Will Inequality Cause the Next Financial Crisis?

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“If you were given an extra dollar of income, how much of that dollar would you use to buy stuff and how much would you save?”

  • In the late 1970s, the top 1% of income earners accounted for only 8.9% of the total income
  • By 2015 the top 1%’s share of total income increased to over 22%
  • Since that time, many workers wages have barely kept up with inflation
Source: Emmanuel Saez, UC Berkeley

You might be asking how growing inequality could have potentially negative impacts on the economy.

Allow me to throw my economist hat on and do a quick review of what Gross Domestic Product (GDP) is.

GDP= C+I+G+(X-M)

where

C= Consumption

I= Investment

G= Government spending

(X-M) = Net Exports (exports minus imports)

You might be surprised to learn that “consumption” (people buying stuff) accounts for nearly 70% of U.S GDP. So, all other things being equal, the more people in the economy we have buying stuff the higher GDP will be.

Source: U.S. Bureau of Economic Analysis

Income inequality is bad for the economy because it suppresses consumption. To understand why let’s consider another term from Economics 101: “The Marginal Propensity to Consume” (MPC).

Basically, a person’s MPC tells us this: “If you were given an extra dollar of income, how much of that dollar would you use to buy stuff and how much would you save?”.

The MPC for high-income earners is much lower than that of low-income earners.

If you give a dollar to a rich person, they are likely to save that dollar rather than spend it because they already have their consumption needs met.

To use food as one example, once the fridge is full you stop buying food no matter how rich you are.

If you give a dollar to a poor person, they are likely to spend that dollar rather than save it.

If you are living paycheck to paycheck, you’ll be more likely to spend that money filling up your own fridge or buying a birthday gift for your kid or putting gas in the car.

If Rule #1 is that more people spending their money will boost GDP and;

Rule #2 is that poor people will spend more of their money than rich people.

It is no great leap to suggest that inequality hurts the economy. If not directly, then indirectly through the opportunity cost of lower consumption.

I would like to put forward my own theory of a second way inequality can have a negative impact on the economy, which is through increased imports.

Referring to our formulas for GDP remember the variable (X-M)? That stands for Exports (X) minus Imports (M) equals net exports. Positive net exports have a positive impact on GDP, negative net exports have a negative impact on GDP as more money is leaving the country than coming in through trade.

If the bottom 80% of income earners have not seen significant increases in their income over the past 40 years, they are likely to have a higher demand for cheap products.

Cheap products like those you would find at a dollar store are primarily produced in countries with a low cost of production, like China.

If we look at the U.S trade balance since in 1960 we will see that the U.S essentially had a $0 trade balance until about 1980. Meaning exports roughly equaled imports.

Since the mid-1970s the U.S trade balance has dropped from roughly $0 to negative $500 billion. This matches up almost directly with the rise in inequality over that same period as depicted by the two graphs below.

On the left, U.S inequality from 1913–2015. On the right, the U.S trade balance since 1960. Trade Balance Source: Source: Industry Week

I know that correlation does not imply causation, but I would suggest that stagnant wages for most Americans since the mid-1970s has increased the demand for cheap products which has significantly lowered U.S net exports and GDP.

(If anyone with research or data that proves me right or wrong I would be happy to take a look if you post it in the comments).

A working paper from the San Francisco Federal Reserve has shown that rising income inequality is a predictor of an impending financial crisis. The paper also found that financial crisis that is preceded by increased inequality is more severe and the economic recoveries are slower.

The paper stops short of saying that inequality causes a financial crisis, only that it can be used as a predictor of a future crisis. Remember that correlation does not imply causation. There could be unknown factors that are also present during times of rising inequality that are the actual trigger for the crisis.

Up until now, most macroeconomic models have focused on financial variables like debt and asset bubbles as the cause of a financial crisis. Examining factors in the “Real economy” as potential causes of financial meltdowns is a fascinating new area of research.

Any Ph.D. candidates looking for a thesis topic might want to consider examining the causal relationship between inequality and financial crises.

What do you think? Could high levels of income inequality cause real damage to the economy and financial markets? Do you think the issue of inequality is overblown? Let me know in the comments, I look forward to the discussion.

Be Prepared

No one knows “when” the next recession or financial crisis will happen but eventually one will happen. If you are concerned about how a recession might impact you personally check out this article “prepping your finance for the next recession

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.

Economic policy wonk by day. Personal finance writer by night. I write about investing, debt, and all things related to money. Editor of Making of a Millionaire

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