Suffering Under the Weight of Inequality

By David Brodwin

September 12, 2013

A report released this week by an economist at the University of California, Berkeley, shows that income inequality in the U.S. economy is at a new high. As the economy struggles in the wake of the Great Recession, income inequality broke records going back nearly 100 years.
According to the study, incomes among the top one percent rose by 31.4 percent between 2009 and 2012, while incomes for everyone else grew just 0.4 percent. The top decile of earners in the economy now captures more than half the total income.
Predictably, the debate rages about fairness. Commentators on the left argue that this income distribution couldn't possibly be fair to workers, while those on the right suggest that any distribution is inherently fair as long as all Americans have the opportunity to compete to make it to the top.
It is difficult to show that any particular distribution of income is the right place to draw the line between fair and unfair. Let's leave that question to others and focus solely on the question of whether disparities of this magnitude help or hinder the economy as a whole.
[See a collection of political cartoons on the economy.]
Economists have shifted their position on this issue over time. At one point, most economists agreed that inequality probably helps the economy. Inequality spurs people to work harder. In addition, some inequality is needed to create a pool of concentrated wealth that can be invested to finance the early stages of economic development: harvesting timber, building factories and so on.
However, more recent research suggests that while some inequality is necessary, too much inequality undermines growth: The research shows that the U.S. economy is probably at or near the point where the negative effects of inequality outweigh the positive effects.  
Now, inequality dampens growth in three ways:

• Wealthy people handle their money differently than the rest. They tend to save a much higher percentage of their incremental income, or invest it in fixed assets like vacation homes. These forms of saving and investment do not trickle down to create significant wage income for others. In contrast, incremental money that flows to the middle class and poor people gets spent much more quickly. It's spent on food, clothing and basic products that are produced in factories and on farms by people who earn wages. Money that flows to the middle class and poor has a multiplier effect, rippling through the economy to create more jobs and income for others. As a result, a shift in income towards the top results in less overall demand.

• In a nation like ours, where higher education is expensive, greater inequality means that fewer people get the skills they need for well-paying jobs. But as World Bank economist Branko Milanovic writes, "now that human capital is scarcer than machines, widespread education has become the secret to growth." Facing a less prepared workforce, companies shift research and advanced manufacturing facilities offshore, which further erodes economic growth. The shift increases the chance that the next Facebook will be founded in India or China. Some other country will reap the economic benefit that comes from hosting breakthrough innovation.

• Other factors beyond the hard costs of higher education are important as well, as inequality rises and class lines harden. Consider two children, both with the same innate potential for accomplishment, one born to a family in the top 1 percent and the other to a family in the bottom 20 percent. The first one will have parents who read to them as a pre-schooler, stimulating his or her brain. The second one, probably not. The first one will grow up surrounded by role models whose hard work brought them success; the second one will grow up surrounded by others whose hard work brought them barely-livable incomes. Is it any wonder that the two children will enter adult life with a different readiness to use their intellect, a different level of motivation and confidence and a different awareness of how to build a successful career?

[Vote: Should McDonalds and Burger King Workers Strike for Higher Wages?]
Two economists, Andrew Berg and Jonathan D. Ostry of the International Monetary Fund, have quantified the impact of inequality on economic growth. In a 2011 article, "Inequality and Unsustainable Growth: Two Sides of the Same Coin?" they examined why some countries enjoy long years of steady economic growth while other countries see their growth trail off after only a few years.
Berg and Ostry found that income inequality is the single most important factor in determining which countries can keep their economies growing. For example, income distribution is more important than open trading arrangements, favorable exchange rates and the quality of the country's political institutions.
Berg and Ostry go on to measure the extent to which economic growth falls as inequality rises. They gauge inequality using the GINI coefficient, which ranges for 0 – 100. At one extreme, a society where everyone earns exactly the same would have a GINI score of 0. At the other extreme, a society in which one person owned all the wealth would have a GINI score of 100. For economies with GINI below 45, growth can be robust, but once it crosses above roughly 45, growth slumps. The GINI of the U.S. economy is in the low 40's currently, so we are dangerously close to the point of decline.
Inequality in the U.S. shows no sign of abating, even as the economy recovers. The decline of unions, the pace of globalization, the abundance of workers in many industries and changes in health care and taxes have combined to staunch the earning power of working Americans, even as the economy grows and productivity increases. There are few options, and none that are consistent with the political climate of the time. But the trend is reaching the point that endangers growth itself, and that should concern everyone, regardless of the size of your paycheck.
David Brodwin is a cofounder and board member of American Sustainable Business Council. Follow him on Twitter at @davidbrodwin.