Michael Pettis Responds; Fantasyland Thesis vs. Reality; Counter-Challenge!

In response to my article Pettis Proposes Savings Glut and Income Inequality are Source of Global Imbalances; Mish vs. Pettis: I Respectfully Disagree, I received an interesting reply from Michael Pettis.

Before posting his response and my reply to his response, I reiterate my gratitude to Pettis. He has taught me much of what I know about trade. I recommended his book "Great Rebalancing", and still do. I also deeply appreciate even having this discussion and for Pettis to personally respond.

That said, Pettis failed to convince me. Here is his reply. Does he persuade you, or do my arguments make sense?

Michael Pettis Responds

Thanks for the discussion, Mish, but I don't really think you've addressed the essay, which provides a logical argument, not a moral or political one. My argument has been praised as brilliant by one group of people and as evil by another, but too many people on either side have failed to understand and instead have resorted to political prejudices.

The problem is that you cannot agree with just the part you like. Either the entire argument is true or it is false. In fact all of these conditions can be true but are likely to be more or less important under different conditions. One of the great follies of contemporary debate, it seems to me, is that certain policies are considered to be intrinsically and always wealth-enhancing, or intrinsically and always wealth-destroying, depending on your political beliefs, whereas I would argue that these policies, and in fact many others (free trade, unionization, free banking, etc.) can be wealth-enhancing under certain conditions and wealth-destroying under others. Rather than close the door to debate we should try to figure out the conditions under which they are one or the other, and guide policy according to the relevant conditions.

But let me explain why I do not think you, or most others, have addressed the argument. To summarize, I start with three propositions, from which everything else follows:

1. The rich in any economy save a greater share of their income than do the poor. This is an assumption that can be proven or disproven empirically. The fact that some countries are rich and others poor may complicate things, but this only means that income inequality inside a country matters, whereas income inequality between countries might or might not matter.

2. In every closed economy savings is equal to investment. This is true by definition because the demand side of an economy consists of consumption and investment, while the supply side (how we allocate total production of goods and services) consists of consumption and savings. Because demand and supply always balance, savings is always equal to investment. I know you understand this.

3. No one has infinite debt capacity. I don't know if this is an assumption or true by definition, but at any rate I know you agree.

Here is the argument which, if you accept the three propositions above, can only be logically true or logically false:

1. From Proposition 1, if income inequality rises, the savings rate must rise.

2. From Proposition 2, if savings in one part of the economy rises, we must see one or both of the following:
a) investment must rise, or
b) savings in another part of the economy must decline.

3. If investment rises, one or both of the following must be true:
a) productive investment rises
b) non-productive investment rises

4. If savings in another part of the economy declines, one or both of the following must be true:
a) the "non-rich" increase their consumption
b) unemployment rises.

So far I think you would agree that the argument is true and in fact obvious. You might question whether there are indeed only two ways for savings in another part of the economy to decline, but these are the only two ways I can think of. If you find a third way, it would interesting to see how it would affect the argument.

This leaves us with the following. If income inequality rises, we must see one or more of four possible outcomes, which I list as 3a, 3b, 4a, and 4b. Unless you discover any other possible outcome, these are the only ways to balance an increase in income inequality, right?

Let us focus on 3a and 3b:

5. If productive investment rises, we all get wealthier, both rich and poor (this is what the supply-siders mean by "trickle down"). The process is clearly sustainable.

6. If non-productive investment rises, wealth declines. Once wealth declines to some limit (it could be zero but it could also be, and is likely to be, much higher than zero) the process can be maintained only by rising debt, but from Proposition 3 there is a limit to rising debt, so this process is not sustainable.

Now let us focus on 4a and 4b:

7. If some of the non-rich increase their consumption, they eventually draw their savings down to their minimum level (which might be zero, but doesn't have to be), at which point they have to borrow to consume. But again, from Proposition 3 there is a limit to rising debt, so this process is not sustainable.

8. If unemployment rises, total savings decline, although because it might also cause investment to decline, unemployment might have to rise a great deal, which is what happened in countries like Spain once debt-fueled consumption and debt-fueled non-productive investment came to an end in 2008. This is, unfortunately, sustainable.

End of the argument.

The conclusion, which follows inevitably from the three initial propositions, is that a rise in income inequality can lead temporarily to an increase in non-productive investment or to an increase in debt-fueled consumption, but in both cases they are unsustainable. A rise in income inequality can also lead to a rise in productive investment or a rise in unemployment, neither of which is unsustainable (unemployment in the long run might be unsustainable, but of course this does not invalidate the argument).

This means that rising income inequality must eventually lead to more productive investment or to more unemployment. There is no other conclusion.

Can this argument be attacked? Of course it can. If you disagree with any one of the three initial propositions, then even if the argument is completely logical, the conclusion may be wrong. Alternatively, if you disagree with any of the logical steps, then even if the three initial propositions are correct, the conclusion can be wrong. These, of course, are the only ways in which the conclusion can be wrong.

From my reading of your piece, you agree that all three propositions are correct. This means that you must believe that the logic is wrong, but I cannot find where you disprove the logic. In fact I do not think the logic is wrong anywhere, and economists ranging from Keynes to Friedman, including both liberal democrats and the supply-siders, all invoke the same argument because it is based either on propositions that are true by definition or on propositions that we all believe empirically to be true. They all agree with the propositions and the logic. Where they disagree is wholly on the issue of whether or not higher savings will lead to higher productive investment.

This I would suggest, is where you must concentrate your own arguments, unless perhaps you disagree with Proposition 1. I cannot think of any other way to attack this argument except by calling it politically incorrect, which of course is not a refutation at all. That does not mean that there are no moral, social, or political arguments in favor or against rising income inequality, but these have nothing to do with the economic impact of rising income inequality.

Regards,
Michael