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  • Writer's pictureOren Levin-Waldman

Rising Inequality is as Harmful to the Economy as it is to Democracy

The rise in income inequality, especially wage inequality, speaks to the decline of the middle class. In this space I have written about how that threatens democracy, but it can be detrimental to the economy as well. Much has been written in the economics literature about how a main source of the Great Recession in 2008 was indeed inequality. And yet, policymakers have tended to focus on symptoms, rather than root causes.

Economic policy in the U.S. appears to have two speeds: either through monetary policy the Fed pumps money into the economy during recessions to make borrowing easier through lower interest rates, or it applies the breaks through interest rate increases in an effort to control inflation. What it often misses is that recessions are often the result of insufficient demand for goods and services because of inadequate purchasing power. In other words, wages and/or earnings matter, and no matter how much easier the Fed makes it to expand production facilities because borrowing has become cheaper, employers have no reason to expand operations and create new jobs if the demand isn’t there.

How, then, does inequality affect demand? A growing gap between the top and the bottom of the distribution means that while the top can continue making purchases, those at the bottom cannot. Moreover, as the middle is dropping out because of the increase in inequality, there is indeed less of a middle to make purchases either. Therefore, raising interest rates in a period of rising inequality is probably more likely to result in a recession because the middle, which has been keeping the economy going by borrowing, is no longer able to do so. Their purchasing power has effectively been diminished, thereby lessening aggregate demand for goods and services.

The question, of course, is how we got here. Monetarists have long assumed that if money is easier to obtain during a recession, firms will in turn borrow money at a lower cost, thereby expanding their operations and hiring more workers. Or conversely, if money was more expensive, i.e. interest rates are higher, then firms will be forced to lay workers off. In reality, they will slow down their operations because inflation will result in less demand for goods and services due to higher prices.

The assumption of neoclassical economists has long been that because workers had it in their power to lower their wage demands to the point where firms would demand their labor services, there really could not be unemployment. John Maynard Keynes recognized that it really did not matter how little workers might be willing to work because firms would have no need for them if there was no demand for their goods and services. In other words, creating new jobs because the cost of money, i.e., capital, has become cheaper does not create a demand, in and of itself, for goods and services.

On the contrary, it is aggregate demand for goods and services that becomes the engine of growth. If there is an increase in demand for goods and services, then employers have a need to hire more workers. What, then, would lead to greater demand in the aggregate? Well, purchasing power. If workers’ earnings are increasing, so too is their purchasing power, which in turn means greater aggregate demand for goods and services.

During the Great Depression, which may also, in part, have been caused by increasing inequality, the thinking, also Keynesian, was that in the absence of private investment the public sector would compensate through public investment. Public transfer programs, social insurance, and public works were intended to shore up the economy by giving people purchasing power so that they could demand goods and services. To this end, part of the New Deal focused on wages. Collective bargaining would add stability to the labor market and help inflate wages, and so too would a minimum wage.

To put it simply, Keynesian economics assumed the need for some type of wage policy. That is, unless there is in place a policy seeking to ensure that wages rise, or at the very least they keep up with the inflation rate, there may be little hope to ensure that economic policy will achieve its objectives. Putting it bluntly, incomes matter. And yet, during the 1970s, beginning with the oil shocks, Keynesian economics failed to explain how there could be both inflation and unemployment at the same time, i.e. stagflation.

With the Keynesians discredited, neoclassicals dug in their heels and focused more on monetarism but ignored the need for a serious wage policy, but if they had focused on rising inequality, they might have understood why this was a glaring omission. Rising inequality means that the gap between the top and the bottom has been getting bigger with fewer — the middle — in between. Those at the bottom, especially if their wages have been stagnating, are not in a position to maintain the same level of demand as they may have in the past.

It is also important to point out that by building an economic policy on low interest rates, it was assumed that workers whose wages, in and of themselves, were insufficient to maintain purchasing power, could compensate with the use of credit. In other words, they could borrow. And yet, this is another reason why the Fed’s response to inflation of raising interest rates is misguided. It disproportionately hurts those in the lower rungs of the income distribution.

Low interest rates and easy access to credit, especially for consumers, has effectively created a moral hazard on a couple of levels. For the consumer, easy credit leads to more purchases and living beyond what one’s income supports, with the result being that more and more people are carrying a heavy debt load. For firms, the increased demand that easy credit creates may also in the aggregate obviate the need for higher wages. There was a time when the mantra of many economists was savings equals investment, and savings for consumers would mean in time to make purchases. Easy credit, of course, boosts demand but the resulting growth rests on a house of cards.

Not only have the prices of goods and services for ordinary workers increased if using credit while their incomes have not, but they are more likely to lose their jobs due to an interest rate hike induced recession. As the United Auto Workers are currently on strike, what is truly incredible is that no one has thought to ask just why doing nothing about inequality may be precisely why we are here. Several decades ago, a corporate CEO earned maybe 40 times what the typical line worker was earning.

Now with CEOs getting 400 -500 times the typical line worker, the union is bound to ask, why shouldn’t we get more too? Most of the time, policymakers will say the union is being unreasonable because of the belief that it is wage rigidity that causes recessions. But when increased globalization is pushing workers out of the middle class, the answer cannot continue to be that recessions are caused by wage rigidity. On the contrary, they may be caused by the absence of labor market institutions, or at least their absence is a contributing factor. As inequality increases, we can only hope that policymakers wake up and learn how to connect the dots.

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