The Devastating Cost of Inequality

A general complaint that I have about the discussion of inequality and poverty is that the subject is often treated as a zero-sum game. Solutions to inequality involve taking from the rich and giving to the poor, which is a money transfer that only has distributional impacts. The treatment of the topic as zero-sum is what results in the "class warfare" we see in American politics. It is an easy trap to fall into and a difficult one to escape because of its passionate story line with defined characters. Depending on your disposition, it is easy to define one group as virtuous and the other as corrupt. The story line is politically convenient because it is a tried and true formula to energize both conservative and liberal bases during election season, but it ignores the devastating cost of excessive inequality to the macroeconomy.

The effects of income on a child's development and family environment is no secret. Families with greater income security tend to have more stable family environments, better parent-child relationships, and better educational opportunities. The environment and attention a child receives is a major factor in his/her development later in life, which is the motivation for President Obama's push for universal pre-k. Early childhood development is the first and, perhaps, most important step in unlocking the potential human capital of an individual. However, greater degrees of inequality creates a situation where fewer children receive the minimum amount of parental attention and education needed to proceed along a good development path.

Greater inequality disproportionately impacts young children compared to other groups in society due to poor schooling and unstable households. Welfare programs designed to reduce inequality should not be considered as a redistribution based on some idealistic notion of equality. They should be viewed as way to raise the floor of society instead of lowering the ceiling. The lost productivity due to unrealized human capital among low income populations is unknowable, and, in all likelihood, enormous. Policies designed to reduce inequality also reduce the number of children who grow up neglected and under stimulated.

The millennial generation (of which I am a part) grew up on the message of unlimited human potential signified by the slogan "you can be/do anything if you work hard." For the most part, this was a selfish motto used to try to convince ourselves that we will end up rich and respected. However, the magnetism of that often scorned philosophy gains new power when it is applied to the subject of growing inequality. There are millions of children growing up right now who could, but likely won't, be computer scientists, engineers, technicians, analysts, or a thousand other professions. In a time a social and political disunity, the universal human instinct to protect and invest in our children likely provides the greatest return on investment for our tax dollars. The reduction of inequality in this country is an investment designed to avoid the squandered productivity of millions of workers. The story of reducing inequality will be one of productivity and growth once we move past the trap of class warfare.

The Economic Damage of Political Instability in the United States

There is a significant amount of literature that discusses the impact on inequality on economic growth and political stability. One logical hypothesis is that inequality impact economic growth through political instability. Political instability in its extreme form is open conflict between the government and its population. This form of political instability is all too common in Latin America. Developed nations are more likely to experience sub-optimal fiscal policy and government regulation as a less threatening, but still damaging, form of political instability. The United States is a good example of how the second form of political instability can hamper economic growth.

The current levels of inequality is the United States created a less stable economy that has struggled to recover from a debt driven financial crisis in 2008. Fed Governor Sarah Bloom Raskin gave a speech at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies in April that strikes at the heart of how inequality has weakened the economy. Member of the middle class and below had the majority of their wealth tied up in home equity that was destroyed by the collapse of the housing bubble. The past five years has been a painful period of deleveraging (see chart) as many families were stuck with unrealistic mortgages as a result of irrational exuberance in the housing market. Families most damaged by the housing collapse were also the ones most vulnerable to the increase in unemployment. The wealthiest members of society have fared well since the financial crisis while others are still struggling to regain financial stability.

The result of the dramatic disparities in economic circumstances for the different income classes since 2008 has lead to a disturbing increase in political polarization. Below is the Political Polarization Index developed in a study by Marina Azzimonti at the Philadelphia Fed. Polarization has been trending sharply upward since 2008 and reach its highest level at any point from 1981-present during the 2012 election. To a large degree, the political polarization of the country has been driven by inequality and the result of the 2008 financial crisis. Republicans are sternly on the side of low taxes and reduced welfare benefits, which is supported by many extremely wealthy donors and social conservatives. Democrats have been advocating increased taxation of the rich and financial relief for those hit hardest by the financial crisis. The two sides of the wealth spectrum have been placed on opposite ends of the wealth spectrum, and the result has been a contentious partisan environment.

The polarized political environment has done far more than slow down the legislative branch and inspire hateful debates in the last election cycle. It has created sub-optimal policy initiatives that are actively harming economic growth in both the short and long-term. Political polarization has created instability in the legislative process that has damaged fiscal policy in the U.S. Sequestration was intended as a bitter pill to end debt ceiling squabbles that Republicans have been all too eager to swallow. In reality, Sequestration is a temporary band-aid that serves very little purpose in the long-term debt ceiling or budget battles but causes very real damage to portion of society that have been hurt the most by the financial crisis. Long-term unemployment is still a pressing issue for legislators who are barely able to keep the government operational. The future growth path of the economy gets bleaker every day as long-term unemployment remains an issue that politicians are content to stash on their shelves until it becomes politically useful during 2014 or 2016.

Political instability even shares part of the blame for the botched implementation of Obamacare. The Obama administration has been forced to expand the scope of the federal exchange due to state-level intransigence and even the development of the project was damaged by party politics. The administration felt the need to be secretive and insular during the development of the federal exchange because of constant attacks from the right. Now the country gets to wait with bated breath for another doomsday deadline to see if the exchange can be fixed in time to avoid extensive damage to insurance markets. Politics is not an excuse for the mismanagement of the launch, but it is still a reality of the situation.

There is a long strand of literature in academic economic journals discussing the theory of how economic growth might be damaged by inequality and political instability. Lucky for us, we get to see the dirty details of it firsthand.