Concern for the wealth and income gaps has been growing worldwide since the global financial crisis. The income gap has been widening since the end of the 20th century, as the Paris School of Economics Professor Thomas Piketty warns in his book Capital in the Twenty-First Century.
One cause of the widening gap is that individuals face a variety of risks at every stage of their lives, which that they cannot insure against in advance. If there are many such risks, gaps will develop over time between the luckiest and unluckiest. Surveys of the causes of the gap include a 2015 paper by University College London Professor Mariacristina De Nardi.
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There is also growing interest in the question of whether a widening gap affects economic growth. Researchers from such institutions as the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) have suggested that wealth and income gaps do have an adverse effect on economic growth.
In a 2014 paper, Federico Cingano (OECD) points out that the income gap has increased in most OECD countries in the last 30 years, and asserts that it inhibits economic growth. Cingano argues that since members of the lower class of society tend to invest less in education when their incomes decline, a widening gap lessens the amount of educational investment in society as a whole, putting a drag on economic growth. Therefore, he claims that using the tax system and social security policies to correct the gap will keep growth from being hindered if appropriate policies are designed.
Jonathan Ostry (IMF) et al. found similar results in their 2014 paper. Research using the latest IMF data shows that a widening income gap lowers medium-term economic growth. Moreover, redistribution policies intended to rectify the gap have practically no negative impact on economic growth.
These research findings go against the conventional wisdom on gap correction and economic growth in some ways. Up to now, it was believed that adopting generous redistribution policies to correct gaps would impair economic activity via higher taxes and the like, which would reduce growth. In other words, it has been considered that there is a trade-off between gap reduction and economic growth. The OECD and IMF research, however, vigorously suggests that conventional wisdom is wrong. The data reveal a possibility that a gap reduction, if undertaken appropriately, does not interfere with economic growth (and in fact increases it).
As I noted in my newspaper article published on February 16, 2015, Harvard University Professor Lawrence Summers promoted a secular stagnation theory in 2013. Since then, there has been a great deal of discussion on whether North American and European economies have fallen into low growth over the long term. There is also research (in a 2014 paper by Brown University Associate Professor Gauti B. Eggertsson et al.) indicating that the growing gaps between the rich and poor created by recent economic trends and financial crises are a factor in secular stagnation.
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Why does a widening gap lower economic growth? Although the research from the OECD and IMF emphasizes a reduction in "supply" capacity such as education and technology as a factor, decline in "demand" also seems to be a problem. House of Debt (2014), co-authored by Princeton University Professor Atif Mian and University of Chicago Professor Amir Sufi, warns that the rise in household debt (one way in which the wealth gap widens) has made the American economy vulnerable. Although no precise model is shown, the authors seem to believe that excess household debt has suppressed "aggregate demand," including consumption demand.
I came up with a theoretical explanation that supports the empirical results of Mian and Sufi. When numerous households accumulate excess debt due to financial crises and so on, fewer funds become available for such households from which to borrow to pay daily expenses. This is the issue of "borrowing constraints" which occurs as a result of the widening wealth gap. The result is that consumption demand declines in households with excess debt, thus, aggregate demand of the entire economy declines.
Economic models heretofore have always assumed that declines in demand caused by excess debt are a temporary phenomenon and do not last long term. But if short-term loans such as for working capital become constrained, the long-term downturn in demand that Mian and Sufi point to actually happens.
When a financial crisis causes a great wealth gap and the issue of borrowing constraints occurs, aggregate demand can stagnate long term. In that case, a redistribution of wealth (here, that would mean reducing excess debt) might ease borrowing constraints and increase aggregate demand. This means that there are probably wealth redistribution channels by which macroeconomic policies (monetary policy, fiscal policy, etc.) could be the mechanism to improve economic conditions.
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In fact, a growing number of researchers are stressing redistribution channels in their assessments of monetary policy. For example, a 2016 paper by Princeton University Professor Greg Kaplan and Assistant Professor Benjamin Moll and New York University Professor Giovanni Violante advocated the Heterogeneous Agent New Keynesian (HANK) model as a new framework for analyzing monetary policy.
The ordinary New Keynesian model that has been used as the standard for analyzing monetary policy hitherto assumes no wealth gap between individuals. Under the HANK model, there is a wealth gap between individuals, and that gap along with the differences in assets owned by individuals have a major impact on the effectiveness of monetary policy.
Under the ordinary New Keynesian model, the effect of monetary policy is to raise or lower interest rates (the interest rate channel). Under this mechanism, when interest rates fall, borrowing rises, more businesses make bigger capital investments, and aggregate demand rises. After the financial crisis, however, Japan and Western industrialized nations have kept their interest rates close to zero and thus have had no room to maneuver. It is therefore hard to imagine monetary policy having much effect through the interest rate channel. It is very interesting that research has emerged arguing that in times like these, monetary policy would be effective through a redistribution channel, which we might call a kind of gap correction.
In a 2016 paper, Princeton University Professors Markus Brunnermeier and Yuliy Sannikov developed a theory that monetary policy has an effect by changing the distribution of assets. A unique characteristic of their model is that it explicitly considers the asset of currency.
To keep things simple, the ordinary New Keynesian model assumes that currency does not exist as an asset. Brunnermeier and Sannikov, however, emphasize the problem of selection between currency and other assets. When central banks increase the currency supply, the price of currency drops, which raises the price of other assets in relative terms. Thus, through asset selection, the channel extends the monetary policy.
As such, the idea that the wealth gap has a major impact on economic growth and monetary policy may have an important role to play in the planning of economic policies going forward.
* Translated by RIETI.
February 22, 2016 Nihon Keizai Shimbun
