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Why Goldman Sachs' Big Bonuses May Bad for the Economy

Last Updated May 19, 2011 1:54 PM EDT

By Heather Boushey
The United States has one of the biggest gaps between rich and poor among the developed nations. Economists and many policymakers in the US have tended to think that isn't really a problem, as money is a great motivator. If there's a big prize at the end of the game, then the players will have a greater incentive to win.

Wall Street bankers and CEOs have been justifying their outsized compensation by this logic. They argue that the rest of society benefits because they're being paid so much more for their immense talent, which improves the productivity of their firm and that will help to grow our economy overall.

But, now new research punctures holes in that, showing, in fact, that high income inequality may actually hurt long-term economic growth. Two economists at the International Monetary Fund, Andrew G. Berg and Jonathan D. Ostry, released a paper in April that concludes that countries with high inequality are more likely to have shorter spells of positive growth compared to countries with less inequality. That's another way of saying that high inequality hurts the economy.

Gaps between rich and poor "key" factor
Instead of looking purely at the relationship between inequality and growth, Berg and Ostry examined the relationship between inequality and the duration of periods of positive growth. They measure a growth spell as a period of sustained growth and estimate the effect of inequality and other factors on how long growth spells last.

Their model included a variety of factors that economics have previously found to affect economic growth, such as external shocks, the initial income of the country (ie., did it start out very poor or wealthy?), the institutional make-up of the country, its openness to trade, and its macroeconomic stability.

The finding: Only income inequality stood out "as a key driver of the duration of growth spells."

The economics concluded with the following:
"The main results in this note are that (i) increasing the length of growth spells, rather than just getting growth going, is critical to achieving income gains over the long term; and (ii) countries with more equal income distributions tend to have significantly longer growth spells. .... growth and inequality-reducing policies are likely to reinforce one another and help to establish the foundations for a sustainable expansion."
What does this mean for policymakers?
If high inequality shortens growth spells, it may be time to rethink the US acceptance of high and growing inequality. If Berg and Ostry are correct, then the basket of policies the US should be considering should focus on promoting growth while ameliorating inequality, rather than exacerbating it. A key place to start is focusing first and foremost on unemployment.

Maybe a focus on growing the middle class is exactly what we need to pull us out of slump. What do you think?

Related:
Heather Boushey is Senior Economist at the Center for American Progress. Her research focuses on employment, social policy, and family economic well-being. Much of her current work focuses on the Great Recession's impact on workers and their families, as well as policies to promote job creation. She co-edited The Shriver Report: A Woman's Nation Changes Everything (Simon & Schuster ebook, 2009).
image courtesy of flickr user, Carl Lovén