Growing Inequality Will Lead To Deeper Recessions And Bigger Booms

If the gap between rich and poor people in countries like the UK and the United States continues to widen, future economic recessions will be more severe and future booms more pronounced. That is the central conclusion of new research by Professors Murat Iyigun and Ann Owen, published in the April Economic Journal.

The widening gap between rich and poor in several industrialised economies has generated concern among politicians, economists and the general public among… who is concerned? Politicians? Economists? because they associate lower equality it with a less fair economic system. less fairness in the economic system. However, this research suggests that increased income inequality should be troubling for other reasons too.

Using data from 27 countries over 25 years, the researchers show that increases in income inequality in developed countries are associated with more severe business cycles. In developing countries, however, they find the opposite: greater inequality is associated with less severe fluctuations in consumption and GDP growth. The results of this research indicate that the effect of greater inequality would be noticeable. For example, increases in income inequality in the United States over the past decade would (do you mean would or have? Hasn''t the real per capita GDP growth changed? I am a little confused) increase the volatility of real per capita GDP growth in the next several years by about 15%.

The reasoning behind this finding is that in more developed economies, an increase in inequality means that there are more poor households. Because poor households do not have the same ability to borrow as the rich, when they fall on hard times, they must reduce their spending. Rich households, however, are able to borrow and do not have to reduce their consumption when their income is temporarily low.

As a result, when there are more poor people in an economy, consumer spending will be more variable. Because consumption accounts for such a large portion of GDP (or national income), (it might help to offer a basic definition of GDP here) more variable consumption leads to greater GDP volatility as well.

Applying this same reasoning to developing countries leads to the opposite conclusion because in these countries, a large fraction of the population is poor and does not have access to credit. Although many people equate poverty and inequality, in developing countries where many people are poor by Western standards, equality is generally achieved when most households are poor.

Therefore, greater inequality in developing countries actually translates into fewer poor households. As a result, in developing countries and increases in inequality in these countries means that fewer households are poor and are vulnerable to negative income shocks. (I don''t understand why, because a larger fraction of the population is poor, they would be less affected by inequality and why there would be fewer poor households – I am missing a piece of the logic – it might just be me) Iyigun and Owen find corroborating evidence for their theory that consumption volatility and income inequality are related through access to credit by showing that countries with more developed financial markets also experience less severe swings in consumption and output growth.macroeconomic (you might give a simpler definition or offer examples of what this represents – examples of what changes when there is macroeconomic volatility) volatility.

In other words, the income distribution and level of financial development determine the percentage of the population vulnerable to negative shocks. When a larger percentage of households is vulnerable, aggregate consumption will be more volatile. These results suggest that the traditional dichotomy between equity and efficiency may not exist. Policy-makers in developed economies should be concerned about growing income inequality not just for its own sake, but also because greater inequality causes the economy to be less efficient and exhibit more volatility.

In other words, if inequality in developed economies continues to increase, future recessions will be more severe and future economic expansions will also be more pronounced. In developing countries, the opposite effects will be felt.How does this impact the man on the street? If inequality continues to grow, what will happen in rich and poor countries alike that the general public would care about and therefore journalists would care about. 

''Income Inequality, Financial Development and Macroeconomic Fluctuations'' by Murat Iyigun and Ann Owen is published in the April 2004 issue of the Economic Journal. Murat Iyigun is Assistant Professor of Economics at the University of Colorado, Boulder; Ann Owen is Associate Professor of Economics at Hamilton College in Clinton, New York.