Inequality and the economy

Joseph Stiglitz makes the argument that inequality is holding back the economy:

The United States is in the midst of a vicious cycle of inequality and recession: Inequality prolongs the downturn, and the downturn exacerbates inequality. 

...The Great Recession has made inequality worse, which is likely to prolong the downturn. Those at the top spend a smaller fraction of their income than do those in the bottom and middle — who have to spend everything today just to get by. Redistribution from the bottom to the top of the kind that has been going on in the United States lowers total demand. And the weakness in the U.S. economy arises out of deficient aggregate demand.

First off, Stiglitz's contention that US economic ills stem from insufficient demand is not the established fact that he attempts to present it as, but for the sake of argument let us assume it is true. Second, and more importantly, there has been no redistribution of wealth from the bottom to the top. No one is worse off because the rich are better off. As the Congressional Budget Office notes (in a study labeled by lefty Jonathan Chait as "masterful"):

Right away, the thrust of Stiglitz's argument has been destroyed, as all groups have higher incomes than previously and thus have a greater rather than reduced ability to contribute to aggregate demand. 

But let's also pause to consider the silliness and irrelevance of Stiglitz's note regarding the fraction of income spent by the bottom and middle. As he correctly points out, the reason such groups spend a higher fraction of their income than the rich is not necessarily that they are predisposed to spend more, but rather out of simple necessity. A household with an income of $50,000 will have to spend a much higher percentage of that just to pay for basics such as food and housing than one with an income of $1,000,000. 

What this means, however, is that even if money were redistributed from the top income bracket to those in the middle and bottom, it is not at all clear that this would do much for demand as the bottom and middle groups would no longer be required to spend a high fraction of their income just to get by. 

Lastly, with regard to the broader idea that inequality is bad for macroeconomic health, it's worth noting the introduction of this 2008 report from the OECD:

Inequality of incomes was higher in most OECD countries in the mid-2000s than in the mid-1980s. Only a few bucked the trend: France, Greece and Spain moved towards greater equality of incomes over the past 20 years.

France, Greece and Spain, those paragons of economic vitality...