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How Inequality Freezes The Economy And Makes Us All Less Rich

People on middle and lower incomes are vital for economic growth, and a new paper offers proof.

How Inequality Freezes The Economy And Makes Us All Less Rich

Inequality has a ripple effect on the economy.

Photo: Spencer Platt/Getty Images

Even if you consider income inequality a natural function of people being different, and even if you don't see anything abhorrent in vast differences of wealth accumulating around the world today, you might worry about inequality simply because it's bad for the economy. If you have lots of people who aren't earning decent amounts of money, it stands to reason that they're not spending and boosting economic growth. The Organization for Economic Co-operation and Development estimates that growing income gaps in the developed world killed 4.7% of GDP growth between 1990 and 2010—that's a huge amount.

A new paper shows how inequality "freezes" economic activity by placing constraints on people with less money. In other words, when your paycheck decreases, your ability to transact with others also decreases, and their economic activity in turn decreases as well. "The main result of this model is that the flow of goods among agents becomes more and more congested as inequality increases until it halts completely," says the paper, from five European physicists.

Flickr user Mike Roberts

The researchers model the economy on a "Pareto curve" where most wealth is held at the top end, and they assume people will trade randomly with each other when their budget allows. As wealth concentrates, the model shows a reduction in liquidity because a few rich people can't compensate for the transaction volume of many people.

"As inequality in the wealth distribution increases, cash concentrates more and more on the wealthiest agents, thereby suppressing the probability of successful exchanges," the paper says. "Therefore, the economy freezes because financial resources (i.e. cash) concentrates in the hands of few agents."

The paper offers more proof of what many economists have been saying for years: People on middle and lower incomes are vital for economic growth. It also adds to the case for so-called "helicopter money," where instead of stimulating the economy through low interest rates and quantitative easing, central banks give money direct to consumers. Quantitative easing—the usual sort of policy to boost growth, which involves creating money to buy financial assets—has been great for the stock markets, some commentators argue. But it hasn't revitalized the main economy as much as everyday consumers could.

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