IMF: Inequality Increases National Debt

Inequality Creates Economic Instability and Widespread Poverty

Leading economists agree that rampant inequality leads to unstable economies and depressions, and makes the middle and lower classes poorer.

Inequality Increases National Debt

This month, International Monetary Fund economists demonstrated that “higher income inequality in developed countries is associated with higher domestic and foreign indebtedness”:

Unequal imbalances



We find (see Chart 1) that what unites the experiences of the main deficit countries is a steep increase in income inequality over recent decades, as measured by the share of income going to the richest 5 percent of the country’s income distribution.

This increase in inequality has contributed to a deterioration in the richest countries’ aggregate savings-investment balances, as the poor and middle class borrowed from the rich and from foreign lenders. This, along with the other factors mentioned above, can fuel current account deficits.

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The increase in debt happens over the decades of below-trend incomes that result from the persistent shock. In an open economy, the task of financing the bottom group’s borrowing demand following a negative income shock is shared between the domestic top group and foreigners. This enables the top group to deploy more of its higher income in domestic plant and machinery investment and consumption than would be possible in a closed economy. But externally the result is a deterioration of the current account, which peaks at more than 1 percent of GDP.

In reality, increases in income inequality are often followed by political interventions to prop up the living standards of the bottom group, whose real income is stagnating. This is generally done not by directly confronting the sources of inequality, such as declines in the collective bargaining power of the bottom group or shifts in the tax burden from the top group to the bottom group, but rather by promoting policies that cut the cost of borrowing for both individuals and financial institutions (Rajan, 2010). These policies include domestic and international financial liberalization, and they put additional downward pressure on current accounts.

Unequal imbalances



As shown in the simulations in Chart 2 (solid line), a reduction in financial intermediation spreads leads to much lower lending rates, which draw more of the top group’s resources into financial rather than real assets. Initially this allows the bottom group to maintain a much higher consumption level. But in the long run it means the top group underinvests in real assets such as plants and machinery, and so the bottom group sees lower real wages over time. At the same time, debt-to-income ratios rise more strongly, as do current account deficits.

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If lending is liberalized without addressing the underlying income inequalities, the result would simply be an increase in indebtedness within surplus countries (between the rich and the rest of the population), rather than vis-à-vis the rest of the world. In other words, there would be a globalized rather than a regional increase in domestic indebtedness of the poor and middle class. While this would reduce cross-border financial imbalances, it would exacerbate domestic debt-to-income ratios and thus vulnerability to crises. In the long run, there is therefore simply no way to avoid addressing the income inequality problem head-on. Financial liberalization in surplus countries buys time, but at the expense of an eventually much larger debt problem.

Conservatives and Liberals Agree: Government Should Not Worsen Inequality

Conservatives tend to be much more worried about debt than liberals. Given the fact that – as shown above – runaway inequality fuels debt, conservatives should be against policies that make inequality even worse. As I noted in July:

Inequality in the United States is at insane levels. Inequality among Americas is worse than in Egypt, Tunisia or Yemen. As NPR notes, inequality is higher in the U.S. than in many banana republics in Latin America. And social mobility is lower in America than in most European countries (and see this, this and this).

In fact, most conservatives already are against insane levels of inequality.

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