In Which World Would You Rather Live?

by Don Boudreaux on January 14, 2018

in Myths and Fallacies

Yesterday, C____ W____ sent to me this e-mail (the text of which I share here, in full, with his kind permission):

Good afternoon Professor,

Quick question. Discussing tax cuts generally somebody says to me, “Well if rich people get a tax cut, their marginal propensity to consume is lower.”

I responded that he’s not putting the money under his mattress, but how can I respond to that better?

Here’s the reply that I sent to C____:

I’d respond by saying: “You’re absolutely correct – which means that rich-people’s marginal propensity to save and invest is higher.  And it’s savings and investing that are key drivers of economic growth.”

……

Allow me to elaborate a bit.  While saving and investment are not sufficient for economic growth and mass flourishing – market-tested innovation is indispensable, as is security of property rights – saving and investment are among the many necessary conditions.  And I believe that, among all of the many necessary conditions, saving and investment are especially important to emphasize given the man-in-the-street’s naive, Keynesian conviction that the great driver of economic prosperity is consumer spending.

For non-rich people it’s a blessing, not a curse, that rich people save.  Saving (rather than consuming) releases resources to be used, among other ways, to produce capital goods, to refurbish factories and stores, and – importantly – to fund and sustain research and development and other innovative institutions and efforts.  It is simply untrue that the economy necessarily “slows” or otherwise suffers insofar as money is not spent buying consumption goods and services.

So here’s a mental experiment, one that probes cases that, while admittedly extreme, are instructive.  Ask yourself in which world would you prefer to live: Smithworld or Keynesworld?

These two worlds are remarkably like each other except for one feature.  In Smithworld, many people save, while in Keynesworld no one saves.  Also in Smithworld, wealthier people save higher portions of their incomes than do their less-wealthy fellow Smithworlders.  In stark contrast, in Keynesworld every cent earned as income, within the week of it being earned, is spent to satisfy an immediate consumption desire.  Put differently, the marginal propensity to consume in Keynesworld is much higher than it is in Smithworld.  Indeed, in Keynesworld, the marginal propensity to consume is 100 percent, and it is 100 percent regardless of income level.

If you had to choose to be a life-long resident of one of these two worlds, which of these worlds would you choose for you and your family?

Without a split-moment of hesitation I’d choose Smithworld.  While Keynesworld’s prospects for economic growth are nil, such prospects exist in Smithworld.

……

To be upset that “rich” people spend for consumption a smaller percentage of their incomes than do other people is to be upset that “rich” people do not personally gobble down and use up for their own gratification as many resources as their current incomes permit.  To be upset at such a thing is to be upset that “rich” people are reserving resources for entrepreneurs and investors to put toward activities that increase outputs for others.

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