The blockage of the circular flow of income provides a unified explanation of the way in which extreme inequality has contributed to both the underlying economic weakness that is characterized by slow growth and stubbornly high unemployment on the one hand, and the financial crises of 2000 (the bursting of the dot-com bubble) and 2008 (the bursting of the housing bubble) on the other.
There are, in other words, two sides to the coin of extreme inequality. On the one side, low wages (and high unemployment) are unable to support adequate consumer demand for the products of sound investments. The other side of the coin is high corporate profits and bloated high-end incomes that result in a build-up of unused cash, literally trillions of dollars that cannot be put to use, given the absence of demand for the products and services of further investments. In these circumstances, excess profits and high-end incomes feed speculative excesses such as the dot-com and housing bubbles, which sooner or later are bound to burst.
To understand the concept of the circular flow of income that underlies this analysis, imagine the closed economy of a town in which everybody works for one company, which is owned by one local owner, and which provides full employment and produces all their consumption needs.
The townspeople including the owner spend all their income on the goods and services sold to them by the company, which pays out all its revenue in wages and profits.
Diagram 1 is a simplified depiction of the circular flow of money from households to companies (in the form of purchases of goods and services) and back to households (in the form of wages and profits). In other words, what goes around comes around – in a good sense – and the town economy can continue to function indefinitely with full employment.
A simple economy of this type will not have unemployment or slack in the use of resources, assuming that other features of the town economy are also in balance. These features would include any spending on “imports” from other towns, which we assume would be equal to receipts from any “exports” to other towns. Likewise, savings (which reduce demand) would be equal to investment (which increases demand).
In the diagram we introduce some notional numbers. Assume the townspeople are paid $9 million a month in wages and salaries by the company, and the owner makes $1 million profit which he uses for his own consumption. In this example, the company will continue to have revenues of $10 million to disburse on wages and profits each month, which will enable it to continue to hire all the workers.
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Now consider what happens if the owner – the “1%” – decides to cut costs by reducing wages to the townspeople – the “99%” – from $9 million to only $8 million a month, maintaining the level of prices and trying to double his profit to $2 million, although he does not or cannot spend more than $1 million on his own monthly consumption. This is the situation depicted in Diagram 2, which roughly reflects the “bubble” period leading up to 2008.
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Note that demand for the goods and services produced by the company would be short $1 million a month, if it were not for the fact that we introduce a bank, in which the owner deposits his additional $1 million savings and which in turn lends that $1 million to the townspeople. Focusing on the center-left part of the diagram, we see that the 99% maintain their standard of living of $9 million by borrowing an additional $1 million each month from the bank in the form of cash-out refinancing of their homes, home equity lines of credit, etc.
In this case the 99% not only maintain their spending at $9 million, the 1% can make a profit of $2 million, spend $1 billion from revenues and deposit $1 million in the bank, from which the bank can lend money to the other 99%. Together the 99% and the 1% can continue to buy 100 percent of the output of the company, which can continue to operate at full employment. Welcome to the bubble economy!
The bank, however, is accumulating additional deposits from the 1% and making additional loans to the 99% every month, with no prospect of the loans being paid off. So long as the 1% are willing to finance the debt from the bank, and the bank is willing to turn a blind eye to the financial situation of the 99%, this imbalance can continue indefinitely. But of course at some point the 1% and/or the bank will have second thoughts about the creditworthiness of the 99%, who are likely to be defaulting on their mortgages at an increasing rate. A “financial crisis” must ensue. Welcome to the “subprime” mortgage crisis of 2008!
As the crisis unfolds, bad debts and unemployment emerge as huge problems and everybody looks to government to bail them out. This is the situation depicted in Diagram 3, in which the government underwrites consumer spending by the 99%, directly or indirectly, to the tune of $1 million per month.
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What the government is doing is replacing the bank as the lender of last resort. It does so in this case, however, by borrowing from the 1% without increasing taxes to pay for the $1 million consumer spending each month. The situation is sustainable to the extent that the government deficit is sustainable. We believe that this deficit spending is necessary to avoid a double-dip recession, although it is not a permanent solution to the problem of inadequate demand, since it kicks the deficit can down the road for future governments to pick up.
Of course, in reality we know that despite the boost to demand provided by government deficit spending, the situation deteriorated in 2008-2009 to the point where demand has remained far short of the level needed to create full employment. For the sake of simplicity, this is not shown in the chart. What has happened is that, as argued by critics such as Paul Krugman, the federal government simply is not spending enough, state and local governments are being constrained to tighten their belts, and other sources of demand such as investments are falling short.
A broad solution is reflected in Diagram 4, in which the government increases the tax bill of the 1% by $1 million, and returns the economy to sustainability. Full employment is feasible in this situation, provided other sources of demand such as investments and exports (not shown in the diagram) contribute to the economic recovery, even if there is no stimulus from government deficit spending.
(click on chart for larger version)
Is this a full account of the current economic “blockage” and a solution? Clearly not. For instance, the saving necessary to finance investment for the future would need to come from the 1% and hopefully a larger contribution from the now better-paid 99%. But the central fact remains that a tax regime that shifts a significant amount of the tax burden from working households to corporations and the wealthy is perhaps the largest single element of a solution. Other elements would include additional measures to favor investment and enterprise, which not only add to demand in the short term, but increase productivity over time.
Very helpful -- as no one has provided anything like this before. How would you incorporate the net drain resulting from loaned money supply inflow always less than principal plus interest outflow over time and the fact that the 1% put their money offshore and let the 99% fill the gap with refinancing that loses them front-loaded interest. Your system does not show or mention deflation. Ultimately are you not blaming greed for profit rather than for interest and deflation premium?
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