It’s a fact: inequality slows growth

My latest in Salon cites new research on the inequality and growth debate. Toward the end to the piece, I discuss the political implications of the findings:

First, we should not assume that the mere fact that inequality reduces economic growth will be enough to convince the rich to reduce it. 

On Twitter, @richisglorious objects:

 

Initially, I was tempted to respond simply that this is a slightly pedantic point – my argument is that even if the wealthy accept the proposition that inequality reduces growth overall, they may still oppose redistribution for other reasons.

As I thought about the question though, I realized the sentence is true: inequality reduces growth. To see why, simply imagine a perfectly unequal society where one person controls all income and everyone else has nothing. There will be no economic growth. Imagine a slightly less unequal society, where ten people control nearly all the income, and everyone else struggle to survive. Again, no growth. The question then, is not whether inequality reduces growth, it’s at what point inequality reduces growth.*

The evidence I summarize in my essay strongly suggests we might be at the point. Other research suggests this as well. But let us not re-litigate this and instead make an important distinction between good inequality and bad inequality.

In my interview with Branko Milanovic, we discussed this distinction. He tells me:

These two extremes [absolute inequality and absolute equality] are clearly not good. We know that the optimum must be at some point in-between. Now, we don’t know what it is. Is this the Gini of “X” or “Y”? We have no idea, but we have in mind a certain “good” range simply by observing things empirically or, sort of, heuristically looking at the world. We see that there are countries that do well economically and socially and what type of inequality they have. Moreover, we have now studies, and I’m quite encouraged by them, which  for the first time try to empirically ascertain what percentage of overall inequality is caused by so called bad inequality. And that leads us to the issue of “deserved” and “undeserved” inequality and social mobility.

The bad or undeserved inequality would be the one that arises from the factors over which you have no control: what was the income level of your parents, whether you were born male or female, what is your race, and things like that. Actually, these studies do show that, in some countries, a large chunk of inequality is due to these factors. Thus we can rank countries by their bad and good inequalities. The good inequality, calculated as the residual between overall and bad inequality, is inequality we effort, work, luck and so on.**

The studies to which he refers can be found here and here. They find, after studying Europe and the United States, that inequality which stems from factors beyond an individual’s control (father’s education/race) are correlated with lower growth. Their study of 23 U.S. states over a two decade periods finds, “Inequality is good for growth when that comes from differences in the returns to effort, while it is harmful for growth when that comes from differences in opportunity.” They also find a strong correlation between changes in total inequality and inequality of opportunity.

Inequality and Opportunity

I believe that there are persuasive reasons to believe that the much of the exploding income inequality in the U.S. is due not to the good inequality, but bad inequality. As inequality increases, the opportunities for rent-seeking through the political system, education system and labor market become greater.

It is also worth noting that good inequality quickly become bad inequality unless mitigated (see: Walton family). Call it the The First Law of Inequality: inequality tends to perpetuate itself unless acted upon by an outside force. Estate taxes and capital gains taxes can limit such rent-seeking.

To summarize: in a state of perfect inequality, there will be no growth. In the state of perfect equality there will be little growth. At some point, inequality will become high enough to choke off growth, mainly by reducing demand and opportunity. Most of the research here is being done by economists who aren’t as cocky as Reinhart/Rogoff and therefore uncomfortable declaring a cut-off point. Instead, we’ll have to use Potter Stewart’s maxim: “I know it when I see it.” I think we see it.

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* We might have a similar thought experiment with perfect equality, in which no one is motivated to work since they earn the same amount as everyone else. Even if we assume that Amour-propre provides some incentive, we can assume growth would be slower.

** The full interview will be available next week on the Demos Policyshop blog.

11 thoughts on “It’s a fact: inequality slows growth

  1. Colin

    A few points:

    * It’s not pedantic at all. You asserted something to be a fact when the research you cited doesn’t even go that far. That’s not a small point. Also it would be helpful if you included my second tweet which explains my position/rationale more.

    * Your theoretical arguments are so difficult to relate to in real life that I find them next to useless. If one person controlled all income, presumably they would have to attain this empire while also having zero employees (if they did have employees presumably they would have to pay them something, thus ending their monopoly on all money). Also, what’s the point of having all that income if you can’t spend it on something, which presumably would place income in the pockets of others thus eliminating this situation?

    * Even if we accept these scenarios, they still don’t make your statement true, as you flatly stated “the mere fact that inequality reduces economic growth” without any caveats about very extreme inequality reducing growth or the scenarios you outlined here inequality reducing growth. In this very blog post you quote Branko Milanovic as stating that “the optimum [for growth] must be at some point in-between [full equality and full inequality]”. Thus, it would be just as accurate to state that “inequality” without any caveats increases economic growth as it would be to say that it reduces economic growth without caveats.

    I realize that income inequality is a hobby horse of yours and you are eager to seize on any evidence which supports your position, but I don’t think you help the debate at all by overstating things or asserting things as facts which in reality are far from proven as such.

    Reply
  2. pseudoerasmus

    “Most of the research here is being done by economists who aren’t as cocky as Reinhart/Rogoff and therefore uncomfortable declaring a cut-off point. Instead, we’ll have to use Potter Stewart’s maxim: “I know it when I see it.” I think we see it.”

    But in order to be seeing the cutoff point of inequality above which growth slows down, mustn’t you first notice a growth slowdown ? I don’t see it. http://www.bls.gov/lpc/prodybar.htm If anything the trend rate of long-run growth in the US economy has picked up since the slowdown of 1973-92. Even in the 2007-13 period the average would probably be above 2% if it hadn’t been for the financial crisis in 2008-9. http://insights.bt.com.au/wp-content/uploads/2014/02/caton-us-080214-productivity-growth.png

    At some point, inequality will become high enough to choke off growth, mainly by reducing demand

    But another sign of that should be, higher savings/GDP, no ? But no sign of it. In fact rising inequality in the USA coincides with falling savings/GDP.

    So I think It would take a lot more immiseration at the bottom to really affect aggregate demand. The upper ends of the income distribution can sustain a higher level of consumption. And if they can’t, then they can turn to international demand by exporting.

    Reply
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