On the Rajan hypothesis and toxic theories of consumption
The notion that inequality is causally related to the Great Recession of 2008 is currently one of the hottest topics in macroeconomics (see http://www.socialeurope.eu/2012/04/the-impact-of-inequality-and-macroeconomics/). Before the crisis, most economists were hardly interested in the links between the distribution of income and financial stability. Although the higher inequality and rising indebtedness of U.S. households were well-known empirical facts, most economists, relying on the dominant theories of consumer behaviour, did not see the storm coming.
Much of the impetus of the current debate stems from what can be called the “Rajan hypothesis”: In his widely discussed book “Fault Lines” (2010), Raghuram Rajan argues that many lower and middle-class consumers have reacted to the decline in their relative incomes since the early 1980s by reducing saving and increasing debt. This has temporarily kept private consumption and thus aggregate demand and employment high, despite stagnating incomes for many households. But it also contributed to the creation of a credit bubble, which eventually burst, and a large current account deficit in the United States.
In a new paper (http://www.boeckler.de/pdf/p_imk_wp_91_2012.pdf), I place the Rajan hypothesis in the context of competing theories of consumption, and survey the empirical literature on the effects of inequality on household behaviour beyond the largely anecdotal evidence provided in Rajan (2010).
According to the standard textbook theories of consumption, the permanent income and life-cycle hypotheses, rational consumers use all the statistical information at their disposal to compute their expected future income path. From this they deduce their optimal levels of current consumption, saving and debt. Consumers are also rational in the sense that their decisions to spend are not influenced by the standard of living of others.
Up until the crisis, a very influential view inspired by the standard consumption theory, was that the rise in measured inequality since the early 1980s reflected mainly a higher income volatility rather than higher permanent inequality between households (see http://www.nytimes.com/2002/11/07/business/07SCEN.html?pagewanted=all). The higher variability of individual incomes seemed to be inherent in the post-Fordist, or “New Economy”, which has led to more rapid structural change, faster labour turnover and thus higher job insecurity.
According to the standard view, households could insure against this higher income volatility through efficient credit markets and smooth their consumption in the event of temporary adverse income shocks. Hence, the idea was not that easy credit was a palliative for households that were falling behind, as argued by Rajan, but an efficient market response. Most economists thus welcomed the deregulation of the credit market.
However, recent empirical work strongly suggests that the rise in inequality over the past decades has been largely due to the permanent rather than transitory components of income. In other words, many households have lived beyond their means and were lured into credits they could not afford. In hindsight, the dominant theories of consumption look rather toxic.
While Rajan puts a lot of emphasis on government failure and the political economy of income inequality and financial market deregulation, the more important implication of his analysis is the rejection of the conventional theories of consumption, which see no link between the inequality of (permanent) income and aggregate personal consumption, and hence no need for government action stimulating consumption and jobs in response to higher inequality. I conclude that the Rajan hypothesis calls for a renaissance of the relative income hypothesis of consumption, first formally stated by James Duesenberry and more recently developed by behavioural and Keynesian economists.
The behavioural bottom line of the relative income hypothesis is that consumers care about their consumption relative to others in their reference group as a signal of social status. There is strong evidence that the rise in inequality in the United States increased the pressure for households below the top of the income distribution to keep up with top income consumers.
The figure below gives a first indication for this in that it compares the growth rate of median income for families of four with the growth rate of what consumers perceive as the minimum amount of yearly income a family of four would need to “get along in your local community”. From 1947 to 1967, both the perceived minimum income and actual median income grew considerably, and the actual income growth was even somewhat higher than the growth of subjective minimum income for the median family.
Note: Subjective minimum income is based on responses to the Gallup poll (http://www.gallup.com/poll/26467/public-family-four-needs-earn-average-52000-get.aspx) question: “What is the smallest amount of yearly income a family of four would need to get along in your local community?” Actual median income is taken from the Current Population Survey.
Interestingly, in 1987 the amount of money that was perceived as necessary to “get along” was no higher than in 1967, while median family income continued to grow quite considerably (and roughly in line with mean family income) during 1967-1987. In other words, it would seem that the typical American family of four considered their material standard of living as (more than) satisfactory during that period, despite a slowdown in growth. And yet, after 1987 the amount of income considered necessary to get along again increased strongly, by more than 40 per cent until 2007, even though median real incomes were only a bit more than 15 per cent higher in 2007 than in 1987 (real mean income grew by a bit more than 20 per cent).
It is very likely that rising inequality contributed to this new perception of need among lower and middle-class consumers, as most individuals develop consumption norms by looking at the consumption of others above them.
In the paper, I summarise the more formal empirical evidence of how households below the top responded to higher inequality. Higher wage and income inequality seem indeed to have contributed to the fall in the personal saving rate, the rise in personal debt and to a higher labour supply in the United States. When income was not sufficient, debt could finance medical bills, the ever increasing costs for children’s college education and a house. But at some point the bubble burst.
The renewed interest among economists in inequality as a macroeconomic risk is highly encouraging. While it seems obvious in the light of the recent crisis that the once dominant theories of consumption and financial market efficiency are largely discredited, more research is required to pin down the macroeconomic implications of inequality under different country-specific circumstances.
In a forthcoming paper, which is part of the International Labour Organization project “New perspectives on wages and economic growth”, Simon Sturn and I argue that it is perfectly conceivable that the same cause, rising inequality, has led to very different reactions by private households in the United States, China and Germany due to various country-specific institutions. In China and Germany, higher inequality has contributed to the increase in middle-class saving, weak consumption demand and a strong dependence on exports. In this sense, thus, inequality is also closely related to the international current account imbalances.
The Economist (17/3/2012) (http://www.economist.com/node/21550246) recently noted that “Mr Rajan’s story may work for America’s 2008 crisis” but added that “(i)t is not an iron law”. While this is certainly true, inequality has created considerable “fault lines” outside the United States.