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Excessive income inequality destroys economic growth

A disruptive level of inequality in income and wealth was a principal cause of the great depression according to Marriner S. Eccles, who served as Franklin D. Roosevelt's Chairman of the Federal Reserve. His argument then is equally valid for the financial collapse of 2008. Many bad decisions led to both disasters. However, a disruptive level of inequality created the opportunities that made it possible for so many to get rich making decisions that they knew or should have known were dangerous and destructive to their institutions and the economy.

When the fruits of growth in productivity goes disproportionately to a small percentage of the population, a dynamic is created that can only end in disaster. The few who benefit will only consume a small portion of their increased income. They will try to invest the rest. But demand is increasing slowly from those with stagnant wages and can only profitably support a small portion of the available investment capital. Thus there is an incentive to loan money at as high an interest rate as possible to those with stagnant wages and limited ability to repay. In the short run this has the double advantage of increasing consumption and creating profitable investments, but it is a fools game. Eventually the credit runs out, demand plummets and the value of most investments tank. This leads to increased unemployment and underemployment followed by increased defaults on debt in an accelerating vicious cycle.

The argument is essentially the one Henry Ford made in 1914 when he doubled wages to $5 a day. He said he wanted his workers to be able to afford the cars they were making. At the time Ford was the only company selling cars at a price most workers, even at this doubled wage, could afford. Today every company can make more profit by driving down the wages they pay. However, if every company succeeds in doing this, the result is disaster for all. As the Banana Republic Computer illustrates, this does not even require a reduction in wages. Failing to pass on productivity gains to workers leads to a Banana Republic.

Today globalization complicates the situation. Globalization is nothing new but the advancement of communication technology combined with the massive emerging economies of China and India has created a unique reality. This has helped to hollow out the United States economy though the exporting of low skilled jobs to cheaper labor markets. India especially, because of their elite technical universities, is importing an increasing number of highly skilled jobs. As more Chinese and other third world citizens get a first class education, this trend will expand. This has already done great damage to the prospect for unskilled labor in this country and is an increasing threat to a larger fraction of the middle class.

The most surprising aspect of recent trends in globalization is the immense US debt held by China, a country with a quarter of the GDP of the US. The principal reason for this is that the Chinese masses are enjoying a rising standard of living albeit from a very low base. In contrast, the middle class in the US is experiencing a gradual decrease in their standard of of living. Thus the rising masses in China have both memory of very hard times that is a strong incentive to save and a rising income that makes this possible and relatively painless. In the US more and more people are struggling to maintain what they previously had.

The only long term solution is a more equitable distribution of the benefits of greater productivity. In the depression this was accomplished in the short run through stimulus programs that created jobs. Many factors contributed to a more equitable distribution of income during the 50's and 60's. These included:

The wide distribution of the fruits of the economy during the 50's and 60's benefited almost everyone and the same thing can happen today. Ultimately no investment in the economy has value if there are no consumers of the products that investment helps to create directly or indirectly. How is it possible to do this in a globalized, over populated, highly competitive world where technology grows exponentially and facilitates ever increasing productivity? There is intense competition for jobs and the capital it takes to support them so wages are stagnant or declining as profits, as a portion of total revenues, keeps increasing even if total revenues fall.

Economic stimulus through government borrowing and spending is an important short term response to limit the damage, but it is no long term solution. It has the potential to make matters worse in the long run as the loans are repaid to the wealthy from the pockets of those who can least afford it.

For a computerized illustration of this argument click here.
For possible solutions click here.

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