The savings of the rich are recycled into household and government debt.
By guest author Peter Coy. Peter Coy is the economics editor for Bloomberg Businessweek and covers a wide range of economic issues.
We know three things about the U.S. economy: The rich are getting richer, everyone else is in debt, and interest rates have fallen. Is there a connection? Yes, and the link has implications for fiscal and monetary policy.
By forcing interest rates down, extreme wealth inequality pushes the U.S. economy toward a “debt trap” that’s hard to escape with conventional macroeconomic tools, write Atif Mian of Princeton, Ludwig Straub of Harvard, and Amir Sufi of the University of Chicago in an important paper that came out earlier this year, titled “Indebted Demand.” They advocate unconventional measures such as redistributive tax policies that narrow the gap between rich and poor.
The paper is in the same vein as work by former Federal Reserve Chairman Ben Bernanke, who publicized the concept of a global savings glut, and former Treasury Secretary Lawrence Summers, who revived the Depression-era notion of secular stagnation. Mian, Straub, and Sufi’s contribution is the theory of indebted demand, which they write is “the idea that large debt burdens lower aggregate demand, and thus the natural rate of interest.”
Here’s their concept: The rich can’t possibly spend everything they earn, so they save a lot. In theory those savings can be recycled into productive investment, but in practice a lot of the money finances borrowing—i.e., dissaving—by people farther down the income ladder. “A substantial amount of borrowing by households in the bottom 90% of the wealth distribution was financed through the accumulation of financial assets by the top 1%,” the economists write, citing their own prior work.
The lending from rich to poor can be indirect. For example, let’s say a rich person buys shares issued by a company. The company stashes the proceeds in a bank. The bank in turn makes a loan to a non-rich person to buy a car or a house. The borrowers have a higher propensity to spend than the lenders, but they have less money to spend because part of their income goes to debt service.
The excess of desired savings over desired investment pushes interest rates down and down until the effective lower bound of around zero. Rates can’t get much below zero because savers won’t tolerate it—they’d rather put their money under a mattress than earn a negative return on it.
Any policy that attempts to fix things by encouraging more borrowing makes things better in the short run but worse in the long run by saddling the private or government borrowers with even more debts that will eventually have to be repaid, the economists write.
That’s why they favour redistribution through income or wealth taxes, which would increase the spending power of the 90 %. “One-time debt forgiveness policies can also lift the economy out of the debt trap, but need to be combined with other policies, such as macroprudential ones, to prevent a return to the debt trap over time,” they write.
Not everyone agrees, of course. An article about the research in the latest issue of the Chicago Booth Review, a publication of the University of Chicago’s Booth School of Business, quotes Booth’s Steven Kaplan as saying that wealth taxation was tried unsuccessfully in Europe. Kaplan also tells the publication that wealth inequality had been shrinking before the pandemic struck.
Chicago’s Sufi responds in the article: “Any decline in inequality from 2017 to 2019 was tiny compared with the rise in inequality since the 1980s, and the Covid-19 crisis will almost assuredly amplify inequality going forward.”