Is Inequality Inhibiting Growth?

Two facts stand out. First, overall demand for goods and services is much weaker, both in Europe and the United States, than it was in the go-go years before the recession. Second, most of the economic gains in the US in recent years have gone to the rich, while the middle class has fallen behind in relative terms. In Europe, concerns about domestic income inequality, though more muted, are compounded by angst about inequality between countries, as Germany roars ahead while the southern periphery stalls.

Persuasive explanations of the crisis point to linkages between today’s tepid demand and rising income inequality. Progressive economists argue that the weakening of unions in the US, together with tax policies favoring the rich, slowed middle-class income growth, while traditional transfer programs were cut back. With incomes stagnant, households were encouraged to borrow, especially against home equity, to maintain consumption.

Rising house prices gave people the illusion that increasing wealth backed their borrowing. But, now that house prices have collapsed and credit is unavailable to underwater households, demand has plummeted. The key to recovery, then, is to tax the rich, increase transfers, and restore worker incomes by enhancing union bargaining power and raising minimum wages.

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The short-sighted political response to the anxieties of those falling behind was to ease their access to credit. Faced with little regulatory restraint, banks overdosed on risky loans. Thus, while differing on the root causes of inequality (at least in the US), the progressive and alternative narratives agree about its consequences.

The alternative narrative has more to say. Continental Europe did not deregulate as much, and preferred to seek growth in greater economic integration. But the price for protecting workers and firms was slower growth and higher unemployment. And, while inequality did not increase as much as in the US, job prospects were terrible for the young and unemployed, who were left out of the protected system.