Thematic BlogSpot - Inequality at the Center of the Policy Debate
With the Great Recession, inequality has come to the fore of the policy debate. This is illustrated by concerns about the potential adverse effects of unconventional monetary policies on inequalities, expressed by Janet Yellen herself.
Inequality is multidimensional, encompassing different spheres such as gender, health and education. The UNDP Human development indicator (HDI) takes into account health (life expectancy), education (literacy rate) and income. Other indicators, such as the Gender-related Development Indicator or the Inequality adjusted-HDI, take into account the human development cost of inequality. Joseph Stiglitz explains that America ranks fifth according to HDI but when its score is adjusted for inequality, it drops 23 spots, one of the largest declines among developed countries.
We focus on income and wealth inequality within advanced countries. These inequalities have risen lately whereas global inequality and poverty worldwide decreased dramatically over the past decades.
Global Overview of Inequality
A worrying widening in inequalities
Atkinson, Piketty and Saez draw stylized facts on income and wealth inequality in the long run. The previous climaxes of inequality in the western world were just before World War I for Europe and 1929 for the United States. The destructions provoked by two world wars and the 1929 crisis reduced inequality of wealth.
Wealth is a key variable to understand the evolution of inequality. Looking at wealth unveils savings and inheritance inequalities as Saez and Zucman explain.
Since the 1970’s, inequality has risen again: income inequality has turned into wealth inequality. This is illustrated in the chart below.
Source : Saez and Zucman, october 2014
The Gini coefficient measures the income or wealth distribution in the society. If the Gini coefficient is zero, the distribution is egalitarian and if the Gini coefficient is 1, the society is completely unequal. According to David Dollar, Tatjana Kleineberg, Aart Kraay (VoxEU), the Gini coefficient has risen in the United States (from 0.3 to 0.4) in 40 years, whereas income shares of the top decile have been stable or declined slightly since the mid-20th century in countries such as Germany, France or Switzerland.
Source : OECD - June 2014
Two recent trends are striking: the widespread increase in inequalities across all countries and the greater polarization of income. Gini coefficients increased in all advanced countries, even in Nordic countries, known to be more equalitarian. The polarization of income has shifted from the last decile and the rest of the population to between the last percentile and the rest. Danny Dorling argues that in the new model, the country is run by the 0.1 percent, backed by the rest of the one per cent. The other nine percent of the last decile (in other words, the upper middle class) began to have lower incomes. In the United States, the benefits of growth are accruing to the richest 0.1%, not the richest 10% or 1%. The wealth share of the top 0.1% in the United States was around 7% of the total wealth in the late 1970s and it was more than 22% in 2013 whereas their share in the American total income was only 8% in 2013.
Source : OECD - June 2014
Inequality : a worrying prospect? Credit Suisse projects global wealth to increase by 40% in 2019. Saez and Zucman argue that if income inequality remains high and the saving rate stays unchanged, wealth disparity will increase further. Piketty’s forecast is also worrying, as he predicts that inequality in inheritance will lead to a higher concentration of wealth and that the rate of return on capital will overtake growth rate. Those predictions are in line with two FAO scenarios for 2050 presented by Evan Hillebrand, which predict that the gap between per capita income in OECD and non-OECD countries and Gini coefficients will remain high.
Why did inequality rise lately?
Technological progress, globalization and liberalization of labour market are the three factors of inequality for Coen Teulings. The income of the top 10% increased rapidly whereas the gap between wages of medium skilled and low skilled workers was reduced. The share of middle skilled job decreased, claims Laura Tyson. The middle skilled are forced to look for low skilled job and increase the competition for low skilled individuals. The social construct matters as well, as the richer and more skilled marry individuals of their social level, entrenching inequality.
Technological progress led to an unequal distribution between labor and capital (disadvantaging the labor). According to Jeffrey Frankel, within the context of technological progress, the gap is widening between the skilled and unskilled individuals, differentiated by their level of education. This is accentuated by a winner-takes-all situation.
While globalization increased the standards of living of part of the BRIC population, it widened inequalities in the developed countries. Nouriel Roubini emphasizes the role of an emerging global labor force and of less progressive taxation.
Source : OECD 2012
Inequality and the crisis
The crisis, an amplificator of inequality
The crisis has raised income and wealth disparities. Following the differentiation between the evolution in wealth and income inequality pointed out by J. Frankel (in a Project Syndicate article that criticizes Piketty’s approach), Edward Wolff (whose paper is discussed in a FT Alphaville post) argues income inequality was actually lightening in the early years following the crisis. An OECD Report indeed indicates that top incomes are more sensitive to cyclical variations, because their asset portfolio is more composed of capital revenues than of wages. The financial crisis pushed down top richest people’s incomes by 6.6% in 2009.
Source : OECD - June 2014
Emmanuel Saez claims that the real victims of the financial downturn are people down the income ladder – middle-income American families experienced a 17.4 % drop in their income from 2007 to 2009. Income inequality (measured by the Gini coefficient of market income) in OECD countries increased by 1.2 percentage point in three years, as much as in the previous twelve (as another OECD Report explains). This widening is especially marked in countries strongly hit by the crisis like Ireland or Spain. In the United States, the top 0.1% now holds as much as the bottom 90% of the population (Free Exchange).
Source: OECD May 2013
What are the channels through which the crisis has led to growing inequalities? In addition to Janet Yellen ‘s speech on inequality, Sarah Bloom Raskin argued that low- to middle-income families were more exposed to the crisis than richer people because of a composition effect of their wealth. Housing represents 70% of families’ wealth at the bottom of the ladder while it accounts for only 15% in top 10% families’ wealth. For Saez and Zucman, these assets being financed through mortgages, middle-class individuals did not benefit from the housing bubble and suffered the most from the collapse in housing prices, having no other financial asset to buffer the shock. Nouriel Roubini explains that in the United States 80% of the rise in income inequality is due to a sharp fall in wages, with unemployment hitting harder people who already suffered from home foreclosures and over-indebtedness.
The crisis has also exacerbated other dimensions of inequality: it has led to disparities between rich and poor but also between younger and elder people (as a European Commission Report cited in a WSJ article and an OECD Report proclaim) and skilled and low-skilled workers (Aaronson and al. say, through the study of the American labor market polarization).
Have post-crisis macroeconomic policies triggered more intense inequality?
H. James (Project Syndicate) contrasts policies implemented after the 2007 crisis with those of the Great Depression: while the latter were specially aiming at preventing the deepening in inequalities (See Stiglitz’s Project Syndicate article), the former widened them.
Both conventional low interest rates policies and unconventional Quantitative Easing (“QE”) worsened the gap between top rich and middle-income households, according to Ron Paul and the Austrian School (VoxEU). Even if such accommodative policies were to boost the economy (see this WS Thematic BlogSpot), Cardiff Garcia claims that they triggered a sharp rise in asset prices that favored most top incomes who hold relatively more stock assets—the Bank of England estimates that the top 5% of the population holds 40% of the financial assets.
The adverse impact of monetary policy is nevertheless open to question. Matthew Klein in his FT Alphaville’s post argues that adverse effects are temporary thanks to the Central Banks’ unemployment target, notably in the US. Edwards suggests that QE prevents a winner-take-all situation, while Paul Krugman claims that QE has not really impacted low- to middle-income people. To him, “the belief that QE systematically favors the kinds of assets the wealthy own is wrong” – it depends on the context. What matters is the counterfactual and stock prices that favor top richest people would have risen again, with or without QE, given the shift away from housing.
Has fiscal policy played its redistributive role and stabilized monetary policy? The OECD highlights the effectiveness of fiscal stimulus and counter-cyclical social public transfers. However, with fiscal consolidation, cuts in social spending (WSJ) intensified vulnerability among the bottom segments of the population, therefore increased inequality, as explained by Joseph Stiglitz. For H. James, expansionist state spending policies paradoxically do not benefit to the entire population but create even more disparities between the average family and “corrupt elites”.
What about structural reforms? In times of secular stagnation (see this WS Thematic BlogSpot), structural reforms are needed but the OECD highlights they can have either negative, neutral or positive impact on inequality.
Why does it matter?
What is the link between economic growth and inequality ?
Inequality does not have the same effect on growth in different stages of development. The Kuznets curve helps understanding what the theory says about inequality and growth. In pre-industrial or industrial economies where physical capital is what matters the most, inequality is a necessity for economic development. The Rich’s saving propensity and their income are key to capital accumulation—as described in the Solow model. After this initial stage, physical and human capital become complementary in the growth process. The more educated the labor force, the stronger the growth is. The theory of human capital considers that there are positive externalities in the accumulation of human capital and a lot of workers with intermediate education accumulate more capital than few very well educated workers and many uneducated workers.
Inequality affects the economy through different channels.
Inequality can be seen as an incentive for hard work, innovation and entrepreneurship (Lazear and Rosen, 1981) but it may be also harmful for growth because it deprives the poor of the ability to stay healthy and accumulate human capital (Perotti, 1996; Galor and Moav, 2004; Aghion, Caroli, and Garcia-Penalosa, 1999). Stewart Lansley argues that in fact, since the 1980s, equality and growth decreased at the same time—the incentive channel did not work as expected: the share of output going to wages declined, purchasing power declined, and households increased personal debts.
Inequality impacts political stability and public policies. Large inequalities generate political and economic instability that reduces investment (Alesina and Perotti, 1996) and jeopardizes the social consensus needed to adjust to shocks and sustain growth (Rodrik, 1999).
Higher inequality will create pressures for redistribution (Meltzer and Richard, 1981) and those redistributive measures hurt growth. Higher taxes and subsidies create price distortions and reduce incentives to work and to invest (Okun, 1975).
Empirical evidence generally supports the view that inequality impedes growth, at least during the medium term, nevertheless there is no simple link between inequality and growth and economic evidences are often ambiguous.
Source : OECD 2012
Does inequality impede the recovery? Mohamed A. El-Erian argues that “a trio of inequalities (income, wealth and opportunity) undermines potential growth in developed countries”. According to a report from Standard & Poor’s, a certain level of inequality is acceptable and can help any market work efficiently. However, too high inequality can weaken growth. The United States are close to that situation, especially given the reduction in social mobility and education, as stressed by Alan Krueger. Inequality can also weaken growth by the channel of social and political instability. According to Stewart Lansley, one lesson of the 2008s crisis is that demand is led by wages. Thus, a larger wage share is necessary for growth.
Did inequality cause the crisis?
The debate revolves around whether inequality could be a deep faultline that induces the recent crisis, as argued by Raghuram Rajan. In the 1950s, John Kenneth Galbraith and Marriner S. Eccles wrote that income inequality were a key factor of the Great Depression of 1929. Immediately after the US financial crisis of 2008, inequality was not mentioned as a cause of this crisis. It is absent from the report from the financial crisis commission.
Inequality and indebtedness. However, Rajan argues that the response to income inequality was an increase in lending to the poor which led to the 2008 financial crisis. Increasing indebtedness, rising asset prices and deflation could be the cause of the crisis, according to Stewart Lansley.
Inequality and demand shortage. For Joseph Stiglitz, the reason of the crisis is that wealth was distributed to the richest with a higher marginal propensity to save. Jean-Paul Fitoussi and Francesco Saraceno describe the different steps from inequality to crisis in “Inequality and Macroeconomic performance” in 2010. Marianne Bertrand and Adair Morse explain that household saving rate decreased before the Great Recession because of income inequality. Till van Treeck supports Rajan and adds that his theory implicates necessary change in consumption theory in « Did inequality cause the US financial crisis? ».
Inequality and public debt. In Europe, the response to diminishing purchasing power was not easy credit but public services—leading to the debt crisis.
Paul Krugman questions the causality between inequality and US financial crisis and suggests looking deeper into the structural specific channels and for natural experiments. For Edward L. Glaeser, easy credit is not the cause of the financial crisis. The causality could be reversed. The booms of 1920 and 2000 have raised inequality.
As inequality is threatening the recovery and more broadly growth, it has become central to the policy dialogue, as in a recent OECD Forum for instance.
By Lisa Kerdelhué and Lucas Depasse
To further explore some of the topics discussed in this article, please click on the tags below:
