Income inequality hurts economic growth, researchers say

Income inequality has emerged as a central fact of the modern U.S. economy, one that President Obama is expected to denounce as a growing threat to the American dream of upward mobility in his State of the Union address next week.

Now, a new paper argues, inequality is not only bad for those at the bottom. It is also bad for economic growth as a whole and a major reason why the recovery from the Great Recession has been so weak.

The paper by Barry Z. Cynamon and Steven M. Fazzari, economists working with the Weidenbaum Center on the Economy, Government and Public Policy at Washington University in St. Louis, says that stagnant income for the “bottom 95 percent” of wage earners makes it impossible for them to consume as they did in the years before the downturn.

Consumer spending, which drives 70 percent of the U.S. economy, dropped sharply during the recession. And while it has picked back up in the years since for the top 5 percent of wage earners — which the Census Bureau defines as households making more than $166,000 a year — “there is no evidence of a recovery whatsoever for the bottom 95 percent,” Fazzari said.

The paper makes its case by examining the connection between consumer debt, household spending and rising inequality.

For two decades after 1960, real incomes of the top 5 percent and the remaining 95 percent increased at almost the same rate: 4 percent a year for those at the top, and 3.9 percent for everyone else. But incomes diverged between 1980 and 2007, with those at the bottom seeing annual increases of 2.6 percent, while income growth for the top 5 percent accelerated to 5 percent a year.

For decades, households at the bottom compensated for that by increasing household debt, which kept consumption — and the broader economy — growing even as interest rates were low and inflation was in check. The paper says the debt-to-income ratio rose nearly 12 times as much for those at the bottom as for those at the top between 1980 and 2007.

But that borrowing spree ended with the recession.

Traditional economic theory holds that during lean times, people draw down on savings or increase debt to sustain their lifestyles. But in the case of the last recession, people in the bottom 95 percent were already tapped out from years of debt-fueled consumption, leaving them with next to nothing to draw on or borrow.

And now, nearly five years into the recovery, the top 5 percent are back to normal, consuming as they did before the downturn. But everyone else is still hurting, and their consumption levels are far below what they had maintained for nearly two decades before the downturn, the paper says.

That is a big problem for the larger economy. Those tapped-out consumers represent about half of the nation’s overall economic activity. With them financially shackled, slow overall growth is all that can be expected, the paper argues.

In an interview, Fazzari said he has no silver bullets to offer. But he knows that any response would have to go beyond raising the minimum wage, a proposal that Obama is expected to reiterate in his State of the Union address. Full employment, which would bid up wages for workers across the board, is what is needed, Fazzari suggested.

“We know the top 5 percent are doing better,” he said. “But can that drive the economy by itself?”

Michael A. Fletcher is a national economics correspondent, writing about unemployment, state and municipal debt, the evolving job market and the auto industry.
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