, on the other hand, should not have to incur debt, temporary or otherwise, to do so.
Wealth is relative. Any other belief is a cruel one.
That is the other thing. It is increasingly illegal to be poor. By which I mean the raft of legislation passed by one or more orders of government (demanded largely by but not exclusively by business associations making pan-handling, wind-shield washing, squatting (the poor man’s contribution to urban renewal) and street (park) sleeping illegal.
Lord: “I wonder if people’s discount rates are not independent of wealth, but that greater wealth (eventually) raises discount rates and lessor wealth lowers them. People would adjust their wealth to levels that are comfortable to them.”
I wonder about that too. It would be nice if it were true. It would create a stable long-run equilibrium. But I don’t know if it is true.
“I am not that fond of permanent income because it seems to assume too much clairvoyance.”
It doesn’t really assume clairvoyance. It does open the question of how people form their expectations of the future, without answering it. But I don’t think we can just ignore it, and say people’s saving doesn’t depend on what they expect about the future. Life would be a lot easier for macroeconomists if we could just go back to the old Ct=a+bYt. But it doesn’t really make sense.
vim: I’m not quite following what you are saying in that utility function (hard to do math notation in Typepad). I’m going to take a guess:
1. Suppose that by buying (say) a weapon you could increase your power, and you would enjoy power for its own sake, independently of its ability to get you more other goods? At the individual level it’s just like any other investment in a consumer durable. At the aggregate level it would be different, if its relative power that matters (rather than power relative to lurking wolves) it’s different, because if all invest in weapons nobody is better off.
2. Edgeworth is talking about diminishing marginal utility. He should be talking about diminishing marginal utility of consumption, but he says wealth instead (assuming that greater wealth means greater consumption). I’m not sure what you are asking. But some economists model state-dependent preferences. If it’s hot outside I enjoy ice cream. If it’s cold I don’t. Complicates things a bit, but I don’t think it makes a lot of difference.
Forgive me for plugging my own blog, but I’m unashamedly trying to drum up some interest. So my thoughts as to why poor save less and rich more, which I would put down to a combination of altruistic parents trying to help out their kids and mean reversion of incomes, are here:
http://guerilla-economics.blogspot.com/2011/01/inequality-and-pt-i.html
Would welcome any comments.
RSJ: Milton Friedman explained why we see C=a+bY in short run cross-section data, and C=cY in long run time-series data. Yes, he did sort that one out 40 years ago. He also tied the macro theory of consumption/savings back into micro. He also resolved the problem that anyone seeing C=a+bY would immediately see is wrong with that theory (and that I remember seeing when I first saw it as a schoolkid): how can people go on consuming more than their income forever, which this theory says they can? How come whole economies saved negative amounts through almost all of human history?
Does Friedman’s simple theory resolve all questions? Of course not. Has theory moved on from there? Of course it has. But too many knuckles have been dragged across the internet saying “C=a+bY and the poor can’t afford to save so inequality causes debt”. Which is where I came in. Trying to drag this discussion out of the stone age.
By the way, I think Friedman’s Theory of the Consumption Function is a beautiful book precisely because it blends theory with so much empirical evidence. He goes through example after example showing how his theory can fit the facts better than the C=a+bY.
Friedman only had adaptive expectations, which is not a very good theory, and not very falsifiable (too many free parameters). Since then, starting with Hall, people have tested the joint hypothesis of Permanent Income plus Rational Expectations. That’s very falsifiable. It fails, of course. All theories do, if the test is powerful enough. But no theory has yet replaced it. (And certainly not the old C=a+bY). Borrowing constraints is probably the most important thing that needs adding to the theory. It makes sense, and makes the modified theory work better.
My guess is that the middle-aged “hump” in consumption can be explained by two things: borrowing constraints when young; kids.
And my guess is that the sensitivity stuff may be due to consumer durables and the costs of adjusting quickly and learning new patterns of behaviour.
And maybe, just maybe, the rich are different. And that’s why they are rich.
In moments of idle reflection I wonder if the whole thing isn’t totally wrong.
But, Oh God, when I hear the knuckle-dragging words “The poor can’t afford to save” I reach for my Milton!
Nick,
I have a micro exam tomorrow (panic!), which may go some way to explaining why I’m not making a great deal of sense. Apologies if I continue in that vein.
I’m trying to give (kind of) an old ordinalist critique of the permanent income hypothesis and the way you’re applying it here.
In the textbook model of intertemporal choice, you want to maximise lifetime utility subject to the market constraint (permanent income or whatevs), i.e. optimal consumption in a two period model is defined by the usual tangency condition where the marginal rate of substitution of the highest indifference curve is equal to the slope of the market opportunity / permanent income curve.
Now the MRS is just the ratio of marginal utilities. Your claim is that the only reason that ratio is different to -1 is the rate of time preference (call it p); different individuals have different values of p, and hence different MRS—some people are more patient than others.
I’m wondering whether this is a great description of reality. My uncertainties relate to the two :
1, Utility derived from consumption isn’t just a function of the consumed bundle; it’s a function of relative preferences over a given set (U(X)), and extraneous factors (E). So a change in the extraneous factors would alter the total welfare you derive from consuming X, even though U(.) is the same and X is the same. But those extraneous factors themselves might not be independent of your saving-consumption decision. If as a consequence of my having a bloody great broadsword, everyone bowed and curtsied and called me “My Lord”, my enjoyment of every good might increase. In fact, I’m already putting money to one side in anticipation.
2, Of course Edgeworth is talking about (diminishing) marginal utility! His point (and mine) is that utility (that is, the satisfaction) derived from consumption depends on the distribution of income, not just relative preferences. Poor people live in a world with people who are not poor, and so the increased wealth of the not poor may reduce the utility the poor derive from a fixed bundle of goods. In order to maintain the same level of utility, the poor need to increase their spending.
That any better?
“And my guess is that the sensitivity stuff may be due to consumer durables and the costs of adjusting quickly and learning new patterns of behaviour.”
By which you mean, willing to live even poorer.
OGT: “Interesting post, though in an odd and kind of cranky way.”
Thanks! That’s all I am hoping for. The cranky bit is the only bit that’s new in this post. Any semi-competent macroeconomist could have written the rest 30 years or more ago. And the cranky bit is the bit that’s hardest for me to think clearly on, and articulate.
I definitely think there is something to the conspicuous consumption or relative status consumption ideas. BUT:
Take the really extreme case. Suppose it’s 100% true. Suppose we only get utility from our consumption relative to others. How would that affect saving?
At the individual level, it makes no difference at all, as far as I can see. We still face a trade-off between looking cool today and looking cool tomorrow. The incentive to save is unchanged. The response to interest rates and discount rates is unchanged.
The response to an individual-specific shock to transitory income or permanent income is unchanged from standard theory. I want to smooth my coolness over time.
Here’s the difference: if I could predict how other people’s consumption would vary over time, I would vary my consumption over time too, to follow theirs, even if my income and permanent income never changed.
BUT: Could I predict how their consumption would vary over time? Permanent income, by definition, cannot be predicted that way.
My GUESS, though I haven’t worked this out fully, is that this model would have exactly the same predictions about savings as the standard model. EXCEPT, in the presence of borrowing constraints, because those might make it possible to predict other’s future consumption.
Changing the model from U(myC) to U(myC/othersC) does not necessarily change the results. Too many people are calmly assuming it does, without thinking it through.
“I’m trying to give (kind of) an old ordinalist critique of the permanent income hypothesis and the way you’re applying it here.”
Should read, “old cardinalist critique…”
Doh!
Travis: What do you mean “revive” those theories? They never went away! Despite Marx’s clever invective. Economists just stopped using those words, and used math instead!
It would be a good thing if some people were just a little bit more like your grandparents. One difference is memories of the 1930’s (if that timescale works for your grandparents, as it certainly did with mine). Another is it’s easier to borrow now. Another is there’s more forced savings now. (E.g. we pay CPP contributions and get a mortgage instead of saving that money to buy a house.)
I resist buying a cellphone. The kids, much poorer than me, cannot imagine life without all those gadgets. Eventually it will be impossible for me not to have one. I am holding out as long as I can. And I am fixing my own car as long as I can (one place where modern gadgets like this here internet actually make DIY easier, because I can very quickly get lots of information from other people with the same car).
Yes, it’s getting harder and harder to live like your grandparents. And that’s a problem. But see what I said above to OGT. We need to keep up today, but we will also need to keep up tomorrow. It doesn’t affect the incentive to save. It does, however, affect the incentive/need to work. The kids’ Icrap things have put them on a work/leisure treadmill, not a consumption/savings treadmill.
Mandos: “Oy. This sort of moral logic goes to the root of what annoys me about economists as a group. Are you seriously suggesting that unless the poor exempt themselves from the modern world and return to an agrarian subsistence lifestyle, they have no one to blame but themselves for their debts? Because that is what the entire opening post is suggesting, ultimately.”
I find it hard to resist the temptation to say “Yes, that’s exactly what I am saying! It’s 100% the poor’s own fault they are poor. And yes, they should all go back to the land and live on gruel.”
Instead I will answer “No”.
Dissaving is not a cure for poverty. It cures poverty today, at the expense of even greater poverty tomorrow. So saying it’s OK as a cure for poverty is daft. And the paternalistic attitude that assumes only the poor have problems acting with foresight is not good. And the paternalistic attitude which says it’s OK for the poor to act without foresight is not good.
I knew my post would generate that reaction, which is why I parodied it right at the start. Any discussion of inequality and debt always triggers these responses. Usually it’s the “debt is always bad, so everybody ought to always be a lender and nobody should ever be a borrower” reaction.
vimothy: (I saw your “cardinalist” correction by the way).
I think I’ve got this bit right:
1. The ordinalist/cardinalist distinction is orthogonal to the question of whether you can make interpersonal comparisons of utility. E.g. I can say A is happier than B, but refuse to say how much happier. And I can say that quadrupling A’s consumption will double his utility, but refuse to say that A is happier than B.
2. Saying that U=U(myC/othersC) implies neither cardinality nor interpersonal comparisons of utility.
3. Saying W=U(C1)+BU(C2) implies cardinality. Whereas the Irving Fisher diagram you describe, with intertemporal indifference curves and the implied W=W(C1,C2,B) intertemporal utility function does not imply cardinality. (I’m less sure on that, I hadn’t thought about it before).
See my response to OGT on the other stuff.
Good luck on the exam! Now stop reading this stupid blog and go study!
Guerilla Economist above has a good critique. He argues that the rich will save more over their lifetimes, because they expect their kids to have lower income, due to mean-reversion, so will save for the kids. This is like applying the Permanent Income Hypothesis to dynasties, rather than individuals. See his blog.
Nick- In part my model was to explain why seemingly poorer people, past-xwesterners and Chinese households of today have a higher savings rate. Borrowing constraints are certainly part of that, consumer credit is still tiny and novel in China, for example.
But, I think you miss something with the ‘Cool’ frame, think of it more as ‘Not a Loser.’ It is not a continous variable but a dummy variable. You only have to display enough wealth to be certified as ‘Not a Loser.’ There is actually some research that supports this, and it’s certainly not hard to come across negative stereotypes of those who are poor, which would make it worthwhile to counter signal against.
This is an incredibly naive argument. Clearly the author has met more Martians than Americans making the median income or less. Arguing that the poor, which in economics circles these days means 80-90% of all Americans, just aren’t saving enough ignores simple reality. Sure, you can live on sorghum boiled in water, or bread, weak tea and treacle, but for most having money saved is much less valuable than having better food to eat, a slightly better place to live, or some other lifestyle upgrade.
Most people have fractal demands on their cash flow. On typical incomes, which, due to inequality, have been stagnant or falling for 30 years, there is no way they can save enough to make any real difference in their vulnerability to financial shocks. Saving money just isn’t worth it compared to other basic needs. (One friend of mine has a daughter who may need a heart transplant. Another friend suggested he buy cheaper cuts of meat to help pay for it. Maybe in 1,000 years it might make a difference.)
Kaleberg: “Sure, you can live on sorghum boiled in water, or bread, weak tea and treacle, but for most having money saved is much less valuable than having better food to eat, a slightly better place to live, or some other lifestyle upgrade.”
That’s a perfect example of the fallacy I’m criticising. The choice is not between “money saved” vs “having better food to eat, a slightly better place to live, or some other lifestyle upgrade.” The choice is between “having better food to eat, a slightly better place to live, or some other lifestyle upgrade.” today vs tomorrow.
What Kaleberg said.
Um, no:
Dissaving is not a cure for poverty. It cures poverty today, at the expense of even greater poverty tomorrow. So saying it’s OK as a cure for poverty is daft. And the paternalistic attitude that assumes only the poor have problems acting with foresight is not good. And the paternalistic attitude which says it’s OK for the poor to act without foresight is not good.
First of all, your use of paternalism is a utter reversal of the notion. I don’t know who you’re talking about, but what I do know is that I believe that all members of our society have the right to partake of an equitable and at least minimal share of the spoils of modern life. And in fact need, as people have pointed out, to have a share in it even to live legally.
Paternalism is to assume that the poor do not know about the conditions of their indebtedness and have not justified it in terms of their own lives.
This is sort of like the people who scorn the homeless because some of them carry such “luxuries” as cell phones. You yourself set the limiting case as the brink of starvation. Guess what, not only do people’s “luxuries” give them access to the social infrastructure they need to improve their own lot, they at least allow them and their children to keep up in the Red Queen’s race for good health and opportunities. The stress of poverty itself brings ill health.
I suspect that you are comparing apples to oranges when you are talking about your grandparents. In a world in which society as a whole, and particularly business and government, is willing to pursue policies of expansion (building railroads, hospitals, universities, etc), it may appear that fortitude of the poor is resulting in better prosperity. In our modern world, we’ve reached a point where government proposes continuously to contract, and the wealthy and powerful seek to harvest increasingly pervasive rents from the public. A voluntary choice by the poor to keep themselves in greater discomfort in order to save is not going to make a dent in that.
So, you should feed your kids cheap unhealthy food today so that you can buy them better food tomorrow? For a good chunk of the current North American public, that is what you are arguing. Yes, your children will live, probably.
Wealth is relative.
I mean, this is the thing you’re missing: that self-denial now, especially in today’s politics and social structure, has costs too, costs for which you are not accounting, and costs for self-denial that still leaves you well above the bring of starvation. Such as future foreshortened life-spans.
Then there are the larger social costs of inequality…