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The Impact of Inequality on Growth

SOURCE: AP/Bebeto Matthews

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  • The Impact of Inequality on Growth
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Among the most important economic challenges facing the United States and some other advanced economies today is the increase in the inequality of economic outcomes. In the case of the United States, the distributions of income, wages, and wealth are more dispersed than ever. Though measurement issues abound, it is widely agreed that U.S. economic inequality is at historically high levels.

This fact, however, has different implications for different observers. Many critics of higher inequality suggest that it violates basic fairness, particularly when considering, for example, the divergence of median compensation and productivity growth. Such trends, these critics hold, are evidence of working people no longer getting their “fair share” of the growth that they are helping to generate.

Others note that inequality serves as a wedge between growth and living standards, funneling income largely to those at the top of the scale and thus making it harder at any given level of economic growth for living standards to grow as they have in more equitable times or for poverty to fall during business cycle expansions. Economic growth, as this report argues, has become a spectator sport for too many poor and middle-class households that watch as the gross domestic product, or GDP, productivity, the stock market, and corporate profits rise while their incomes either stagnate or grow much more slowly.

To add a few concrete numbers to this observation, note that so far in this expansion, which officially began in the second half of 2009, the stock market is up 60 percent, GDP is up 8 percent, corporate profits as a share of national income are at historic highs, yet median household income is down 5 percent, with all figures adjusted for inflation.

Another more recent line of argument holds that persistently high levels of inequality are eroding opportunity and mobility for those whose living standards and economic well-being are negatively affected by the wedge dynamic justdescribed. This is a fundamental critique because it is widely held that in America, while we do not aspire to equal economic outcomes, we believe strongly in equal opportunity. If inequality were to thwart the opportunities of the “have-nots,” this would represent a significant violation of a basic American tenet.

While this paper will reference these arguments, the goal here is to examine something different, though not unrelated, to the problems noted above—specifically, the impact of inequality on growth. Virtually all of the research on the impact of inequality takes growth as a given and examines the distribution of that growth, or in the case of the opportunity research noted above, the extent to which higher inequality is associated with less opportunity and mobility. This other line of research asks whether there is causal linkage between higher inequality and slower macroeconomic growth.

This paper begins by examining the channels through which such a causal relationship might flow, recounting arguments made previously in other reports. Next, it explores several theoretical models in a hunt for empirical evidence of a causal relationship between higher inequality and slower growth. Such evidence is generally quite elusive, as might be expected. Both inequality and growth are complex phenomena with many moving parts. While some of the theories are clear and persuasive, finding evidence in the data to support their predictions is tricky. It is widely believed, for example, that the wealthy have a lower propensity to consume at the margin. That is to say, since their income is such that they can handily meet their needs and wants, an extra dollar that goes their way is more likely to be saved than spent. Thus, we would expect that income concentration, by distributing national income away from those with higher consumption propensities—generally seen as poor and middle-class individuals to those with lower consumption propensities such as the rich and the financially well off—would lead to slower growth in consumer spending.

But this was not at all the case in the previous economic expansion of the 2000s, in part because easy access to credit and a housing bubble were intervening variables. That is, while historically high levels of inequality meant that most of the economy’s growth was channeled to the top of the income scale, many middleclass homeowners experienced sharply increased housing wealth. This higher “wealth effect”—the extra spending that occurs when assets you hold appreciate—drove consumer spending higher in recent years, even while real incomes, excluding wealth effects, were flat.

Of course, when the bubble burst, this wealth effect reversed, leading to the deep and long recession from which the U.S. economy is still recovering.

These dynamics make it difficult to find evidence to support the most commonly cited negative growth impact of higher inequality: that in a highly consumption-driven economy such as ours, the upward distribution of growth to those with lower propensities to consume should lead to slower growth. The logic is sound; and, in fact, that dynamic better describes the current recovery than the last one. But the credit bubble intervened in ways that cannot be ignored.

But—and this is perhaps the most interesting finding of this report—what if the credit bubble itself is associated with inequality? If that connection is convincingly made, given its impact on the deepest recession since the Great Depression—a recession that we are still climbing out of—it would be a strong indictment of the role of inequality in slower growth. There is circumstantial evidence to support this connection between inequality, financial instability, and credit bubbles. There is no smoking gun, but recent work, both theoretical and empirical, reveals potential linkages between high levels of inequality that appear to have interacted with underregulated financial markets, contributing to overleveraging, the housing bubble, the Great Recession, and its aftermath.

Financial bubbles and busts have clearly occurred in periods when inequality was not as high as it is now, so it will take a greater and more careful examination to determine if this connection really exists. If evidence from future study in this rich area of research supports this linkage of inequality and the appearance of financial bubbles, it will have uncovered an important and economically destructive way by which high levels of inequality are hurting growth.

Other causal channels deserve close watching as well. More and better data, for example, continue to surface, suggesting causal linkages between inequality and opportunity, most notably in the educational sphere. While such connections do not necessarily have a near-term impact on growth, they do imply a situation where some children will not achieve their productive potential. This in and of itself is a tragedy in a rich country such as ours, but it also has obvious longer-term growth implications, as the quality of human capital is an important input into any credible growth model.

Moreover, other connections suggested by the research reviewed below have growth implications as well. The interaction between high levels of wealth concentration and a political system heavily influenced by money threatens to give rise to politics that are more responsive to special interests than, for example, the need for investments in public goods that would boost productivity and growth. As alluded to above, other recent research is building connections between rising inequality and deeply damaging financial instability as too many families with stagnant incomes find that borrowing is the only way they can get ahead. At the same time, it is argued that high levels of wealth concentration is leading to higher savings among the wealthy and thus cheaper capital for leveraging households.

Again, all of this research is relatively new, and while it makes suggestive connections, there is not enough concrete proof to lead objective observers to unequivocally conclude that inequality has held back growth. Yet even if it is determined by future research that no such linkage exists, there are still good reasons to address the excessive levels of inequality in the U.S. economy. Inequality puts at risk fundamental American precepts: the belief that hard work and fair play pays off, the conviction that the opportunities for upward mobility are available to all, and the trust in the basic fairness of American society. This remains true no matter what effects inequality has on growth.

In that regard, the high level of inequality that we have today requires a policy response leading to a more equitable and inclusive economy. Full employment is especially important, and given the persistence of weak labor markets since 2000—very much predating the last recession—achieving full employment may require public-sector job creation, either directly through public infrastructure projects or indirectly through public subsidies for private jobs. Incentives such as greater union representation, increased minimum wages, a solid safety net, progressive taxation, and sectorial policies that lift productive sectors such as manufacturing can help raise the relative incomes of middle- and low-wage workers.

Jared Bernstein is a senior fellow with the Center on Budget and Policy Priorities.

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