High indebtedness drives gap between the haves and have nots

Countries that combine high levels of debt with austerity policies create a more unequal society. For nations such as Portugal, Italy and Spain, austerity has widened income inequality, while for countries with lower personal and business debt, the gap between rich and poor has remained constant.

These are among the findings of research by Mathias Klein and Roland Winkler, to be presented at the Royal Economic Society''s annual conference at the University of Bristol in April 2017. Their study analyses 17 OECD countries between 2007 and 2011 to explore the impact of austerity on social equity.

One surprising result is that the level of indebtedness has a big influence on the Gini coefficient, a widely used measure of inequality, but not whether the country was in a boom or a slump when the austerity policies were enacted.

The researchers conclude that austerity should be employed with caution if debt levels are high: ''The true effect of austerity on inequality is underestimated when private indebtedness is high, but overestimated when private indebtedness is low.''


Private indebtedness determines whether austerity affects inequality

Does austerity increase income inequality? It turns out that it depends on how much debt firms and households have. That is the finding of this research.

Using international data from 17 OECD countries for 1980-2011, the authors find that austerity leads to a strong increase in inequality if firms and households have a lot of debt, but if they have little debt, austerity does not affect inequality.

These insights suggest that the large-scale austerity programmes undertaken in the aftermath of the global financial crisis have increased inequality substantially, as most countries had high levels of private debt; debt carried by firms and households. For Portugal, Italy, and Spain, this means that austerity caused a dramatic widening of the gap between rich and poor.

There is widespread concern that the recent rush towards austerity threatens not only economic stability, but also social equity. Against this background, this study conducts an empirical investigation of how fiscal consolidations affect income inequality, as measured by the widely used Gini coefficient. Thereby, the distributional effects of austerity are allowed to vary depending on the level of private indebtedness.

The analysis reveals that the level of private debt determines whether or not austerity affects income equality. When private indebtedness is high, then income inequality will increase dramatically, with the Gini coefficient increasing by two percentage points in four years.

But when private debt is low, austerity has no effect on inequality. Thus, policy-makers concerned about inequality should only use austerity measures if private indebtedness is low.

Importantly, inequality increases considerably during periods of high private indebtedness, irrespective of whether the economy is experiencing a boom or a slump. Likewise, in a boom or a slump, austerity has no discernible distributional consequences when private debt is low. Therefore, the private debt cycle has a greater impact on how austerity affects inequality than does the business cycle.

The study implies that ignoring the state of the debt cycle will lead to poor policy decisions. Studies ignoring private indebtedness would incorrectly conclude that austerity increases the Gini coefficient by 0.4 percentage points. Thus, the true effect of austerity on inequality is underestimated when private indebtedness is high, but overestimated when private indebtedness is low.

''Austerity, Inequality, and Private Debt Overhang'' – Mathias Klein and Roland Winkler