How Inequality Hurts the Economy

The gap between the rich and the rest makes for short recoveries

The public discussion about the widening gap between rich and poor hasn’t been this loud since the Great Depression. Warren Buffett has condemned the disparity, Occupy Wall Street has inveighed against it, President Barack Obama cites it to justify higher taxes on the wealthy. Much of the debate, though, has focused on inequality’s moral dimension. Somehow it just doesn’t seem right that so many Americans struggle while a handful prospers. What many are missing is the actual impact rising inequality is having on the U.S. economy. Hint: It isn’t good.

Since 1980 about 5 percent of annual national income has shifted from the middle class to the nation’s richest households. That means the wealthiest 5,934 households last year enjoyed an additional $650 billion beyond what they would have had if the economic pie had been divided as it was in 1980, according to Census Bureau data.

The typical U.S. household, meanwhile, has yet to regain the ground it lost during the recession. The median income of $49,445 at the end of 2010 remains a shade below the level reached in 1997, adjusted for inflation. “Income inequality in this country is just getting worse and worse and worse,” says James Chanos, president and founder of money managers Kynikos Associates. “And that is not a recipe for stable growth.”


In the 1960s economists such as the late Arthur M. Okun, who was chairman of the White House Council of Economic Advisers, believed that societies could emphasize equality or growth, not both. Today, when the quality of the workforce plays a larger role in determining who prospers, many economists—including Federal Reserve Chairman Ben S. Bernanke—now believe that equality and growth are linked. As Branko Milanovic, a World Bank economist, wrote in September: “Widespread education has become the secret to growth. And broadly accessible education is difficult to achieve unless a society has a relatively even income distribution.”

Thus the growing chasm in the U.S. between the haves and the have-nots has serious consequences. Societies that manage a narrower gap between rich and poor enjoy longer economic expansions, according to research published this year by the International Monetary Fund. Income trends in the U.S. mean that future U.S. expansions could last just one-third as long as in the late 1960s, before the income divide began widening, says economist Jonathan D. Ostry of the IMF. The average postwar economic boom lasted 4.8 years, according to the National Bureau of Economic Research. The current expansion, which is just 27 months old, may peter out within a few months. Goldman Sachs (GS) said on Oct. 3 that the U.S. would be “on the edge of recession” by early 2012.

Expansions fizzle sooner in less equal societies because they are more vulnerable to both financial crises and political instability. When such countries are hit by external shocks, they often stumble into gridlock rather than agree to tough policies needed to keep growth alive. Raghuram G. Rajan, the IMF’s former chief economist, says political systems in economically divided countries become polarized and immobilized by the sort of zero-sum politics now gripping Washington. “It makes the politics more difficult, and that makes it more difficult to grow,” says Rajan, now a finance professor at the University of Chicago’s Booth School of Business. “There is no consensus on any of the solutions that are proposed.”

As rich and poor drift apart, the constituency that favors redistributive tax and spending policies grows. “The guys who are falling behind don’t see much hope of getting ahead and therefore are more focused on redistribution,” says Rajan. Ultimately, unbridled inequality threatens social stability as rich and poor nurse their mirror-image resentments.

Inequality is not just a problem for the have-nots. Barry Ritholtz, chief executive officer of the investment research firm Fusion IQ, says millions of potential investors may conclude, as they did after the Great Depression, that the market is a rigged game for insiders. Such seismic shifts in popular sentiment can have lasting effects. The Dow Jones industrial average didn’t regain its September 1929 peak of 355.95 until 1954. “You’re going to lose a generation of investors,” says Ritholtz. “And that’s how you end up with a 25-year bear market. That’s the risk if people start to think there is no economic justice.”

During the 1920s and the most recent decade the rich enjoyed large income gains, while politicians encouraged the poor and middle class to use credit to make up for flat-lining wage income, according to Rajan’s 2010 book, Fault Lines. Household debt nearly doubled in both periods, setting the stage for the Great Depression and the latest financial crisis, says a December 2010 paper by economists Michael Kumhof and Romain Rancière of the IMF. That increasing debt burden exposed the economy to widespread defaults when the financial shocks of 1929 and 2008 hit. “If nothing is done about income inequality, there may be recurring crises,” says Kumhof. “Leverage has not significantly improved. In terms of the danger of another crisis, we’re right back where we started.”

The bottom line: With $650 billion in income shifted to the top 5,934 households, the result could be shorter recoveries and gun-shy investors.

Article Source