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Economic Research: How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways
To Change The Tide

have harmed the U.S. economy.

Professor of Public Policy at U.S. Berkeley Robert Reich argues that increased inequality has reduced overall aggregate
demand. He observes that high-income households have a lower marginal propensity to consume (MPC) out of
income than other households, and they're currently holding a bigger slice of the economic pie. Research by
economists Atif Mian, Kamalesh Rao, and Amir Sufi backed that up, finding the MPC for households with an average
annual income of less than $35,000 to be three times larger than the MPC for households with average income over
$200,000 (39). Mian and Sufi also found that, as home values increased between 2002 and 2006, low-income
households very aggressively borrowed and spent (possibly borrowing on increased home equity)--while high-income
households were less responsive. Unsurprisingly, when housing wealth declined, the cutback on spending for
low-income households was twice as large as that for rich households (40).

Mian and Sufi further used ZIP codes to locate areas with disproportionately large numbers of subprime borrowers
(those with low incomes and credit ratings) and found that these ZIP codes experienced growth in borrowing between
2002 and 2005 that was more than twice as high as in ZIP codes with wealthy "prime" borrowers (41). They also found
that ZIP codes with lower income growth received more mortgage loans during that time period, supporting the notion
that government policy targeting low-income groups increased lending to the less well-off. After 2006, the subprime
ZIP codes experienced an increase in default rates three times that of prime ZIP codes.

Raghuram Rajan claims that, while high-income individuals saved, low-income individuals borrowed beyond their
means in order to sustain their consumption, and that this overleveraging, as a result of increased inequality, was a
significant cause of the financial crisis in 2008 (42). An IMF paper by Michael Kumhof and Romain Ranciere also
details the mechanisms that may have linked income distribution and financial excess and have suggested that these
same factors were likely at play in both the Great Depression and Great Recession (43).

Unfortunately, coming back from the Great Recession appears to be taking longer than many had hoped. With a
postrecession annual growth rate of 2.2%, our recovery is not even half the historical average annual growth of 4.6%
for other recoveries going back to 1959. This is not a complete surprise, given that financial crises are often followed
by prolonged recessions and a long bout of subpar growth--thanks in part to the deleveraging that comes as people try
to repair their finances.

Indeed, during the recession, the consumption-to-income ratio of the bottom 95% of earners fell sharply, as banks and
other lenders imposed tighter borrowing constraints, according to a study by Barry Z. Cynamon and Stephen M.
Fazzari (44). Though the consumption-to-income ratio of the top 5% rose, this increase was not enough to offset
inadequate demand coming from the bottom 95%. That makes sense. Between 2007 and 2010, the average U.S.
household lost 39.6%, or about 18 years' worth, of their net wealth in the three years when the recession started in
2007 to the early recovery in 2010. The middle class lost over 40% of their wealth in just three years, while the top
10% of income earners actually accumulated an additional 2% to their wealth (see chart 7). Corporations that have
been reluctant to invest or to cut prices to gain market share because of distorted incentives to seek short-term stock
market gains have also depressed demand, according to Andrew Smithers (45). These two factors go a long way to
explain why the recent recovery has been subpar in comparison with other postrecessionary periods.

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