Does inequality help growth- or hurt it?

By Chrystia Freeland
May 16, 2013

One of the most urgent questions in economics today is the connection between inequality and growth. That is because one of the big economic facts of our time is the surge in income disparity, particularly between those at the very top and everyone else. The other big fact is the recession set off by the financial crisis and the consequent imperative to jump-start economic growth. Figuring out the relationship between these two tent-pole issues is therefore a good way for economists to spend their time.

There are two main and contradictory ideas about how that relationship might work. One is that inequality is the price of robust economic growth. If the private sector is thriving, the most successful capitalists will be getting very rich. Creating a system that allows – indeed, encourages – the best and the brightest to pull away from everyone else is how you shift your economy into its highest gear.

There is, however, another theory, and it has been winning adherents in the aftermath of the financial crisis. In this view, rising inequality is not a symptom of a fast-growing economy or an incentive that will help create one. Instead, too much income inequality crushes economic growth.

There are different arguments for why that might happen. One is that high income inequality creates an unstable system that is vulnerable to costly booms and busts. Another is that when too much of the income goes to the very top and not enough goes to the middle, spending slumps – how many yachts does a plutocrat need? – putting a brake on growth.

David Howell, a professor of economics at The New School in New York, has written a draft paper for the Center for American Progress, a progressive research group, that investigates the first argument. Howell argues that the United States and Britain have acted over the past three decades on what he calls the laissez-faire theory, that the equation of rising inequality and increasing gross domestic product is correct.

As Howell puts it, “the laissez-faire case for high inequality is grounded in the belief that growth in output and employment depends mainly on strong incentives to work and invest.”

Howell tested that view by comparing the United States and Britain to their peers. He asked whether “compared to other rich countries, U.S. income inequality has paid off in relatively high growth.” His answer: not particularly. He finds that “there is no simple correlation between our measures of growth and income inequality.”

That may come as a surprise to many Americans, who are accustomed to hearing, as Howell explained, “that the U.S. middle class is doing relatively well, at least compared to Europe, because of productivity growth and because we allow higher inequality.”

But the reality is that at least some of those allegedly sclerotic European economies, dragged down by their highly redistributive welfare states, have outperformed the United States.

“What we see is Sweden having really good productivity growth by all measures, despite much more modest increases in inequality and starting at a much lower level,” he said.

“The U.S. is anywhere from an O.K. to middling performer in the Age of Inequality,” Howell said, using his term for our era. But while his work suggests inequality is not needed to get growth, he does not show that inequality actually hurts growth either: “I don’t show a strong measurable inverse effect.”

Lars Osberg, an economist at Dalhousie University in Nova Scotia, takes on this second argument – the case that inequality, at least beyond a certain point, can stifle growth.

He, too, adopts a comparative lens, looking at Canada, the United States and Mexico.

Osberg argues that a growing chasm between those at the very top and everyone else imperils the overall economy. His worry is financial instability.

“The added savings of the increasingly affluent must be loaned to balance total current expenditure,” he writes, “but increasing indebtedness implies financial fragility, periodic financial crises, greater volatility of aggregate income and, as governments respond to mass unemployment with countercyclical fiscal policies, a compounding instability of public finances.”

This is a variation of an argument by Raghuram Rajan, a politically center-right professor at the University of Chicago, who has suggested that rising income inequality was one of the drivers of the financial crisis. As income inequality increased, and the incomes of the middle class stagnated, the U.S. government responded by increasing the consumer credit available to the middle class.

In the short term, that was a win-win solution: consumption, and therefore the economy, grew, and the middle class was quiescent because stagnating incomes were masked by increasing consumer debt. But in the medium term that Goldilocks scenario broke down – the middle class consumption bubble, and the Wall Street bubble it helped finance, popped with devastating consequences.

Both Howell and Osberg are skeptical, at best, of the value of rising income inequality as a driver of economic growth. When you put that conclusion together with the arithmetic of democracy – rising income inequality means a majority of voters are on the losing end of the deal – a political backlash seems inevitable.

“Go back to the 1920s or the 1870s and economists were worried about the stability of the capitalist system,” Osberg said. “One of the things the 1930s experience teaches us is there are some catastrophic outcomes which can happen.”

The investing class and the academic world are focused on those dangers. “Can capitalism survive?” is one of the trendiest conference topics among red-blooded capitalists and left-leaning professors alike. So far, at the ballot box and on the street, this question has not been as salient. That does not mean it will not be in the future – and in ways we cannot predict.

4 comments

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Too much inequality will starve the growth engine. If money is being extracted from the economy because profits are being accumulated by a narrow sector of the economy that cannot recirculate it, the economy will shrink. There isn’t a magic number or model, but we have passed the point where an economy can grow organically, that is, without printing money.

When inequality gets too extreme, and so much profit is extracted from the economy that growth stalls, societies (at least those with a loose connection between the people on the short end of the inequality stick and politicians) demand some kind of remedy. The usual remedy is government spending to replace the spending that is not being done by the profit accumulators.

Posted by KenG_CA | Report as abusive

Income inequality generally creates an unstable system. However, most economic systems are more or less unstable. Risk management should prevent these instabilities and should make sure we don’t fall apart.
However, that is the key point on which we continuously fail. The only probable method of achieving economic sustainability is monetary regulations that are based on a system of risk management. However, enforcing such systems is usually faced with large political problems. What we’re seeing in Europe is unpopularity of such restricting measures due to the growth restricting and time consuming nature of such legislation, combined with resistance from lobbying influence.
To force the issue popularity has to be won amongst the ‘greater public’ for balanced growth. In my personal opinion a party has yet to rise that is able to sell these ideas.

Posted by theAntagonist | Report as abusive

The fallacy with both arguments is that their objective entails economic growth. In my opinion, the best long-term direction for society involves sustainable, environmentally neutral activity on a decreased scale. “Growth” is not a solution to anything, and how best to promote it is akin to arguing metaphysics – ultimately of little import. A substantial contraction in both population and industrial activity is the best thing that could happen to humanity – regardless of what percentage of the population ostensibly controls the distribution of scarce resources.

Posted by Nurgle | Report as abusive

In this age of global economics the rich still get richer, but on a global scale. The goal of the international bankers and their political lap dogs is exploitation of the natural resources and labor of the people. The economic inequality in the US is just the results of a global push to internationalize currencies, capital and labor. Exploiting the poor and middle classes for labor, both military and civil and exploiting the natural resources of all countries to centralize capital in the hands of the rich. The mass extermination and economic oppression of the poor will continue under the guise of economic expansion and growth. As more of the “middle class” are forced into poverty the end results of the economic equality will be realized the complete enslavement of the majority the world ruled by a minority of super rich ushering in one world government and the rule of the antichrist.

Posted by danielcamalloy | Report as abusive