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The Inequality Trap

From Project Syndicate:

WASHINGTON, DC – As evidence mounts that income inequality is increasing in many parts of the world, the problem has received growing attention from academics and policymakers. In the United States, for example, the income share of the top 1% of the population has more than doubled since the late 1970’s, from about 8% of annual GDP to more than 20% recently, a level not reached since the 1920’s.

While there are ethical and social reasons to worry about inequality, they do not have much to do with macroeconomic policy per se. But such a link was seen in the early part of the twentieth century: capitalism, some argued, tends to generate chronic weakness in effective demand due to growing concentration of income, leading to a “savings glut,” because the very rich save a lot. This would spur “trade wars” as countries tried to find more demand abroad.

From the late 1930’s onward, however, this argument faded as the market economies of the West grew rapidly in the post-World War II period and income distributions became more equal. While there was a business cycle, no perceptible tendency toward chronic demand weakness appeared. Short-term interest rates, most macroeconomists would say, could always be set low enough to generate reasonable rates of employment and demand.

Now, however, with inequality on the rise once more, arguments linking income concentration to macroeconomic problems have returned. The University of Chicago’s Raghuram Rajan, a former chief economist at the International Monetary Fund, tells a plausible story in his recent award-winning book Fault Lines about the connection between income inequality and the financial crisis of 2008.

Rajan argues that huge income concentration at the top in the US led to policies aimed at encouraging unsustainable borrowing by lower- and middle-income groups, through subsidies and loan guarantees in the housing sector and loose monetary policy. There was also an explosion of credit-card debt. These groups protected the growth in consumption to which they had become accustomed by going more deeply into debt. Indirectly, the very rich, some of them outside the US, lent to the other income groups, with the financial sector intermediating in aggressive ways. This unsustainable process came to a crashing halt in 2008.

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