In this blog post, I ask why economists and especially macroeconomists should care about economic inequality in advanced countries. I review standard arguments and evidence on the associations and causal pathways from income and wealth inequality to a range of macroeconomic outcomes. These include the more typical effects on economic efficiency and growth but also the potential implications on macroeconomic volatility and financial instability.
Everybody talks about inequality
Rising income and wealth inequality have been common trends across the developed world as least for the past three decades. In recent years, however, more attention than ever has been devoted to the phenomenon.
One of the drivers for the heightened interest is economic research popularized for a mass audience. Most notably, Thomas Piketty’s Capital in the Twenty-First Century was a worldwide bestseller . For the analysis here, this work is less relevant. Rather than focusing on the effect of inequality on the macroeconomy, Piketty was interested in the reverse – how wealth inequality trends are affected by the difference between r and g, the average returns to capital and the economic growth rate.
Another reason for the growing interest in inequality is the global financial crisis. Economic inequality was unlikely to be a major causal determinant of the crisis – although some economists have made the argument  – and similarly for the consequences, inequality typically goes down as incomes and asset prices fall. Yet the collapse of the financial system led to concerns about economic and social polarization across the developed world. In many cases, this was for a reason. In addition to the public outcry resulting from the bailout of large financial institutions by governments, low-income households arguably suffered the most from low growth and the painful process of deleveraging after the crisis.
But putting aside how devastating the consequences of economic depressions can be or how subjectively unfair inequality can be, why should economists – or anyone concerned with economic efficiency – care about inequality? After all, economic inequality incentivizes education, innovation, work, saving and investment, and is therefore a vital prerequisite for any market economy to thrive. If taxation of profitable companies and wealthy households reduces those prospects, the result is slower economic growth. But can the negative effects of higher inequality on efficiency offset these positive effects under some circumstances?
Inequality, efficiency and growth
I divide the key arguments on how inequality can hurt efficiency and economic growth into four general categories – politics, rent-seeking, human capital, and aggregate demand. Each channel is discussed in more detail below.
The first place where economists might forget to look is politics
Nobel laureate Michael Spence has argued that inequality can lead to “gridlock, conflict, or poor policy choices“ and hence undercut the political consensus around growth-oriented policies . Spence refers to research suggesting that the systematic exclusion of subgroups based on ethnicity, race, or religion – sometimes correlated with income and wealth – is particularly damaging in this respect. Another Nobel laureate, Joseph Stiglitz, has made similar arguments :
“Widely unequal societies do not function efficiently and their economies are neither stable nor sustainable. The evidence from history and from around the modern world is unequivocal: there comes a point when inequality spirals into economic dysfunction for the whole society, and when it does, even the rich pay a steep price.“
How far one can take this line of argument is however questionable. Are the levels of inequality in the developed world close to being detrimental with regard to social cohesion or stability, in a way that would deter economic growth? Considering the clear lack of evidence, this does not seem like a reasonable fear.
A related argument is that higher inequality would incite the poor to envy the rich, so that the latter would advocate for policies that are harmful to growth – higher marginal tax rates, less openness to investment and trade, and industry protection in general. By the same token, Stiglitz and others have argued that the perception of unfair distribution of wealth might decrease the motivation to work .
The more typical culprits are rent-seeking and regulatory capture
In economics, a rent is a payment to a factor of production in excess of what is required to keep that factor in its present use . Different types of market restrictions, monopolies, licenses, and other forms of exclusive ownership claims fall into this category. Regulatory capture instead refers to public regulatory agencies advancing the interests of special interest groups at the expense of the society at large . As a broad example involving both, major financial interests that are dependent on political decisions may incentivize businesses to engage in aggressive lobbying activities, and thereby lead policymakers to protect the rent‐capturing advantages of these groups.
Political scientists have demonstrated in recent years that economic inequality is a major driver of campaign contributions by the rich . The extent to which such contributions are associated with rent-seeking is less clear. Suggestive evidence is provided by Page et al. (2013) who conduct survey on the topic for American billionaires. The authors find that around half of the very wealthy that made campaign contributions in the past six months “acknowledged a focus on fairly narrow economic self-interest” . There is also some research indicating that, in countries were political connections drive wealth inequality, the correlation between inequality and growth is negative  – again, not alone that convincing. Third, there are the non-productive activities in the financial industry that are increasingly studied by economists . Regardless, overall the magnitude of rent-seeking is notoriously difficult to quantify and empirical literature in the area very limited.
Lastly, it is important to remember that rent-seekers don’t have to be billionaires or part of an elite in a traditional sense. Successful rent-seeking through privileged access to resources and market opportunities may mean nothing more than taxi or hairdressing licenses.
The third set of arguments concerns human capital
Circumstances outside of an individual’s control, for instance family background, pre-existing health conditions or race, may be important determinants of economic opportunities. Education or job opportunities may not always be given to those that are most talented and diligent. Paths to specialization and investment in human capital may be constrained in a way that is harmful to economic growth in the aggregate.
There are of course many potential mechanisms behind such effects. For example, one can easily assume that capital and insurance markets are in important respects imperfect, and that a considerable fraction of the population in a given country is both relatively poor and risk-averse. Then, simply because of liquidity constraints, some of these individuals will forgo education or entrepreneurship opportunities that would have paid off in terms of, say, lifetime income . And it can be even more concrete than that. Perhaps parents cannot buy a computer to their child simply because of constrained household wealth, and this will eventually show in the child’s interests, endeavors or abilities. Low incomes are similarly associated with worse health outcomes, with potential productivity implications for the individual .
Regardless of the specific channel, the worst-case result is that the economy as a whole will not be able to employ the available resources in the most efficient manner, leading to weaker economic growth. Yet is should be noted that related concerns with human capital might not be best treated as a question of inequality. It seems more appropriate to talk about poverty, low incomes, inequality at the bottom, and generally the many environmental factors that influence the functioning of poorer families and the development of poorer children.
What about aggregate demand?
Again focusing more on low incomes and perhaps inequality at the bottom, we know that less income over time for those with a higher marginal propensity to consume may end up slowing down economic growth. In layman’s terms, the middle classes in developed countries could become too weak to support the consumer spending that has historically driven growth.
There is some evidence of this. Alichi et al. (2016) find that, between 1998 and 2013, the rise in income polarization and lower marginal propensity to consume in the U.S. suppressed the level of real consumption at the aggregate level by about 3.5% . This is equivalent to over a year of consumption. Other cross-country analyses such as Ferreira et al. (2017) , Atems and Jones (2015)  and Cingano (2014)  find similar results, although they typically don’t focus only on the consumption channel.
The potential endogeneity issues with this line of work are certainly something that warrants attention. Yet at the same time, the growing body of empirical evidence does speak against the idea that a more unequal distribution of economic resources would necessarily damage economic growth.
Inequality and macroeconomic volatility
The traditional channels through which inequality may influence efficiency and growth are definitely important. More recently, researchers have also studied other features of macroeconomic performance potentially affected by inequality. One of them is macroeconomic volatility – essentially the frequency and persistence of the ups and downs across business cycles.
Robert Frank published a book in 2011 titled “The High-Beta Rich: How the Manic Wealthy Will Take Us to the Next Boom, Bubble, and Bust“ . One of his main arguments is that drastic changes in consumption and investment by the rich make the economy at large more volatile. This argument and the daring title of the book seem to have some truth to them. According to research by Bakker and Felman (2014) from the IMF, wealthy households played an important role in the Great Recession. Since those in the top income decile account for nearly half of the national income and two-thirds of wealth, the large swings in their saving were an important determinant of the boom-and-bust cycle in consumption between 2003 and 2013 .
Older IMF work is consistent with this, although inconclusive with respect to causality: Berg et al. (2012) find that periods of high growth tend to be longer in countries where the degree of equality of the income distribution is higher . And considering the lower end of the distribution specifically, it is reasonable to believe that poorer households, those with a higher marginal propensity to consume, suffered most from sinking house prices and incomes after 2007. All in all, one potential implication emerges: Perhaps with lower inequality, macroeconomic volatility would be lower as well.
There is also empirical evidence suggesting that income inequality has substantial predictive power over financial crises in developed countries  and that, at least in the U.S., income inequality may have retarded economic recovery after the financial crisis .
Inequality and financial imbalances
Related outcomes of higher inequality have to do with the accumulation of financial imbalances, in particular the accumulation of debt and leverage. Kumhof et al. (2015) use empirical data from 1920–29 and 1983–2008 to show how accumulating household debt – and ultimately economic crises – can be caused by changes in the income distribution .
Inequality can help increase leverage in different ways. The former governor of the Reserve Bank of India, Raghuram Rajan, has made the point that governments often respond to inequality by easing the flow of credit to low-income households . Stockhammer (2012) in turn argues that, in the build-up to the recent crisis, working class families in the U.S. may have “tried to keep up with social consumption norms despite stagnating or falling real wages“ . Evidence for this second channel does not seem very robust. Coibion et al. (2014) find that low-income households in high-inequality regions in the U.S. borrowed relatively little compared to similar households in low-inequality regions before the crisis .
Overall, based on a broad review by Morelli and Atkinson (2015), the causal impact of inequality on instability and the accumulation of financial imbalances is at best controversial . Especially when moving from empirical correlations to microdata, there is very limited evidence of a robust link. Nothing for macroeconomists to write home about.
The discussion of inequality typically reduces to its causes. It is not clear how much of the past increase in inequality reflects, say, privileged access to the policymaking process as opposed to technological change or globalization. Ideal policy responses are certainly very different depending on the cause. Simultaneously it is useful note that the available measures of inequality and where they apply differ substantially. And still, while global inequality has shrunk in the past few decades, not only economic inequality but also relative poverty across the developed world – often important to this analysis – has risen .
Moreover, there seems to be little reason to doubt that income and wealth inequality can hurt efficiency and growth. The idea that economic polarization can be justified on mere economic grounds – that there is a one-dimensional equality-efficiency trade-off  – is largely unsubstantiated. This post has provided a few suggestions as to why macroeconomists and economic policymakers should, if not target inequality, at least keep an eye on selected channels through which inequality can impact the macroeconomic environment.
Some concluding notes on these channels are in order. First, the political instability hypotheses are so difficult to prove that it would be wrong to argue that they warrant much attention from economists. Rent-seeking suffers from similar verification problems, but the nature of related theory and evidence seems much more convincing. Especially considering the recent polarization between those at the very top and others, excessive influence over policymakers seems like an important channel for economists and policymakers to keep track of. The human capital effects also appear very real, yet they are clearly more relevant at the lower end of the income distribution – something that also applies to the effect of inequality on consumption and aggregate demand. The evidence that rising inequality would reduce the resilience of economies to shocks or increase volatility is hardly convincing, although future research may change this.
Overall, as Dani Rodrik notes ,
“the relationship between equality and economic performance is likely to be contingent rather than fixed, depending on the deeper causes of inequality and many mediating factors. So the emerging new consensus on the harmful effects of inequality is as likely to mislead as the old one was“.
Finally, something that seems very relevant to these debates are the related developments in macroeconomic research. Ahn et al. (2017) presented a paper two months ago at the NBER Macroeconomics Conference in which they develop a relatively simple computational method for solving general equilibrium heterogeneous agent – not representative agent – macro models with aggregate shocks . Similar DSGE models with heterogeneous agents have only recently become a widespread topic of research.
The basic result of Ahn et al. (2017) is, perhaps expectedly, that inequality may matter greatly for the dynamics of standard macroeconomic aggregates. The authors conclude that their new method “opens up the door to estimating macroeconomic models in which distributions play an important role with micro data“. The future of macroeconomic research may be in important and unprecedented respects about modeling inequality.
Figure 1. Income inequality in selected OECD countries (2015).
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