Of Old Ideas about Inequality and Growth

Update: An edited version of this piece appeared as a Project Syndicate commentary

A few weeks ago on Project Syndicate Raghuram Rajan offered his view on inequality and growth, thought provoking as usual. His argument can be summarized as follows:

• Inequality increased starting from the 1970s, across the board
• Two different explanations of this increase can be offered: a progressive one, that blames pro-rich policies, and an “alternative” one, that focuses on skill biased technical progress. I do not understand Rajan’s restraint, and as I like symmetry, I will label this alternative view “conservative”.
• Both views agree that inequality led to excessive debt and hence to the crisis.
• According to Rajan, nevertheless, the alternative/conservative view is more apt at explaining what happened to Europe, that remained more egalitarian, but was able to hide the ensuing low growth and competitiveness through the euro and increased debt.
• The exception is Germany where, following the reunification, structural reforms had to be implemented to reduce workers’ protection. This explains why Germany today is so strong in Europe.
• Thus the solution is for Southern Europe to implement structural reforms and accept increased inequality through lower workers’ protection; the alternative is sliding into an “egalitarian decline” like Japan.

The way I see it, there are a number of problems with Rajan’s analysis, and more importantly a fundamental (and unproven) assumption that underlies his argument. Let me start with the problems in his analysis, and then I’ll turn to the core of this piece, i.e. challenging the underlying assumption.

The first problem is that Rajan makes a fundamental confusion between causes and consequences of the increase of inequality. A large literature already exists on the causes of the increase of inequality; I do not know many “progressive” economists who would deny some impact of globalization and technical progress on wage inequality. Likewise, a “conservative” economist would have a hard time denying that that pro-rich policies deepened the gap (yes, even in Europe, where the marginal income tax rates, and corporate rates dropped dramatically almost everywhere). Probably the two phenomena interacted, as low skilled workers saw their bargaining power, and their capacity to affect the political process, reduced by skill biased technical progress and competition from emerging countries. At any rate, Rajan’s piece was not supposed to address the issue of what caused inequality, but rather its effects, as the title suggests (“Is inequality inhibiting growth?”). Creating a largely artificial divide between progressive and conservative views about its causes, Rajan hampers his own argument, confusing the reader.

More important, I find questionable the claim that “inequality caused the crisis”. ;Taking this view, in effect, it becomes hard to account for the differences between the US, where the nexus inequality-debt-crisis is evident, and Europe, where this is much harder to establish (except for Spain and Ireland). The increase of inequality, on the other hand, can be associated with the compression of demand on one side, and with the increase of savings of the wealthy on the other. This happened in the EU as well as in the US. Institutional differences and policy choices then led to the divergence between the US, where consumption was sustained by increasing debt, and most European countries where debt did not increase and the compression of demand resulted in insufficient growth. ;In both areas, the savings in excess from the rich financed either a series of bubbles (in the stock market, and then in the housing market), or the increase of debt of some countries (the US, Spain, Ireland, and so on). ; This interpretation relates inequality to the crisis only indirectly, through the accumulation of global imbalances that made the economy fragile, and are making the recovery slow and painful. It is an interpretation perfectly consistent with different performances of Europe and the US, thus running counter the Rajan’s claim that the conservative view better accounts for transatlantic differences in performance.

Finally, the third and more serious flaw in Rajan’s analysis, is the assumption, that he does not even discuss, that the increase of inequality is a necessary condition for sustained growth. Only accepting structural reforms that reduce workers’ protection, he claims, will Europe be able to embark in durable growth. Rajan assumes an inverse link between inequality and growth, that in his book the Fault Lines he complements with a sort of “trickle down” argument, i.e. that even with increasing inequality the wealth of the rich makes all society better off. In other words, Rajan presents as an evidence that does not even need to be discussed, the old idea of a tradeoff between inequality and economic efficiency, which should be solved by policy makers in favor of the latter. This is probably the real divide between conservative and progressive economists. A number of recent contributions (James Galbraith and Joe Stiglitz, for example) have extensively discussed how increased inequality has hampered the very capacity of the economy to produce wealth, thus arguing that a more egalitarian society would not only be ethically desirable, but would lead to more growth, not less. One may for example claim (and the Scandinavian experience somehow confirms this claim) that more egalitarian societies are better able to attract more productive firms. Rajan rests his tradeoff argument on a textbook dichotomy between a long run in which only supply factors matter, and a short run in which demand may also affect the economy. Only in such an ideal world the long run efficiency of the economy, and hence its capacity to grow, is disconnected from the distribution of income (the fundamental idea behind Paretian optimality), and the quest for efficiency should dominate distributional concerns. But when long and short run are not disconnected, the tradeoff vanishes, or at least becomes controversial. Take Rajan’s example, labor protection. In his analysis, reducing it would only bring advantages, as it would free resources for profit and investment, thus facilitating growth. But labor protection also means, in the short run, guaranteeing income to workers, who would then invest in their own human capital, or simply consume and provide revenues for the firms. How can we be sure that for society as a whole, the positive effects of reducing labor protection would be superior to the costs?

To help make the point it may be useful to look at an example from a somewhat different domain: one positive aspect of the current eurozone crisis is that it definitively dismissed the theory of “expansionary budget contractions”. Austerity may well be self defeating, because its short run recessionary effects may spill to the long run hampering the capacity of the economy to grow. It is about time that economists generalize this type of analysis and try to better understand how the linkages between short and long run challenge the traditional dichotomy between supply and demand side, that justifies the argument in favor of structural reforms.

A couple of sidenotes. ;Rajan at the end of his piece indicates that Europe should follow the US model but, in the first paragraphs, he acknowledges that US growth was doped by debt and ultimately unsustainable.

As for the “trickle down” argument, the statistics show that median wages in most countries stagnated; while this is not necessarily an indicator of transfers from the poor to the rich (the composition of the labor force changed over time), it suggests that the trickle down is not automatic. The tide does not necessarily lift all boats.

To come back to the question “is inequality hampering growth?”, the most correct answer is probably, at the moment, “maybe”. What is certain is that to find out we need to abandon the mainstream emphasis on supply side economics that constitutes the basis of Rajan’s analysis.