In late 2007, the United States started feeling the effects of the Great Recession. And over the ensuing two years the economic disaster spread across the globe.
Precisely when and if the recession ended remains open for debate. Recently, the National Bureau of Economic Research announced that the economic recovery began in June 2009. However, the resumption of growth has been surprisingly slow, to the point where few people can feel the recovery happening regardless of what the statistics say.
One of the key characteristics of the Great Recession was its relationship to consumer borrowing and spending. Indeed, the crisis was followed by a fall in consumers saving and an increased spending fueled by rising individual debts level. In addition, the recession was followed by a sharp increase in the income gap between those who are at the top of income distribution and the rest.
None of this is a coincidence, according to Steven Fazzari of Washington University in St. Louis, who is studying the issue under a research grant from the Institute for New Economic Thinking. In fact, a paper written Fazzari and Barry Cynamon, a visiting scholar at the Federal Reserve Bank of St. Louis, digs into this issue by studying the relationship between household spending, consumer debt, and rising income inequality, going as far back as the 1980s.
Fazzari and Cynamon studied new data that break down income and other important macroeconomic measures, between the bottom 95% and top 5% of income distribution. Macroeconomists, starting with Michal Kalecki, challenge the viability of growing income inequality claiming that high-income households, which are often affiliated with receiving profits, typically save more and spend smaller percentages of their income than wage earners. This being the case, a further increase in inequality should lead to a decrease in demand that will be followed by higher unemployment or even secular stagnation. Two 2013 studies, one by DeBacker et al. and the other by Alvaredo et al., both show that income inequality rose dramatically over the 20 years from 1987 to 2006, which created a permanent shift of income across households rather than merely changing the transitory shocks.
However, despite experiencing a significant shift in income distribution that the theories suggest might cause a fall in demand, the U.S. actually performed reasonably well indeed in the decades leading up to the Great Recession.
The other surprising aspect of this era, considering the substantial change in income distribution, is that personal consumption expenditure (PCE) was both the largest and fastest growing part of the gross domestic product. This trend, along with the substantial increase of inequality, demonstrates a paradox that is a core feature of Fazzari’s paper, specifically that, “Rising inequality should theoretically reduce the consumption-income ratio if affluent households spend a smaller part of their growing share of aggregate demand. But the period of rising inequality, starting roughly in the early 1980s, corresponds almost exactly with a historic increase in American household relative to income.”
How can this be true?
To answer this question, the authors carefully examined how rising income inequality influences income growth rates and how this in effect changes household balance sheets. In their conceptual framework, Fazzari and Cynamon show that stagnating income growth for any group of households need not lead to an immediate drag in the level of income. However, the decision to maintain consumption growth at a higher rate than declining income growth eventually will reduce savings and increase the vulnerability of wage earners’ balance sheets. More importantly, net worth cannot decrease forever and debt levels cannot increase indefinitely relative to income. So eventually rising debt levels force households with lower income growth to reduce consumption to meet their intertemporal budget constraints.
Fazzari and Cynamon pushed the discussion even further by studying the changes in income growth, spending, and balance sheet differs between the bottom 95% and top 5% of the U.S. population. They compared the income growth of these the groups and found that inequality widened mostly due to a significant drop in real income growth by wage earners. This combination of slow income growth for the bottom 95% and rapid aggregate consumption growth indicates that the rise in leverage was likely a significant factor for households in this group.
Furthermore, the researchers considered the extent to which the rise in the debt-to-income ratio is influenced by the change in assets.
Between 1989 and 2000, there is no evidence of a rise in the change in assets that would offset the rapid increase in the debt-to-income ratio of the bottom 95%. This suggests that faster asset accumulation was not the reason for rising balance sheet fragility for this group. From 2000 to 2007, however, the story is different. Suddenly, the bottom 95% experienced a change in the ratio of assets to disposable income ratio by an average of about four percentage points from the 1990s. This is most likely due to the ramping up of house construction and renovation after 2000.
The researchers also show that, perhaps not surprisingly, the wage earners group consumed a considerably larger share of disposable income prior to 2008. Prior to Great Recession, the average consumption rate for the bottom 95% was eight percentage points higher than the consumption rate of the top 5%. Following the Great Recession, however, the U.S. population started seeing large changes in its consumption-income ratios.
Fazzari and Cynamon interpreted these observations to mean that prior to 2008 the spending trend of the bottom 95% was unsustainable. It is worthwhile to note that the fall in the consumption rate of the bottom 95% occurred simultaneously with the stall in debt-to-income growth.
On the other hand, the consumption rate for the profit-earning group behaved very differently. In line with the smoothing consumption hypothesis, the rate for the top 5% is relatively volatile. From 1994 to 2000, when the real income growth of this group accelerated, their consumption decreased. This exact pattern repeated itself in the 2001 recession and the subsequent swift recovery of top 5% of income during the middle 2000s.
Fazzari and Cynamon argue that this contrast between the spending patterns of the top 5% and bottom 95% is striking, especially during the Great Recession. The researchers note that: “The collapse of the 9% spending rate, consistent with a forced end to this group’s balance sheet expansion, is the exact opposite of the significant consumption smoothing evident for the top 5%, a group that did not appear to have balance sheet fragility problems on the eve of the Great Recession.”
This contrasting impact was so significant that from 2009 to 2011 the top 5% spent a bigger share of their disposable income than the bottom 95%.
This change in consumption patterns has significant macroeconomic implications. The evidence implies that wage earners reacted to slower income growth in large part by continuing consumption at the expense of saving. In a sense, this temporarily saved the U.S. economy from the fall in demand that many theories suggest would be the result of increasing in inequality.
However, the research by Fazzari and Cynamon also shows that the worsening balance sheets of the bottom 95% eventually lead to the Great Recession. This being the case, it is clear that the problem of inequality goes far beyond questions of social justice. In fact, it is a significant reason for the current economic stagnation that the world is experiencing.
