IMF: Income inequality is bad for economic growth

As the Occupy Wall Street protests swell in size and people pay closer attention to the gap between the wealthiest Americans and everyone else, one question is why this divide even matters. One way to look at income inequality, after all, is that it’s no big deal. If a country is growing at a healthy clip and everyone is steadily getting richer, then it’s hardly an outrage that a few titans at the very top are doing freakishly well, right?

But a recent study from the International Monetary Fund suggests that this conventional view is misguided. Excessive income inequality, the authors find, can actually inflict a lot of harm on a country’s long-term economic prospects.

In the IMF’s Finance & Development magazine, the authors, Andrew Berg and Jonathan Ostry, summarize their recent research (see also Josh Harkinson’s piece for Mother Jones). It’s relatively common, the authors note, for countries to experience small growth spurts here and there. But sustained, long-term economic growth, of the sort that the United States and Britain enjoyed after World War II, is rare. Plenty of poorer countries — say, Brazil or Jordan or Cameroon — don’t ever seem to be able to maintain that momentum.

For sustained growth to occur, Berg and Ostry found, the most important factors are a relatively equal income distribution and trade openness. (See the chart on the right.) Having healthy, democratic political institutions matters quite a bit, too. Conversely, having a lot of foreign investment or keeping debt under control, among other factors, aren’t nearly as crucial. In the end, the most important factor is inequality: “a 10 percentile decrease in inequality... increases the expected length of a growth spell by 50 percent.”

Why would inequality be so crushing for a country’s economy? For one, the authors note that inequality tends to be associated with financial crises. When inequality runs rampant, people on the lower end tend to borrow more to keep up, which increases the risk of a major crisis. (Earlier IMF research suggested that this may have contributed to the 1929 and 2008 financial crashes in the United States.)

What’s more, inequality can foster political instability, which discourages investment. Berg and Ostry also argue that inequality makes it harder for governments to deal with external shocks — it’s politically dicey to, say, cut public spending to avoid a debt crisis when the middle class already feels like it’s falling behind.

Do these lessons apply to the United States? They might. In 2005, Ohio State University’s Mark Patridge conducted a study of economic growth in the 50 states and found that “a more vibrant middle class… increased long-run economic growth.” In Democracy earlier this year, David Madland tried to tease out the causality, arguing that societies with less inequality and a stronger middle class tend to have more trust, less corrupt governance and stronger “capitalist values” that encourage entrepreneurship.