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

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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Reuters

"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.

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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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