Not Just a Talking Point: How Income Inequality Warps the U.S. Economy

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Economic research shows that the growing gap between rich and poor harms America by creating instability and suppressing growth.

Corbis/John Springer Collection

At a salon dinner in Washington recently, the subject was inequality. An economist took the floor. Economic inequality, he said, is not a problem. Poverty is a problem, certainly. Unemployment, yes. Slow growth, yes. But he had never yet seen a good reason to believe that inequality, as such--the widening gap between top and bottom, as distinct from poverty or stagnation--is harmful to the economy.

Perhaps he spoke too soon.

Once in a while, a new economic narrative gives renewed strength to an old political ideology. Two generations ago, supply-side economics transformed conservatism's case against big government from a merely ideological claim to an economic one. After decades in which Keynesians had dismissed conservatism as an economic dead end ("Hooverism"), supply-siders turned the tables. The Right could argue that reducing spending and (especially) tax rates was a matter not merely of political preference but of economic urgency.

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Something potentially analogous is stirring among the Left. An emerging view holds that inequality has reached levels that are damaging not only to liberals' sense of justice but to the economy's stability and growth. If this narrative catches on, it could give the egalitarian Left new purchase in the national economic debate.

"Widely unequal societies do not function efficiently, and their economies are neither stable nor sustainable in the long term," Joseph E. Stiglitz, a Nobel Prize-winning economist, writes in his new book, The Price of Inequality. "Taken to its extreme--and this is where we are now--this trend distorts a country and its economy as much as the quick and easy revenues of the extractive industry distort oil- or mineral-rich countries."

Stiglitz's formulation is a good two-sentence summary of the emerging macroeconomic indictment of inequality, and the two key words in his second sentence, "extreme" and "distort," make good handles for grasping the arguments. Let's consider them in turn.

INEQUALITY'S BROKEN PROMISE

Equality and Efficiency: The Big Trade-off was a 1975 book written by the late Arthur Okun, a Harvard University economist and pillar of the economic establishment. Okun's title encapsulated an economic consensus: Inequality is the price America pays for a dynamic, efficient economy; we may not like it, but the alternatives are worse. As long as the bottom and the middle are moving up, there is no reason to mind if the top is moving up faster, except perhaps for an ideological grudge against the rich--what conservatives call the politics of envy.

For years, the idea that inequality, per se, is economically neutral has been the mainstream view not just among conservatives but among most Americans outside the further reaches of the political Left. There might be ideological or ethical reasons to object to a growing gap between the rich and the rest. But economic reasons? No.

"The debate for many years looked settled," said Robert Shapiro, an economist with Sonecon, a Washington consulting firm. "Changes in the economy and changes in the data have reopened the debate."

Economists know more today than they did in Okun's day about the distribution of income. "There's been enormous progress in measuring inequality--Nobel Prize-level progress," said David Moss, an economist at Harvard Business School. As the data came in and the view got clearer, the picture that emerged was unsettling.

"In the 1990s," Moss said, "it began to appear that income was being concentrated among the very highest earners and that stagnation was occurring not just at the low end but across most income levels." It wasn't just that the top was doing better than the rest, but that the very top was absorbing most of the economy's growth. This was a more extreme and dynamic kind of inequality than the country was accustomed to.

According to a recent Congressional Budget Office report, those in the top 1 percent of households doubled their share of pretax income from 1979 to 2007; the bottom 80 percent saw their share fall. Worse, while the average income for the top 1 percent more than tripled (after inflation), the bottom 80 percent saw only feeble income growth, on the order of just 20 percent over nearly 30 years. The rising tide was raising a few boats hugely and most other boats not very much.

It thus began to seem that the old bargain, in which inequality bought rising incomes for all, had failed--much as the Keynesian bargain (bigger government, faster growth) had failed two generations earlier. "The majority of Americans have simply not been benefiting from the country's growth," Stiglitz wrote, overstating things--but not by a lot.

PATHWAYS TO PERIL

So much for "extreme." Next came the financial-system meltdown of 2008 and the Great Recession, which bring us to "distort"--how an excess of inequality may have warped the economy.

As the data on inequality came in, economists noticed something else: The last time inequality rose to its current heights was in the late 1920s, just before a financial meltdown. Might there be a connection? In 2010, Moss plotted inequality and bank failures since 1864 on the same graph; he found an eerily close fit. That is, in both the 1920s and the first decade of this century, inequality and financial crisis went hand in glove. Others noticed the same conjunction. Although Moss recognized that a simple correlation based on only two examples proves nothing, he wasn't alone in wondering if something might be going on. But what?

Different economists suggest different pathways by which inequality at the microeconomic level might cause macroeconomic problems. What follows is a composite story based on common elements.

As with supply-side, the case starts with the two extreme ends of a curve. Supply-siders pointed out that two tax rates produce no revenue: zero percent and 100 percent. Inequality traces an analogous curve. At both extremes of inequality--either perfect inequality, where a single person receives all the income, or perfect equality, where rewards and incentives cannot exist--an economy won't function. So, Moss said, "the question is: Where are the break points in between?"

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Jonathan Rauch is a contributing editor of The Atlantic and National Journal and a senior fellow at the Brookings Institution.

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