Diverse observers from Raghuram Rajan of the University of Chicago to Robert Reich of Berkeley have suggested a second way in which rising inequality and slow income growth for the vast middle class have harmed the U.S. economy – namely, by encouraging families to borrow to try to maintain consumption, a practice which cannot go on forever, and by reducing aggregate consumption. As a result of the rise in inequality, the amount of income going to the top 1 percent of American families has increased by about $1 trillion on an annual basis. Because the middle class has a higher propensity to spend their income than the top 1 percent, this curbs consumption. An increasingly top-heavy distribution of income is a drag on aggregate demand and economic growth, and a contributing factor to credit bubbles.
President Obama made this point very clearly in a speech in Osawatomie, Kansas: “When middle class families can no longer afford to buy the goods and services that businesses are selling, it drags down the entire economy, from top to bottom.”
Third, an active line of research examines the connection between inequality and longer term economic growth. In a seminal study, Torsten Persson and Guido Tabellini found that in a society where income inequality is greater, political decisions are likely to result in policies that lead to less growth.