In Part II of this series of blogs on the dominant causes of the Credit Crisis, we analysed the growing divide between productivity and household income, growing income inequality, decreasing capacity utilisation and the growing imbalance between demand and supply covering a period from the sixties to the early 2000’s. We showed how the top wealth groups gained an ever increasing share of total US household income since the early eighties; how their accumulated savings and investments have since caused overcapacity; and why the lower income groups’ (bottom 80%) financial ability to absorb the increased production from expanding capacity, diminished to such an extent that it caused an imbalance between supply and demand.

In Part III of the blog series, we analysed the Balance Sheet of US Households from 1962 to 2010 and showed the different savings patterns between the bottom 80% and top 20% of households in terms of income and net asset wealth. We also showed how the top 20% and especially the top 1% of households substantially increased their savings from 1983 to 2007 while the bottom 80% of households had substantial negative savings. The effects of a worldwide savings glut on overinvestment in productive capacity and lower interest rates are also discussed in Part III.

Evidence suggests that when too much wealth, earnings and savings accumulates in too few hands, the ability to produce goods and services will exceed the ability to consume those goods. This is so because those who have a need for more consumption cannot afford to increase their consumption whereas those who can afford such increase in consumption have no need to consume more. Few people want to buy 100 cars or 20 boats simply because he can afford it.

Consumption and expenditure of all income groups, continue to increase from the eighties right through to 2008. The substantial increase in disposable income for the top income groups enabled them to consume and save more. The obvious question is, how did the bottom 80% manage to keep pace with the expansion in expenditure and consumption when the growth in their incomes, since the eighties, did not?

Various factors played a role in filling the growing “income gap” between the expenditure and income (earnings from wage and salary) of the bottom 80%. Incomes were supplemented by tax decreases and benefits, negative savings, lower interest rates and expanding credit over a period of three decades. Credit expansion, the most dominant stimulus in the 2000’s, was the first to waver in 2007 and lower interest rates (mortgage rates) might be the last to go. By 2009, it was clear that the full potential of the above sources to fill the “income gap”, were just about fully tapped. A new stopgap measure was implemented. Huge amounts of government stimulus was used to fill this gap to some extent. By 2011, this government stimulus has caused many governments to run up huge debts which they find difficult to service. As austerity measures are becoming a more popular method to limit expanding government budget deficits, it is clear that most countries have run out of stopgap measures.

Why does wealth concentration tend to lead to economic expansion and then contraction? Part II and Part III tell us much about the dynamics that caused the imbalance between supply and demand and its association with wealth concentration, measured by income and/or net assets. To explain how and why it happens however is somewhat more difficult.

As shown in Part III, wealth concentration of financial assets in the hands of the top 20% continued to grow from 82% in 1962 to just below 90% in 2007. This is very important statistic because the savings that households put into financial assets will always seek investment opportunities, either to increase the supply of goods and services or to finance credit to the consumers who wish to acquire more goods and services. Where savings struggle to find an investment opportunity in any of the above alternatives, money is often temporarily diverted to the “speculation circuit” where money changes hands between speculators with the exclusive intent to profit from the speculative buying and selling of financial assets, without any intent to produce or to acquire any goods or services for consumption. This speculative investment may include shares, commodities, bonds and other more sophisticated financial instruments.

The chart below illustrates to what extent each category of US household invested in different types of assets in 2004.  (Financial assets includes common stock and non –equity financial assets)

Percentage Ownership of Each Category of Assets

Source: The State of Working America

The table below shows that although the bottom 80% earned only 52.4% of total disposable income, it contributed 61.4% to total US consumption. As explained previously, factors like credit expansion and negative savings enabled this group to spend more than what they earned from wages and salaries.

The table below demonstrates the extent to which credit has expanded, especially from the eighties, and the following table show how this growth in credit was distribute between the two US household categories (measured by income). 

The table below confirms that the major part of the fast growth in credit in the 2000s, as reflected in the above table, was attributable to the bottom 80%.

Data and trends in the above three tables correlate to a great extent to the basic trends as reflected in the US household balance sheets analysed in Part III. In fact, one could say it is the logical consequence of structural changes in the economy since the early eighties, as describe in Part II.

In order to provide some insight as to why growing wealth inequalities are likely to create economic imbalances, we will use simplified economic models that consist of three interdependent modules that will focus on income from labour and investment; production and personal consumption. These “closed” economic models will compare approximate trends of the 1950s and 1960s with approximate trends observed in the 2000 to 2008 period and 2010.

Throughout this series of blogs, wealth inequalities and changes therein are explained by comparing two groups: the bottom 80% and top 20% of income earners. There is no particular reason why one could not split the groups differently, such as into the bottom 90% and the top 10%, or even the bottom 99% and the top 1%. In fact, it may be more appropriate to use the latter in many instances. The 80 and 20% groups are used because historic data are more readily available in this format and are commonly used to demonstrate the effects of growing wealth inequalities on economies.

Models A, B and C below, assume that there is a “closed” economy with a limited number of players. In addition, total household income ($100/$200) is assumed to be equal to the value of all products and services produced by the economy and consumed by only two groups (the top 20% and the bottom 80%). In the real economy, savings, government expenditure, private investment, imports and exports, taxation, and various other factors may also play a significant role. For the sake of simplicity, however, models A, B and C will only address those role players and economic factors that are considered necessary to illustrate the impact of growing wealth inequalities.

Model A reflects a situation where income distribution is similar to what was observed in the 1950s and 1960s in the United States. The bottom 80% of households earned around 57% of total disposable income and the assumption is made that they contributed 59% to total consumption. Model B refers to the period from 2001 to 2007, where the 80% group earned around 52% of total income but contributed 62% to total consumption. Model C refers to 2010 where the assumption is made that the bottom 80% share income (without government benefits) has decreased to 50% and its consumption to 61% of total consumption.

In Models A, B and C the 80% group contributes mainly labour to the Production Module, where goods and services are produced for sale to the Personal Consumption Module. For this input, the Production Module compensates them in the form of wages and salaries. The top 20% also contributes labour to the Production Module, but its main contribution is financial assets (finance, share capital, etc.). For its contribution, the top 20% is compensated in the form of salaries, interest, dividends, trading profits, and other forms of remuneration associated with its financial asset investments.

The total compensation paid to the Household Income Module in Model A comes to $100, of which the 80% group receives $57 and the 20% group gets $43. The 20% group receives a higher portion of total income if measured by individual household for mainly two reasons. The first reason is that it owns most of the capital; more than 90% of all common stock and non-equity financial assets (see chart above). The second reason is that members of this group are compensated more for their labour input due to their higher perceived value in producing goods and services. The Household Income Module then decides how to utilize this income. The 80% group spends its full income of $57, plus $2 it borrowed, on the goods and services received by the Personal Consumption Module and produced by the Production Module. The 20% group spends $41 ($43 – $2) of its income on the above goods and services and saves $2, which in turn gets lent to the 80% group.

Model A: Example of a Closed Economy in the 1950s and 1960s

By looking at Model A, there seems to be no alarming imbalance that threatens the above closed economy. The 80% group could have conceivably serviced the cost (interest and capital) of the $2 it borrowed and the 20% group benefited by virtue of the interest received. More importantly, there was a market for all of the goods and services produced by the Production Module, which in turn led to higher profits via dividends and interest. The system also benefited labour via wages and salaries, because the Production Module would employ all workers required to satisfy demand. Credit plays a relative minor role in the balance between supply and demand, compared to what happened in Model B below.

The situation has changed substantially from Model A to Model B. It is assumed that the closed economy doubled in growth to $200 without new entrants. It is also assumed that the Production Module increased the quantity of goods and services due to greater innovation and improved productivity. Importantly, expenditure patterns and the way income is distributed between the two groups have changed significantly from Model A.

The total compensation paid to the Household Income Module in Model B comes to $200, of which the 80% group receives $104, or 52%, and the 20% group gets $96, or 48%. The 20% group receives a higher portion of total income as measured by household, for reasons described in Model A. The Household Income Module then decides how to utilize this income. The 80% group spends its full income of $104, plus $20 it borrowed, on the goods and services received by Personal Consumption Module and produced by the Production Module. The 20% group spends $76 ($96 – $20) on the above goods and services and saves $20, which in turn gets lent to the 80% group.

Model B: Example of a Closed Economy in the 2000s

The imbalance in the closed economy of Model B is obvious. The 80% group’s share of total income has diminished substantially, and it borrowed a substantial amount ($20) from the 20% group, which enabled it to contribute 62% ($124) to the Personal Consumption Module. The 80% group therefore maintained a higher standard of living than that justified by its income from salaries and wages alone. On the other hand, the 20% group benefited significantly from this arrangement. It received a relatively greater share of total income as measured by household. Its net worth was increased by way of savings and the rising value of its investments (e.g. value of listed shares also increased). This was mainly achieved by finding a market (Personal Consumption Module) for all of the goods and services produced by the Production Module, which led to higher earnings. Without substantial lending by the 20% group and borrowing by the 80% group, there was no market for 10% ($20/$200) of the goods and services produced by the Production Module. If they could not sell the 10% of goods and services, it would result in overcapacity or excess production and less sales to the Personal Consumption Module. That would have translated into economic contraction and less compensation to the Household Module.

The imbalance comes about because the production of goods and services cannot be absorbed by the consumers (both the bottom 80% and top 20%) without the top 20% affording ever-increasing debt to the bottom 80%. As the 80% group’s debt increases every year by the above $20, it becomes less likely that it will be able to service it. These imbalances, however, would not have come about if the 80% group still received 58% or more of total income as stated in Model A and/or consumed a smaller percentage of goods and services. However, if productivity increases and more goods and services are produced by roughly the same resources—mainly labour and capital—and the benefits of productivity are not shared equally between the respective wealth groups, supply will overwhelm demand. This growing gap between supply and demand can only be bridged by growing credit, lower taxes, lower interest rates and negative savings – as it did from 1980 to 2008 - but it could not last forever.

The imbalance reaches the breaking point when the 80% group is unable to service its ever-increasing debt from limited income growth (salary and wages) and the value of the collateral (mainly housing) begins to collapse. This collapse in the value of collateral is inevitable in a bubble economy because credit fuels the rise in value, which in turn fuels a further rise in credit (as collateral values increase) to the point where it becomes unserviceable.  The actual divide between house prices, credit expansion and growth in income (2000 to 2007) and the subsequent implosion (2008 – 2009) are aptly demonstrated by the chart below.

Median Household Income vs. National House Price Index vs. Mortgage Credit

Source:  US Census Bureau; S&P/Case Shiller; Federal Reserve—Flow of Funds Account

This inability of the 80% group to service its debts has the potential to destroy the net worth and income of both groups. The 80% group’s net worth is destroyed by the decreasing values of its members’ homes, while the value of their debt (mortgages and other forms of debt) remains the same. In addition, as production is cut back and job losses increase, the Production Module aims to cut costs in an attempt to remain profitable, and to ensure maximum compensation to the owners of capital (share capital, bonds, debt, etc.). This further undermines the 80% group’s ability to negotiate a higher price for its labour, and hence leads to even less income with which to buy goods and services.

The net worth and income of the 20% group are also threatened by the following disturbances:

1. The value of its stock investments might drop significantly in value due to an expected decrease in future earnings,
2. The value of its debt investment deteriorates because of increasing defaults by the 80% group and a drop in value of the collateral for that debt, and
3. There is a decrease in income from bonuses, commissions, and other compensation previously justified by high earnings.

The higher income groups are further threatened by a lack of liquidity and by insolvency because they or the vehicles (banks, insurers, etc.) in which they are invested, are highly leveraged in order to maximize profits. Because neither party (mostly banks and investment institutions) wants to buy the other’s assets above the market value and because the sale of investments at market value could make the seller insolvent in a crisis, trading stops and the velocity of money in the economy slows. This situation is further worsened when the creditworthiness of trading partners’ banks is under suspicion. This happened to the United States and most of the other developed countries in 2008.

If the Fed, other central banks, and governments did not step in to save the top wealth groups and/or its investment vehicles (e.g. banks), trading could have slowed much more than it did; and the net worth and income of all income groups could have suffered even greater losses. This is not to say that the alternative of no assistance from governments and central banks would have been worse in the long run. By supplying more than ample liquidity, at virtually no cost, to this group’s various investment vehicles (mainly banks) against their illiquid investments as security, the investment vehicles started to speculate and/or trade among themselves, the Fed, and the US Treasury. This speculation and/or trading increased the value of various financial assets (especially shares and corporate bonds) in 2009 and subsequently, thereby improving the net worth of the wealthiest owners of capital. Despite receiving this extensive assistance from the Fed, credit lines to most of the 80% group have been cut and the cost of finance increased in many cases. The rationale is obvious: why lend to people who cannot service such debt, who have little hope of real income growth, who have insufficient collateral, or whose financial position will probably deteriorate further due to increasing job losses? Neither is it sensible to invest in further capacity as capacity utilisation has dropped to all-time lows. Hence, trading with each other and the government was the best option for the banks and other investment vehicles.

In Model C, the top income group lends its savings to the government instead of the bottom 80%. This has two distinct advantages. Firstly, it is much more secure form of debt. Secondly, it is just about doing the same job as their previous lending to the bottom 80%. It stimulates demand for goods and services, because government now has the responsibility to assist the consumer (e.g. tax concessions, unemployment benefits, food stamps, etc.) and stimulate the economy.

A further change is that the bottom 80% now receives an even smaller share (50%) of the income cake due to its negative real (inflation adjusted) income growth and greater unemployment. Governments attempted to fill the “income gap” of the 80% between earnings and consumption expenditure but can only do so for a limited time.

Model C: Example of an economy where government replaces top 20% as funder of bottom 80%

Once most governments’ debts have reached unsustainable levels, it will probably be forced to apply austerity measures, because the only other realistic alternative is to raise taxes significantly. Some governments, like the United States, which can print more of its own money to fund government budget shortages, may avoid the above for the time being. However, such money printing comes with the threat of hyperinflation.

If austerity is pursued, a major portion of demand from the bottom 80% will disappear for good, because there are nothing (credit, lower taxes, etc.) left to fill the gap between real income from earnings (salaries and wages) and the level of expenditure that supported the economy in the past. Utilisation of capacity has to drop, resulting in less investment, less employment, less income for the bottom 80% and further decrease in demand. The concentration of wealth will accelerate and the remaining wealth of a major former driver of demand, the bottom 80%, will continue to disintegrate. A substantial rise in the real income of the bottom 80% can change the picture but there is little evidence that this is likely to happen, given the structural defects in the current economy and the US government and Federal Reserve’s (and many other governments) policy to keep wages flat, as to prevent secondary  inflation effects from occurring.

Due to high unemployment, there is little room for labour to negotiate higher wages. Most increases in production are now achieved by way of increased productivity which is made possible by requiring more input (time and labour) from the currently employed, mechanisation, outsourcing and improving technology.

Central banks have expanded the money supply via quantitative easing in an attempt to stimulate the economy. This liquidity flowed mainly to the owners of financial assets that are owned (90%) by the top income groups or the financial vehicles (hedge funds, banks, etc.) in which they are invested. The hope is that this group will invest the additional liquidity in the production of goods and services, thereby creating extra jobs. But why would an investor do this given the existing low utilisation of production capacity and the continuing threat to growth in organic demand? Furthermore, in an economy where rapidly increasing wealth concentration (measured in terms of income distribution) is now the accepted norm, how could any new investment, hope to create more demand than supply? If investments over the last three decades created overcapacity and failed to keep supply and demand in balance, why would it be different this time, especially where the beneficial support from expanding credit, tax concessions, lower interest rates and negative savings have all but disappeared?

What do the top income households or their investment vehicles do with the increased liquidity from central banks? They are pumping much of it into the “speculation circuit”, speculating on the share markets, commodity markets and other financial assets. The rise in the value of the above assets does have some beneficial consequences for the economy in that it creates a “wealth effect” that makes consumers feel better about their financial position, encouraging those (mostly owners of financial assets) who have the ability to increase their spending, to do so. However, it probably has more negative consequence because of its effect on inflation, mainly due to heavy investment in commodities (oil, copper, aluminium, wheat, etc.). These speculative investments cause the prices of commodities to rise, and higher commodity prices are slowly but surely working its way through to consumer products. When wage increases don’t match price increases caused by inflation forces, demand effectively drops because the bottom income groups can buy even less goods and services (in terms of quantity) with its limited income.

Wealthy households’ needs have a limit. It is similar to the law of diminishing returns; that determines that for every additional unit that one consumes the added benefit or satisfaction that one derives from it diminishes. For example, say a household has bought four cars for each inhabitant. It is unlikely that there is a need to buy a fifth or sixth car. Irrespective of his or her wealth, few people want to buy 100 cars simply because they can afford to do so. The same goes for food, clothing, electronic equipment, and so forth. Once the needs of a household have been satisfied, it will tend to save the balance of its income. On the other hand, most of those in the 80% group have little discretionary spending and are more likely to have many unsatisfied needs that they would like to satisfy if they could. Thus the 80% group would increase spending and consumption substantially if it had access to additional income or credit.

Conclusion

Organic demand can only come from an increase in real personal income, especially those income groups that are more likely to increase its consumption expenditure as their incomes increase. This lies at the heart of the dominant causes of the Credit Crisis and a stuttering economy. Economic policy that in effect opposes real wage increases, does not give much hope for the future.

Increases in businesses’ inventory levels, speculative investments in commodities, lower interest rates, government stimulus and quantitative easing may have been a relatively successful stopgap measure that supported economic growth from 2009 to 2011. It may even continue for months or another year, but the hour of truth is drawing nearer as these stopgap measures cannot continue indefinitely. Continuance of some of the above stopgapmeasures can by itself cause future economic ruin.

Neither Britain nor Ireland’s austerity measures have produced convincing evidence that it could save the day or serve as an example to prevent economic ruin. In the end we may be left with two choices: find a way to increase the income of the lower income groups or face up to severe economic contraction.

In future blogs we will expand on the inflationary effects of excessive savings, low interest rates and quantitative easing.

 - David Collett, http://www.anchorage-investments.com/

© Copyright David Collett 2011.

Whilst every effort was made to ensure the accuracy of this article,  neither this document; nor its author, David Collett; nor any publisher of this article; offer any warranties (whether express, implied or otherwise) as to the reliability, accuracy or completeness of the information appearing in this article. Neither do any of the above parties assume any liability for the consequences of any reliance placed on opinions expressed or any other information contained in the above article, or any omissions from it. Its content is subject to change without notice. Any information offered, is intended to be general in nature and does not represent any investment or business advice of any nature whatsoever. If you choose to rely on such information you do so entirely at your own risk. Neither David Collett nor any third party involved in publishing this article, assume any responsibility or liability for the outcome of such reliance.

-- Posted Monday, 2 May 2011 | Digg This Article