Income Inequality Causes Recession

I suspect that this isn’t an original insight, but I think it is important.

It is triggered by reflecting on the fact that the 1% pay 26% of the tax that the government collects. The state relies on the 1% for over a quarter of its revenue. So it’s all very well the 99% moaning, but we depend on the 1% for our hospitals. The political right use this statistic as an argument against higher tax rates on the wealthy, implying that it shows that they already contribute “more than their fair share”, whatever that is.  But I think this is missing the point, which is not that the top earners are over-taxed but that the  very few get so much more money than everyone else that they end up paying  much more tax in aggregate.

That is, these statistics  are a symptom of a much deeper malaise – income inequality.   My argument – which I rehearse here – is that this  skewed income distribution is an economic problem, and not just a social one.

One of the failures of the 1980-2010 financial era (the era of deregulation and debt and neoliberal economics) is that  income distribution in those nations, particularly the UK and the USA worsened.    Worse meaning wider.  A loaded word, “worse”.

True, we all got richer, but the rich got richer much faster than the poor got richer.

So, this is a problem, how?

First, it creates social pressures, class envy if you like. It seems unfair, even if (perhaps? I don’t know?) it isn’t. That’s a political position – those on the economic right tend to think that it isn’t a problem, those on the economic left think it is.  I’m a soft lefty, so I think it matters, but I respect those who think that so long as we’re getting richer we should just get over the fact that others are getting  richer still (and if or  when  expanding wealth gaps trigger social unrest, use force to suppress it…)

Let’s ignore the socio-political issues, and concentrate on the economics.

My contention is that excess income inequality suppresses growth . I think there is a point at which the degree of inequality helps to tip an economy into recession and that this has been a significant factor behind the recession of 2007-12. The process probably began more than three decades ago. 1978 doesn’t sit in my memory as a particularly good year (I graduated), but it’s the year when UK incomes were most evenly distributed. The growth in relative income of the industrial working class started by successful trade unions, and the corresponding decline of the relative wealth of the aristocracy reached its peak in 1978.

This is a fairly major claim – that the worst recession in modern times was caused by income inequality rather, than, say, irresponsible lending by financial institutions and irresponsible borrowing by governments, so before I get too stuck I’ll moderate my claim. Income inequality was a factor, one of the causes, not necessarily the only cause. I also think that it is a significant factor in making the recovery slower and longer than it need to be.

The mechanism for this is that the rich spend less of their money.  Since in an unequal society they have most if it, the proportion of the national income spent on consumption falls as inequality grows. Income can be spent, or saved. On the whole, poorer people save less of their income because they need to spend more of it on essentials like rent and food.  (The ratio of savings to income is known as the savings ratio;  its complement is the consumption ratio, and they must, by definition, add up to one)

As the rich have a greater share of the national income, they save more so less of it gets spent.

Saving and consumption – the right balance

Economies need some investment; without investment, there will be no growth. People need to save some of their money.  But equally, consumption needs to grow as fast as the economy grows; if it falls behind, you will get surplus capacity, and recession. Consumption is people spending their money on stuff, and doing so enough to generate a return on the the savings that they have invested in productive capacity to make the stuff they are buying.   Productive capacity tends, naturally, to deteriorate – assets depreciate, technology becomes outdated. So to maintain a steady economy, we must invest in productive capacity at least as fast as it deteriorates. If investment exceeds the rate of decline of productive capacity, then capacity can grow – it might not, however, if investment goes to the wrong thing or to unproductive assets.

So, as the rich save more they invest more in the economy (since savings and investment are the same thing), leading to growth and job creation. That’s what’s supposed to happen. But it isn’t quite so simple.  If consumption is lower than it should be, then productive assets won’t operate at full capacity which means that investment yields will fall.  The extra capital available for investment drives down yields further, by pushing up the price of  assets.  Yield becomes a less important determinant of the price of an asset than the potential for capital gain, so capital is diverted from productive assets (such as factories making stuff that people want to buy)  to non-productive assets (such as, in the extreme case, gold, but usually property).  Low interest rates mean banks lend money to investors to put into inflating (but not necessarily productive) assets, creating an asset price bubble. When a particular bubble bursts, the banks that have lent against that class of asset record a loss, weakening their  capital ratios and thus their ability to lend more; this has a knock-on effect on other aspects of their business, including in particular routine business lending. This is what has happened in a lot of the world in the last decade or so – the US, Ireland, Spain being acute examples, but it is also (and most scarily) happening in China now.

On the other hand, if more money is being spent on consumption, then factories making stuff are more profitable, yield is more important than capital gains and savings go into productive investment rather than to capital speculation.

So: skewed income distribution (the rich have most money) leads to more aggregate savings and less aggregate consumption; growth comes from capital appreciation; bubbles develop.

even income distribution (poorer people having more money) leads to more consumption and lower savings; growth comes from profitability; trade is sustainable.

But the amount being saved must be enough to provide the capital investment a growing economy needs – new plant and equipment, education and training, research and development, infrastructure; and consumption must be enough to earn a return on this investment greater than the returns available from capital appreciation.

There is an equilibrium point for optimal growth at which the population as a whole:

(a) saves enough to provide the economy with the capital it needs for sustainable growth; and

(b) consumes enough to generate the demand so that the capital earns a return.

(Note that savings and consumption must equal income just as the savings and consumption ratios (to income) must equal one).

However, if savings exceed the demand for capital then asset prices rise and bubbles develop. This happens when more of the national income goes to fewer people; they are more likely to save than to spend, so push up prices of assets. This draws savings away from productive investment (which generates its return by satisfying the demand for consumption) towards unproductive investments (like property) which generate their return by inflating in price.

On the other hand, if consumption is excessive then there is insufficient aggregate investment in productive assets, so production is limited, prices rise and inflation follows.

The result of this analysis is that there are two sorts of inflation, both pernicious, but pernicious in different ways. Asset price inflation – such as you get with stock market and property booms – depresses interest rates and leads to bubbles and crashes; consumed goods inflation leads to higher interest rates.  The former is likely when you have excess savings which arise from a skewed income distribution; the latter when you have an income distribution that is too flat.

This last conclusion is somewhat surprising, but perhaps should be expected. A too-flat income distribution is just as undesirable as a badly-skewed one.  (It is also undesirable because there would be no incentive to work)

It now being a very long time since I did any significant mathematics, I am not sure I quite have the head on me to put into concise symbolic terms the points I have tried to express above and to generate the necessary simultaneous inequalities that could specify the ideal income distribution for an economy; however I am damn sure we are far too unequal now.


3 comments so far

  1. Tel on

    Assuming that the money supply is somehow constrained (by whatever means) and people are free to trade with one another without interference, asset price inflation means people are bidding up assets in the belief those assets represent future profits or wealth (possibly a capital gain), which must also increase the demand for money and drive up interest rates.

    In a properly balanced system, those rising interest rates naturally apply a brake to asset speculation (loans become increasingly expensive) and they also discourage consumption (more attractive to save/invest the money when interest rates are high).

    However, in our current system government has interfered with every single stage of the process so nothing balances. No surprise there.

    • ejoftheweb on

      The flaw lies in your first assumption – that the money supply is constrained. Since credit is created by the financial system, and lending against apparently secure assets which often show a book profit, banks continue to lend against inflating assets and there’s no pressure to increase interest rates. Result: the bubble bursts, as it did in Japan more than a decade ago and Europe/USA more recently. Monetary reform such as state seigneurage or a return to the gold standard might address this (I can guess which one you’d go for, and no I don’t agree with you).
      But your comment only addresses one of the mechanisms I have outlined and doesn’t touch on the claim that income inequality suppresses growth. It is, perhaps, worth conjecturing that if there were a constrained money supply, then a very skewed income distribution would tend to restrict growth less than it does with unconstrained money. But it would still restrict growth because it limits consumption.

  2. Boris B*****cks | The Transparency Extremist on

    […] both necessary and inevitable.  It does not follow that extremes of inequality are better. In an earlier post I argue that excessive income inequality has an adverse effect on growth, mainly because the rich […]

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