Does Inequality Stifle or Promote Growth?

January 20th, 2013 at 3:53 pm

Today’s NYT features two different views on the impact of inequality on growth.  In a magazine piece I wrote about earlier in the week, Adam Davidson frames the question in the traditional way: a modern economy can have faster growth or less inequality, but it can’t have both.  We need to decide, he asserts: “What do we value more: growth or fairness?”

Joe Stiglitz disagrees, arguing that “inequality stifles, restrains and holds back our growth.”

…it used to be that we asked how much growth we would be willing to sacrifice for a little more equality and opportunity. Now we realize that we are paying a high price for our inequality and that alleviating it and promoting growth are intertwined, complementary goals.

Who’s right?  Is inequality negatively (Stiglitz) or positively (Davidson) linked to growth?

It’s true, as Stiglitz suggests, that Davidson’s view of the tradeoff is “old school” and no longer widely believed by economists who study the issue.  A simple look around the globe at advanced economies with much narrower income and wealth distributions and growth rates at least comparable to our own (e.g., Scandinavia) began to raise eyebrows re the traditional view, and subsequent analysis found little support for it.

As the OECD recently noted, “Despite a vast theoretical literature on the link between inequality and growth, no consensus has emerged and the empirical evidence is inconclusive.”

Why might you expect inequality to be positively correlated with growth?  Because many economists and the policymakers who listen to them believe that interventions and institutions that push back against inequality distort market signals and thus dampen growth.  Unions and minimum wages, for example, are thought in this context to interfere with market-driven wage setting.  Same with anything that protects domestic industries from foreign competition.

There’s a lot obviously wrong with this view, not least of which that it ignores the power dynamics that shape both political and market outcomes.  Those who lobby against unions, minimum wages, and industry regulation don’t do so because they seek clearer market signals.  They do so to claim a larger slice of the pie, and they’ve been extremely successful.

As Stiglitz puts it:

Market forces don’t exist in a vacuum — we shape them. Other countries, like fast-growing Brazil, have shaped them in ways that have lowered inequality while creating more opportunity and higher growth. Countries far poorer than ours have decided that all young people should have access to food, education and health care so they can fulfill their aspirations.

Our legal framework and the way we enforce it has provided more scope here for abuses by the financial sector; for perverse compensation for chief executives; for monopolies’ ability to take unjust advantage of their concentrated power.

True dat.  Yet, as the OECD finding suggests, there’s not much evidence for causality going in the other direction—from higher inequality to lower growth.

That doesn’t prove Joe wrong.  He lists a number of common-sense linkages, as did I in this post from a while ago.  I’m working on a longer paper on the topic but so far, I’m finding the empirical inconclusiveness that the OECD notes.  Why might that be?

It’s of course possible that no relationship exists, but I think the problem has more to do with big timing and thus big signal-to-noise challenges in the measurement.  For example, one potentially important pathway by which inequality may lower growth is through diminished quality of labor inputs.  That’s a fancy way of saying that young, economically disadvantaged kids faced with lousy education opportunities will be less productive in the workplace years down the road.  But if that occurs, it does so with a 15-or-so-year lag, and there’s a lot else going on in the economy in those years.

On the other hand, some aspects of the Stiglitz version of inequality/growth relation seem inarguably clear.  Financialization of markets, the underpricing of risk, and the inflation and implosion of massive asset bubbles seems clearly and recently correlated with more inequality and our protracted recession/growth slog.

For now, I’d say the important things are to a) not subscribe to the traditional tradeoff view as per Davidson, as it leads to false and economically harmful policy choices, and b) promote policies that are both pro-growth and likely to help reduce inequality and particularly immobility, like quality pre-school and access to higher education by those on the wrong side of the inequality divide.

At the end of the day, our historically high levels of economic inequality may or may not be found to be causally linked to worse growth outcomes.  But either way, as long as inequality is blocking opportunity, keeping working families from benefiting from the growth they themselves are helping to create, and violating the social contract and the basic American value that hard work should pay off, it’s a huge freakin’ problem.

QED.

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18 comments in reply to "Does Inequality Stifle or Promote Growth?"

  1. jhm says:

    On the other hand, even if preserving (or enhancing) equity were a drag on overall growth, the part of Mr. Stiglitz’ essay about 93% of the growth going to the top 1% of earners raises the question of why it would be worse for slightly less growth which was actually experienced by the vast majority or people as higher growth.


    • Auros says:

      Indeed. Given the opportunity, a rational majority would clearly vote to have 10% less growth, but distributed equally — the bottom 99% would then go from getting 7% of 100 points, to 99% of 90 points. This is not difficult math.


  2. RS says:

    Agreed. Even if there is no causal link, then all else equal I think most people would agree that a society is better off with less inequality than more.


  3. foosion says:

    We tend to view market outcomes as natural and that efforts to correct them as interference with the market.

    The problem with this view is market outcomes are often a product of government actions, but those actions are not as visible as taxes or safety net provisions. For example, intellectual property laws allow pharma companies to earn huge profits, way above those which would be earned in a free market, exchange rate and trade policy increase competition for many low and middle income workers, holding down their compensation compared to what they would be absent these actions, too big to fail and other policies are massive subsidies to financial institutions, licensing laws restrict the supply of doctors, raising prices and their profits.

    These are as much interference with a free market as taxing policy or food stamps or Social Security, yet they are usually ignored by those commenting on inequality.

    >>Why might you expect inequality to be a negative causal factor vis-à-vis growth?>>

    I believe you meant to say why would inequality help growth, rather than saying why would inequality hurt growth.


    • Jared Bernstein says:

      Fixed–thnx.


    • Mike says:

      Very much agree with this take; it’s straight from Dean Baker, whose “End of Loser Liberalism” should definitely be more widely read (especially considering it’s free)

      Also, when I read the above article, I instantly thought of your hobby horse, Jared: full employment! When our institutions are geared toward high growth and low unemployment, rather than focusing blindly on a low price level, inequality will tend to decrease (like we saw during the post-war boom as well as during the late ’90s). So that trade-off between growth and inequality doesn’t necessarily hold when we have a considerable amount of slack in the economy. All we need now are a few more full employment hawks in Congress and the executive branch and a few less “Very Serious People”…


  4. cdamon says:

    Don’t we have to define growth first?


  5. Rima Regas says:

    You’ll be writing about this some more tonight or tomorrow, when Paul Krugman’s op-ed for tomorrow goes live. He’s been thinking out loud in his blog and disagrees some with Stiglitz’ last two points.

    Interesting topic.


  6. Kevin Rica says:

    At an early stage of development, when savings are scarce, inequality is a natural outcome of growth. Most of the economy is primitive and anyone who enters the modern economy has more.

    Furthermore, that is where the savings come from that drive investment and growth.

    Then, as the modern economy absorbs the available workforce, wages start to rise generally. The important point is the modern economy has to grow enough to provide jobs for everyone and make labor scarce.

    Obviously, in America now, savings aren’t scarce — that is why real, risk-adjusted interest rates are zero or below. Increasing savings will only reduce aggregate demand. That is Keynesian economics — too much savings can cause recessions.

    Right now we are getting a double whammy. We have a huge inflow of China’s surplus savings and the same time we have have a huge influx of the unemployed of the rest of the world. That means that labor is not scarce and wages are depressed. That redistributes money to the rich and increases savings even more.

    But, as long as the American economy is run as a mechanism to put surplus Chinese savings to work employing the surplus labor of Central America, Americans won’t prosper.


  7. Greg says:

    Hey Dr. J:

    Faster growth or lower inequality? Really? Haven’t we already tried the faster growth idea for thirty years … and all we got was a stock market boom and bust, a dotcom boom and bust, and a housing bubble boom and bust that led to an economic collapse, massive unemployment and the worse recession since the Great Depression. It looks like the faster growth model isn’t a very sound one to follow, does it?

    I noticed that Adam Davidson never highlighted the post WWII era specifically (1945 – 1975), when all five quintiles grew at roughy the same rate, as the US economy grew at a rapid pace. The era was marked by strong unions and high taxation as prosperity was shared by all.

    That all changed when tax cuts were slashed and we deregulated the financial services industry. Yes, it is true, our economy grew a lot since 1980, but we’ve had multiple economic crises, pensions have been robbed or destroyed, and the average worker hasn’t had an increase in income.

    Why can’t we have an era of high growth and shared prosperity once again? What’s holding us back? There appears to be rampant epistemic closure by our economic decision makers.

    Our elites are failing us. They believe deficits should be the top priority and the poor and weak among us need to suffer more pain because the last 30 years have been just peachy. Ugh.


  8. urban legend says:

    “Unions and minimum wages, for example, are thought in this context to interfere with market-driven wage setting.”

    How incredibly amusing it is that allowing combinations of industrialists (using that term broadly) to use the state police power apparatus and private armies to prevent people with no market power from exercising their freedom of association to engage in collective bargaining can be deemed by store-bought economists as an interference with “market-driven wage setting.”

    The sheer hypocrisy in reacting to mere wage earners exercising their Constitutional right is astounding.


    • Fred Donaldson says:

      Economic growth for the residents of a castle means more wealth, spent and saved. Economic growth among the middle class is not going broke because of college costs, no job, or declaring bankruptcy to pay for a nursing home.

      We have been doing a good growth job for the castle dwellers for 30 years, but meanwhile the serfs have less gruel, less hope, no free time – just work for the standard peanuts for peons. More education for jobs that don’t exist is no solution, when we need more jobs for folks who have less education, but are willing to work.


    • Kaleberg says:

      They ignore that limited liability corporations also distort market forces. Collectivism isn’t always good. The bulk of the Industrial Revolution took place without limited liability corporations, so they are not at all necessary for growth.


  9. Kevin Rica says:

    I don’t know if this is the place, but I’ve just read Paul Krugman’s blog on Stiglitz’s column.

    Krugman has shown himself again to be unique among major economists. Unlike many I could name (but won’t because I’m just praising Krugman) — Krugman does not change his technical analysis to please the fashion trendoids in the modern Democratic Party. Maybe it’s because he won the Nobel Prize or because he doesn’t want to be Secretary of the Treasury (he’s temperamentally unfit anyway).

    So Krugman is capable of saying “given my political views and general concerns about inequality, I’d like to agree. But.. I’ve thought about these issues a lot, and haven’t been able to persuade myself that this particular morality tale is right.”

    http://krugman.blogs.nytimes.com/2013/01/20/inequality-and-recovery/?smid=tw-NytimesKrugman&seid=auto

    Krugman won’t say it because he’s sucking up to others on the left-wing establishment. He says what he believes when they are wrong.

    In 2008, when so many on the left were trying to blame high oil prices on “speculators,” Krugman noted that inventory levels were depleted and didn’t support the speculation story (duh!). At the same time other economists were doing somersaults to work around the obvious.

    http://www.nytimes.com/2008/06/27/opinion/27krugman.html?scp=1&sq=krugman%20oil%20speculation&st=cse&gwh=CFF4D3A28EE1F9D2E85D31D99E683554

    Krugman has criticized the Administration for not taking a harder line on China Many left-wing economists are reluctant to notice that “Communist China” is an authoritarian plutocracy. That is where income inequality really is a hindrance to growth.

    http://krugman.blogs.nytimes.com/2009/12/31/macroeconomic-effects-of-chinese-mercantilism/

    And almost uniquely among liberal economists, Krugman has the jewels to say that an open, mass immigration policy conflicts with all the traditional objectives of the old FDR, New Deal Tradition.

    http://krugman.blogs.nytimes.com/2010/04/26/the-curious-politics-of-immigration/

    How many others know that from the bottom of their soul and are too chicken to say so?

    Three cheers for Paul Krugman! It’s not just what you know. It’s what you have the guts to say. If there were more like him, the current Administration wouldn’t have to settle for a “new normal.”


  10. James Salsman says:

    The IMF pointed out in 2011 that if you stop measuring income equality’s effect on growth by assuming that the cause-and-effect relationship takes less than a year (a terribly incorrect assumption per http://economics.mit.edu/files/753) and use growth run lengths instead, then the relationship is abundantly clear: Income equality is the most determinate factor causing growth, fully 10% more influential than free trade: http://www.imf.org/external/pubs/ft/fandd/2011/09/berg.htm

    But really, the only thing you need to know about the subject is in http://www.incomeaction.org/_/rsrc/1358899890782/home/ieagraph.gif


  11. John M says:

    I believe that at these extreme levels of inequality, refering to overall growth is as meaningless as this average: “on average, you, I, and Bill Gates are decabillionaires.” The problem:

    The actual numbers may vary, but something like 80% of the growth goes to the top 1% of the population, 25% goes to the next 19%, and the remaining -5% goes to the bottom 80%. In this context, growth is seen as a negative, a liability, or a the very least a meaningless quantity.

    I have other issues regarding growth. See, for example, “Shoveling Fuel for a Runaway Train.”


  12. Edward Lambert says:

    In the last 3 months I have worked on a new growth model based on labor share of income. The equations have opened up a new view into the dynamics of factor utilization and labor share of income. The bottom line is that labor share of income must rise as real GDP increases through time, in order to maintain a healthy economy.
    Graph #23 in the first link pulls the work together… and the second link below is an interactive graph of graph #23 where you can raise the real GDP and watch the balanced growth point rise up and to the right (the intersection point of blue line and the 45 degree slope green line. The intersection point is rising slower than a couple decades ago, but it shows that labor share of income should be rising, not falling.)
    https://docs.google.com/file/d/0BzqyF_-6xLVELWVQUkpPa1pEN1k/edit
    https://docs.google.com/file/d/0BzqyF_-6xLVEQWJ6V1ZJU1lZczg/edit


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