Understanding the macroeconomic consequences of rising income and wealth inequality in the United States
One of the big questions in economics today is to understand how rising inequality matters for the U.S. economy as a whole. There has been a sharp increase in income and wealth inequality over the past four decades, driven largely by a growing share of income and wealth going to the top 1 percent of income and wealth holders in the United States. What impact does this persistent rise in extreme inequality have on the macroeconomy?
It is naturally difficult to understand the influence of slow-moving forces that take decades to build. As the proverbial frog who fails to jump off the water that is slowly coming to a boil teaches us, slow-moving but persistent forces may be the most important. The effects of rising inequality over the past four decades on our economy may be the most consequential going forward.
How may increasing inequality affect the macroeconomy? In many macroeconomic models that are used to analyze policy, including those with heterogenous agents, inequality does not have much of an effect on macroeconomic outcomes. The reason is that the models typically assume that preferences are homothetic, technical parlance for everyone having a similar tendency to save out of their lifetime or permanent incomes. An important implication of this assumption is that permanent shifts in the distribution of income, as observed in the United States and other peer economies, do not have much of an impact on the macroeconomy.
Yet economists now know from a wealth of empirical data that the key assumption of everyone saving in a similar fraction out of a lifetime of income is not true. In particular, it is now well-documented that the very rich tend to save a much higher fraction of lifetime income. This particular behavioral trait has very important implications for the macroeconomy in the face of rising income and wealth inequality.
In joint work with Ludwig Straub of Harvard University and Amir Sufi of the University of Chicago Booth School of Business, we show that when the rich save more out of their lifetime income, an increase in inequality leads to a persistent fall in the long-term interest rate and an growing reliance on credit for sustaining aggregate demand. The central element in our theory is that greater savings rates among rich households mean that a rise in extreme inequality leads to downward pressure on aggregate demand. The downward pressure on aggregate demand can be countered through increased borrowing by nonrich households.
This kind of upswing in aggregate demand, however, is “indebted,” meaning the boost in credit-driven spending today becomes a drag on spending tomorrow, when the amount borrowed by the nonrich has to be paid back to the rich, who will not spend the debt repayment back into the economy at the same rate. This is what we refer to as “indebted demand.”
An important consequence of indebted demand is that it can only be sustained over time if interest rates fall. A decline in interest rates reduces the debt service payment that the nonrich owe to the rich, thus reducing the potential drag on aggregate demand. In short, rising income and wealth inequality generates debt to sustain demand, which, in turn, reduces interest rates going forward.
As we show in a companion paper, the theory of indebted demand fits the empirical patterns observed in the United States. A rise in the share of income for the top 1 percent of income earners generated a substantial increase in total savings by the top 1 percent as a share of the economy. Importantly, this growth in savings was not associated with a rise in real investment in the U.S. economy, thus creating a savings glut that we refer to as “saving glut of the rich.”
We find that the saving glut of the rich financed dissavings by the bottom 90 percent of the income distribution in the United States to sustain aggregate demand. Moreover, as predicted by the indebted demand framework, the increase in inequality and debt-driven consumption has been associated with a persistent decline in the long-term interest rate, which has fallen all the way down to negative numbers in real terms.
An important implication of the indebted demand framework is that once the private household sector is no longer willing or able to dissave further in order to absorb the saving glut of the rich, government has to step in by running a fiscal budget deficit to absorb the saving glut and generate demand. In the absence of a sufficiently strong fiscal policy in the face of high inequality, there is a danger that the U.S. economy will fall into a liquidity trap, or secular stagnation.
The indebted demand framework also has important implications for the conduct of monetary policy. In an age of rising inequality that puts downward pressure on aggregate demand, the easing of monetary policy helps by making it easier for households to borrow and boost demand. Yet the rise in debt subsequently puts downward pressure on interest rates. Monetary policy thus has limited ammunition: Lowering rates today helps boost demand, but also makes “normalization” of rates harder in the future.
The core policy lesson to come out of the indebted demand framework is that persistently high inequality poses a structural challenge to the macroeconomy. An economy where too high a share of income or wealth is concentrated in the hands of a few can push the economy into a corner, with very high levels of debt and ultra low interest rates. A high debt, low interest rate environment can create other problems as well, such as creating financial fragility and financial asset bubbles, and reducing intergenerational mobility.
Extreme inequality is one of the defining issues of our times. The Washington Center for Equitable Growth has created a valuable space for researchers to come together and analyze the causes and consequences of the multiple dimensions of inequality. I hope that young scholars will use this opportunity to help us understand the nexus between inequality and the broader economy.