Economics Homework Help

So one of the challenges of learning macroeconomics is understanding the relevance of the investment equals saving (I = S) identity.  Our strategy is to present it in Week 2 and then review it in Week 4.  While that might help familiarize you with the concept, it is still a somewhat ambiguous idea.  Even in its “real world” extended form of I = S + (T – G) + (M – X), which shows how private, public, and foreign saving finance domestic private investment, most still wonder why this matters so much.  For those skeptics, this week’s DB might help. 

First, take a look at a review of a recently published working paper about saving and investment in the U.S. up to the mid 2010s and what this might mean post pandemic.  As it’s written for the general public, you should be able to follow the author’s core argument, even if something here and there might not ring familiar.

https://review.chicagobooth.edu/economics/2021/article/how-1-percent-s-savings-buried-middle-class-debt

(Note:  the article also incorporates arguments from other papers as well.  Regardless, the Sufi/Lian/Straub paper is the focus of the review.) 

As per the analyses reviewed, does increased saving by the wealthy increase inequality of income and wealth or does increased inequality of income and wealth increase saving by the wealthy?  What is the mechanism that drives this?   What is the argument given about the desirability of investment in housing?  Do you agree?  Why or why not?

At first glance, the author of the review appears to be arguing that the top one percent of income earners and wealth holders in the U.S. save too much.  Say what?  Too much saving?  Isn’t the U.S.’s chronic current-account deficit explained by too little saving?  What’s going on here?

Finally, the author of the review critically discusses Sufi/Lian/Straub policy recommendations.  Assuming the analysis holds, how might the Biden Administration use this analysis to support its agenda, including unifying corporate tax rates around the world?  Do you agree with Sufi/Lian/Straub that a more progressive tax system and/or a wealth tax are/is the answer?  Why or why not?  Explain.  Anything else you might suggest as possible possible solutions?  (You need not limit your answer to what’s reviewed in the article.)  TWO INCLUDE TWO PEER RESPONSES.

Response One 

Increased saving by the wealthy increase inequality of income and wealth, argue Sufi, Mian, and Straub. They argue that the majority of saving by the wealthy can be categorized as unproductive saving, fueling household and government debt, and leading to the wealthy saving more. As this cycle perpetuates, it further exacerbates income inequality.

They use the example of a yacht to illustrate what happens in the case of “productive saving”, or productive investment. Billionaire’s and their mega-yachts are often vilified in the media, however yachts are rooted in the real economy. Money spent on the yacht goes directly to pay wages, buy supplies, and is circulated in the broader economy. Sufi says the mass consumption of the wealthy is the preferred course of action, “People get angry about seeing the rich consuming a lot, but that’s better than what they’re actually doing.”

What occurs more often, the authors argue, is the savings of the wealthy are largely unproductive. When the top 1 percent save, it is found that they finance the debt and dissaving of the lower 90 percent. In the decades leading up to the 2008-2009 financial crisis, it was found that the top 1 percent financed a third of the rise in household debt owed by the lower 90 percent.

How did this come to be? Lenders -the same we get our mortgages and credit cards from- used the top 1 percent’s savings to finance household borrowing, enabling the wealthy to benefit from the bottom 90 percent’s debt repayments. This perpetuates the cycle, allowing the wealthy to grow their savings from household’s debt repayments, while households are incentivized to go further into debt with access to easier credit and lower interest rates. The ensuing result? Household debt held by the top 1 percent as a financial asset rose by 15 percentage points of national income from the 1980s to 2007. Concurrently, household debt owed by the bottom 90 percent as a liability rose by 40 percentage points.

Investment in housing is speculative, and therefore unproductive. While mortgages enable homeownership by households, they are less productive than investments in manufacturing plants or technology. And yet the wealthy continue to finance mortgages and home equity loans, as opposed to productive investments. The authors say this desire for unproductive investment in housing is not deliberate, but just the easy option. The wealthy “just cannot spend all the money they make,” says Sufi, and they want to put their excess savings to use. The US government promotes unproductive investment by providing tax breaks on debt interest, and by encouraging banks to lend via debt financing. Why wouldn’t the wealthy take advantage of the opportunity, and get returns on their excess saving?

I agree that this is what is occurring, but I do not believe most investors are aware of it. The wealthy hold claims to household debt through time deposits at financial institutions, bonds, pensions, equity, and mutual funds. These are passive investments that anyone with excess savings will invest in. While undeniable that it indirectly contributes to the finance of mortgages and the housing market, I doubt that it is the intention of most investors- they are simply seeking returns on investment.

Economists tend to agree that the U.S.’s chronic current-account deficit is explained by too little saving. And yet, the author of the review argues that the top 1 percent save too much. I would argue that they are both correct statements. The top 1 percent is saving too much, leading to them being unable to spend their money on productive investments, leading to excess savings being spent on unproductive investments, leading to the increased debt of households in the lower 90%. The top 1 percent is indeed saving too much – but it results in the lower 90%, and the entire U.S. going further into debt.

Sufi, Mian, and Straub propose solutions to this issue, namely a more progressive tax system or a wealth tax. Naturally, these solutions are controversial. A wealth tax has already been tried in Western Europe. In 1990, there were 12 countries in Europe taxing net wealth. Because of its ineffectiveness it is now down to Norway, Spain, and Switzerland. As recently as 2018, France complained about its then-wealth tax causing millionaires to flee France. “A better-designed corporate income tax may be more effective than a wealth tax,” says Booth’s Eric Zwick. This is inline with the Biden Administration’s current agenda: unifying corporate tax rates around the world. A more progressive tax system in an attempt to indirectly target the wealthy, or even a more direct wealth tax is ineffective and will not work. If your goal is to tax the 1 percent, the effective solution is to tax corporations. Investments of the 1 percent are incredibly concentrated into their companies. The most effective way to tax Jeff Bezos is to tax Amazon. If the current administration were able to succeed in their goal to unify corporate tax rates around the world, it would prevent corporations from fleeing, as they would have to pay the same rate anywhere. The Biden administration should stick with their current course of action, instead of attempting to also add a more progressive or wealth tax.

Response number 2

Much of the focus of the inequality debate has been on the rising incomes of the 1%. But there is also growing concerned about the economic situation of a large swathe of low-earners. Economists have long theorized over the relationship between growth and inequality and vice versa. Today, there appears to be increasing evidence that excessive inequality is bad for economic growth. High inequality has other negatives, too, such as lowering social mobility and, in education, reducing people’s opportunities to learn. In terms of income and wealth, inequality has been a hot topic for the past couple of decades, but it has been unclear what role saving plays in it, whether as cause or effect.

Income and wealth, define as many vital concepts that are essential to any discussion of income inequality. These include the distinction between income and wealth as well as definitions and measures of inequality and poverty. Recent studies demonstrate that inequality is bad for everyone in society. The primary mechanism through which inequality affects growth is undermining education opportunities for children from poor socio-economic backgrounds, lowering social mobility, and hampering skills development. Children from the bottom 40 percent of households are missing out on pricey educational opportunities. That makes them less productive employees, which means lower wages, which means lower overall participation in the economy. That is not a piece of good news for the top 1%. Billionaires have the objective to maximize their profit; therefore, it should be essential that they want people to afford their products. Thus, in neo-classical economics, it is assumed that the level of saving will equal the level of investment. That is because available savings determine investment in the economy. If there is an increase in savings, banks can lend more to firms to finance investment projects. In a simple economic model, we can say the level of conservation of money will equal the level of investment (S=I). Although US income inequality began a marked increase in the 1980s, the wealthiest 1 percent of households increased their savings while the bottom 90 percent fell into debt. The researchers say the rich aren’t deliberately shying away from productive investments to finance household and government debt. And, indeed, many wealthy people contribute to effective investment and philanthropic causes. However, the rich are seeking returns on their excess savings because, as Sufi says, many of them “just cannot spend all the money they make.” The rich seek returns by investing.

In principle, there’s nothing wrong with a savings investment culture. Higher savings can help finance more heightened levels of investment and boost productivity over the longer term. In economics, we say the level of savings equals the level of investment. Investment needs to be financed from saving. I agree with Sufi/Lian/Straub that a more progressive tax system and a wealth tax because it enables the banks to lend more to firms for investment when people save more. Savings should mean to be keeping the money in banks, not keeping it at home. Otherwise, in both the short and long run, it will create the condition of recession. The traditional model of Saving and Investment states that S=I. If you increase savings as a % of income, investment as a % of payment will be higher, and consumer spending as a % of income lower. Thus, in this economic recovery period, the Biden Administration might significantly increase its borrowing, but it’s helpful to see this in the context of rising private sector lending. By cutting government spending, there will be an interest for all sectors, private and public, increasing savings and reducing spending, which will engender an increase in the employment rates in the future.

Reference

Stropoli, R. (May, 2021). How the 1 percent’s savings buried the middle class in debt. CHICAGOBOOTHREVIEW. Retrieved from https://review.chicagobooth.edu/economics/2021/article/how-1-percent-s-savings-buried-middle-class-debt