Inequality Hits Fiscal Reality

By Karen Petrou

Readers of this blog know well that we think U.S. economic inequality is not only a profound social-welfare and political-consensus problem, but also a scourge to financial-market stability.  We have not generally wandered into fiscal-policy questions, preferring to focus on a far less well-known, but potent inequality force:  U.S. monetary and regulatory policy.  However, financial and fiscal policy are inextricably intertwined.  If inequality increases the risk of financial crises – which it does – and financial crises pose macroeconomic risk – which of course they do – then fiscal policy must ride to the rescue to prevent prolonged recession or even depression.  Could it, given how acute U.S. economic inequality has become?  A new report from Moody’s says that the rating agency may well have to downgrade U.S. debt – the AAA sine qua non of global finance – due to inequality. 

Could it be that we have a negative feedback loop of systemic proportions?  In it, will inequality spur crises that force spending that undermines fiscal discipline that then drops debt ratings, raises borrowing costs, and reduces transfer payments, making inequality still worse and starting this deadly cycle all over again?

Although the Moody’s report fears the worst, it may still be under-estimating inequality’s impact on fiscal policy because it misses the link to financial crises.  Still, its thinking is sobering, especially given that the global rating agency is well-positioned to make its fears about rating downgrades a reality.

Moody’s reasoning – with which we concur – goes as follows:

  • S. wealth inequality has grown sharply worse since the crisis due to the large difference in asset holdings across U.S. wealth distribution. Those with financial assets have done well; those without have lost ground even if they are homeowners.
  • Rising inequality undermines U.S. fiscal strength because higher government expenditures will be needed to support a worse-off nation. These spending increases are unlikely to be offset by revenue in light of the huge deficit spawned in part by the tax cut. 
  • A larger population of older Americans and the resulting spike in entitlement spending exacerbates deficit strain and resulting U.S. credit risk.
  • Rising inequality worsens already-strong political impediments to constructive fiscal policy, a conclusion Moody’s does not back with substantive analytics but seems obvious in light of recent events.

A final irony of this grim analysis is that dysfunctional fiscal policy will make dis-equalizing financial policy all the worse.  As we have frequently noted, the usual central-bank defense against our inequality analyses is not only that inequality is due to structural forces beyond their control, but also that inequality clean-up is solely the responsibility of fiscal – not financial – policy-makers.  The Bank of England’s Mark Carney has said this perhaps most clearly, but Jay Powell has said the same to Congress.  When he does, he echoes former Chairs Yellen and Bernanke.  Assuming that this fiscal policy will rescue or excuse them, U.S. financial policy-makers are plowing on with unconventional monetary policy, ultra-low real rates, and ill-constructed rules to make inequality worse, increase fiscal-policy stress, and await salvation that, as Moody’s makes still more clear, cannot come.


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