More Inequality for More Growth?

Raghuram Rajan recently argued that reviving growth in Europe requires reducing labor-market protection and, in turn, exacerbating growth in inequality. But Rajan’s analysis is problematic for three main reasons, pointing to the need for economists to abandon their reliance on mainstream supply-side theory.

PARIS – In a recent commentary, “Is Inequality Inhibiting Growth?”, Raghuram Rajan argues that income inequality, which has been on the rise since the 1970’s, can be explained in two ways. Progressive economists blame pro-rich policies. The “alternative” explanation (or, more accurately, the conservative view) focuses on skill-biased technological progress.

According to Rajan, while both explanations maintain that inequality led to excessive debt, causing the global economic crisis, only the “alternative” explanation accounts for European countries that maintained more egalitarian policies, despite low productivity. According to this view, Germany’s economic strength stems from the structural reforms – entailing fewer worker protections, limited wage increases, and reduced pensions – that were implemented to contend with historically high unemployment following reunification.

Now Southern Europe should implement similar reforms, Rajan argues, and accept the resulting increase in inequality, in order to avoid sliding into an “egalitarian decline” like Japan.

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