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Why Income Inequality Matters for Global Growth and Trade

Matthew C. Klein

The distribution of income has macroeconomic consequences. Under certain conditions, income concentration (rising inequality) can make society as a whole more prosperous. Other times, such as in the past few decades, however, high or rising inequality makes everyone worse off than they otherwise would be. The trade conflicts of recent years can ultimately be explained by the class conflicts within certain societies that lifted the incomes of the rich and the companies they control at the expense of everyone else.

That may sound surprising, but a few simple steps show why it has to be true.

Globally, everything that is produced is either consumed immediately or used as an input to invest in future production. That means that when the global economy is running at full capacity, there is a trade-off between consumption today and consumption tomorrow. In those circumstances, cutting current consumption is necessary to increase investment. As long as there are worthwhile investment projects that aren’t happening, the standard of living for most people would improve if they reduced current consumption.

In practice, the easiest way to do this is to increase inequality. Surveys across countries have consistently found that almost everyone spends about 95–100% of what they earn, which is equivalent to saying they consume about 95–100% of what they produce. By contrast, the people at the very top of the income distribution save about 40–50% of what they earn. Meanwhile, companies generally put any incremental revenue gains toward capital spending, cash accumulation, or distributions to investors, rather than higher wages for workers. This means that a shift in the distribution of income away from workers toward higher corporate profits and higher incomes for the super-rich tends to reduce consumption. In certain circumstances, it also leads to higher investment in productive enterprises, which would be good for everyone.

This may seem like a strange scenario, but it has happened before, most obviously during Britain’s industrial revolution. Urban workers did not experience real wage increases for decades even as rising productivity and mechanization lifted overall economic output. The surplus accrued to the owners of the new factories, who in turn invested in additional useful machines and factories.

The flip side to all this is that income concentration is bad for growth when the global economy isn’t running at full capacity, or in what usually amounts to the same thing, when there aren’t any worthwhile investment projects deprived of funding. In those situations, restraining consumption doesn’t enable additional investment that leads to a rise in living standards, but simply stifles demand and ends up idling existing productive capacity. Rising inequality makes society as a whole poorer.

So how does this connect to trade? The simple answer is that what’s true at the global level (everything that is produced is either consumed or invested) often isn’t true for smaller units of the world economy. Trade makes it possible for many societies to produce either more or less than they use for their domestic consumption and investment, with surpluses exported to places with deficits.

These trade flows aren’t inherently good or bad. Trade deficits can be good if they make it possible for a society to develop worthwhile investment projects without needing to stifle consumer spending. Those deficits wouldn’t be possible without corresponding surpluses elsewhere. What matters is whether the returns on the investment in the deficit societies are high enough to justify the under-consumption in the surplus societies. Problems arise when trade deficits are used to fund wasteful investments or, even worse, compensate for falling domestic production. That’s when you end up with trade conflicts between countries.

But these trade conflicts ultimately have their roots in changes to the income distribution. After all, rising income concentration tends to lead to rising trade surpluses (or shrinking deficits) by constraining domestic consumption and discouraging domestic investment, while increasingly equal societies tend to end up in the opposite situation because more money ends up in the hands of consumers who will spend it on goods and services.

So while it may not seem as if Germany’s inheritance tax system or China’s household registration system has anything to do with their international trade positions, it turns out that these domestic policies have profound global implications.

Matthew C. Klein is the economics commentator at Barron’s.

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