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The Banana Republic Computer (BRC)

A disruptive level of income inequality is the driving force underlying the 2008 financial collapse and the Great Depression. Click here for the argument. The BRC illustrates the effect of distributing a large portion of the gains from productivity to those who will spend a comparatively small fraction of it. The result is a corrosive increasing imbalance with too much investing and too little spending.

I use "banana republic" to refer to a country where most of the power and resources reside in relatively few hands. The economic course we have been following for the last few decades is leading in that direction. The BRC is an, admittedly simplistic, demonstration of how this happens. Before we present the BRC here is some background to justify it.

There are loosely speaking two things you can do with your income. You can spend it or you can invest it. If you have little income you will probably spend most of it just to survive. If you have a fabulous income you will probably invest most of it because you can buy whatever you need and most of what you want with a fraction of your after tax income.

It is important to maintain a balance between spending and investment. Too much spending and there is nothing left to invest. Too much investing and there is no profit in investing because the investors are all competing for the same limited opportunities to create products and services to satisfy a limited demand.

One might think that whether money is invested or spent on consummation it is still spent and contributes to demand. However it is not only the amount of money in circulation that determines demand, but even more importantly the rate at which money is recycled by the financial system. If a bank cannot find relatively safe profitable ways to lend money from recent deposits it will either retain the funds limiting its profits or take an imprudent risk. In the first case total demand decreases. In the second case, if the loan turns sour, total demand will shrink even more as the bank limits its lending to maintain its capital requirements.

The following plot shows the distribution by percentile of household income in 2003 dollars from 1967 to 2003. During this period many families went from a single earner to two or even more contributors to household income. Thus for the bottom 3 percentiles (10th, 20th and 50th) relatively flat household income translates to a lower hourly rate and a declining standard of living. Even the 80th percentile which goes from 55,265 in 1967 to 86,867 in 2003 is not a significant increase in earnings when the increase in two earner households is factored in.

Elizabeth Warren in the video lecture The Coming Collapse of the Middle Class: Higher Risks, Lower Rewards, and a Shrinking Safety Net suggests that things are worse than suggested by family income. Two major nondiscretionary items, mortgage payments and health insurance have increased much more rapidly than inflation imposing both a greater burden and greater risk on most families. Education (college is now considering mandatory by most parents and students) as well as childcare and the necessity of owning a second car in two earner households all add to the burdens families bear today.

Income Distrobution Plot
U. S. Household Income at Selected Percentiles 1967 to 2003
Data is in 2003 dollars and is taken from Table A-3 in
Income, Poverty and Health Insurance Coverage in the United States: 2003
by the U.S. Census Bureau.

During the 37 years covered in the above plot, the cumulative increase in nonfarm productivity was roughly a factor of 2 according to the Bureau of Labor Statistics. The 90th and 95th percentiles are the only ones that came close to doubling their incomes in this period. This implies that most of the benefits of the increase in productivity went to a tiny fraction of the population at the very top of the income distribution.

A flat income distribution over time for most workers in an economy in which productivity is improving, will ultimately become disruptive. The problem is that an ever increasing percentage of income will be invested and an ever shrinking percentage will be consumed. The imbalance will eventually lead to layoffs and increased competition for the remaining jobs. This will in turn lead to lower wages and an accelerating divergence between spending and investment.

The BRC is a simplistic model intended to illustrate the effects of productivity increases that are not widely distributed. It is not intended as a realistic economic model. It ignores many factors. For example the wage declines and job losses over the last decade that this model predicts were averted by the housing bubble. Instead of happening gradually they are occurring in a few months. They were averted temporarily by the increased lending and resulting consumption that is not a part of this model. Click here for an explanation of how this lending was a short term help that contributed to the collapse.

Most importantly the BRC does not reflect the negative sentiment that is a self fulfilling prophecy in the current economy. As most businesses and individuals limit their spending the economy including the GDP goes into reverse.

Although the BRC is too simple to be a realistic economic model it does illustrate a critical issue. Distributing the gains in productivity in a way that most of it is invested leads to inadequate demand for the existing GDP with falling employment, wages and ultimately GDP.

What does the Banana Republic Computer do?

It computes unemployment, change in Gross Domestic Product (GDP) and change in wages based on a simple model.(Click here for a detailed description of the model.)

You can set the following parameters:

productivity increase:%    demand factor: %    job change: %

wage demand: %    wage elasticity: %    last year:


     

Projection for    unemployment:%

change in wages: %    change in GDP:%

The purpose of the model is to demonstrate how corrosive ever increasing income inequality can be and how it will eventually dominate every attempt to mitigate its bad effects. We need to reverse the current dynamics or we will become a banana republic with a handful of super rich in a starving nation. Click here for my suggestions.

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