Its the consumption stupid!

A couple weeks ago I made the point that it is strange to look at changes in income inequality and make calls for redistribution. First, its not clear that changes in inequality should matter for someone that cares about social justice. Even if changes in inequality rather than just the existence of it mattered for some reason, I made the argument that tracking changes in the differences between income percentiles confuses the subject.

Income levels vary drastically over a family’s lifetime ((BTW, the statistics on incomes are usually measured by the household or the family. This can be confusing if you try to compare these statistics to your own paycheck… something to keep in mind.)). Young families are smaller (maybe one or two people), the income earners are less experienced and therefore less skilled and often a big chunk of the family’s time is spent building human capital (an economist’s phrase for what normal people call “going to school”). All of these factors mean that younger families have less income.

As the family’s income earners get older they have more and more experience and they spend most of their time in the work force. Also, more people are married at this stage in their lives and most couples have children so family size is much larger. The family’s income go up, but they don’t consume all that extra income; they build their nest egg instead.

Later in life, the kids leave home and the income earners start retiring from the work force. The family shrinks and its income shrinks. It lives off its savings instead.

This is why income data show an inverted U shape over lifetimes. Young and old families have low incomes and middle aged families have high incomes. Also, this life-cycle story tells us where to look for explanations of changing inequality. Inequality could be increasing as a result of demographic changes (more middle aged families relative to young and old). I suspect the ageing of the baby boomers plays an important part in the story.

But the demographic story doesn’t explain this picture:
median_incomes_by_cohort.JPG

If demographics were the main driver of inequality, the inverted U wouldn’t be getting more dramatic over time.

Increasing inequality also could be a result of changes in the way the economy rewards different kinds of human capital. There were two types of human capital in the above story: the kind that you get at school and the kind you get with experience on the job. First, if skills learned in college ((Or if college let you demonstrate you have certain skills. I’ve suggested before that college is more about signaling quality rather than actually building quality.)) are more and more important for today’s jobs then people will have the incentives to get more education. Young people spending more time in college lowers their incomes and exasperates income inequality.

Second, if on the job knowledge is more important these days, then experienced folks will be paid more. By definition only older workers can be more experienced so this can be driving what we see in the above diagram.

The point of this post’s title, though, is that its not incomes that families care about for the most part. Its consumption. You can’t eat, drive or live in your paycheck. Consumption, as it turns out, varies much less over the life-cycle than income ((It varies about 10%, relative to about 50% variation in incomes, and is hump shaped like income (Gourinchas and Parker). This is an unsolved mystery in economics because standard theory says it shouldn’t vary at all.)) and this NYT opinion piece by two Fed economist argues consumption, surprisingly, doesn’t vary much between rich and poor.

UPDATE: Mark Thoma has more on consumption vs. income inequality. That post, Krugman’s reply to Cox and Alm and the general discussion is so damned muddied. People slip so easily between a descriptive “this is how it is” discussion to a normative “this is how it ought to be” discussion. For example, the Fed piece Thoma excerpts starts off by talking about the best measure of the poverty line (income or consumption) and then quickly gets side-tracked into a discussion of which measures are easiest to construct. Thoma himself uses the Fed’s measurement discussion as a spring board for a short discussion about what he thinks poverty really is (short Thoma, “its not about material stuff, except it is”). What that has to do with data issues, I don’t know. He then jumps from his quick and dirty definition of poverty to a sermon on the “decent and right” thing to do.

Often times, popular discussions of this topic have an air of back filling and data mining. People have some policy they want to implement and then they go squeeze data until it supports their policy. Call me naive, but I think policy should be guided by the science not the other way around.

One of the reasons I’m so attracted to this topic, though, is this level of muddiness. I’d like to think there would be some premium in it for the guy that can try to make sense out of it all. Economic inequality is an extremely complex topic. I believe we need to take a deep breath and try to understand the issue as level headed as possible. This means we need to measure it, understand inequality’s stylized facts and have clean theories that can be explicitly tested.

10 Responses to “Its the consumption stupid!”

  • Gabriel says:

    Krugman has a reply, but it’s not all that impressive. Economist’s View has the link.

  • swong says:

    “Second, if on the job knowledge is more important these days, then experienced folks will be paid more. By definition only older workers can be more experienced so this can be driving what we see in the above diagram.”

    Not strictly true. I’m hard pressed to think of fields and disciplines that haven’t seen dramatic shifts over the past 40 years. Manufacturing techniques and technologies have changed and improved, agriculture has changed, medicine has changed, construction has changed, even law is constantly sprinting to catch up. In some tech fields, I’d argue that useful job-specific knowledge has a half-life of roughly four years.

    Younger workers can definitely have more experience in a given job. Old knowledge tends to go stale. This is a byproduct of innovation. Even many of the metaskills that an older worker has developed will decay with time. Standards mutate, practices evolve, and new design patterns emerge. When something really new comes out, an older worker isn’t really in a much better position than a younger worker.

  • pushmedia1 says:

    Well, you’re making an empirical claim. I’m saying a theory that says on the job knowledge is worth more over time can explain the blowing up of the inverted U over time. One would need to look at the data to see if that’s actually the case.

    Having said that I wonder about your logic. If workers are accumulating knowledge all the time, even if any bit of knowledge has a quick half-life, older workers would have more knowledge than younger. Its not like all the on the job knowledge gets handed to you on your first day at work. Well, only in very task specific jobs is this the case.

    Also, there are some skills that don’t have quick half-lives. Learning to effectively manage projects is the first example I can think of… It takes years to figure out how to be a good project manager; to be able to manage time, take care of sequencing issues, customer facing skills, etc. While the content of projects change over time, these organizational skills don’t become less valuable.

    If fact, its this movement from routine task specific jobs to the more abstract organizational/design jobs that would make on the job knowledge more valuable these days.

  • swong says:

    Those are some of the metaskills I was thinking of. Maintaining a good relationship with a client is an important skill, but the means by which you accomplish this have changed. You can’t exactly take a client out to a jazz club for martinis at lunch anymore.

    Likewise, project management has evolved. For years, I’ve collaborated with younger colleagues over a wide range of technologies including IM, file servers, message boards, shared desktop sessions, and email. Some older colleagues have a tremendous amount of difficulty adapting to this, insisting on printed documents, phone calls, voice mail, and daily face-to-face meetings.

    I’ve heard of a Zen concept called “Shoshin,” or the “beginner’s mind.” If I understand it correctly, an experienced person develops certain practices and prejudices that may handicap their further development in a field. A beginner, approaching a subject with no prior experience or habits, has an easier time assimilating new knowledge and practices.

    I’m arguing that after a certain point, extra experience can be more handicap than advantage. An older worker, given a novel task, can insist on using deprecated or obsolete practices that take them in a bad direction. This doesn’t just happen in technology fields (consider a veteran salesman who takes a group of clients out to a strip club).

    I don’t disagree with your assertion that experience is more valuable than schooling. I disagree with its explicit relationship with age. I’d argue that the rate of innovation over the past 50 years is equivalent to starting a new career roughly every 10. A 45 year old starting at a new career doesn’t have much over the 30 year old who’s been in that career for five years.

  • pushmedia1 says:

    I’m not making empirical claims. I’m talking about theoretical possibilities. The data shall set us free.

    Let’s assume we look at the data, though, and it tells us that experience doesn’t matter. What then explains the difference in wages between mid-aged and younger workers? (The funny thing here is that age is usually used as a proxy for experience in these empirical studies so I’d be curious to see why that might be a bad idea.)

    My experience, in a start-up at least, with older workers is very different from yours. I learned a lot from watching them work with customers, manage projects, etc. Granted their extended us of IT might be due to them being in a start-up environment, all that other meta stuff we were talking about was their too. This was true for mid-career folks and the founders that were in their 60′s.

    BTW, for the discussion at hand I take “older” to mean mid-career (because those are the guys with highest incomes). Actually, its pretty well established that experience is productivity enhancing up to a point and then it starts being counter productive (it itself is an inverted U in age). So maybe we’re just talking about different sides of that curve (me younger older workers and you older older workers).

  • swong says:

    That might be the case. I was taking your “older” to refer to biological age… as if we could just throw a random group of octogenarians in a room and have them apply their folksy wisdom to a heuristic data mining algorithm.

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  • Paolo says:

    What about globalization or the growing importance of services. It makes soft managerial skills look as a stronger asset to navigate in such more volatile environment. For soft skills I mean also networking, people you know, which is definitely related to experience, whatever the pace of echnological change.

    Divide and rule souns like something mid-career folks are adept to play to squeeze the young working class, and having a fresh degree in compu science might not be enough.