For decades now the consensus amongst those with the power to decide policy has been that inequality is key to spurring the competition needed to bring growth. While stagnating wages at the bottom were an unfortunate side-effect, the incentive of large rewards at the top would encourage the kind of risk-taking needed to create an innovative and vibrant economy. Anyway, those riches would trickle down eventually. A rising tide lifts all boats after all.
It’s a nice theory, but it’s deeply flawed. Because rather than facilitating growth, high levels of inequality actually appear to increase the likelihood
of economic crisis and act to stunt growth. Inequality peaked before the two worst recessions of the last century, and the correlation between inequality and bank failures seems remarkably tight. Even the IMF is coming around to the idea that more inequality means less sustained growth
As always with economics, the reasons behind these correlations are theoretical and debatable, but a growing mass of evidence is pointing towards four key issues.
Firstly, inequality restricts consumption. On the face of it that may seem like no bad thing, but our economy depends on consumer spending – in the UK, before the crash, it made up 63-64% of GDP. Because lower income households consumer a greater proportion of their income than those with higher incomes, flat-lining real wages help cause the slump in demand that encourages recession.
Secondly, in years past, this has been disguised by ever-rising levels of personal debt, or in some countries by export dependency (also for a long time by the flow of women into the workplace which upped the average household income and is now necessary for household survival). However, not only are these options no longer available (as banks stop lending and demand slumps) but they act to create unsustainable bubbles and unstable economies.
Unfortunately, and thirdly, the ever-increasing amout of money flowing to the top did not lead to the kind of productive risk-taking that policy-makers had intended. Rather than investing in businesses, innovation and jobs, the super-rich preferred to follow the market and make quick money through speculation and risky investments. As the crash in 2007 demonstrated, this was to be disastrous for the global economy.
And finally, inequality creates instability by preventing democracies from acting effectively. As the rich get richer, they also inevitably get more powerful and gain more influence in the lobbying process. As a result, and as Mervyn King highlighted yesterday, policy decisions are more likely to give preferential treatment to those with large amounts of assets, like capital gains and stock dividends. Evidence shows the resulting close link between inequality, regulation and bank failures.
Logic would dictate that our policy-makers might want to think twice and re-design their economic models to take this evidence into consideration. The rhetoric would certainly point that way. Obama states that economic inequality “hurts us all” and “distorts our democracy”, Ed Miliband declares “inequality did not just have bad consequences for our society; it had real consequences for our economy as well” and Nick Clegg tells us that “wealth and influence hoarded among the few [is] bad for the economy”.
But for all this talk, there is little action. Although governments are making token gestures – reclaiming bonuses from a few wealthy individuals, increasing shareholder power to set remuneration and waxing lyrical about greedy bankers, signs of a move towards systemic change are not forthcoming. The public outcry over excessive inequality could hardly have been stronger over the past few months and yet our governments have failed to act. History tells us change only comes when all other options are removed – when governments panic and are forced to change track. So with economic stagnation in the UK, perhaps this is the perfect time to be putting these arguments forward.