The evidence comes in a research paper by the economists Dirk Krueger of the University of Pennsylvania, Kurt Mitman of the University of Stockholm and Fabrizio Perri of the Federal Reserve Bank of Minneapolis. They use federal data on household incomes and wealth to examine how consumer spending patterns changed during the recession, as a way of testing the effects of inequality on an economic shock.
What they found is simple, intuitive and important: Americans with no wealth — or negative wealth — saved a lot higher share of their incomes during the recession than anyone else did. That additional savings at the bottom end may well have been a smart move for those wealth-poor Americans, but the trend also drained some critical consumer spending power from the economy when it really could have used it.
“Without wealth inequality, there still would have been a consumption recession," Krueger said in an interview. "It just would not have been as large.”
One of the classic features of recessions is what economists call a "demand shock." It's basically a downward spiral of money being pulled out of the economy. Growth contracts, business sales begin to fall, workers are laid off. The unemployed spend less money, which slows growth even more.
Krueger and his colleagues investigated whether inequality made that demand shock worse in the Great Recession. To do it, they divided American households into five groups, based on their net worth in 2006. They looked at the average disposable incomes for each group, and how much of that income each one tended to spend in 2006. Not surprisingly, the least wealthy Americans spent the largest share of their incomes, at 90 percent. The wealthiest spent the lowest share, 63 percent.
Every group pulled back its spending as a share of income during the recession, the economists found, which makes sense: When the economy is contracting and people around you are losing jobs, it's rational for households to save more money. What surprised the researchers was how much more the least-wealthy consumers pulled back than anyone else. The spending rate for that bottom group fell by four percentage points during the recession, more than double the rate of decrease for the wealthiest group.
If the least-wealthy had only pulled back as much as the very wealthy, overall consumption would not have fallen as rapidly. But that would have left those most vulnerable households even more vulnerable to job loss or wage cuts as a result of the recession. Which is to say, it's logical for people with no assets to save something, anything, during a downturn when economic fears mount, but it's bad for consumption growth overall.
An economy with more evenly spread wealth, the economists conclude, would by extension shed less consumption during a recession than one with pronounced income inequality. They also conclude that policymakers can mitigate the consumption effects of inequality by helping the wealth-poor endure the uncertainties of a downturn — namely, by providing them extended unemployment insurance.
That insurance, Krueger said, "is an effective tool for stabilizing aggregate consumption.” He added "This is not something that is earth-shattering as a novel finding. It comes out very clearly in the models that we study.”
That's true, but it's also worth repeating. Models are nice for policy, but evidence is even better.