Income Inequality & Economic Growth, Part 1
The Mechanics
Someone is sitting in the shade today because someone planted a tree a long time ago.
~Warren Buffett
When Will the Bridge Collapse?
The American Society of Civil Engineers (ASCE) provides, every four years, an assessment of America’s infrastructure. They divide their report into eighteen categories like aviation, levees, roads, and bridges. The U.S.’s overall grade was C- in 2021. (Broadband is left ungraded; rail and ports got Bs; everything else is a C or D.)
When the ASCE assesses the state of, for example, our bridge infrastructure, they do not try to predict when bridges will finally collapse. Collapses are triggered by unpredictable events. For example, a combination of extreme temperature fluctuations, heavy traffic, and an especially rumbly truck engine might conspire to overpower a bridge’s deteriorated structure.
We ask our engineers to assess resilience, not specific triggers. We do not ask them to predict the nature and timing of the final event. We should be making similar requests of our economists. As Noah Smith wrote, “…there’s no macroeconomic model in existence that can know with a high degree of certainty whether a recession is imminent.” (His italics.)
On the other hand, we have a pretty good idea about how economic vulnerabilities progress. Economies, like bridges exposed to the forces of entropy, deteriorate. Economic deterioration comes in the form of naturally increasing inequity. If we want to offset the collapse of bridges and economies, we must monitor and mitigate deterioration. Then we make repairs as deterioration approaches a certain level of risk, not after a collapse. Economic repairs amount to policy updates aimed at improving equity.
To do that effectively, we need to understand the relationship between inequity and our default measure of economic success — growth. One challenge is that, unlike bridges, our macroeconomy wasn’t engineered. It emerges from our individual behaviors. Meanwhile, our behaviors, infrastructures, and institutions evolve even as we speak, so macroeconomics is a moving target. That said, we are much smarter than we were a hundred or even fifty years ago.
Which Causes What?
Does income inequality help or hurt economic growth? The sheer number of people trying to answer that question suggests there might not be a simple answer to the simple question. Even the studies that focus more on data than theory don’t all agree. A given study’s answer depends on the exact question they ask, the data they use, and the assumptions they make about how macroeconomics even works.
My answer depends mostly on the time horizon in question. Six months from now or twenty years? In this post, I will summarize, with attention to time horizons, the important links economists have studied between income inequality and economic growth.
The rich get richer. The nature of capitalism, as explained in previous posts here and here, is wealth begets wealth. Absent extreme corruption and catastrophe, this has two main consequences over the medium- to long-term: economic growth and increasing income inequality.
Big investments get better terms. Bigger investments get bigger returns dollar-wise, of course. They also get bigger annualized rates of return. People with little to invest do not have the same high-quality investment opportunities as the wealthy. This exacerbates the already existing tendency for the rich to get richer.
The supply of skilled labor lags demand. This is a decidedly long-term link between growth and income inequality. In an economy’s transition from agriculture to industry, emerging technology requires skills that agricultural workers do not yet have. The workers who do have the necessary new skills command a higher wage than ag workers, so income inequality increases. But that provides an incentive for workers to get training and then transition to higher-paying industry jobs. As they do so, supply and demand for labor in industry and agriculture rebalance, so wages equalize, reducing income inequality.
As technology further improves, it becomes possible and profitable for industry to automate and operationalize low-skill work. Then low-skill workers find themselves competing with machines with the very purpose of being cheaper. They also compete with other, often overseas, workers who need the same low-paying job. So the demand for low-skill workers decreases while the supply of low-skill workers remains constant. Low-skill wages therefore receive downward pressure. Meanwhile, wages for high-demand high-skill workers (like the ones developing automation) increase. Income inequality reverses course again to increase.
To summarize, over the long-term, growth continues while income inequality gets worse, then better, then worse again. The U.S. is well into the second “worse,” so as a practical matter, this link between income inequality and economic growth indicates they both tend to increase over the medium- and long-term.
The Fed’s recession response temporarily reduces income inequality. The Fed has learned to immediately reduce interest rates when a recession occurs. Low rates make it attractive for firms and individuals to borrow money. We borrow to invest in longer-term projects, like real estate for individuals or capital investments of various kinds for corporations. Project investments only make sense for investors who believe the pay-offs will outperform their borrowing costs. So when the Fed lowers rates, borrowing rates decrease and project investments become more attractive. Projects’ eventual pay-offs contribute to future economic growth, which was the the Fed’s intent.
Meanwhile, projects need workers. Labor demand goes up, increasing wages and reducing unemployment in the relative short-term — six months to two years. Workers benefit immediately from work opportunities and better pay; investors expect their pay-offs later. Therefore, income inequality decreases in the short-term.
Eventually, rising wages contribute to rising inflation, which signals the Fed to return the interest rate to its target. If all goes well, growth, inflation, and unemployment return to their targets, as well. Income inequality also returns to its normal behavior, which, left unmanaged, increases.
Summarizing, modern recessions managed by a modern Fed informed by modern macroeconomics, are associated with short-term dips in growth (by definition) and tend to be associated with short-term dips in income inequality.
Social unrest hurts growth. Inequity makes people angry. Angry people cause disruptions. Disruptions cause uncertainty for entities who might otherwise invest. Although social unrest looks convulsive in the news, it arises after sustained periods of unresolved increasing inequity. Therefore, I place this link — in which income inequality hurts growth — in the medium-term category.
If income inequality is already high, more inequality hurts growth. By the nature of banking, one person’s saving is another’s borrowing. And most borrowing is done to invest in projects with future pay-offs. So in macroeconomics, aggregate saving is equal to aggregate investment. Since investment is good for growth, saving is good for growth.
Income inequality has two competing effects on the savings rate. On one hand, high income earners save more, percentage-wise, of their income, so more income inequality applies upward pressure on savings. This is the argument behind trickle-down economics, sometimes called “Reaganomics” in the U.S. But it is only half the story, and as it happens, not the important half.
Lower earners tend to spend more (save less) when other people’s high incomes get higher. “Keeping up with the Joneses” is an actual macroeconomic factor.
The combined effect is that at low levels of income inequality, a little more inequality helps growth; at higher levels of income inequality, a little more inequality hurts growth. So somewhere in between, there is a sweet spot inequality is constant while growth continues. In the U.S., it turns out the sweet spot is well below any level we have had since 1961 at the latest. Bottom line: Income inequality hurts growth in the medium-term via lower savings rates. Reaganomics was never a good idea.
Unregulated free markets become monopolistic. Free entry and fair competition in markets are good for consumers — prices stay reasonable and quality stays high. At the same time, incomes for investors in free-market businesses are kept in check by competition. Therefore, in theory, free markets lead to high growth and low income inequality.
But competition drives innovation, and eventually some business’s innovations create a competitive advantage. Over time, if a business is successful enough, it may use its stronger influence in its specific market to diminish free entry and fair competition. They may even “invest” in politics to get favorable policies enacted. As competition wanes, income inequality increases. This is why we have laws against monopolies. It is also, for example, why Google keeps getting fined in Europe where anti-competitive laws are stronger.
Our economy is made up of multiple markets, all in different stages of their evolution from almost purely free to nearly monopolistic. But since income inequality and economic growth move in opposite directions regardless of whether markets are free or monopolistic, the aggregate economic direction depends on regulation. In a well regulated economy, free markets dominate, increasing growth and decreasing income inequality in the medium-term.
Investments in human capital decrease income inequality and increase growth. Education and healthcare for the poor increases their income. Their income increases because their work is more valuable — they are more productive, which improves economic growth. In this process, growth is associated with a decrease in inequality. The cause of both is human capital investment. It is most effective when the investments are made in children, which means the results emerge in the medium-term.
Money in politics is bad. When the wealthy influence election outcomes and thus policy, they tend to self-deal, making themselves wealthier, increasing income inequality. This leads to corruption and waste, which hurt growth by decreasing investors’ confidence and stifling fair competition. Self-dealing, corruption, and waste follow short-sighted thinking. Over time, political trespasses stack up. Thus, money in politics is bad in any timeframe and gets worse over time.
Next up: Part 2, in which we tame the complexity.