Morgan Stanley
  • Research
  • Jan 23, 2015

The Economic Cost of Inequality

Consumer spending—the biggest engine of US growth—has been anemic since the financial crisis of 2008, but leading indicators suggest that change is on the horizon.

Debilitating debt, tight credit, depressed home values, stubborn unemployment and stagnant wages: These comprise the unrelenting reality of the American economy in the wake of the financial crisis. They have also exacerbated growing inequality, which has slowed consumer spending, the biggest engine of US growth.

There are signs that this is about to change. A rise in core inflation and tighter labor markets could spur higher wages for working class Americans. Household efforts to pay down debt and control budgets mean many families are feeling more financially balanced. Expectations of higher wages, along with less debt, have begun to boost consumer confidence and, ironically, nudge the inclination to expand monthly credit card bills. These are essential steps to a healthier, sustainable pace of consumer spending, leading the economy into a virtuous cycle of increased profitability, more jobs, higher salaries, more spending, and so on.

Inequality is hardly a new phenomenon. It had been growing well before the financial crisis came to a head in 2008. “For decades, the average American household had been taking on more and more debt to supplement the lack of income growth, all so that Middle America could stay, well, in the middle,” says Ellen Zentner, Morgan Stanley’s Chief US economist. Then the housing bubble burst in 2007. By the time the full brunt of the financial crisis hit in late 2008, the credit tap was dry. The uneven recovery since then has only widened the chasm between the haves and the have-nots.

Deep Impact, Broad Reach

To be sure, the financial crisis and Great Recession touched everyone at every level of society. For the first time in generations, even affluent households felt the sting of the massive drop in home and equity values. Consumer spending, which accounts for more than two-thirds of the US economy, experienced the sharpest decline of any recession—and has taken the longest to claw back to its previous peak.

For some, the nightmare has receded. Real estate in many major markets has rebounded, and then soared; so have stock markets. Affluent households benefit disproportionately from these wealth effects. An extreme example: Pleasure aircraft was the single fastest-growing category of consumer spending in 2013, “taking off” by nearly 25%.

The working class hasn’t fared as well. Amid high unemployment, stagnant wages, and little to no access to credit, lower- to middle-income US households have limited spending for bare necessities: food, housing, health care and education. Discretionary spending is a luxury. These segments make up 60% of total households and account for 40% of consumer spending. No wonder the recovery has been anemic.

Roots of Inequality

The structural roots of American inequality go deep. The rise of low-wage jobs and slowing wage growth has been a long-standing trend, amplified by deep labor market downturns, followed by weak recoveries during the past two business cycles. This slide coincides with the decline of manufacturing and the rise of the low-wage service sector.

Wage growth, adjusted for inflation, trended above 6% in the 1940s, fell to half that in the 1970s and, after regaining some ground in the 1990s, dropped to a low near 1% during the first decade of the 2000s. As of the end of 2013, it hovered between 1% and 2%. Working class households, which rely more on salary income, have taken the biggest hit.

Easy access to debt—home refinancing, equity loans and credit cards—helped paper over the growing gap. “What the financial crisis did was lay bare the ugliness of a growing income gap by removing the layer of debt accumulation that had been masking its presence,” Zentner says, exposing deep-rooted issues. These range from demographic shifts and educational opportunity, to fiscal policies and taxation that are harder to address.

Higher Wages and Consumer Confidence

Near term, however, the prospects for wage growth have improved. The once moribund job market has revived and shows signs of gaining strength. Small business owners, who account for a large slice of the labor market, are feeling good about their outlook and indicate they plan to raise worker compensation. In addition, signs of an uptick in core inflation should also help drive up wages.

It has taken more than five years for US households to “feel” like they are in recovery. Less debt, more savings, job stability and prospects for higher pay add up to more robust consumer confidence, which often dictates how they spend today. For example, the recent growth in credit card debt, which saw unprecedented drops in 2009 and 2010, actually signals growing consumer confidence and demand beyond everyday essentials.

Indeed, the rise in working class discretionary spending will ripple through the entire economy. But certain categories stand out, including housing and furnishings, vehicles, recreational goods, clothing, footwear and food away from home.

Morgan Stanley Research has written a Research Note, “US Economics: Inequality and Consumption” (Sept 1, 2014), which provides a com prehensive review of US income inequality and how it affects consumer spending. Explore more Ideas and Research, or contact your Morgan Stanley representative for the full report. Find a Financial Advisor to discuss your investment goals and strategy.

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