Inequality Will Crush Growth

Updated 21 August 2013 12:29 am NY time.

Econintersect:  A paper by Robert J. Gordon, Stanley G. Harris Professor of Economics at Northeastern University, has considered the six headwinds to continued economic growth for the U.S..  The analysis concludes that the biggest headwind is the growth of income inequality.  This economic drag  is greater than the sum of any other two drags and constitutes nearly 30% of reduced GDP growth going forward compared to that of the period 1987-2007.

Click on graphic to view larger image.

The six headwinds for future economic growth (and their projected impact for the future in percent reduction from recent past growth) are (looking at consumption per capita):

• Income inequality (28%)
• Debt removal (17%)
• Education (11%)
• Demographics (11%)
• Globalization (11%)
• Energy (11%)

The accumulation of all the headwind subtractions would lead to an annual growth of consumption per capita of an average of only 0.2% per year.  If this would happen, it would mean that future growth rates would be only a tenth of the nearly 2% annual average growth rate of real GDP since the U.S. Civil War.

The second largest headwind effect comes from debt removal.  Gordon writes:

There is also an inevitability to the subtraction from growth implied by headwind (6), the future repayment of consumer and government debt.  U.S. consumption grew faster than real GDP over a long period, fueled by increasing consumer and government debt, a process that cannot continue forever.  Over a substantial number of years in the future consumption must grow more slowly than production.

The size of the impact of debt may be reduced if the impacts of government debt and private (consumer) debt are considered separately.  Consumer debt must be repaid or defaulted.  U.S. government debt has seldom been repaid and when it has been it was accompanied by severe economic shock.  Some monetary theorist include federal government debt as part of the monetary base.  From that point of view, removal of government debt is serious (and unnecessary) economic headwind.

Gordon concludes the dismal projections need not be realized.  He concludes that much better economic growth can be achieved through revamping of education and improvement of immigration policies to remove many restrictions that have been instituted over the past 100 years.  If those two headwinds were more than reduced but actually converted into tailwinds, a much less dire outlook can be achieved.

Gordon provides several illustrative graphs, two shown below.

Click on either graph to view larger image.

Here is the abstract of the paper:

This paper raises basic questions about the process of economic growth. It questions the assumption, nearly universal since Solow’s seminal contributions of the 1950s, that economic growth is a continuous  process that will persist forever. There was virtually no growth before 1750, and thus there is no guarantee that growth will continue indefinitely. Rather, the paper suggests that the rapid progress made over the past 250 years could well turn out to be a unique episode in human history.  The paper is only about the United States and views the future from 2007 while pretending that the financial crisis did not happen.  Its point of departure is growth in per-capita real GDP in the frontier country since 1300, the U.K. until 1906 and the U.S. afterwards. Growth in this frontier gradually accelerated after 1750,reached a peak in the middle of the 20th century, and has been slowing down since. The paper is about “how much further could the frontier growth rate decline?”

The analysis links periods of slow and rapid growth to the timing of the three industrial revolutions (IR’s), that is, IR #1 (steam, railroads) from 1750 to 1830; IR #2 (electricity, internal combustion engine, running water, indoor toilets, communications, entertainment, chemicals, petroleum) from 1870 to 1900; and IR #3 (computers, the web, mobile phones) from 1960 to present. It provides evidence that IR #2 was more important than the others and was largely responsible for 80 years of relatively rapid productivity growth between 1890 and 1972. Once the spin-off inventions from IR #2 (airplanes, air conditioning, interstate highways) had run their course, productivity growth during 1972-96 was much slower than before. In contrast, IR #3 created only a short-lived growth revival between 1996 and 2004. Many of the original and spin-off inventions of IR #2 could happen only once – urbanization, transportation speed, the freedom of females from the drudgery of carrying tons of water per year, and the role of central heating and air conditioning in achieving a year-round constant temperature.

Even if innovation were to continue into the future at the rate of the two decades before 2007, the U.S. faces six headwinds that are in the process of dragging long-term growth to half or less of the 1.9 percent annual rate experienced between 1860 and 2007. These include demography, education, inequality, globalization, energy/environment, and the overhang of consumer and government debt. A provocative“exercise in subtraction” suggests that future growth in consumption per capita for the bottom 99 percent of the income distribution could fall below 0.5 percent per year for an extended period of decades.

Update 21 August 2013 12:29 am NY time:

Econintersect has calculated the impact of income inequality on real GDP using the 1987-2007 baseline provided by Gordon.  If the baseline were continued to the year 2100 the real GDP for the U.S. would be approximately $76.5 trillion.  If the only headwind considered to take effect is income inequality and all else is held constant, the 2100 real GDP would be approximately $49.8 trillion.  The reduction from the potential GDP due to income inequality alone is 35%.  Or, looking at this differently, the amount of GDP to be gained by eliminating the effect of income inequality from what would otherwise be experienced is an increase of more than 50%.

John Lounsbury

Hat tip to The Big Picture.

Source:

• Is U.S. Economic Growth Over?  Faltering Innovation Confronts the Six Headwinds (Robert J. Gordon, NBER Working Paper No. 18315, August 2012)