Friday, October 22, 2010

Inequality and the Economy

Every time I teach the reasons for the Great Depression, one possibility often mentioned in textbooks is income inequality. Here it is in Wikipedia's reasons for the Depression. The link I just shared and what I've read before all point to an over-investment (or what I'd call a mis-investment) of resources. Perhaps the mistakes of a few can have a large ripple effect, but there's no reason to think the wealthy would be so much worse at investment than the average person. The inequality explanation never seemed to have legs, until I read this article:
The rich have been spending more simply because they have so much extra money. Their spending shifts the frame of reference that shapes the demands of those just below them, who travel in overlapping social circles. So this second group, too, spends more, which shifts the frame of reference for the group just below it, and so on, all the way down the income ladder. These cascades have made it substantially more expensive for middle-class families to achieve basic financial goals.

In a recent working paper based on census data for the 100 most populous counties in the United States, Adam Seth Levine (a postdoctoral researcher in political science at Vanderbilt University), Oege Dijk (an economics Ph.D. student at the European University Institute) and I found that the counties where income inequality grew fastest also showed the biggest increases in symptoms of financial distress.
This helps explain consumers buying houses they can't afford, a main cause of the most recent recession. It's difficult for economists to put a value on fairness, but we know there is one and now we see it has an important measurable impact.

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