On April 1st, my book,” Dagbok från USA”, came out in Sweden. It will also soon be published in English (as an e-book for Kindle and for other readers) with the title: “Diary from the United States – Notes on a society in crisis“. As an appetizer for English speaking readers, I will the coming weeks publish some excerpts from the book.

The fact that the United States is getting poorer because of big income inequalities is often overlooked

If one examines only the one percentage of U.S. households with the highest income after tax (“top 1%”), it’s only a slight exaggeration to speak of “Winners Take All”. This group increased its share of total U.S. income by over 120% between 1980 and 2007. The group with the 20% highest income (“top 20%” which includes “top 1%”) has also increased its share but only with more moderate 25%. The other four-fifths of households received a smaller proportion of the total income during this period. This graph (click for bigger picture, from Gilson & Perot, 2011) shows that clearly.

What a widening income gap means socially and for the social contract is one thing. It’s not the issue I will address here. Instead I will discuss the skewed income distribution’s adverse effects on growth. It’s an often-overlooked consequence. The fact is that a reasonably even income distribution is good for growth. A country will become richer, all else being equal, if income isn’t too unfairly distributed. John Kenneth Galbraith, renowned economist, in fact considered reasonable income distribution to be a prerequisite for a well functioning capitalist society. “One of the least talked about facts, and most unpleasant economic truths for the very wealthy, is that an even distribution of income in society is highly functional”, as he puts it.

The basis of the argument is what is known as Say’s law, after the French eighteenth century entrepreneur and philosopher, Jean-Baptiste Say, which simply states that the sale of each product creates the funds to buy the product on the market. What you pay for the item includes everything from materials costs, labor costs, interest and profits (or losses), and it’s, of course in theory, exactly what it takes to buy the item. So at the aggregate level and for a closed system, Say’s law prevails, provided all income is used to purchase the goods offered. It’s just that this ideal state is not the real world, which for instance is affected by the times. For example, in bad times most people are cautious and wait to buy. The working of Say’s law is also influenced by how income is distributed in society.

If a majority of all income earners, say 60%, feel they do not have high enough income to consume what they would like to consume, and if they do not borrow, the consequence is, ceteris paribus, that demand in the economy at large decreases and thus GDP growth goes down. The reason is that when there’s so little money in the wallets of a large proportion of the population that there’s only enough for the bare essentials, then – not surprisingly – fewer goods are sold, many companies have less to do, people lose their jobs and for the community at large unemployment increases. That is exactly the situation we have in the U.S. today, only with the amendment that the situation is particularly difficult since the 2008-2009 crisis radically lowered the wealth for this group, in effect the net value of their real estate, usually their homes. On average, the price of American single-family homes has dropped by more than 30% since the peak in 2006. Falling value of one’s assets dampens optimism, and caution increases. For those families in this group who took out mortgages on their homes during the go-go years of the last decade – and there were many – the situation is even more serious. They shall, in addition to everything else, also find the money for servicing their debt.

Demand may also fall because those with very high incomes, those who really can afford to consume, may think they have enough and prefer to save a large portion of what they earn. It’s more or less inevitable when we talk about people with very high incomes, say the tenth of one percent who earn the most, “the super rich”. They cannot reasonably consume more than a very small part of what they earn. It’s hard to imagine that one can eat, sleep and live for more than a few million dollars a year. Still some business executives and others with super incomes earn much more than that, many tens of millions of dollars a year, even hundreds of millions of dollars. They can afford to consume a lot to say the least. However, it’s by and large not consumption in the true sense of the word. A person with super income can own real estate in all the world’s large cities or buy art for hundreds of millions of dollars, but it becomes in practice investments which typically give more back when sold than what they once cost. And the money not spent is instead invested in financial assets, and quite often, as the decisions surely would be delegated to professional asset managers, denominated in foreign currencies where the expected return is higher than in the U.S. This clearly won’t do much for U.S. growth. In addition, concentrating much of the income at the top creates an economy of costly uncertainty because no one knows how the top earners will use their money. If 40% of the total income is handled by the already rich, as in the U.S., this uncertainty is a real threat to the stability of the economy. According to classical economics, high-income earners are spending their means in the same way ordinary people are spending their money at, say, the grocery store. That happens not to be the reality. High-income earners have a choice. When they decide not to spend or invest in their own national economy at a level equal to what they have done before, it gives rise to a new equilibrium due to the reduced demand. Such a situation creates volatility and uncertainty in the economy.

Robert Reich, professor of political economy at Berkeley and a former Secretary of Labor in the Clinton administration, tells a story in his new book, Aftershock, of Kenneth Lewis, CEO of Bank of America in 2007, which ingeniously illustrates this argument:

Consider the nearly $100 million Kenneth Lewis earned as CEO of Bank of America in 2007, as he was leading the bank toward a subsequent bailout by the federal government. To spend it all, Lewis would have had to buy $273,972.60 worth of goods and services every day that year, including weekends. If he had devoted twelve waking hours a day to the task, he’d have had to spend $22,831 every hour, $380.52 every minute…

Now suppose Ken Lewis’s $100 million had instead been divided among five hundred people, each of whom took home $200,000 that year. Assume that each spent $150,000 – hardly difficult in and around New York City, or in other big cities – and saved $50,000. Total spending by those five hundred would have added up to $75 million, most of it supporting jobs in the United States. Take the logic a step further. Suppose Lewis’s $100 million had been paid instead to two thousand people, each of whom took home $50,000 – just about what the typical American family earned in 2007. Each of those two thousand families is likely to spend all, or nearly all, of that money. The lion’s share will be for services. Most of that $100 million would have gone directly into the U.S. economy, sustaining jobs.

What is the conclusion? Well, if income is distributed more fairly, so fairly that the largest group of wage earners feels that the income they receive is sufficient for their needs, it means that the economy is approaching the ideal situation that Say’s law describes. The vast majority of disposable income is used to consume, and since it applies to say 80% of income earners, it will have direct positive effects on aggregate demand. The companies will sell more, they will hire more, and the economy will spin ever faster, with GDP growth rising. As a bonus, the uncertainty arising from the fact that one never really knows what the super rich are doing with their income will be reduced.

Possibly, the argument here can be misunderstood. No one is suggesting that there should be no income inequality in a society, and that some people should not have very high incomes relative to the average. Of course, it’s good for the dynamics of the economy, and thus for growth. Even in the most egalitarian Western countries, there is significant income inequality. It’s the extreme income differentiation – as in the U.S. – between a small group of very rich people at the top and a much bigger group with low incomes, which leads to lower GDP growth than what is possible with less income inequity. Even more important is that these income inequalities have increased over time as we have seen in the U.S. over the past three decades. This contributes to a psychological effect that is also likely to dampen growth. Although there are economists (and of course politicians) who argue that there isn’t any relationship of this kind, between extreme income inequality and lower relative growth, they have almost all empirical evidence (and common sense) against them. There are plenty of phases in U.S. history that show that a more even income distribution may well go hand in hand with high relative growth, and there are international data showing the same thing.

Literature:

Galbraith, J. K., 1994, A Journey Through Economic Time, Houghton Mifflin, Boston;

Gilson, D. & Perot, C., 2011, “It’s the Inequality, Stupid!”, Mother Jones, March/April 2011 Issue;

Reich, R. B., 2011, Aftershock, Vintage Books, New York;

First published (in Swedish): October 23, 2011