For over one hundred years, economists have understood the economic consequences of income inequality. They have worked out how, under differing specific conditions, income inequality can foster either unemployment or growth. They also understand how international trade distributes unemployment, even at times forcing countries into beggar-thy-neighbor policies. By the 1890s, for example, John Hobson in England and Charles Arthur Conant in the United States, the former what Americans today would call a liberal and the latter a conservative, had largely worked out the consequences of income inequality in ways that accorded fully with contemporary experience and historical precedents.
Income inequality is such a contentious topic, however, that it is still hard to separate myth from reality, even though the consequences that economists have fleshed out over the last century follow from basic economic identities. Ordinary people consume a larger share of their incomes than do the wealthy, so rising income inequality reduces the consumption share of GDP, which automatically forces up the national savings rate. The strongest argument in favor of allowing and even encouraging income inequality has always stressed inequality's positive impact on savings.
A similar form of income inequality occurs when businesses or states retain a growing share-and households a declining share-of GDP. This phenomenon has been especially noticeable in Germany and China over the past fifteen years as both countries have forced down the household share of GDP by implementing policies aimed at making domestic businesses more competitive in international markets. These policies, intentionally or unintentionally, have also forced down the consumption share of GDP, raising savings rates.Rising income inequality and a declining household share of GDP, together referred to as "repressing household income," both increase national savings rates. But an increase in the national savings rate is not the only consequence of these forces.
Savings must equal investment. If repressing household income causes the savings rate in one part of the economy to rise excessively (a "savings glut"), logically it must also cause the investment rate to rise or the savings rate elsewhere to decline (or some combination of both).
How can repressing household income cause investment to rise? If productive investment had been previously constrained by low savings, the answer is obvious. By increasing savings, repressing household income will foster more investment in productive projects. More productive investment benefits everyone, even if it benefits the wealthy more. This model is generally known as trickle-down economics.
In many undeveloped economies, productive investment may indeed be constrained by low savings. This is why developing countries often either turn to foreign savings to fund growth, as Argentina did in the 1990s, or repress consumption by reducing the household income share of GDP, as China did more recently.
Developed countries, however, generally do not face a savings constraint. If they fail to fund all productive investments, it is for other reasons-political gridlock, for example, or the difficulty of capturing externalities. For these countries, the higher savings associated with repressing household income will not result in more productive investment.
Former chairman of the Federal Reserve Board Marriner Eccles even suggested that during the 1930s, repressing household income reduced productive investment. "By taking purchasing power out of the hands of mass consumers," he wrote in Beckoning Frontiers, "the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants."