What Are They Teaching in Our Schools?!

-- Posted by Neil H. Buchanan

A friend of mine is enrolled in a certificate program at a top-10 U.S. business school. This friend recently sent me an email, the pertinent part of which reads:

The instructor [in the "Investments" course] is a very handsome young man, in his mid- to late-thirties. He has the well-dressed, privileged, but sweet look I was used to on Wall Street in the 80s. The kind of young man so beloved by his fraternity brothers, his trust fund advisors, and his Brooks Brothers tailor that he is secure and happy and isn't even aware he might be a little outside the mainstream of American workers.

So anyway--at last week's class, he made some passing comment about how tax cuts for the rich stimulated the economy more than tax cuts for the poor.

I perked up because I was pretty sure that was the opposite of what I usually hear, and I wanted to make sure I had heard him right.

I raised my hand and said, "But isn't it true that lower-income people spend a much higher percentage of their income, so extra money in their pockets means more money poured into the economy? While well-off people already have their needs covered so more money flowing to them just means they invest or save it?

He said no.

He said rich people are always spending. They go on vacation even when times are tough.

He also said that poor people have so much credit card debt anything extra they get just gets plowed into debt payments and doesn't really stimulate any new purchases.

And finally, that rich people just have so much more money than poor people, that anything affecting rich people has a much bigger total effect on the economy.

So I ended up puzzled. I did not think I was saying anything controversial. It's not even something I've thought a lot about. I just thought I had always heard that lower-income people spend incrementally more of whatever they get.

But the professor made me think about it. It's true that rich people have more money than poor people so they spend more money. So maybe it's true that anything rich people do has a more significant effect on the overall economy . . . ?

Am I missing something?

I have to give my friend credit for being open to new evidence and arguments. It turns out, however, that what the professor said is simply wrong -- although it is wrong in a few interesting ways. As I am not a regular consumer of opinions from the editorial page of The Wall Street Journal or Fox Business Channel, I understand that these beliefs might be held more widely than by one ill-informed (or ill-motivated) business school professor. In any case, this certainly seemed a worthy topic for a blog post.

Professor Privilege made three points, each of which I consider presently:

(1) "He said rich people are always spending. They go on vacation even when times are tough."

This is a true statement that simply does not support the argument to which it is being applied. Recall that Professor P offered this as a reason to believe that "tax cuts for the rich stimulated the economy more than tax cuts for the poor." That rich people spend a large amount of money, and continue to do so during recessions, tells us nothing about how tax cuts will be spent. The reason that rich people go on vacation even when times are tough is that they have more than enough money to do so. They are not spending-constrained, which means that they can keep doing what they would normally do, even when other people are pinched. That means that any weakness in the economy shows up, if at all, as a reduction in their savings. (Of course, we know that the current recession has not even cut into the overall incomes of many of the wealthiest Americans, making it possible to maintain their lifestyles while increasing their saving and net worth.)

If the rich receive a tax cut, therefore, there is no reason to expect them to use that to buy themselves yet another vacation (or anything else). In technical terms, Professor P's error is in confusing total consumption with "marginal propensity to consume." Wealthy people spend a lot in absolute terms, more than the poor (though not as a percentage of their income -- and, as a group, probably not even as a percentage of total spending, although I have not checked the numbers recently). They do not spend much (or any) of the "next dollar of income," which means that they do not spend tax cuts. Giving the rich tax cuts will not, therefore, stimulate the economy.

(2) "He also said that poor people have so much credit card debt anything extra they get just gets plowed into debt payments and doesn't really stimulate any new purchases."

From the standpoint of someone who has more than enough money to spend every month, this probably seems like it simply must be true. It is just good money management, after all, to use additional income to pay down existing debt. Of course, this simply ignores the financial reality of not only the poor but the middle- and even upper-middle-classes in this country. Even if people would dearly love to be in a position where they could "plow" money into repaying debts, they are not. Giving them additional spendable money through tax cuts gives them money to spend immediately on items that they have had to do without or have cut back -- medicines, clothes, food -- because of their tenuous financial conditions.

For many, that paycheck-to-paycheck reality (with personal debt levels rising or, one desperately hopes, barely holding steady) predated the recession. The Great Recession and its aftermath -- continued high unemployment, stagnant or falling wages, costs of health care shifted onto workers -- have only increased the number of people who have no hope of being able to use a tax cut to pay down personal debts.

Again, Professor P's technical error is in not understanding marginal propensity to consume. Most of the non-rich at this point will spend nearly 100% of every dollar they receive (in tax cuts or otherwise). That stimulates the economy. It also, as a passing matter, slightly improves the lives of millions of people living on the edge.

(3) "And finally, that rich people just have so much more money than poor people, that anything affecting rich people has a much bigger total effect on the economy."

It is certainly true that rich people have more money than poor people. (As one of my favorite movie lines puts it: "Does the word 'duh' mean anything to you?") Being a big part of the economy does not, however, mean that rich people's spending is necessarily a driver of the economy. Again, this is an error about marginal effects. Consider an analogy: Even though there are many more people over 25 than under 25 in this country, offering subsidies for higher education is going to affect many more young people than old people. Being "big" does not make something a "change agent" (to use an ugly buzzword that would surely be ever so welcome in a class like Professor P's).

I wish that I could say that I am surprised by my friend's story. One would hope that professors of business would know better than to spout such nonsense. It is possible, of course, that the professor in question actually knows that he is lying, but chooses to do so for ideological reasons. There really is no reason, however, to think that he has ever learned the basic economics necessary to understand this. Being good at, say, describing the relative advantages of debt and equity in a client's portfolio does not require any knowledge of macroeconomics.

And every other incentive in such a person's life pushes him in the direction of believing that which is reassuring: helping poor people is neither necessary nor useful. Nothing that penetrates such a person's consciousness will ever allow him to believe otherwise.