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.
There are two main and contradictory ideas about how that relationship might work. One is that inequality is the price of robust economic growth. Creating a system that encourages the best and the brightest to pull away from everyone else is how you shift your economy into highest gear.
A second theory, however, has been winning adherents in the aftermath of the financial crisis. It sees rising income inequality not as a symptom of a fast-growing economy or an incentive to help create one, but rather that too much inequality crushes economic growth.
One argument for why that might happen 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, then spending slumps, 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 that investigates the first argument. He 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 he 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.”
He tested that view by comparing the United States and Britain with 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.”
At least some of those allegedly sclerotic European economies, dragged down by their highly redistributive welfare states, have out-performed the United States. But although his work suggests inequality is not needed to get growth, Prof. Howell does not show that inequality hurts growth, either: “I don’t show a strong measurable inverse effect.”
Lars Osberg, an economist at Dalhousie University in Halifax, takes on the second argument – that inequality can stifle growth. He, too, adopts a comparative lens, looking at Canada, the United States and Mexico.
Prof. Osberg argues that a growing chasm between those at the very top and everyone else imperils the overall economy. His worry is financial instability, as explained in a paper published by the Canadian Centre for Policy Alternatives last year.
“The added savings of the increasingly affluent must be loaned to balance total current expenditure,” he wrote, “but increasing indebtedness implies financial fragility, periodic financial crises, greater volatility of aggregate income and, as governments respond to mass unemployment with counter-cyclical fiscal policies, a compounding instability of public finances.”
This is a variation of an argument by University of Chicago Professor Raghuram Rajan, who has suggested that rising income inequality was one of the drivers of the financial crisis. As inequality grew, and the incomes of the middle class stagnated, the U.S. government responded by increasing the consumer credit available to the middle class.
For a while, that was a win-win scenario: consumption, and therefore the economy, grew, and the middle class was quiescent because stagnating incomes were masked by increasing consumer debt. But then it broke down: The middle-class consumption bubble and the Wall Street bubble it helped finance popped, with devastating consequences.
Professors Howell and Osberg are skeptical about the value of rising income inequality as a driver of economic growth. Combine that with the arithmetic of democracy – rising income inequality means a majority of voters are on the losing end of the deal – and a political backlash seems inevitable.
“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, the question has not been as salient. That does not mean it will not be in the future, and in ways we cannot predict.
Chrystia Freeland is editor, Thomson Reuters Digital.