The role of income inequality

March 3, 2014

  • The rise in income inequality was a root cause of the U.S. financial crisis and the slow post-recovery period.
  • Mediocre income gains for middle income households have contributed to the slow recovery of U.S. consumption and economic growth.
  • As pressure continues to build to address income inequality, we expect the government to lead on this issue and private sector to lag.

By Marie Schofield, Chief Economist and Toby Nangle, Head of Multi asset Allocation. This is the second part in their series: Slow growth: Why is it here and will it stay? Part one can be read here.

The roots of the great financial crisis and the slow post-recovery period can be traced to many factors, but a predominant one is the rise in income inequality. What is not generally known is that this is not a new or recent development—income inequality for both wages and earnings in the U.S. (and other advanced economies) began to rise starting in the 1980s. The income share of the top 5% in the U.S. income distribution was a fairly constant 20% from 1960 to 1980, with income gains for the top 5% and for the bottom 95% fairly close at near four percent annually. After 1980 the income share of the top 5% rose steadily in the U.S. lifting their income share to 35% by 2012 (see Exhibit 1). This rise in income gains for the wealthier relative to everyone else has been fairly well documented by several research studies. More recent studies of the post-financial crisis period have found an even higher income share grab for the top 1% in the income distribution.

Exhibit 1: Income share of the top 5%


Source: Cynamon & Fazzari, Inequality, the Great Recession and Slow Recovery, November 2013

This phenomenon largely fell under the radar in the last three decades, however, as spending inequality was less pronounced and consumption trends were less affected. This dichotomy is largely explained by the powerful expansion in the supply of and access to credit for households across the income spectrum that allowed them to smooth their consumption via increased borrowing, in combination with a steady decline in savings rates over those same years. As a result, lower income households were more easily able to boost their spending until a tipping point was reached during the global financial crisis. Most studies now point to the lack of income growth for the bottom 95% of the income distribution in combination with an unsustainable rise in borrowing as a causal factor that escalated the crisis. Debt levels relative to income escalated during the same period, but more perilously for the bottom 95% (see Exhibit 2). Debt is merely borrowed spending from the future, and becomes particularly onerous if incomes do not rise in concert. A study by Cynamon & Fazzari postulates that in the recession’s aftermath, tighter borrowing standards cut off credit flows to the bottom 95% leaving them with fewer resources to maintain consumption. While household debt dynamics appear to have stabilized and deleveraging is largely complete, income inequality can continue to rise in the U.S. and consumption remain depressed because wealthier households typically save a greater share of income and have a lower propensity to spend per dollar of income. In addition, permanently tighter lending standards have left many households unable to access credit or unwilling to do so. So it is both a demand and a supply story as it relates to credit. But the main point is that income gains have been mediocre for a broad swath of middle income households for some time, and borrowing temporarily masked the demand drag. In combination these factors have been a contributing factor to the slow recovery of U.S. consumption and economic growth.

Exhibit 2: Debt-income ratios across income groups in the U.S., 1989-2010


Source: Cynamon & Fazzari, Inequality, the Great Recession and Slow Recovery, November 2013

Advanced economies experiencing slower recoveries and a rise in income inequality are somewhat handicapped to deal with these layered headwinds. The response by central banks has been to provide some stimulus by reducing interest rates to zero and thereafter employ non-traditional measures such as quantitative easing in an effort to restart demand. However, central banks have limited experience using non-traditional tools. Suppressing yields in high-quality fixed-income securities and attempting to push more to take risk have merely raised the price of financial and real assets (which benefits the top 5%) without a commensurate rise in demand and economic activity (which would benefit the bottom 95%). As a result, any wealth effect mainly benefits the wealthy who have a lower propensity to consume and a higher propensity to save—which perversely reinforces the income inequality dynamic. As a result, income inequality is more than a social justice issue, it also compromises consumption. But it also appears that monetary policy alone cannot assure demand growth. Government and fiscal policies can play a role in addressing this thorny issue. But policymakers have remained silent, either unaware of its significance or unwilling to tackle it. Most importantly the income inequality problem is an issue to be confronted in order to avoid stagnation. Many believe there is a “golden rule” for sustainable economic performance and that is to try to align wage growth with productivity growth—a noble and desired goal, and also one that will be difficult to engineer.