Four reasons why inequality matters

Traditionally, economists have shied away from studying inequality. Controversial in nature, it’s a tricky subject to engage with since any policies that deal with wealth distribution require the state to take from one group of people and give to another. Say there’s too much inequality, it was thought, and you’ll be seen as a socialist; deny it’s an issue and you’ll become a right wing pin-up like Milton Friedman. Perhaps, then, it’s a matter best left to elected politicians to engage with, rather than unelected technocrats.

But inequality, both across the wealth and income spectra, has gained more public attention in recent years, and economists are beginning to respond to it. Normally, when there’s a rising tide that lifts all vessels, everything seems fine and nobody cares too much about wealth distribution. But nine years ago, in the wake of the financial crisis, that tide stopped rising; in fact, it actually fell for many people. Suddenly, it became awkwardly apparent that some boats were still rising, and very high indeed for a privileged few.

Here are four reasons why inequality matters not just from an ethical point of view, but for the economy, too.


  1. Lower growth

The classic argument against pushing for perfect equality goes something like this: “we should be more concerned about how to grow the size of the pie, rather than worrying about how it’s sliced”.

But perhaps these two goals aren’t entirely mutually exclusive. Recent research by the IMF has found that inequality can actually lower economic growth. The authors estimate that a one percentage point rise in the income share of the top 20% can reduce growth by 0.08 percentage points over five years. In contrast, increasing the income of those in the bottom 20% actually boosts growth by 0.38 percentage points.

Why is this the case? In extreme cases, low incomes may lead to bad diets and poor health, reducing the productivity of the workforce. A more widespread problem is that the poor struggle to finance investments in education, resulting in a less dynamic and productive economy.


  1. It incentivises unsustainable levels of borrowing

In the run up to the financial crisis of 2008, many households in Western economies were building up unsustainable levels of debt. Part of the reason behind this was that although median incomes had stagnated, households wanted to maintain their standard of living. In order to do this, they borrowed more.

In the build up to the crash, economic growth was being driven mainly by credit-based consumption, rather than investment that increases the real productive capability of the economy. Building a house on sand is never a good idea, and it contributed to the increased risk of a financial crisis.

While nobody is arguing that inequality caused the global financial crisis, it certainly played a role in creating the conditions for it to occur.


  1. It reduces total consumption

As people get richer, they tend to save more of their income. Conversely, poorer folk spend most of their pay packets – they have what economists call a higher “marginal propensity to consume”. If there’s less wealth going towards the bottom, total consumption won’t grow as fast.

In the UK, that’s a problem, because our economy is consumption-driven: consumer spending represents about two-thirds of GDP. This is bad for local businesses who depend on domestic demand, and who provide most of Britain’s jobs.


  1. It has poisoned the globalisation debate

Perhaps the most pernicious effect of income inequality has been the way it has soured public opinion over globalisation. The rhetoric of Donald Trump, Marine Le Pen, or the Brexiteers would not have resonated so strongly without the enduring sense of having been “left behind” by globalisation that pervades the deindustrialised hinterlands of many rich countries.

By threatening public confidence in growth-boosting policies like free trade, inequality creates a vicious circle. It will not be the rich who suffer if Mr Trump slaps tariffs on imported goods from Mexico or China, nor will it be the rich who pay the price when Britain loses some of its access to the European Single Market. No, it will be the poor who pay the price, either through less job creation or higher prices for imported goods (of which the poor tend to buy more).

While it may be the case that free trade leads to greater prosperity, lower consumer prices, and a greater variety of available goods, these arguments are harder to hear when it’s painfully obvious that the gains have been spread very unevenly.