The Impact of Inequality on Growth

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Jared Bernstein, “The Impact of Inequality on Growth.” Center for American Progress, December 2013.

In this paper, economist Jared Bernstein summarizes the research on a vital economic and political question: “Is there a causal linkage between higher inequality and slower macroeconomic growth”? If the increasing economic inequality in the United States is a drag on the growth of the economy, that would be one good reason–though not the only reason–for developing public policies to reduce it.

Bernstein reports that since the current economic expansion began in 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.” The increasingly uneven distribution of economic rewards is getting a lot of national attention and criticism, with many critics charging that it violates basic fairness, impedes the longstanding drive to raise living standards for most people, and undermines the traditional American values of equal opportunity and social mobility. While Bernstein shares these concerns, believing they are good enough reasons to work for equality, he focuses this paper on the narrower question of inequality’s impact on the growth of the economy. He does this by reviewing the main theoretical reasons why inequality might impede growth, and then looking for empirical evidence to support them.

In a classic theory, Simon Kuznets described an inverted U-shaped curve relating inequality to economic growth, but with inequality as the dependent variable. He observed that inequality tends to increase in the early stages of economic development, when owners of productive assets such as land benefit more than others. But as industrialization proceeds, it gradually benefits more people such as factory workers, and inequality tends to fall. This theory does not work very well for the past century in the US, where inequality fell from the 1930s to the 1970s, but then went back up to “heights matched only by those last seen in the late 1920s.” It also proposes no causal effect of rising inequality on growth. For that, Bernstein looks at four kinds of theories: supply-side, demand-side, political-economy, and a more recent credit bubble theory.

Supply-side theories discuss how inequality might affect the quality of inputs to the production of goods and services, especially the quality of human labor. If too much wealth and income are concentrated in the hands of the rich, then more children will grow up in impoverished families and neighborhoods that cannot invest much in their human development and education. That will presumably hurt growth by making it harder to raise labor productivity.

Demand-side theories assert that the distribution of income affects the general demand for goods and services in the economy because of its effect on the “marginal propensity to consume.” A rich person who receives additional money is not as likely to spend it (as opposed to saving it) as a person with a modest income. Since it is consumer spending that accounts for 70 percent of economic activity, too much inequality can lead to underconsumption and economic recession. Saving and investment are important too, but a low demand for consumer goods and services also discourages investments to expand production.

Political-economy theories mostly concern a political mechanism through which economic inequality feeds on itself. The wealthy can use their power and influence to bring about public policies that benefit themselves at the expense of others, especially where campaign finance regulations are minimal. In extreme cases this dynamic can lead to “intense poverty, deep human exploitation, failed political systems, and ultimately failed states.” Democracies can defend against this by having inclusive political systems that create a countervailing force against this tendency toward oligarchy. How well those countervailing forces are working today is a good question. Political-economy theories do not necessarily say that inequality hurts economic growth; that would depend on the specific policies pursued by the rich and powerful. But the supply-side and demand-side theories suggest some ways that self-serving policies could take the economy in the wrong direction; for example, if elites oppose public spending on education or social insurance because the private market serves their needs just fine.

The credit bubble theory develops the connection between rising inequality and unsustainable bubbles of credit and debt. “The wedge of inequality diverts income growth from middle- and low-wage workers; at the same time, high-income households acquire more capital assets.” The middle class sustains its standard of living by borrowing more; the wealthy have ample capital to lend, and the financial sector expands by making loans more widely available, with decreasing regard for risk. The increasing ratio of debt to income is ultimately unsustainable, and when consumers have to cut back spending, the economy crashes. A political-economy notion can enter into this argument too, since those who profit the most from the bubble may have the power to block regulations that might keep the financial sector from taking on so much risk.

Macroeconomic theories are hard to test. I’d love to be able to conduct a controlled experiment on the economy, re-running the last thirty years while holding inequality constant. Would we have had better educational outcomes, more middle-class spending with less debt, less influence of big money in Washington, and–most to the point–more sustainable economic growth? None of the theories linking inequality and growth are conclusively supported by the data, although Bernstein finds the credit bubble theory very plausible.

Supply-side theory proposes that inequality creates educational disadvantages, which in turn impede economic growth. The first part is well supported; for example, as the income gap has widened, so has the gap in college completion, as well as the gap in what households spend to provide private education and other “enrichment” experiences for their children. The impact on economic growth is not as clear however, since average educational attainment and worker productivity have both been rising for a long time, whether inequality was falling or rising. One can speculate that the economy would do even better if all segments of the population participated more equally in these advances [and even that an emerging high-tech economy depends on it], but the data reported here don’t really answer that question.

Demand-side theory says that the concentration of wealth and income reduces economic demand because the rich have a lower marginal propensity to spend. During the period of increasing inequality between 1979 and 2007, per-capita consumption grew a little more slowly than in the previous three decades, but the difference was only 0.2 percent. As in the case of educational advances, a general trend of rising consumption overshadows any growth constraints imposed by inequality.

However, the credit bubble theory provides an explanation for that. Economic demand can remain high despite rising inequality if consumers take on more debt. Especially after 2000, the housing boom financed by riskier lending made households with stagnating incomes feel wealthier and encouraged them to keep spending. So inequality may not slow down growth, but instead create a more volatile, unstable pattern of growth, with bigger booms and busts.

Cynamon and Fazzari, who wrote one of the major papers on credit bubble theory cited by Bernstein, put forth these facts in support of their theory: that after 1990 consumer spending rose more than income, that after 2000 the debt-to-income ratio rose dramatically for the bottom 95% of the population, and that this ratio became unsustainable when the housing bubble burst. They also calculate that if the share of income going to the lower 95% had not fallen, those households would have been able to support their increased spending without increasing their borrowing. Maybe other factors would have induced them to borrow too much anyway, but a role for inequality seems very plausible. Piketty and Saez wonder if it can be just a coincidence that both the Great Depression and Great Recession occurred after periods of rising inequality. Bernstein points out that inequality does not seem to be a necessary cause of financial bubbles, since bubbles have occurred in times of falling inequality as well. But it may be an important cause of certain very damaging ones.

With regard to the political-economy theories, it is easy to show that the rich often have a self-serving political agenda, such as favoring tax cuts for themselves. The theory does not say that they always have their way despite democratic resistance, or that the policies they endorse are always bad for economic growth. Research would have to proceed policy by policy, drawing on the other theoretical perspectives and empirical evidence as needed. Some policies raise fundamental economic questions, such as whether budget-balancing austerity measures hurt the economy by reducing aggregate demand, or help it by leaving more capital available for private investment. Bernstein acknowledges that many economists see a threat to growth and jobs coming more from efforts to combat inequality, such as by strengthening unions or raising the minimum wage. That made me wonder if there are credible theories that see positive rather than negative effects of inequality on economic growth. Another way of asking this is whether “trickle-down” economics has much serious intellectual support any more, or if it is mostly an ideological position popular with rich conservatives.

In the end, Bernstein reaches two main conclusions: First, that the research remains inconclusive even though some alleged negative effects of inequality on economic growth are plausible. Second, even if inequality turns out to have little effect on growth, excessive inequality is offensive for other reasons.

Fundamental American precepts–such as basic fairness, the conviction that opportunities and upward mobility should [be] available to all, and the social contract that links hard work and playing by the rules with a chance to get ahead–are at risk when inequality is where it is today. This will remain true no matter how inequality impacts macroeconomic growth.

In a previous post, I discussed Bernstein’s plea for pursuing full employment, with obvious relevance for both reducing inequality and stimulating economic growth.

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