Underconsumption And The Rate Of Saving

It is sometimes said that capitalists consume a lot and the theory of underconsumption fails.

For example, Federal Reserve paper (h/t WinterspeakDisentangling the Wealth Effect: A Cohort Analysis of Household Saving in the 1990s – although not suggesting a failure of underconsumption – says that in the ’90s, personal saving rate fell a lot due wealth effects from a rise in the market value of equities held by high-income earning households (although suggesting alternate interpretation as well) inducing them to consume more.

But some on internet discussion groups seem to have interpreted it as a failure of the underconsumption theory.

Before I say what I want to say, some preliminaries: In Keynesian theories, there are two things – propensity to consume and propensity to save. A lot of people erroneously think that these add to 1. I will go further and say that a theory which considers the interaction of stocks and flows with a notion of a propensity to save will end up with paradoxes. Rather saving – household saving in particular should be seen as a result of a model which traverses in historical time between one configuration of stocks and flows to another. With consumption depending on income and wealth, the notion of propensity to consume is more appropriate than the somewhat inferior “propensity” to save. Or one may say that the propensity to save is a derived concept.

What is the underconsumption theory? It can be conjectured in various ways. One is to say that the propensity to consume out of wages is higher than the propensity to consume out of interest income, dividends and capital gains. Another is to say that low income earners have a higher propensity to consume out of wages than high income earners. This is then given a policy angle and the underconsumptionists then claim (rightly in my opinion) that a better distribution of national income will lead to stronger effect on growth because low income earners will consume more and have multiplier effects on output – in contrast to “supply-side” policies.

Back to the Federal Reserve paper. Some seem to have interpreted it as saying that it is a blow to the theory of underconsumption citing low rate of saving for high income earners. There are several things wrong with this. The fact that high-income earners spent a lot in some periods doesn’t mean it is a better policy than aiming for a better distribution of income, especially when the former is more unpredictable because of the unpredictability of stock-markets, while the latter is more direct. Although this point is more important, the citing of low saving of high-income earners in some periods following high capital gains should be dismissed. Low saving was not the result of a low “propensity to save” – which is a derived concept but the result of higher consumption due to rise in wealth than due to a rise in “propensity to consume” by high-income earners.  

So if household consumption is given by

C = α1·YD +  α2·W-1

where C is consumption, YD is disposable income, and W is wealth. α1 and α2 are the propensities to consume out of income and wealth, respectively. The subscript -1 indicates it is the value for the previous period. The wealth term also includes capital gains at the end of previous period.

Saving is given by

S = YD – C

Now, as per national accounts, income doesn’t include capital gains, although taxes on capital gains may reduce YD but let’s ignore that. This doesn’t mean capital gains are irrelevant, because consumption behaviour depends on capital gains. So the rate of saving  S/YD is given by

S/YD = (1 – α1) – α2·W-1/YD

which may hit zero or even turn negative if there is a large rise in W-1 because of capital gains even if the parameters αand αhave not changed. So for example αmay be something like 0.5 and yet the rate of saving may be negative.

In other words, the data of the 90s doesn’t disprove the fact that low-income earners’ propensity to consume out of income is higher than high-income earners – it just shows that some high income earners’ saving may have gone negative because of higher consumption due to capital gains in some periods.

So what if there is a fair distribution of income? Since low-income earners have a higher propensity to consume, less inequality will lead to a higher output and national income than otherwise.

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