Inequality, Veblen and the crisis

Is inequality to blame for the US financial crisis?  To see why it might be, start - as all American stories must - with Calleigh Duquesne. She drives a Chrysler Crossfire, which probably costs almost half her annual salary. It’s implausible that her British equivalent - would that one existed - would own something so flash.
Why the difference? Thorstein Veblen had one answer. In capitalist society, he said:

property now becomes the most easily recognised evidence of a reputable degree of success as distinguished from heroic or signal achievement. It therefore becomes the conventional basis of esteem. Its possession in some amount becomes necessary in order to any reputable standing in the community. It becomes indispensable to accumulate, to acquire property, in order to retain one's good name.

Americans, then, buy conspicuous consumption goods in order to signal to others, and themselves, that they are worthy of esteem.
And Americans are more prone to do this than others because Americans, much more than Europeans, believe wealth comes from hard work rather than luck; even the poor remain hopeful of moving up. It is a cliché that Americans see a flash car and think; “if I work hard I’ll get one of those” whereas the British think “tosser.” 
This naturally leads them to save little and spend much - to get into debt.
And this is where inequality comes in. As this rises, the less well-off feel the need to stretch further to appear to keep up with the wealthy. A 1000 square foot house might be adequate when others live in 1500 sq foot houses. But it’s not when they live in 3000 sq foot ones.
As inequality rises, then, so savings fall and debt rises as people scramble to keep up with the rich. The result is a greater vulnerability to financial crisis caused by people defaulting on loans.
This story is beautifully told by Jon Wisman in this new paper.
What’s the evidence for it? A few things:
1. The US has a much lower household savings ratio than most other developed countries. Is it really a coincidence that the US also has both a greater belief that wealth is due to hard work and greater inequality?
2. There have been three episodes in US history of rising inequality: the late 19th century, the roaring 20s and the post-1980 period. All were accompanied by general consumer booms.
3. Since 1980, the US savings ratio has fallen sharply.  What, other than rising inequality, might explain this, given that many other developed economies have not experienced such a fall?
It is, therefore, at least plausible that measures to prevent this crisis happening again would have to include policies to reduce inequality.
However, although nationalization and “Keynesianism” are back in fashion, equality isn’t. Funny that.

Comments

[Moretaxcutsplease]

On your little points at the end:

1. America is also generally a pretty optimistic country. You've made the point before that high borrowing can be a sign of optimism, not greed and excess.

2. I think that you're missing a variable there, i.e. general economic growth. Rising inequality is often associated with periods of high growth - the 20s would be a canonical example - and that could clearly finance a consumer boom. Particularly if it also induces optimism about future incomes (clearly an issue in the States in the 20s, crucial to the debate over the stock market).

3. Greater economic confidence perhaps. Many other developed countries had obvious and serious economic weaknesses - manifested in high unemployment. The States had the Greenspan eternal boom, or thought they did.

Beyond intangibles, the US economy was growing a lot more quickly so there would be a certain logic, in PILCH terms, to borrow against your expected share of that growth in future.

[Matthew Sinclair]

Oops, that last comment was me by the way. Posting on another thread on another site :)

[Tristan Mills]

A point of data - the other night my wife mentioned this:
In her experience British people, on a reasonable income are far more likely to worry about saving money in public, than Americans.
In the US people are also far more likely to spend money on something like a car which other people see than on things other people won't see.

As for the equality point - I'm starting to think greater equality is a good thing in general, the problem comes with politicians who try to enforce equality through reduction of liberty. This then creates more opportunity for those with power to amass greater wealth at the expense of the 'equal' masses.
Pursuit of equality through coercion just leads to greater inequality as well as less overall wealth.

[Luis Enrique]

How do people who like the conspicuous consumption hypothesis that people drive expensive cars to signal status first reject the hypothesis that people drive expensive cars because they really like driving expensive cars?

What is the cross country relationship between inequality and the savings rate? Presumably, to test this idea, you'd need to explain savings rates as a function of inequality, with an interaction term between inequality and some measure of having a US style self-made mobility culture, and hope that interaction term turns out to be significant.

So the hypothesis is that if society is more likely to regard success as deserved rather than given, you are more likely to want to signal success? Hmm. I quite like that. In some respect aristocrats signal their status like crazy, but on the other hand certain kinds of ostentatious display are frowned upon. "Only the rich can afford to look poor".

However, the modes of conspicuous consumption employed by the poor are not very well chosen if the aim is to emulate the rich, who, for instance, tend to prefer rather more understated jewelry. If rather signaling is more like a competition within peer groups, then it's not clear that the gulf between richest and poorest has much of a bearing on the signaling effort.

But I don't really get it - if you want to signal your status, why not save for a while and then once you're on a better financial footing, knock yourself out with the caviar and the Porsche. If you don't save, you'll never get a better signal than a wicked pair of trainers. I don't think a greater desire to signal brought about by culture and inequality can explain this, because what you're really looking at is a reluctance to forgo immediate consumption signaling in order to achieve a greater signal in the future. You argue that the stronger the desire to signal, the greater incentive to save in order to achieve the greater signal, eventually.

[Luis Enrique]

sorry, last sentence should start "You could argue .."

[Luis Enrique]

hang on - why would a higher savings rate have made the USA less prone to financial crisis? What, they'd be better off if American consumers had given more of their income to the financial sector, to look after?

Do mortgages count positively or negatively towards the savings rate? I can see that borrowing is of course negative saving, but on the other hand it's borrowing to purchase an asset, not for consumption, and is a form of saving. Does anybody know how the statistics handle it? What is the relationship between high house prices and lots of mortgage borrowing, and the reported savings rate?

[Tom]

Time to start reading through "The Conscience of a Liberal" again then....

And to Tristan Mills:

"I'm starting to think greater equality is a good thing in general..."

Of course this depends as to what level of equality you are referring to, but what doubts do you have about equality in the first place?

"...the problem comes with politicians who try to enforce equality through reduction of liberty"

What the hell does that mean, sounds like a typical cliché populist right-wing response to me. Whilst ridiculously high taxes will restrict people's liberty, surely if America were to have, for example, universal health care, more people would have liberty and the freedom to pursue what they desire as falling ill is no longer a restriction to continuing with their lives in a normal way.

[Charlieman]

Luis Enrique: "How do people who like the conspicuous consumption hypothesis that people drive expensive cars to signal status first reject the hypothesis that people drive expensive cars because they really like driving expensive cars?"

One way is to talk to engineers (not petrol heads) who understand that "Vorsprung Durch Technik" actually means "Bullshit Baffles Brains".

Another way is to look at the cost break down reports for expensive versus cheap cars, and to note how profit margin increases with price.

[spz]

There's an older, stronger tradition in the U.S. of not paying up front, i.e. paying it off over years. Which I think happens in the UK too now, but it's not as well established. Which might help explain the different U.S. and UK attitudes to buying a car. (Me, I walk.)

[Luis Enrique]

Charlieman,
Consumers being gullible is not the same thing as consumers having a signalling motive. Neither do high profit margins say anything about the consumer's motivation. Are there no engineers who are also petrol heads? I think I know one or two. And if I'm interested in the existence of people who spend a high proportion of their income on their car because they really like cars, I think avoiding talking to petrol heads might be something of a sampling error.

[Luis Enrique]

I don't mean there's no such thing as conspicous consumption, I just think people attribute way too much explanative power to it.

[reason]

Maybe the inequality and high levels of consumer debt are directly related. I saw a very good argument which suggested that, given that mostly (if we ignore the government and overseas sectors for the moment) a firms costs are the same as its customers incomes, the only way expediture can exceed income substantially is if people borrow to consume. This excess of consumption over wage income pushes up profits (and/or execution "compensation").

I think it is reasonable to think that people mostly adjust their consumption to their real incomes with a lag, and flat or falling median incomes (US last 30 years) result in falling savings, whereas rising median incomes result in high savings rates (China last 20 years).

Matthew Sinclair

As for high (measured) growth being correlated with rising inequality (in only some periods though 1950/60s?) I just wonder how much of that growth is illusory (lots of people earning money taking commissions from buying/selling inflated assets).

[reason]

Luis Enrique
Why would a higher savings rate have made the US less prone to a financial crisis.

http://www.debtdeflation.com/blogs/2008/11/02/debtwatch-no-28-november-2008-what-is-really-going-on/

But besides that, I think the question is wrongly posed. The problem in the 10-15 has been GLOBAL inbalance (see for instance the jeremiads of Stephen Roach) caused by parts of the world financing the US in an unsustainable borrowing binge. US balance sheets had become highly leveraged and so very vulnerable to a fall in asset prices.

[reason]

Chris,
I don't think current economic models incorporate sufficiently the assymetry in the economy that comes from bankrupcy and limited liability. Can you care to comment?

[reason]

Mathew Sinclair
"Beyond intangibles, the US economy was growing a lot more quickly so there would be a certain logic, in PILCH terms, to borrow against your expected share of that growth in future."

I seen it argued ...
http://trueconservative.typepad.com/trueconservative/2008/05/europe-vs-us-wh.html
...
that this is just not true, and it is certainly not true for the median earner.

[kinglear]

Chris - as ever I like the use of an attractive female to make a point. I think more of it would shorten the recession...

[Ben]

It is a cliché that Americans see a flash car and think; “if I work hard I’ll get one of those” whereas the British think “tosser.”

That may be, but the UK household debt ratio has skyrocketed (over 80% GDP) And the household savings ratio in the UK is only .9% above the US...so I think conspicuous consumption is alive and well in the UK (regarding your comment, a lot of British people must not mind being "tossers").

[Luis Enrique]

reason.

I like that argument that consumer borrowing means spending can exceed wages (firms' costs) allowing increased profits, and because profits are distributed unequally, then borrowing leads to inequality - presumably though that means the correlation is in changes, not in levels - a high but stable level of consumer debt would mean expenditure is once again matched by costs and profits are no higher. You can only spend more than you earn while you are increasing borrowing. So stable but high debt would see excess profits fall again, if that was the mechanism behind them, although accumulated wealth could leave inequality high. Have to think about this some more.

I'm not convinced by your debtwatch link - for a start there is the tedious and erroneous diatribe against mainstream economics - you don't have to be heterodox to have been worried about US deficits. Mainstream economists weren't exactly unaware of financial bubbles and their consequences (see for instance 'Rational Herds' by C Chamley). Lots of economists predicted trouble (calling debt / deficit levels unsustainable) - few predicted the extent of the cock-ups made inside Wall Street - but why would they, most of them being busy studying other things and banks' positions were private information. It's just not the case that mainstream economics regards the finance sector as perfectly rational etc. At any given point during economic good times, any fool can predict it will all end in tears.

Do run ups in debt always lead to disaster, or are there sometime smooth reductions in debt? We are only shown data in your link for when high debt has been followed by a bust. Need to see full sample - but prepared to accept high debt/GDP = high probability of disaster.

But really I'm less sure how Americans consuming less and saving more would have prevented the run up in house prices, the creation of mortgage-backed CDOs and all that stuff. As you say, global imbalances and incentives within banks have more to do with the crisis that simple excessive consumption by American citizens.

[Bob B]

S&M: "However, although nationalization and 'Keynesianism' are back in fashion, equality isn’t. Funny that."

As best I can tell, "keynesianism" is now mainly used as a smear word by the self-styled political right similar to the way "commie" or - in America - "liberal" was/is applied.

As Mankiw - who was for a while chairman of Pres. GW Bush's council of economic advisers - says somewhere, neither Keynes nor "keynesian" have precise connotations. I notice that George Osborne seems to have recently stopped using it.

Keynes endorsed Hicks on: Keynes and the Classics (Econometrica 1937) at the time and that eventually became hugely influential in textbook presentations of Keynes but Hicks's interpretation is essentially a comparative static model which determines aggregate demand. Whatever is happening on the supply-side is taken as implicit and expectations are treated exogenously.
http://www.eco.utexas.edu/~hmcleave/368hicksonkeynes.html

There are some instructive parallels in the way FDR and the New Deal are regarded in America by self-styled conservatives and admitted liberals. For conservatives, FDR was a dangerous socialist intent on expanding the frontiers of the state. For liberals, the New Deal was rather conventional and Roosevelt's fiscal policy was barely expansionary. Try this recent assessment:

Eric Rauchway: The Great Depression and the New Deal (OUP)
http://www.amazon.co.uk/Great-Depression-New-Deal-Introductions/dp/0195326342/ref=sr_1_1?ie=UTF8&s=books&qid=1226663874&sr=1-1

[Kevin Carson]

Inequality's behind the crisis in a far more fundamental way: the maldistribution of purchasing power that results from privilege. When wages are artificially depressed or even stagnant because of unequal exchange in the labor market, and the income of the rentier classes is artificially inflated, we wind up with chronic crises of overproduction and overaccumulation, and a class of absentee investors with more money than they know what to do with who can't find enough profitable investments to soak it all up.

World War II provided a partial and temporary solution to overproduction and overaccumulation, by blowing up most of the capital in the world outside the U.S. and creating a permanent war economy to absorb the amount of surplus output and capital that still existed. Concurrently with the permanent war economy, the rise of the automobile-highway complex and the suburban reconstruction of the U.S. was another example of Marx's counteracting tendencies to the falling DROP in Capital vol. 3. But still, the chickens came back home to roost around 1970. According to Walden Bello, globalization was adopted as a new expedient for disposing of surplus capital abroad, but fizzled out in turn as China became saturated with industrial capital. The tech bubble served the same function as suburbanization and automobilization for a while, but it went bust. And according to Bello, securitization and derivatives served as another sponge to sop up surplus capital that couldn't find sufficient productive industrial investments. We're seeing right now what happened with that.

The solution is

1) to eliminate privilege, which separates effort from income, and shift the national income downward to people who will actually spend it to improve their own material standard of living; and
2) to stop subsidizing capital-accumulation and large-scale industry on the Sloan/Chandler model, that can't dispose of its full product without resorting to push distribution and government policies to make water run uphill.

[reason]

Luis Enrique...
I'm perfectly aware that lots of economists were concerned about the run up in debt, but unless they were Austrian they were doing that in spite of their models not because of them. (Hence Tyler Cowan spotting Paul Krugman about his "inner Austrian".) And Steve Keen is perfectly right to point out that the models that central banks use ignore debt ratios.

[Luis Enrique]

" economists ... concerned about the run up in debt, were doing that in spite of their models not because of them" (unless they were Austrian)

I don't think that's true. The literature on debt is vast - check out Handbook of International Economics or copious IMF research or say somebody like Calvo http://www.columbia.edu/~gc2286/ .

You could be referring to internal debt rather than external .... I know even less about that than I do about the international variety, but I wouldn't bet on the mainstream econ literature on that subject featuring no models where debt levels are a worry.

also how do you know what models central banks use? (I don't ask rhetorically - you could be a BoE economist for all I know)

[reason]

I did work for the Reserve Bank of Australia for a while (in the economic modelling department), but that was long time ago. But Steve Keen just quotes what the Reserve Bank of Australia spokesmen have said, and what the Reserve Bank has done.

And while concern about debt may be of interest to specialists in third world international economics, it is not normally incorported in general equilibrium theory growth models.

[Luis Enrique]

Ah - well the list of things excluded from growth models is a long one. There are GE growth models with external borrowing (optimal borrowing either in a Ramsey type or an OLG type model) but I don't imagine they are terribly useful for purposes of modeling crises. I haven't come across any growth models that use internal debt levels, but then again isn't it more of a business cycle rather than a growth thing, isn't it? Surely business cycle research has looked at consumer saving/debt?

I'm surprised to learn that models with debt levels aren't used by CBs - how can you model the response to, say, interest rate changes without that?

[reason]

Business cycle models? You would have to a theory that regarded it is something other than random chance for that.
As for response to interest rate changes - all the models just look at flows. That is the problem of equilibrium models, it is assumed everything happens at the margin and that portfolios are always in balance or moving towards balance.

[Noumenon]

She drives a Chrysler Crossfire, which probably costs almost half her annual salary. It’s implausible that her British equivalent - would that one existed - would own something so flash.

Really? If you buy a new car every 7 years a car that costs half your annual salary will cost just 1/14 of your salary per year. That's nothin.'