Growth and Inequality: Analyzing an Important Relationship

Written By: Dennis Shen

In academic circles, it has become commonly accepted that rapid economic growth can increase inequality. This has been supported by international developments in recent decades that show declining inequality between countries but increasing inequality within countries. China and the United States are just two examples. To explain the reason, some point to globalization as the natural conduit not only for high growth and inter-country convergence but also the agent for downward domestic pressures on working class payrolls, capping wage increases in response to international labor competition and resulting in intra-country divergence.  Others have argued that unregulated laissez-faire economics is both an apparatus for rapid economic advances and the natural environment for the development of a Darwinian economy (see Robert Frank’s “The Darwin Economy”) of winners and losers across an increasingly segmented income distribution, requiring a strong state to intervene and re-balance.

In a recent article on Project Syndicate (link here), Columbia professor Alexander Stille acknowledged this accepted relationship between rapid economic growth and increasing inequality, but also interestingly pointed to a novel alternative hypothesis: in addition to rapid growth driving rising inequality, could times of relatively weak growth also be associated with the very same inequality phenomena? As Stille writes, “might slow growth and rising inequality – the two most salient characteristics of developed economies nowadays – also be connected?” At first, it would seem counter-intuitive that very weak growth be commonly associated.

The basis to Stille’s argument is recent research done by French economist Thomas Piketty (link here to the 2011 paper), amongst the world’s foremost authorities today on inequality.  In the work, Piketty points out that periods of structurally low growth in France’s history were endemic of rising inequality. He argues that low growth is not only associated with but has a causal effect on high inequality. Central to his argument is a “r>g” intuition that in low growth eras, asset returns, “r” (that tends to accumulate to the wealthy), exceed real growth, “g” (that accumulates to everyone), resulting in higher inequality.

Piketty’s measure of inequality is the annual domestic inheritance flow as a percentage of the total market value of all French assets (tangible and financial assets, net of financial liabilities). A high inheritance ratio signals that past wealth is dominating new wealth, representing low economic mobility and a condition in which rentiers dominate labor earners.  Annual inheritance flows were 15-25% of French national income between 1820-1913, a very high level. This period was characterized by a rentier state with low taxes and proportionately high asset returns that accumulated to the French elite and ensured that the wealthy stayed wealthy. Growth was very low in this period, averaging 1% per year. The next period in history however – 1914-1945 – was fundamental to dismantling this old oligarchical status quo: war destructions and a prolonged fall in asset prices put a large shock to the system that had annual inheritance flows plunging to less than 5% of total assets by 1950. The following post-war period 1949 to 1979 witnessed very high growth rates (averaging 5.2%) and inheritance flows stayed close to all-time lows around 6%: high growth and equitable policies buoyed everyone upwards, keeping inequality low. But the concern today is that in part due to the low growth since 1979 (averaging only 1.7% over 1979-2009), inheritance flows have been back on the ascendency, tripling to 15-20% of total assets as financial returns continue higher in successive bubbles accumulating to the top but wages stay unchanged for those in the middle and bottom. Piketty importantly warns that inherited wealth will likely play as big a role in 21st-century capitalism as it did in 19th-century capitalism.

And so what is the connection between the principle that rapid growth fosters inequality and Piketty’s insight that it is low growth that is the true culprit? Though these two proposals seem in opposition, the truth is that the incidence of inequality can be dynamic to either environment. To start, it is important to state that growth and inequality form a single complex mutually-dependent relationship in which growth rates can affect inequality but changes in inequality can too affect growth rates. In the case of America’s modern inequality, it was neoliberal economic policies begun in the 1980s and which included inflation targeting and the great moderation, tax cuts for the wealthy and financial deregulation that gave rise at-first to a period of very high growth in-synthesis with the onset of globalization. This post-Reaganomic boom would also present the sharpest rise in inequality since the 1920s. By the 2000s, cash-strapped working class families would have to borrow extensively to make up for deficient income growth in what had become an increasingly unequal society, contributing eventually to the 2008 financial crisis and the modern era of high debt and low growth. As such, rapid growth and rising inequality would be the story of the 1980s and 1990s but high inequality and low growth would be the story of the early 21st-century. The conjecture that it was inequality that would bring low growth in the US supports the direction of the causality argument made by Joseph Stiglitz in his book “The Price of Inequality”.

Importantly, times of high inequality and low growth are not just cyclical, transitory periods but instead show elements of structural stasis once entered into. In France, the pre-industrialization rentier society lasted the entire 19th century and it took two wars and an economic depression to shake the foundations. In his article, Stille points to the phenomena of “last-place aversion” as exceptionally pervasive in times of greater hardship. Hard times trigger amongst the economy’s losers a psychological response akin to economic retrenchment such that they look to protect what they still have from those below them rather than take action on those above them. As Stille puts it, “experimental economists have found that subjects asked to play distribution games become much less generous toward those below them when they are in second-to-last place. They would rather distribute money to those above them on the totem pole than help those at the bottom to surpass them.” As such, in unequal societies, not only do those at the top keep power via the role of money but those in the middle and bottom protect this status quo by favoring repression of those below them rather than action against those above them.

But it is not always high inequality that drives low growth. It can also be the other way around. In the French case, the economic slowdown since 1979 was the outcome of structural devices ranging from demographic decline to the end of the post-war convergence boom. It was this structural movement to low growth that would lead to higher inequality.

The interpretation then is that the relationship between growth and inequality is dynamic and interchanging: slow or rapid growth can cause income distribution imbalances, but similarly high inequality can weaken growth potential. Countries like Sweden and Norway, amongst the world’s most equitable countries, have sustained amongst the highest growth rates in the advanced world. But developing countries like China and India, which are amongst the fastest growing, are also places exhibiting the largest advances in inequality.

High growth managed by unsustainable policies can thus be as much an undesirable imbalance as low growth. It is short-sighted policies that attempt to break from equilibrium, structural rates of growth, whether on the upside or downside, which create imbalances elsewhere in society, including in the income distribution. We must then recognize that policies which attempt to maximize short-term growth without long-term vision can be immensely counter-productive in the long-term. Next, we must also consider that inequality is not just a social issue, but very much an economic issue that hits at the heart of a sustainable, long-term development model.

More Information:

Alexander Stille, “The Hiers of Inequality” (2012)
Thomas Piketty, “Of the Long-Run Evolution of Inheritance: France 1820-2050” (2011)
Robert Frank, “The Darwin Economy: Liberty, Competition, and the Common Good” (2011)
Joseph Stiglitz, “The Price of Inequality” (2012)

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