We are not as wealthy as we thought we were, and its consequences

by on May 2, 2013 at 1:26 pm in Economics | Permalink

Erzo G.J. Luttmer has an interesting new paper and model (pdf):

When consumers realize they are not as wealthy as they thought they were, they reduce consumption and save more. This lowers the real interest rate, making the development of new projects more profitable. The price of new projects rises relative to the price of consumption. The Stolper-Samuelson theorem therefore implies an increase in managerial wages, and a decline in worker wages. If the economy operates in a region where the supply of worker labor is sufficiently elastic, this can lead to a significant reduction in the employment of workers, while managers are reallocated towards developing new projects.

You should not believe in this to the exclusion of traditional aggregate demand channels, but still it is an interesting way to visualize some supplemental effects.  Note that workers who are quite good at building new projects will earn premia, while others, in the declining sectors, are losing their jobs.  That is not so different from the world we live in.

For the pointer I thank Paddy Carter.

foosion May 2, 2013 at 1:40 pm

This is among the reasons the best off support austerity, which reduces consumption and lowers the real interest rate.

Ray Lopez May 2, 2013 at 1:41 pm

Well the rebuttal is in Wikipedia under Stolper-Samuelson and Leontief paradox (see). Excerpt: The Stolper–Samuelson theorem is a basic theorem in Heckscher–Ohlin type trade theory. It describes a relation between the relative prices of output goods and relative factor rewards, specifically, real wages and real returns to capital.The theorem states that—under some economic assumptions (constant returns, perfect competition, equality of the number of factors to the number of products)—a rise in the relative price of a good will lead to a rise in the return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the return to the other factor. The validity of the Heckscher–Ohlin model has been questioned since the classical Leontief paradox. An advanced course textbook writer estimated that “the Heckscher–Ohlin model is hopelessly inadequate as an explanation for historical and modern trade patterns.”[2] As for the Stolper–Samuelson theorem itself, Davis and Mishra (2006) pointed recently that “[i]t is time to declare Stolper–Samuelson dead.”[3] They argue that the Stolper–Samuelson theorem is “dead” because following trade liberalization in some developing countries (particularly in Latin America), wage inequality rose and, under the assumption that these countries are labor abundant, the SS theorem predicts, they argue, that wage inequality should have fallen. Aside from the declining trend in wage inequality in Latin America that has followed trade liberalization in the longer run (see Lopez-Calva and Lustig (2010)), an alternative view would be to recognize that technically the SS theorem predicts a relationship between output prices and relative wages. Interestingly, papers that actually compare output prices with changes in relative wages find moderate to strong support for the Stolper–Samuelson theorem, such as Beyer et al. (1999) for Chile, Robertson (2004) for Mexico, and Gonzaga et al. (2006) for Brazil.

dead serious May 2, 2013 at 1:50 pm

I support austerity, if by austerity you mean reducing the defense budget to 1/3 its current size, reducing perks for the elected (salaries and bennies), means-testing government pensions and lifetime benefits, means-testing SS, and identifying and prosecuting benefits fraud.

I am guessing the right-wing version of austerity sees all cuts on the social services side.

Doug May 2, 2013 at 3:06 pm

“If by austerity you mean reducing the defense budget to 1/3 its current size”

Much of military spending is Red-America welfare. Either in the form of jobs for blue collar middle-Americans, military bases in the middle of rural areas that prop up the economy, or regional defense contracts. One way to view the Federal government is as a giant wealth transferring machine. Control of the machine isn’t stable or unitary, but is divided and alternates between Red-America and Blue-America. Consequently some of the wealth transfer largesse flows to Team Red and some flows to Team Blue. The primary conduit to the former is through the military, the primary conduit to the latter is through the rest of the civil service bureaucracy (on the high end) and the welfare state (on the low end).

Asking the military to cut its budget by 66% would cut Team Red’s share of the lucre by well more than 66% (since the military has to allocate some of its budget to the functional role of carrying out actual defense). My sincere guess is that your means testing plan isn’t going to be cutting the civil service bureaucracy, medicaid, social security disability, CHIP, etc. by anywhere near 66%. Add in the fact that top marginal taxes and capital gains and dividend taxes have gone up, which hurts Red-America more than Blue-America, and your austerity hurts one side of the country much much more than the other side.

Any austerity plan should at the minimum require Team Blue to sacrifice as much as Team Red. First of all it’s largely Blue policies that got us into this budget mess to begin with. Massive cost overruns in medicare, which is a Great Society program, are the primary reason our budget is where it’s at today. Second Team Red’s version of welfare is much less socially corrosive than Team Blue’s, so we should reduce the latter more. Welfare in the form of military service promotes responsibility, honesty, discipline and virtue. Welfare in the form of mailing checks to people for popping out illegitimate babies or fraudulently claiming “lower back pain” is a recipe for distilling pure human garbage.

dstraws May 2, 2013 at 3:47 pm

Ha, Ha, Ha, Ha! Team Blue is already subsidizing Team Red, that is they get few dollars in return from the dollars they send to the government.

dead serious May 2, 2013 at 4:15 pm

TLDR; yes, right-wingers want austerity but only certain kinds.

Ray Lopez May 2, 2013 at 11:37 pm

Well said, +1. However, this statement rings false: “Second Team Red’s version of welfare is much less socially corrosive than Team Blue’s, so we should reduce the latter more” – most military hardware is never used, so it’s like digging a hole and burying money (sort of like mining and storing gold), whereas a welfare check will be spent on booze and this will by contrast create more positive knockoff effects in GDP, in particular consumer spending, which is 67%. Whether one form of welfare is any better than the other (promote war or laziness: Team Red vs Team Blue?) is debatable, so I guess I disagree with you. BTW I vote all over the map–Libertarian, Blue and Red.

jseliger May 2, 2013 at 2:27 pm

If the economy operates in a region where the supply of worker labor is sufficiently elastic, this can lead to a significant reduction in the employment of workers, while managers are reallocated towards developing new projects.

I wonder if areas like San Francisco, New York, and L.A. are not very elastic due to housing / building constraints: though the number of units isn’t quite fixed, it also can’t grow to accommodate all the demand, so prices rise. One person who moves to SF means another person basically can’t live there.

That’s in line with the statement “That is not so different from the world we live in.”

anon May 2, 2013 at 2:48 pm

Isn’t the expected return of investment projects an important channel by which we have suffered a reduction in wealth? Great Stagnation, etc. This would seem to work the other direction.

mulp May 2, 2013 at 4:22 pm

Who consumes the production of the new production from the new projects?

Not the workers who are consuming less because they earn less from reduced employment from reduced consumption.

Do economists now believe consumers are a distinct class from labor who have a supply of money independent of any labor income?

ThomasH May 2, 2013 at 4:28 pm

If course the main thing wrong with the analysis is that SS operates in a full employment world. Nor is it clear that new projects are necessarily less labor intensive than old projects, though they might be. Where it is right is the disequilibrium, argument. It takes time to find the new projects, especially when the Taylor Rule requires a negative real interest rate.

Bill May 2, 2013 at 5:54 pm

Re: “while others, in the declining sectors, are losing their jobs.”

unless tenured faculty.

j t May 2, 2013 at 7:51 pm

That poor, dead horse

Bill May 2, 2013 at 8:05 pm

This dead horse still runs. I like how the ensconced elite talk about how other declining sectors must accept lower employment, how work rules in Italy explain declining productivity, and how ZMP workers exist everywhere, except in their own ranks.

I’ll wait for a Libertarian economist come out against tenure.

dead serious May 2, 2013 at 8:52 pm

+100. I’ve been saying this for years. Hypocrisy isn’t for the little people.

Bill May 2, 2013 at 10:02 pm

From Today’s NYT explaining why Duke is pulling out of an online college program:

“While Dr. Lange saw the consortium as expanding the courses available to Duke students, some faculty members worried that the long-term effect might be for the university to offer fewer courses — and hire fewer professors. Others said there had been inadequate consultation with the faculty. ”

It extends beyond tenure.

prior_approval May 2, 2013 at 11:36 pm

‘Hypocrisy isn’t for the little people.’

Actually, it pretty much is. Those with sufficient wealth hire people to convince others that what appears to be hypocrisy isn’t, and to stay ‘engaged in one of man’s oldest exercises in moral philosophy; that is, the search for a superior moral justification for selfishness.’ http://en.wikiquote.org/wiki/John_Kenneth_Galbraith

Eric Rasmusen May 3, 2013 at 8:24 am

This wealth theory might combine nicely with increases in the elasticity of supply of labor due to easy disability payments, long unemployment insurance, and means testing for protection against foreclosure.

Honza May 3, 2013 at 5:31 pm

Sometimes I wonder whether there is any economic development that DOESN’t increase the income of managers (absolute or relative),

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