Does income inequality reduce economic output, and is there evidence on way or the other?

Ok, so there’s a pretty basic principle that anecdotally goes back to the days of Henry Ford.

Say a company makes $100. If it spends $20 of that paying workers, those workers have $20 with which to spend on goods and services -including goods and services that the company may in fact provide. If all companies spend $30 instead of $20, the country has 50% more funds flowing about adding to consumer spending.

Anecdotally, Henry Ford perceived this and he paid the workers more than he had to in order to supply his workers with enough money to buy things that included the very cars his factory produced.

So that’s all well and good. But, what about the other $70 or $80? If that money goes to the Rockefellers of the world, won’t *they *in turn spend it, driving the same economic activity?

As the U.S. economy concentrates more and more dollars into the hands of a few, shouldn’t the economy be chock full of job openings for butlers and portrait painters and mansion and exotic car repairmen?

I’ve also heard that the rich don’t tend to spend as large a portion of their money, proportionally speaking, as someone poorer. A poor household might spend 80%-100% of discretionary funds buying goods and services, a rich one might spend only 10% and invest the rest. However, those investments should, in theory, create more jobs because the capital is used to buy more equipment to make money with.

Please try to stay politically neutral in your responses. I am not saying that the concentration of wealth is bad or good, merely that it is an undisputed fact that it has been happening, and I am curious as to why some think it is shrinking the economy.

As a case study in income inequality, one needs only to turn to countries like Brazil. In Brazil, people are either very wealthy (equivalent to American upper middle class), very poor (and live in shanty towns called “Favelas”) or “money is no object” wealthy" (equivalent to American 0.01%).

Yes, there is a higher demand for butlers, McLaren dealerships and exotic pet wranglers or whatever. But 1) there those are very specialized jobs and there aren’t enough rich people to support an entire economy based on luxury services and 2) it’s not a good thing to have your entire economy based on kowtowing to the hedonism of the super rich anyway.

The main problem with massive wealth inequality is that as the wealth gets concentrated into a smaller and smaller group, that group tends to retreat from the rest of society. Both socially and physically. They live in gated communities and walled compounds. They have private schools and private security. They don’t invest in the greater infrastructure which soon degrades.

So while the wealthy becomes a self-perpetuating class of elites who went to the “right schools” and live in the “right neighborhoods”, everyone else lives in corrugated metal shacks beside crumbling overpasses.

But if one looks at the Gini scores of countries (a measure of wealth distributrion)

the answer is not so clear cut. The USA actually has greater wealth inequality than Brazil, but we also have 10x as much wealth.

The questions you asked were:

Paul Graham thinks the answers are no (to the first) and yes (to the second):

Income inequality is created as much by fostering poor spending and saving habits among the bottom tier as it is by any simple difference in income or wealth. Wealth moves; it is almost inherently of no value unless it moves somehow. Wealth is accumulated by diverting part of that movement; the faster the movement, the higher the accumulation.

In the present-day US economy, the upper tiers grow wealthier the faster wealth cycles through the lower tiers, which leads to an encouragement of those lower ranks to spend as much as possible and save as little as possible, even to the extent of ‘negative savings’ - debt.

[continued; damn edit window] So in the US, at least, economic output as a stream to feed that spending by the masses is driven by the mechanisms of wealth inequality.

The Ford paying his workers enough to afford cars idea is a myth. What Ford did was pay an efficiency wage. He was having trouble keeping workers at his factories. The entire workforce was turning over every four months. He raised wages far above the competition so his workers would stop quitting. This lead to lower training costs and higher productivity. That is the reason it was profitable for him to do so, not increased demand.
As for the idea that increased income inequality hurts the economy by suppressing aggregate demand, there is no empirical support for this. Since 1980 real per capita consumer spending has doubled while income inequality has gone up at the same time. Here is a chart that shows total personal savings. It shows that saving fell before the recession which is the opposite of what you would expect if the problem was rich people saving too much money. A 2010 study of 12 developed countries showed no relationship between economic growth and amount of income going to the top 10 percent.
The idea that income inequality hurts the overall economy is not a proven fact but rather wishful thinking.

I think some of the underlying thought here is that the rich lock up so much money that there is none left for the peons to spend, thus promoting a tight-money economy, inflation, reduction of production, etc.

Lovely theory, I suppose, but reality is one long contraindication. Just maybe it was true in some feudal/premodern situation where Count Rugen really did have all the gold and silver in his treasury and the serfs and peasants had only a barter/survival economy.

Your cite constructs a strawman. Reduction of income inequality is not about confiscating private fortunes. Yes, people won’t work without getting paid for it, but you’ll have to show that someone getting $20 million a year is going to slack off compared to someone getting $25 million a year.

Income inequality also involves stagnating wages for the non-rich. Is someone making $12 an hour going to be a more motivated worker than someone making $9 an hour. Even WalMart seems to think so now.

There are many investment opportunities which do not create jobs. Investing in a start up, adding to a plant, opening a new business does. Throwing more money at Google or Apple stock does not. Demand creates jobs. Investment does create jobs if production capacity is inadequate to meet demand. If production capacity is being unused, investing in more is not going to do much good.

I’m lucky enough to not need anything I can’t afford. If I get a $300 bonus and tell myself I should spend it on something fun, I need to think long and hard for something new I wouldn’t buy normally. If I got $1,000 it would go straight into my investment account. I am not a good consumer, alas.

Make money from whom? You need customers to make money from. If your customer base consists of poor folk who’ve already spent all their money, and rich folk who’ve already bought everything they want, you’re not in a great spot.

I wouldn’t disagree, in theoretical terms, but can you name any such customer base?

No diss, but it’s one thing to throw out speculative situations, and another to hook them to reality.

There is an interesting TED talk that addresses these concerns and some of the other reasons why income inequality is a bad thing by Nick Hanauer. You should check it out.

Not that long ago WalMart cut its forecast because its customers did not have enough money to make the same level of purchases. The Dollar stores were doing quite well for a while due to this.
I don’t know that WalMart raising its wages has anything to do with this situation, but as big as they are I’d think forcing up wages of non-WalMart employers would be good for them, since the additional sales volume might more than make up for the cost of the wage increases. They also talked about retention, so they clearly had other reasons also.

Nobody’s claiming income inequality is a good thing- the question is whether or not income inequality reduces economic output, and the consensus seems to be that it doesn’t.

What I’m hearing is that income inequality prevents maximizing the potential of human capital.

A nation, viewed as a whole, is maximally efficient if all it’s citizens are educated to a profitable level, according to their talents. (to explain what I mean : suppose a given citizen has talent in math. You could educate them to the high school level, the bachelors level, the PhD level, the postdoc level. Each additional level costs years of their lifespan they are not working but increases their annual productivity. There is an inflection point, where that citizen will produce the maximum lifetime productivity, to stop educating them at. )

Concentration of wealth in a way that prevents the poor from being educated sufficiently far lowers the nation’s productivity because economic output is ultimately population * average productivity.

Of course, workers in the USA are now more productive than they have ever been. Yet wages have not increased. Where is the extra income going? A simplistic view would simply be to say that the rich are, as a group, stealing it.

But scarcity exists – it isn’t possible for everyone to be maximally educated and still have the maximum incentive to work hard. If you insist on educating everyone to the best degree possible, you’re going to need an enormous amount of taxation, and that’s going to reduce the incentives for people to work hard. Therefore, the current system, with substantial inequality, may very well be the most economically efficient. Different people are different, and will therefore earn different amounts of money. Income inequality isn’t per say unfair – it could just be everyone getting what they deserve.

People will get upset with you for calling it stealing. Much of our income inequality is from a perfectly legal imbalance of power, and a perfectly legal unwillingness to transfer money through government needs to address this imbalance.
Also, while I agree with you about education, there is not a direct link. In New York during the Depression pretty poor kids were able to get an excellent and free college education from the City University of New York. My mother was one of them. During the last recession though instead of making public education affordable the budget balancing mania in the states made it less affordable. But that’s not automatically from inequality.

Now, despite inequality the economy has improved, and though as you say the benefits have primarily gone to the rich the economy has still improved. But I think you can make an argument that inequality can hurt the rich also.
We know the rich lost a lot of money in the recession. One of the root causes of the recession was the debt piled up by the bottom 90% as they tried to increase consumption despite stagnant wages. Some came from the illusory increase in home values, some from credit card debt. If they had more money they would have been able to finance consumption with less debt, and the recession would not have been as severe. If more people could afford homes the number of subprime mortgages would decrease. So income inequality can reduce economic output, even if it is not right at the moment.

I feel like this statement is misleading. Workers are more productive mostly through automation. Which means the workers themselves require less skill and therefore lower wages. Think of it this way. A skilled craftsman can hand carve a chair a week out of wood. Chances are, he trained a long time to learn that skill and can command a decent wage for it. A factory can put in a Chair-O-Matic machine that cranks out a thousand chairs a day. The only skill it’s operator might need is pressing a button.
The rich aren’t “stealing” wealth because poor people never had it in the first place.

First, productivity has increased through automation for about 200 years now, and wages have increased. It’s not like the auto workers making good wages were hand crafting cars.
Second, I’ve spent a reasonable amount of time in factories, and it is more skilled work than you seem to think. At our PBX factory workers on the line were enabled to stop it if they detected quality problems. You want to pay people like that fairly well, and they did. That was 20 years ago, but that line was plenty automated even back then. I’d say an admin today who can use a word processor is more skilled than a secretary who could just type. Automation may cut wages by reducing the number of these highly paid jobs, but factory workers are not George Jetson pushing a button.
Hell, I’d hat to have to do the job of people in drive-thru windows, who take orders and fill orders in parallel.
Not giving more productive workers a cut of the increased productivity is not required, it is a choice.

Worker productivity is one of the most misunderstood and misused economic terms, you’re right. It basically is measured as the number of widgets produced per worker. Productivity has increased as a result of a number of things–robotics and other automation, process improvements, etc. It doesn’t mean grandpa exerted less effort than I do now. This comes up a good bit on this board–how the rich have exploited the poor by stealing their hard work as measured by increased productivity. If anything, increased productivity is a measure of people who are exerting less effort than grandpa had to.