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An income gap theory and its effects on unemployment and economic growth

De Koning, Kees (2013): An income gap theory and its effects on unemployment and economic growth.

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An Income Gap Theory and it effects on Unemployment and Economic Growth

By Drs Kees De Koning


An income gap is often described as the difference in incomes between the rich and poor. This is a relative gap. In economies a different income gap can occur which can be defined as the absolute income gap. Such a gap emerges when collectively individual households show an income shortfall and become unable to buy all goods and services available in an economy. The principal cause why such a gap can emerge is to be found in the use of savings. Savings -financial assets- are turned into financial liabilities -loans or other commitments to governments, banks, companies or other individuals. If any of these households do not return such savings for the full amount or only with a lower return a financial loss will occur. The net worth of all individual households - their equity base- will be written down.

In this study the focus has been on the U.S. and the U.K. In 2004 in both countries the respective governments plus their individual households had accelerated their borrowing levels from earlier years to the highest levels since 1996. In the U.S. 17.41% of the GDP value was financed by the increase in government’ plus individual households’ borrowings in 2004. In the U.K. the level was 14.50% in the same year. Government’ and individual household debt has been added up for the simple reason that individual households are ultimately responsible to service both debts. More than 70% of individual households’ borrowings are used for buying a home. When the pace of borrowing accelerates, the volume of house building usually can not keep pace with the money flows and home prices start to increase rapidly. This happened in 2003 and 2004 and in the years in the run up to 2008. Of course incomes did not grow at the same speed as these borrowing levels. Banks did invent all kinds of loan features to get low income families on the property ladder. They also sold a substantial part of the risks to outside investors. The results were enormous loan losses, which translated in even bigger losses to the net worth of individual households in 2008. In the U.S in 2008 these households lost the equivalent of 110% of the value of the U.S. GDP from their net worth. In the U.K. the loss was about 90% of the U.K.’s GDP in the same year. Individual households did not mean to lose these amounts, however they were at the receiving end of the loss making activities of banks and the financial sector. Individual households were generally speaking not the gamblers.

The effects of such equity losses were substantial. Job losses occurred, which meant income losses; lower labour force participation rates showed up which again caused additional income losses; wages settlements did no longer keep pace with inflation levels. This also caused income losses. Furthermore individual households started to save more and repay their outstanding home mortgage debt, which caused another drain on economic growth. The net equity loss caused a substantial income loss to individual households, further aggravated by the rapidly increasing government debt situations. When income levels are down, one usually looks at the savings levels. However the main savings element is pension funds and they are currently prevented by government rules for turning some of the individual households’ equity into cash incomes at times when the income gap occurs.

There are ways to counteract and prevent the absolute income gap occurring. The key is to act as fast as possible as lost individual incomes from jobs cannot be recouped in future years. Pension funds can help as they currently have accumulated funds both in the U.S. and the U.K. outstripping total financial liabilities of individual households. Long term fixed rates mortgages can help, which if granted through one major vehicle, can help slow down or speed up mortgage lending in a country.

The key to economic growth can be found, but also has to be found, through considering what happened and happens to the collective of individual households, their equity and income position and their actions taken by them and for them. What governments, central banks, banks and companies do is all reflected in the net equity base and income developments of individual households. Economic studies should start with individual households rather than focussing so strongly on governments, central banks and banks.

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