Tuesday, November 25, 2014

Good and Bad Inequality

MILAN – Rising income and wealth inequality in many countries around the world has been a long-term trend for three decades or more. But the attention devoted to it has increased substantially since the 2008 financial crisis: With slow growth, rising inequality bites harder.

The “old” theory about inequality was that redistribution via the tax system weakened incentives and undermined economic growth. But the relationship between inequality and growth is far more complex and multi-dimensional than this simple trade-off suggests. Multiple channels of influence and feedback mechanisms make definitive conclusions difficult.

For example, the United States and China are the fastest-growing major economies today. Both have similarly high and rising levels of income inequality. Though one should not conclude from this that growth and inequality are either unrelated or positively correlated, the unqualified statement that inequality is bad for growth does not really accord with the facts.

Moreover, in global terms, inequality has been falling as developing countries prosper – even though it is increasing within many developed and developing countries. This may seem counterintuitive, but it makes sense. The dominant trend in the global economy is the convergence process that began after World War II. A substantial share of the 85% of the world’s population living in developing countries experienced sustained rapid real growth for the first time. This global trend overwhelms that of rising domestic inequality.

Nonetheless, experience in a wide range of countries suggests that high and rising levels of inequality, especially inequality of opportunity, can indeed be detrimental to growth. One reason is that inequality undercuts the political and social consensus around growth-oriented strategies and policies. It can lead to gridlock, conflict, or poor policy choices. The evidence supports the view that the systematic exclusion of subgroups on any arbitrary basis (for example, ethnicity, race, or religion) is particularly damaging in this respect.

Intergenerational mobility is a key indicator of equality of opportunity. Rising inequality of outcomes need not lead to reduced intergenerational mobility. Whether it does depends heavily on whether important instruments that support equality of opportunity, principally education and health care, are universally accessible. For example, if public education systems start to fail, they are often replaced at the upper end of the income distribution by a private system, with adverse consequences for intergenerational mobility.

There are other links between inequality and growth. High levels of income and wealth inequality (as in much of South America and parts of Africa) often lead to and reinforce unequal political influence. Rather than seeking to generate inclusive patterns of growth, policymakers seek to protect the wealth and rent-capturing advantage of the rich. Generally, this has meant less openness to trade and investment flows, because they lead to unwanted external competition.

This suggests that all inequality (of outcomes) should not be viewed in the same way. Inequality based on successful rent seeking and privileged access to resources and market opportunities is highly toxic with respect to social cohesion and stability – and hence growth-oriented policies. In a generally meritocratic environment, outcomes based on creativity, innovation, or extraordinary talent are usually viewed benignly and believed to have far less damaging effects.

That is partly why China’s current “anti-corruption” campaign, for example, is so important. It is not so much China’s relatively high income inequality, but the social tensions created by insiders’ privileged access to markets and transactions, that threatens the Chinese Communist Party’s legitimacy and the effectiveness of its governance.

In the US, how much of the increase in income inequality over the past three decades reflects technological change and globalization (both favoring those with higher levels of education and skills), and how much reflects privileged access to the policymaking process, is a complex and unsettled question. But it is important to ask for two reasons. First, the policy responses are different; second, the effects on social cohesion and the social contract’s credibility are also different.

Rapid growth helps. In a high-growth environment, with rising incomes for almost everyone, people will accept rising inequality up to a point, particularly if it occurs in a context that is substantially meritocratic. But in a low-growth (or, worse, negative-growth) environment, rapidly rising inequality means that many people are experiencing no income growth or are losing ground in absolute as well as relative terms.

The consequences of rising income inequality can tempt policymakers down a dangerous path: the use of debt, sometimes combined with an asset bubble, to sustain consumption. This arguably occurred in the 1920s, prior to the Great Depression; it certainly occurred in the US (and Spain and the United Kingdom) in the decade prior to the 2008 crisis.

A variant, seen in Europe, is the use of government borrowing to fill a demand and employment gap created by deficient private domestic and external demand. To the extent that the latter is associated with productivity and competitiveness problems, and exacerbated by the common currency, this is an inappropriate policy response.

Similar concerns have been raised about the rapid increase in debt ratios in China. Perhaps debt seems like the path of least resistance in dealing with the effects of inequality or slow growth. But there are better and worse ways to deal with rising inequality. Leverage is one of the worst.

So where does that leave us? For me, the high-priority items are fairly clear. In the short run, the top priority is income support for the poor and the unemployed, who are the immediate victims of crises and the underlying imbalances and structural problems, which take time to remove. Second, especially with rising income inequality, universal access to high-quality public services, particularly education, is crucial.

Inclusion sustains social and political cohesion – and hence the very growth needed to help mitigate the effects of rising inequality. There are many ways for economies to fall short of their growth potential, but underinvestment, especially within the public sector, is one of the most potent and common.

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    1. CommentedBen Leet

      The current Federal Reserve report Flow of Funds, page 2, shows that total net worth for all households increased by $24.5 trillion between 2007 and 2014, a 30% per capita increase inflation adjusted. The increase was due to financial asset inflation of which 75% are owned by the wealthiest 5% of households, a mere 6 million out of 120 million households. That's an increase in wealth of over $3 million per household for 6 million households, on average. The household median income, showing a dramatic surge of inequality, has dropped in the same period by 7% between 2007 and 2013. I add these small facts just to add some bite to an innocuous sentence. Slow growth? Most, perhaps 90%, are not experiencing growth in income or wealth.

    2. CommentedFelipe Manteiga

      Dr. Spence, it is always a privilege to see your efforts addressing a looming crisis. One that our tools as positive economist or even institutional ones, are ill equipped to handle.

      From my own experience, working as economic advisor and program leader in many developing countries I found strong elites, almost medieval in thei institutions (markets, sans accumulation, do not mean free enterprise, and wealth does not mean capital) avoided the "domestic demand gap" through exports, by massive migration and remittances. None of those is open to the U.S. at the required level to bypass the stultifying demand growth imposed by a rapacious elite (or just aristocratic nobility).

      Appreciate your enlightening contribution, please continue to focus on these issues; they will shape our shildren's future.

    3. CommentedTom Shillock

      "But the relationship between inequality and growth is far more complex and multi-dimensional than this simple trade-off suggests. Multiple channels of influence and feedback mechanisms make definitive conclusions difficult."

      The preeminent feedback mechanism is (and probably always has been) the ability of financial power to buy political advantages that increase their economic / financial power. Over the last three decades financial power has enjoyed increasing returns to scale, in America at least. Doubling of the global workforce since 1990 (Richard Freeman) has undermined the value of labor against capital and computerization has apparently helped. How much does the upper class need broad based growth that happened in America between the end of WW2 and 1973? And what would make them change their minds, or rather what would break the aforementioned feedback mechanism?

    4. CommentedGary Palmero

      I would argue that 'wealth inequality" today is more benign and less disruptive than it was before 1900. Before that date, wealth was mostly in the form of ownership of agricultural land or the control of land for other economic purposes. Those without ownership of land were often subsidiary farmers or agricultural workers. If one did not have access to the process, one would have a hard time eating.

      Today, most wealth is in the form of business equity. This equity is widely available for purchase and most of the very wealthy own public shares (Berkshire Hathaway, Facebook, Google etc.) without disrupting day to day life. Asymetric wealth ownership has been a continuing part of history.

      I would also argue that a near zero interest rate central bank policy substantially injures the middle class. They are deprived of income on their savings while still forced to pay well above zero interest to borrow. The wealthy, of course, including government agencies, can borrow at lower costs and thus increase equity ownership and control.

    5. CommentedHamp Skelton

      The near-complete capture of the policymaking process by the very privileged is precisley why income and wealth inequality have accelerated rapidly in the US. The political party controlledby the extremely wealthy has a 5-4 advantage on the Supreme Court, which has the final say on most policy debates. Its 5-4 votes on the Citizens United and McCutcheon cases institutionalized what can only be correctly called "bribeocracy" instead of democracy in the US. The wealthy used their control of policymaking to block meaningful reforms of the financial system needed to correct the abuses that led to the Great Recession. The Republican Party has blocked any taxation changes that could help pay for stimulus and infrastucture spending. Taxation policy assurer that the super-rich get richer. Today in the US, the very wealthy pay a much lower overall tax rate than their accountants, secretaries and even car mechanics. They use the "1031 exchange" rule to pay zero tax on large gains from real estate sales; they pay zero tax on income from municipal bonds; they pay a lower capital gains rate on most other income they earn because in their privileged position, they live more off of sales of stock, companies, hedge fund "carried interest" than off of ordinary income. The question is hardly "unsettled" as the author suggests. The system is rigged. Corporations owned by the very wealthy get government subsidies, whether for agricultural pursuits or drilling for oil. To keep the poor in place, the Republicans have blocked any rise in minimum wage and starve the education system by opposing taxation. The very wealthy control enough of the government to block changes that could help lessen inequality. Obama was able to squeeze by the blockade with his universal health insurance initiative at the start of his presidency, but the vehemence with which the privileged's party has fought it shows the determination of the wealthy to oppose anything that might help the non-rich. How have they managed to accomplish this in a so-called democracy? Through the use of their money (Super-PACS) and skillful propaganda (of which Fox "news" is emblematic but by no means the only vehicle). These propaganda efforts have fooled enough non-rich white voters into voting against their own interests. They will wake up, eventually, and realize that the puppeteers who pull all the strings at the Republican Party don't really care if two lesbians have a wedding, jst as they didn't really belive Obama was a Muslim socialist without a valid birth certificate. The average Republican voter will someday realize that the GOP has been manitpulating voters with such issues as gay marriage and fears of a wave on illegal immigrants to dupe gullible and fearful voters. But the inequality gap will only grow wider until the duped white voter says "enough" and throws out the toadies of the uber-rich. Only when the Republicans are reduced to a size that lacks filibuster power and a majority on the Supreme Court will it be possible to have policies that allow the less privileged to seek and obtain the education necesasry to compete in a globalized economy. Reducing income equlaity will be a long, slow process, but a fair taxation system and fairer allocation of national resources is where it must start

    6. CommentedChiranjivi Chakraborty

      It is understandable that inequality in some measures is part of a free market economy but what is clearly unacceptable for social cohesion and stability is crony capitalist type of inequality which harms the opportunities of the population in the lowest strata as well as makes them discouraged to pursue education of whatever quality provided to them. Secondly, it is imperative for governments in all countries - developed or developing - to enhance the quality and content of public education system to empower the less fortunate population with skills and knowledge which shall in all possibilities help in reducing domestic inequity.

    7. CommentedDallas Weaver, Ph.D.

      To understand what is going on it may be necessary to look beyond income and wealth inequality and add political power inequality to the analysis. You can't describe a 3-D problem in two dimensions (period -- pure mathematics).

      We live in a society where companies are forced to pay tribute to the political class through K street lobbyist (ex. politicians, staffers and connected government employees) and any politician can force any wealthy person to come to his hearing room and be publicly humiliated. This political power inequality variable that accounts for most of the rent seeking, cronism and bad outcomes resulting from inequalities. In the permission-less aspects of our economy such as apps, software, social media, etc. most of the wealth generated has created great benefits for most citizens and where we can have real economic growth.

    8. CommentedNathan Weatherdon

      The Keynesian strategy adopted in Europe (and much of the world) in 2008/09, for example, is highly defensible in a 1-2 year sort of time frame.

      Clearly it cannot be sustained ad infinitum.

      Not a worst case scenario, but looking back to 2008/09, actual outcomes for many monetary policymakers are very much consistent with those grouped closely together with worst case scenarios.

      And still, the world has not imploded.

      I think that wage policy combined with public infrastructure in transportation and major endeavours to facilitate training which most easily benefit poorer classes is probably far superior in addressing inequality for governments who overextended themselves following the crisis through explicitly redistributive measures.

    9. CommentedZsolt Hermann

      The problem is the artificial lifestyle we have generated, built for ourselves.

      There is no question about each and every one of us being different. We all have different necessities, desires.

      But there is also a saying, "...the peasant's son does not desire the king's daughter...", in other words when the natural desires, necessities are not manipulated people are perfectly happy to cater for, fulfill those natural desires they were born with, and they do not even envy each other. The peasant is happy with what he has as long as he has what he needs, and the king is also happy with his part.

      The problem started with the modern, sophisticated marketing campaigns, serving the "infinite growth, infinite profit paradigm" where people are brainwashed 24/7, with new, artificial desires implanted into them.

      Today the "peasant's son" is told he could not only have the king's daughter, but the king's castle and his whole treasury as well, so even if he gets twice, three times more than he ever wanted or needed he still ends up unsatisfied, while in the meantime he already stretched far beyond his means to get what he never really wanted or needed but was brainwashed to want and crave for.

      Equality means a system where everybody can work for, satisfy their own natural necessities, desires, within their available means without being manipulated, inflated, tricked, blackmailed to go beyond their natural sphere. Everybody contributes to the collective according to their natural capabilities, talents and receive what he/she needs for his/her natural necessities in return.

      And we have much more than enough resources to facilitate such system, the only thing we have to do is to re-adapt to a natural necessity and available means based structure.

    10. CommentedMichael Harrington

      I believe inclusion in the globalized market place means access to capital and the returns that accrue to capital. Labor incomes are not enough to survive in the rentier societies of the developed world, nor are they enough for labor intensive developing countries.

    11. CommentedMichael Harrington

      The use of debt is a reflection of stalled economies that do not generate sufficient effective demand. In effect, it is borrowing demand from the future, but productive investment in the present relies on the anticipation of future demand. We've seen the results in amplifying the business cycle into an economic and financial crisis. One factor Mr. Spnce fails to address is the winner-take-all nature of technology and globalized financial markets. There is no easy cure for that without throwing the baby out with the bathwater.