Income Inequality Is Killing the Economy, Obama Says—Is He Wrong?

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The president wants to turn inequality into both a campaign banner and a grand unifying theory of the recovery. But not all economists agree with him.

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"What drags down our entire economy is when there is an ultra-wide chasm between the ultra-wealthy and everyone else," President Obama said in a speech today, citing evidence that income inequality hurts economic growth.

So, is he right?

It's a big hard question with a long history of polar opposite answers. Let's start with the latest, hottest attempt at a Big Answer: Why Nations Fail, a monster economic tome by Daron Acemoglu and James A. Robinson. Nations succeed on the strength of their economic institutions, they write. Countries with so-called "inclusive institutions" that encourage hard work and innovation from top to bottom consistently out-perform countries where wealth is extracted from the middle class and concentrated at the top. And, they add ominously, the United States is in danger of exiting this select pool of thriving nations as more wealth and political power accumulates at the pinnacle, at the expense of the base.

A sweeping answer is helpful. But consider the question through a smaller lens, like college in America. College improves life earnings. But the cost of even community college is rising faster than median incomes. If the poor cannot borrow for lack of collateral, their poverty prevents them from accessing higher education, which is the surest ticket to leading an economically productive life. "Poor people cannot offer their children a good education, cannot obtain loans to start a business, or cannot afford insurance, however profitable their enterprises may be," François Bourguignon, former chief economist at the World Bank, wrote. As a result, countries with highly unequal wealth are like fields of unequally watered wheat. Some areas of the field grow to their potential. Some don't. And that's bad for the entire field's productivity.

So, does inequality hurt growth? Some economists have said "absolutely," and others have said "absolutely not." Here's a serving of both view points.

OBAMA IS RIGHT

"Inequality is harmful for growth." Focusing on the United States and Europe, Tortsen Persson and Guido Tabellini conclude that income inequality creates slower growth by leading to "policies that do not protect property rights and do not allow full private appropriation of returns from investment." In their analysis of eight advanced European countries and the United States, the authors find that a small increase in the top quintile's share of income lowers the national growth rate by about half a percent. Countries grow fastest when more people are sharing the "fruits" of their labor, they say.

The 3 ways inequality kills growth. Economists Stephen Knowles offered a few reasons why inequality was bad for growth. (1) Income inequality leads to higher taxes on the rich for the purpose of redistributing income, which has the effect of slowing growth. The irony here is that inequality isn't bad for growth, but rather a political decision reacting to inequality is bad for growth. (2) Inequality leads to socio-political instability, which makes investors nervous. (3) Income inequality "could reduce investment in human capital, which will in turn reduce growth." This is the argument Bourguignon made above with education.

Inequality can lead to recessions. The most popular line of argument connecting income inequality to the Great Recession goes like this. The bottom half of earners felt their income falling behind the rest of the country's purchasing power. They felt cut out of the American dream. So they filled the gap with credit. A construction boom combined with an innovation revolution in mortgages encouraged these families to buy houses and other expensive things like cars, which they couldn't afford, with money they didn't have. The savings rate turned negative in 2005 at the height of the credit bubble. But an economic downturn popped the bubble, and we're still dealing with the mess it's left.

OBAMA IS WRONG

"Little overall relation between income inequality and rates of growth and investment." Robert Barro, the renowned Harvard economist, published a famous 1999 paper that reached the simple conclusion that higher inequality slows growth in poorer countries but encourages growth in richer countries, like the United States. His findings are very much in line with the "Kuznets curve" -- whereby a country's inequality increases in the middle of an industrial revolution and decreases over the course of further economic development. "The results mean that income-equalizing policies might be justified on growth-promotion grounds in poor countries," Barro writes, but "for richer countries, active income redistribution appears to involve a tradeoff between the benefits of greater equality and a reduction in overall economic growth." In short, tax the rich to help the poor might be a "fairness" strategy, but it's not a growth strategy.

Marketization, not inequality, is what matters. Looking across 19 countries, Qi Su at Humboldt-University Berlin concludes that Robert Barro and Kuznets are right: There is no significant relationship between inequality and economic growth. "We do find that there is manifest constancy existing in the positive relationship between economic growth and marketization," Su concludes. In other words, growth is the outcome of private enterprise.

Inequality doesn't lead to recessions. "We find very little evidence linking credit booms and financial crises to rising inequality," Michael D. Bordo and Christopher M. Meissner concluded in their 90 year analysis of recessions. Credit booms coinciding with periods of strong growth are far more likely to lead to sharp downturns. "Anecdotal evidence from US experience in the 1920s and in the years up to 2007 and from other countries does not support the inequality, credit, crisis nexus," they say.

BEYOND RIGHT AND WRONG: THE GLOBAL VIEW

One thing we know about economic inequality is that the rich are getting richer all over the world, even if the process is on steroids in the United States. This graph comes from an OECD report that finds inequality floating up from the U.S. to Denmark:



What explains this? Maybe it's the nature of the global economy. In a fascinating review of data from the University of Texas Inequality Project, James K. Galbraith revisits the famous Kuznets curve ... and adds another curve. Income inequality rises in an industrial revolution, falls as the country grows and develops, and then rises again. "For some of the richest countries, notably capital goods exporters and the small oil producers, rising incomes are associated with rising inequality once again," he writes. Here's that theory in a graph:

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If this theory is correct, then it's the very nature of the global economy that could be exacerbating income inequality and slowing overall U.S. growth. In the 1950s and 1960s, the U.S. enjoyed dominance in global trade and average incomes kept pace with productivity. But as the rest of the world caught up, the U.S. has off-shored much of our industrial capacity and found that technology could replace some middle-income jobs at the same time that our overall growth has moderated. That's an important subject for the president to address in a speech. But addressing it with public policy? That's much easier said than done.

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Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

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