Sunday 4 August 2013

Marginal Propensity to Consume explained

The Marginal Propensity to Consume (MPC) sounds horrifically complicated, but like many economic terms it is actually quite an easy concept to grasp, in fact many people grasp it intuitively without actually knowing that there is even a specific economic term for it.

I've often heard people talking about how it would have been loads better if the government had've done a "people's bailout" rather than a "bankers bailout", because had people been given tax rebates, food stamps, debt write-off grants, single lump payments (sometimes described as "helicopter drops" - which is a phrase coined by the neoliberal guru Milton Friedman of all people)  they would have spent it within their local or national economy, created extra demand and stimulated more economic activity. This kind of view shows an intuitive understanding of the MPC.

Consumption vs Saving
The Marginal Propensity to Consume is formally defined as the amount of a person's  additional income that gets spent, rather than saved. 

To give a simple example: If the government gave every worker in the country a £500 credit with their next paycheck and you spend all of yours on food, clothes for the kids, and repairs on your car, you would have a marginal propensity to consume of 1.00 (or 100%). If another person only spent £100 on an evening out and put the other £400 into their savings plan or pension scheme, they would have a MPC of just 0.2 (or 20%).

This consumption vs savings definition is the traditional one, however it neglects a couple of important elements of spending which are debt reduction and capital flight. Using additional income to reduce your debt burden (pay off a credit card or outstanding loans from a Payday lender, pay mortgage arrears, reduce overdrafts...) can be seen as a form of saving, only that the returns on these "debt repayment savings" come in the form of reduced future interest payments, fines and fees. The relationship between MPC and capital flight is a more complex issue which I'll pick up later.

The MPC is higher in the case of poor and ordinary people than it is for the extremely wealthy. The greater a person’s wealth, the more of their basic human needs will have already been met, and the greater their tendency to save a proportion of their income in order to provide for future will be.

The marginal propensity to save of the richer classes is greater than that of the poorer classes. Thus it follows that if the government want to increase economic demand, then purchasing power must be transferred from the richer classes (with their lower propensity to consume) to the poorer classes (with their higher propensity to consume).

Disposable income
In essence, the Marginal Propensity to Consume is concerned with how individuals use their disposable income, which is the amount of money the individual has left over after paying their costs of living (usually defined as rent, tax, childcare and utility bills). The most common use of disposable income is consumption. When an individual spends a proportion of their disposable income on consumption (buying a new smartphone, going out for a meal, buying a book or getting some fancy new clothes) the retail sector of the economy benefits.

Aside from basic consumption, disposable income is also an important economic driver in another way. Without disposable income it is significantly more difficult for an individual to set up a small business or to improve their circumstances through education or training. If disposable income is lowered for millions of people (through ideological austerity) economic potential is retarded because significantly fewer people have the financial means to establish new businesses or to improve their productive capacities through education or training.

In a capitalist economy, disposable income is of paramount importance because it is one of the most important drivers of economic demand. When people have money in their pockets, they spend it, creating demand in the economy, or they save it, creating the capital reserves that the financial system is supposed to be based upon (hence the name "capitalism"). When people don't have money in their pockets, they cut back their spending, which reduces economic demand.

If people don't cut back on spending, their only other option is to get into debt in order to try to maintain their standards of living. The ever increasing level of private (corporate and personal) debt was the principal cause of the 2007-08 financial sector meltdown (over-leveraged banks, reckless lending, unsustainable property price inflation and sub-prime mortgages).

Fiscal Multiplication
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Considering relative MPC values for different socio-economic groups provides insight into what kinds of economic activity is stimulated by particular spending priorities. The way that these changes in economic activity are measured is called fiscal multiplication, which is another horrendously complex sounding term to describe a fairly simple concept, which is similar in meaning to "returns on investment".

If a spending project stimulates £1.50 worth of economic activity for every £1 in investment, the fiscal multiplication value is a strong 1.5. If the project breaks even, the fiscal multiplication value is 1.0 and if only 50p of economic activity is generated for every £1 of investment, the fiscal multiplication value is a poor 0.5.

There is solid economic evidence from America that spending on poverty relief programmes such as food stamps generates far more economic activity that giving tax-breaks to the super-wealthy. When the Bush tax cuts for the super wealthy 1% were made permanent, the economic returns on each $1 of lost government revenue was a pathetic $0.29. Meanwhile an increased provision of food stamps resulted in an impressive $1.73 return on every $1 in additional spending.
It is absolutely clear from these results that providing a small amount of additional spending power to the less well off creates vastly superior economic returns on investment than giving large tax cuts to the extremely wealthy minority.
Another extremely strong fiscal multiplier is the provision of social housing, which gradually pays back the investment cost through rent, and also creates a large increase in the MPC of social tenants, because their rent is much lower than the private sector, meaning that they have significantly more disposable income than had they been paying higher private sector rent.

MPC and capital flight 

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The Marginal Propensity to Consume is often contrasted with the Marginal Propensity to Save, as if spending and saving are the only two options to the individual. Things are obviously not that simple. The main problem being that national economies do not exist in a vacuum.

Other than spending or saving within the national economy, there is a third option that becomes more available the more wealthy the individual gets, and that is removing wealth from the national economy entirely. This can be done through the spending on foreign goods such as Italian sports cars or luxury yachts from South Korea for example, however this is more of a balance of trade issue than a capital flight issue. If the United Kingdom was more of a productive economy without enormous trade deficits, then more of that departing wealth would flow back into the national economy through the export of British manufactured goods.

The most problematic form of capital flight is tax-dodging, and the wealthier an individual or organisation becomes, the easier it is for them to shift their wealth out of the national economy into tax-havens.

The reason that it is so much more likely that the wealthy will extract wealth from the economy in this way is obvious. If an individual has a monthly disposable income of just a few hundred pounds, it would be an obvious false economy to pay a tax lawyer over £100 pounds an hour to build a convoluted tax avoidance scheme in order to extract this wealth, however convoluted tax avoidance schemes will create large returns for extremely wealthy individuals (such as the comedian Jimmy Carr or the Tory party donor George Robinson).

The same goes for businesses. A small operation like a barber shop or self-employed builder won't be capable of producing the necessary profit in order to justify the establishment of a chain of offshore shell companies for the purposes of avoiding tax, however due to economies of scale, "offshoring" is common practice amongst major corporations (in fact 98 out of the FTSE100 companies have tax haven based subsidiaries).

Once offshore wealth extraction schemes are factored into the equation, it becomes obvious that there is more to the Marginal Propensity to Consume than the traditional way of formulating it in simple spending versus saving terms.

For more information about how tax-dodging is detrimental to the economy, see my article on the subject.

Current policy
There are two strands of policy to consider in terms of the MPC: Fiscal policy and monetary policy. The government is largely responsible for the fiscal policy agenda, and the Bank of England is responsible for monetary policy. In this section I'm going to demonstrate how both institutions are engaged in policies that result in the transference of wealth to the rich, resulting in a reduction in consumption at the national level.

Since 2010 the Tory led government have engaged in a duel strategy of ideological austerity and wage repression (destroyers of economic demand because they affect poorer people with high MPC the most) whilst simultaneously enacting policies such as cuts in the top rate of income tax and huge reductions in corporation tax, which benefit the wealthy minority who have a a lower MPC.

Under Tory rule the average wage has fallen 9% in real terms (because average monthly wage rises have risen slower than the rate of inflation every single month for three years) whilst the corporate executive class have enjoyed a staggering 152% increase in their annual remuneration between 2010 and 2012. Not only that, but the government cut the income tax burden of the highest earners by 5% in April 2013, meaning an average £100,000 annual tax reduction for Britain's 13,000 income millionaires.

In the very same month that they handed this huge tax break to the wealthy (low MPC) class, the Conservative led government hammered poor and ordinary people with schemes like the Benefits Up-rating Bill, the public sector wage freeze and Bedroom Tax.

It is absolutely clear from these actions that the government has contempt for the Marginal Propensity to Consume, they are simply engaged in enabling a massive transference of wealth from the poor and ordinary to the wealthy, no matter what the cost to the economy.

The Bank of England are no better with monetary policy. Their policy of Quantitative Easing (magicking up money to pump into the financial sector, whilst holding interest rates at an all time record low for 4 consecutive years) has resulted in a massive transference of wealth to the super-rich minority. Their own figures show that 40% of the benefit of Quantitative Easing went to the wealthiest 5% of households. Instead of pumping this new cash in at the bottom of the economy and letting it work its way upwards, stimulating economic activity on its way, the Bank of England pumped it directly in at the top of the economy.

With the government and the Bank of England pursuing policies that result in transference of wealth to those with the lowest marginal Propensity to Consume, it is hardly surprising that the UK economy is suffering the slowest economic recovery in a Century, that the UK is recovering more slowly than any other major western economy bar Italy, and that the economy has still not recovered to pre-crisis levels almost six years after the financial sector collapse began. Given that both the government and the Bank of England have enacted policies which reduce the national MPC, it is almost as if there is an agenda to deliberately prolong the economic crisis.

Given that the Chancellor of the Exchequer George Osborne has absolutely no economics qualifications, it is possible to imagine that the guy is completely ignorant of the Marginal Propensity to Consume, however it is impossible to imagine that absolutely nobody in government, and nobody at the Bank of England has heard of it either. That both institutions have been enacting policies that reduce the national consumption by transferring wealth from the high MPC majority to the low MPC minority, suggests the possibility that the prolongation of the economic crisis is actually a deliberate macroeconomic strategy.

It is easy to understand why a Tory led government would ignore the MPC and damage the economy by reducing the income of the majority, in order to fill the pockets (or should I say offshore bank accounts) of the wealthy minority: Serving the interests of the wealthy establishment, at the expense of the majority has always been their game.

It is more difficult to see what the Bank of England have to gain by transferring wealth to the already wealthy, and robbing the pension schemes and savings accounts of the ordinary to do it. Perhaps it is simply that they so many of them have been indoctrinated with neoliberal pseudo-economic mumbo-jumbo when they studied PPE at Oxford, Cambridge or LSE (as most of them did).

Whatever the case, the fact that the UK is enduring the slowest post-crisis economic recovery in recorded history, and that the political and financial establishment are simultaneously working to ensure an unprecedented transference of wealth from the high MPC majority to the low MPC minority hardly seems like a coincidence.

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