Inequality and Growth

September 29th, 2012 at 9:22 pm

As part of an event celebrating the National Employment Law Project, I participated in a panel moderated by Bob Herbert, former oped writer for the NYT (an extremely compelling one at that, whose themes were race, poverty, inequality, and justice) and now a senior fellow at Demos (the other panelists were Dorian Warren and Lynn Rhinehart).

The question of the impact of inequality on growth came up and that made me want to work out my thoughts on that relationship.  These issues are very usefully addressed in this recent paper by Boushey and Hersh (more on that below; see their page 8 for a short summary of the ineq/growth lit), but here, in an extended post (it’s early Sat AM and no one’s bugging me yet) are some of my thoughts about it.

The classic theory on how growth affects inequality maintains that there’s an inverted U-shaped relationship over long periods of economic development.  As emerging economies grow they initially become less equal as the few with high financial endowments profit off of their ownership of key productive resources, like land.  Then, as industrialization evolves, much more of the population has the chance to participate in higher value-added work which reduces inequality.

[Here’s a very interesting read from yesterday’s NYT on a close cousin to this argument, focusing on growth and personal happiness in China—and a useful reminder, if you needed one, of the importance of job security and safety nets.]

Note that in this argument, as in my own work on this topic, causality goes from growth to inequality, i.e., the latter is the dependent variable.  I’ve stressed the important and inequality-reducing impact that full employment—itself a function of growth—has on the earnings and incomes of middle and low-income households.

But lately, more people have been arguing the other way, suggesting growth is a declining function of inequality.  This turns the causality around, and now growth is the dependent variable (it is “endogenous” to inequality).

So, where’s the evidence for causality flowing it that direction?  This is a gnarly question indeed, as both growth and its distribution have so many moving parts.  Untangling them is a daunting measurement challenge.

But you know my methods, Watson.  We start with the means, as it were, just plotting one against the other, testing correlations, leads and lags, etc.  If there’s not much there, it doesn’t mean further search is fruitless, but it often implies the search will be challenging.

The figure below plots yearly real GDP growth and the share of income going to the top 1%, 1929-2010.  The long inequality series follows a U (as opposed to an inverted U), as broadly speaking, post New Deal reforms and institutions (collective bargaining, minimum wages, safety net, social insurance), spreading industrialization, full employment job markets, and less globalization all led to more broadly shared growth until the 1970s.

Sources: NIPA and Piketty/Saez

Since then, inequality has trended up, with large cyclical movements in recent decades (these data include capital gains and losses, which are both highly cyclical and play a significant role in movements of the income share of the top 1%).

GDP growth used to be a lot more volatile but besides that, it doesn’t match up with inequality in any obvious way.  If you squint at the end of the series, you might see a negative correlation, as inequality takes off and growth rates trend down some.  But I ran a bunch of correlations, with leads and lags and moving averages, against the levels and changes in the top 1% share, and didn’t find anything to speak of.  I’ll post the series if folks want to fool around with the data.

[The recent cyclicality of both growth and inequality imply a positive correlation.  But controlling for this didn’t change the results described above.]

But this is way too crude.  When you’re dealing with relationships between complex variables in economics, it helps to have a simplifying model.  So here’s some thinking about potential relations that could make faster growth a function of less inequality, linkages that don’t show up at such a high level of aggregation as in the figure above but might be deep in the data once we take a closer look.

[Note: This recent IMF paper is often cited as evidence that growth is inversely related to inequality, but its evidence is on developing economies; the authors explicitly note that this correlation is less evident in advanced economies.]

–More equal distributions generate more robust demand throughout the economy, which in turn leads to more broad-based investment and more growth.   

Imagine an economy with two consumers and one investor.  With high inequality, consumer Richie gets all the growth, buys a bunch of cars, some fancy watches, etc.  With low inequality (but similar growth), consumer Poe now has enough money to buy a cheap car and a Timex, but Richie still buys a few cars and a watch or two.

In scenario one, the investor doesn’t see enough demand to expand production, say, to build a new line of mid-range products.  In scenario two, she does, which leads to more growth than would otherwise prevail, and does so as a function of more the broadly-based demand generated by a more equitable income distribution.

Even if Richie can spend enough to offset the reduced consumption of Poe, it is generally thought that Poe’s marginal dollar is more likely to be spent than Richie’s (Poe’s “marginal propensity to consume”>Ritchie’s).  That’s why, in the context of stimulus discussion, we emphasize that mulitpliers are higher for tax cuts targeted at middle-income rather than high-income households.

Our GDP is still 70% consumer spending, so more balanced growth should drive greater consumption and, again, more demand.   This applies more in an economy with output gaps and underemployment, but unfortunately, that’s been the norm of late.

This is the growth model envisioned by Nick Hanauer as described here.  I’ve always thought it made a lot of sense, but I’m not sure.  For one, while Nick correctly points out that he and his fellow 1%’ers can only buy so many cars, I’ve seen some evidence that, in fact, very wealthy households can spend enough to generate a lot of demand.

–High inequality leads to under-investment in the productive skills and well-being of those hurt by inequality, leading to lower potential growth levels.

As Boushey and Hersh convincingly argue here, with high levels of inequality, we will underinvest in human capital (and perhaps physical capital, i.e., public goods/infrastructure—discussed in the next two models) and that will reduce growth relative to a counterfactual wherein poor kids can achieve their intellectual and economic potential.   Economist Joe Stiglitz has also made this argument for years.

To the extent that inequality channels income away from large swaths of households, it blunts opportunity, raises poverty, and heightens the barriers to economic mobility.  Surely, this has growth effects both in terms of the social and budget costs of poverty and the sacrifice of underdeveloped human capital, though here again, the empirical evidence has not, to my knowledge, been developed.

[Nerd alert: One interesting line of analysis here might be through multifactor productivity accounting, which breaks out labor composition’s (education and experience of the labor force) contribution to productivity growth.  Unfortunately, in the BLS accounts, this series only goes back to the late 1980s, when inequality was already on the rise.  It has not, however, decelerated as inequality has grown.]

–Credit busts.

My sense is that political economy models, like this one and the next one, may provide richer linkages between inequality and growth.  The shampoo economy of the last few decades (bubble, bust, repeat) has arguably contributed to the lower growth rates, on average, toward the end of the figure above, especially when you average in the great recession.

Some of the key factors contributing to higher inequality—financialization of industry, deregulation of financial markets, favorable tax treatment of non-labor income, middle-income wage losses replaced by loose credit—are also key factors in the shampoo cycle, suggesting a potentially important causal chain.

–Political collapse.

In a very highly developed thesis, Acemoglu and Robinson explore the linkages between inequality and devolution of political institutions that, in good times, stabilize and promote growth through many of the channels noted above (e.g., rule of law, proper oversight, adequate public investment).

I’ve stressed my own mini-version of this in models like this one here, demonstrating linkages between increased wealth concentration, money in politics, and the ensuing “purchase” of a political agenda that blocks corrective policies.  This in turn reinforces further income concentration leading to the same set of growth reduction problems noted above re the bubble/bust cycle and underinvestment.


In sum, I’d consider the question of the extent to which higher inequality lowers growth to be an open one, worthy of much deeper research, perhaps along some of the lines noted above.  But one uber-caveat:

I’m as much a growth freak as any card-carrying economist, and it should be obvious that for all of our focus on inequality, robust growth is a necessary, if not sufficient, condition for the improved living standards of the broad population.  But suppose, after exhaustive research on the causal chains suggested above, we found that growth wasn’t so much a function of inequality?  Would that make the argument that poor kids should be able to realize their intellectual and economic potential any less compelling?  Would it make the goal of full employment in the name of a more equitable distribution of productivity growth any less of a venerable goal?

Not to me.  You?


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11 comments in reply to "Inequality and Growth"

  1. Jake says:

    The recent PEW study on income and wealth inequality may be a place to look to see how demand was generated by the recovery of the balance sheets of the top 20% versus the middle level. The top 20% saw their balance sheets recover first as the stock market rebounded after the Great Recession. This approach would have more to do with demand generated by recovery from excessive debt than demand generated by income increases flowing from productivity. Those have been at record lows so there isn’t much to study there.

  2. JimZ says:

    It’s time to replace “growth” with “development” as defined in the writings of Herman Daly.

  3. M.A. says:

    Economics is not physics or genetics. It may employ models, but it’s not studying natural phenomena (genes, forces, etc.) directly; it’s studying consequences thereof–an aspect human affairs (in a larger context of culture)–which aren’t nearly as fixed (with high fidelity).

    That, to me, means the moral dimension is imperative, not optional. It’s always about the best outcome for the majority (ideally, our habitat as well).

    As such, I’m not sure the answer you seek is an “open one” because it seems to imply that it’s acceptable to divorce the moral dimension and delve into economics for its own sake.

    In other words, what if we do find that growth can be in spite of inequality (which there seems to be real-world evidence for anyway, albeit anemic growth)? My answer to that would be, so?

    Maybe it’ll win some academic a Nobel Prize, but certainly not for anything useful to humanity, unless we wish the majority of the world’s population hardship and misery.

    I think your final statement is the answer to whether such abstraction is worth the pursuit. Now, if there is a model that finds there can be growth in spite of inequality that still produces increasing standards of living for the majority, then that may be truly something to marvel over.

  4. Nick Batzdorf says:

    The most striking thing to me is that by far the widest spreads between the lines are right at 1929 and 2008! And I have a feeling you’d see the same thing if you were to plot France in the 1790s.

    My hunch is that the top and bottom of the graph are like “cliffs”: everything is great until the inequality breaks loose from its tether, and then both lines tumble over the edges.

  5. Christiaan says:

    A third possibility, and one that I intuitively think is true, is that the relation is not linear, and also strongly depends on other variables.

    Compare it to economic cycles. Compare to a (currently) often botched question related to economic cycles: what is the relation to government deficits and growth? Some say higher deficits lead to slower growth. Another theory (attributed, wrongly, to the opponents of the former) is that higher deficits lead to more growth. The correct answer IMHO came from Keynes: it depends on where you are in the economic cycle; in good times the deficit should be low (negative), in bad times it should be high, in order to achieve optimal growth.

    I think the same is true with inequality and growth. For developing nations, with a high level of unused potential, inequality can induce growth. However, for developed nations, where it’s much harder to find unused potential, and growth is much more demand driven, inequality will dampen growth. Moreover, growth in an unequal society is not sustainable. When the low hanging fruits of untapped potential are worn out, it leads to stagnation, also because more growth tends to threaten the elite that is very strong in such societies. Growth in equal societies is much more sustainable, as the growth comes from many sectors, and growth shared by many does not threaten one small powerful elite, therefore it is self-reinforcing through the channel of demand. BTW, yes, I am inspired by WNF which I just finished reading.

  6. cfaman says:

    Perhaps rather than apparent correlation a good narrative may indicate where to go.

    This narrative is different from those you cite.

    Perhaps growth is primarily a return on investment phenomenon, a yield on capital assets, where capital assets are broadly defined to include the yield on intangibles, which includes not only ordinary intangibles such as copyright but things like training, business relationships, networks, etc. Annual growth may represent primarily the yield on newly made investments in capital assets using the cash flows off prior capital asset investments.

    As an investor, I wrote to Obama early in the crisis to argue that he needed to focus so-called stimulus spending on projects to maintain the cash flows to capital assets, including intangibles, otherwise with falling yields these assets would be not maintained and would be abandoned, reducing aggregate wealth. I see no evidence such a point of view was considered. And I think we are now asset-poorer than we used to be.

    It seemed likely to me that the maintenance level of spending required to preserve our capital assets was the output gap, and that gap was likely to approach 10% once you add up all the contributions from residential real estate.

    Well, back to inequality. In a highly unequal situation, capital assets are highly concentrated in the hands of a few, and so the yield remains in those hands. Yet the cash flows must derive from the many, in general. With few assets themselves, to the extent growth is a function of reinvestment in assets, they see little income growth, the few see little increase in the yield on assets as opportunities to invest to capture new slices of the growing stream of yield from the many are low. Marginal yields trend lower, perhaps too low to justify new investment.

    In a much less unequal situation, the many have significant capital assets which means cash flow growth, slices of which can be captured by investment in new capital assets by both the few and the many, so marginal yields are higher, investment opportunities exist, and therefore growth.

    Personally I think we are rapidly trending toward the first situation where the many have nearly insignificant capital assets including education, and the few find that mobile finance capital finds growing cash streams in other jurisdictions. And I think this situation is purely a result of policy. We are impoverishing ourselves by choice, mostly a conservative choice, but both parties seem to be on board.

    It was the first situation in Adam Smith’s time that led to the “invisible hand” metaphor, where because of the destitution of the many, the few were guided as if by an invisible hand to invest locally, raising local incomes and providing yields once again for the few.

  7. tom says:

    Dean Baker writes about pre-tax inequality versus post-tax inequality, arguing that redistribution in the tax code isn’t enough to restore inequality. Perhaps things like IP and protectionism for high earners inhibit both growth and greater equality. This only complicates the analysis.

    I sympathize with the view that greater equality leads to more growth, up to a point. That point is roughly when everyone has an income that allows them to live in reasonable comfort.

    I also don’t think that pre-tax and post-tax inequality are completely separable from a policy point of view. Reducing the post-tax income of a marginal dollar of income will affect managers’ decisions about how to allocate resources. They could decide to invest more into growing their business, they could choose to invest in hiring better employees to allow them to compete better, etc. To a certain extent, consumption at the highest level is about displaying status. We need to change the culture at the top so that building stronger businesses is higher status than building a car elevator at the expense of driving your businesses into bankruptcy.

    Finally, a large share of the growth in inequality is Madoffian in nature, it has no growth benefit.

  8. AndrewBW says:

    On a slightly different topic, Bob Herbert has always been one of my favorite columnists; in fact, he wrote one of the best political insults I’ve ever read. Years ago when he was with the NY Daily News he wrote a piece calling Ed Meese “a boil on the buttocks of America.” That pretty much sums it up.

  9. bakho says:

    An interesting correlation is the one between growth of income inequality and growth of private consumption as a percent of GDP. Plot the private consumption here:

    against wealth inequality. The wealthy take more of the money from our economic system and they spend it on themselves. The wealthy use political connections to gain no-bid contracts, favorable tax treatment, &c, &c. to take more than their fair share of the economy from the rest of us. Large costs for the middle class (such as college education) that used to be covered in larger percentage by BigG is pushed into the “private consumption” category.

    The push for “Privatization” is a shameless promotion more wealth inequality by limiting the ability of individuals to compete based on equality of opportunity. Privatization funds Inequality of Opportunity as a means of promoting wealth inequality.

  10. Paul Papanek says:

    Another great post. I appreciate the deeper dive into the causality question: IF inequality worsens growth, how exactly? This is a great question, and it’s very interesting that a careful look at a lot of data (“you know my methods, Watson!”) doesn’t give a clear answer. I was also struck by this same question in Stiglitz’s book on inequality. Although we now understand how America became so unequal over the last 30 years, as well as many of the ways that inequality perversely affects society, can we further argue that inequality weakens further economic growth? Maybe not, or at least maybe not in the short-to-medium term.

    Still, I’m persuaded both by your arguments (and those of Stiglitz and others) that inequality leads to bad politics, and bad politics leads to dumb economic policy, and dumb economic policy can lead to dire results that we may not see for a couple more decades–such as the slow erosion of our educational and research base in America, never mind the baneful effects of locking workers into dead-end jobs.

    Finally, it’s a point worth making that even if we cannot prove that inequality itself strangles growth, inequality beyond a certain level may still be bad for America, for social and political reasons.

    By the way, thanks for posting the link to your slide deck, with its detailed consideration of model components. Great stuff.

  11. Michael says:

    Dr. Bernstein, you have the causality backwards. Full employment is not a consequence of growth. Only the most spectacular boom times produce full employment, and those for very brief periods. Full employment is a consequence of government policy to support labor.

    Full employment does CREATE growth, by forcing labor-saving technological innovation. But growth can be captured by the elites just fine, if workers are denied the right to organize.

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