Growing economic inequality is either “a major issue of our time” or “a defining challenge of our time,” depending on your taste for hyperbole. Given America’s recent experience, however, I would like to call for a timeout. What matters is not so much the level of inequality as how we narrow the gap: The important thing is to create the conditions for widespread growth.
After years of a widening gap between the rich and poor in the US, income inequality is finally narrowing — and yet few Americans are happy about the state of the economy. Inequality shrank only because middle and high earners experienced real wage drops, while low earners did better.
In the last four years, lower-income Americans experienced significant wage gains. The bottom 10% saw their wages increase 8% after accounting for inflation. But almost everyone else did worse: Median income earners’ wages fell and are now where they were in 2020, while the top earners had a 6% real wage cut. The result is a decline in wage inequality. In 2019, the top 10% earned about eight times more than the bottom 10%. By 2024, that had dropped to seven times more. The top 10% earned 2.6 times more than the median in 2020, but 2.5 times more in 2024.
What’s more, this fall in inequality was not the result of a deliberate policy. It was mostly due to the return of inflation, which was in part caused by policy errors and high debt. The resulting inflation wiped out nominal wage gains for most Americans but not for lower-skilled workers, for which there was a labor shortage. Lower-paid workers tend to have jobs that need to be done in person, and the demand for services (restaurants and hotels, for example) spiked as the US emerged from the pandemic. So lower earners’ wages increased enough to outpace inflation, but no one else’s did.
The last half-decade shows what has been missing in America’s ongoing conversation about inequality. Economic inequality does feel unfair, but it has never been clear what economic problems it causes.
Economists have traditionally argued that there is a trade-off between equity and growth. If you redistribute so everyone is equal, you’ll reduce incentives to innovate, work hard and take risks — and that means a less efficient and slower-growing economy. That makes everyone poorer, even if it also makes them more equal.
When the debate is focused on reducing inequality, however, such concerns get little attention.
Europe’s experience is also instructive. The continent is starting to address its unsustainable combination of slow growth, stagnant innovation and an aging population. A recent report urges Europe’s governments to better coordinate and ease up on regulation, even as another analysis raises the question of whether high growth is simply inconsistent with the economic and social-welfare policies of many European governments. It is worth noting that in the last few years, the US economy enjoyed robust growth and a booming stock market — but neither of these translated into higher living standards for most Americans.
Nevertheless, the European experience and the recent narrowing inequality in the US offers some valuable lessons. The first is that the economy is not zero sum. Rich people don’t necessarily get that way by taking from poor people. In the last few years, wealthier Americans lost ground in part because their skills had relatively less value and they chose to work fewer hours and at home. Middle earners were mostly just swamped by inflation, while low earners found their work in high demand. The point is, no one got more or less at the expense of anyone else.
The second lesson is there are indeed costs to reducing inequality, and trade-offs to be weighed. But that needn’t mean the US has to choose between more equality or more prosperity. It can have the best of both so long as Americans accept the economy as a dynamic system that has the potential to make everyone better off — just not always at the same rate.
While the last few decades have favored high earners, for example, that may change if AI replaces knowledge workers and the post-pandemic trend of high demand for service workers continues. In that case, market forces will compress wages, shrinking inequality without policy intervention.
The goal for policy should be inclusive growth. Alas, it is not currently in vogue politically. High tariffs and attempts to revive low-skill manufacturing may create some jobs, but they will only worsen inflation, which hits the entire middle class the hardest. Taxing unrealized capital gains may reduce inequality, but it will also take money out of productive investments, hampering growth and innovation (and adding to inflation as well).
Any policy intended to lessen inequality should also facilitate innovation and the development of human capital. The goal is to grow the pie, rather than just divide it more equally. There are a lot of policies that encourage inclusive growth: improving the quality of education, for example, or making it easier for people to move and change jobs. People can disagree about how to achieve these goals, of course, and debate their relative importance. But talking about just inequality on its own is unlikely to get us very far.
Credit: Bloomberg
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