David Frum


Does Extreme Inequality Hurt Growth?

Jonathan Rauch discusses the evidence for an unsettling possibility: that the recent trend to extreme inequality in the U.S. economy may be crimping economic growth.

As the country’s earnings migrate toward the highest reaches of the income distribution … you would expect to see the economy’s mix of activity tip away from spending (demand) and toward investment.

That is fine up to a point, but beyond that, imbalances may arise. As Christopher Brown, an economist at Arkansas State University, put it in a pioneering 2004 paper, “Income inequality can exert a significant drag on effective demand.” Looking back on the two decades before 1986, Brown found that if the gap between rich and poor hadn’t grown wider, consumption spending would have been almost 12 percent higher than it actually was. That was a big enough number to have produced a noticeable macroeconomic impact. Stiglitz, in his book, argues that an inequality-driven shift away from consumption accounts for “the entire shortfall in aggregate demand—and hence in the U.S. economy—today.”

True, saving and spending should eventually re-equilibrate. But “eventually” can be a long time. Meanwhile, extreme and growing inequality might depress demand enough to deepen and prolong a downturn, perhaps even turning it into a lost decade—or two.

Rauch notes also that the concentration of wealth in the hands of rich investors will tend to inflate demand for investment assets, causing asset bubbles.

[F]or decades, more than half of the increase in the country’s GDP poured into the bank accounts of the richest Americans, who needed liquid investments in which to put their additional wealth. Their appetite for new investment vehicles fueled a surge in what Arkansas State’s Brown calls “financial engineering”—the concoction of exotic financial instruments, which acted on the financial sector like steroids.

Those changes, the French economists Jean-Paul Fitoussi and Francesco Saraceno wrote in a 2010 paper, “help explain why the expansion of the financial sector was so out of touch with the economy. And why, for example, in the U.S., the financial sector represented about 40 percent of the total profit of the economy.” Alas, when the recession struck, the financial sector’s gigantism and complexity helped turn what might have been a brush fire into a meltdown.

One footnote to Jonathan's reporting. Rauch describes these ideas as novel. That's not quite true. They revive and update the antique "under-consumption" theory of the Great Depression that enjoyed a vogue seven decades ago - and then went entirely out of fashion after World War II. The rediscovery of these ideas confirms a pet theory of mine: you can get quite a reputation of originality if you have a long enough memory.