February 7, 2017    5 minute read

In Defence of Inequality

Urging Caution    February 7, 2017    5 minute read

In Defence of Inequality

Within the last two months, the issue of inequality has been the topic of several articles in the English media. One dealt with a report predicting that inequality will soon rise to levels seen not seen since the Thatcher era. Another study by Oxfam found a further global rise of inequalities. Next to detrimental social effects, these studies also warn of inequalities’ negative effects on growth.

To some extent, this contradicts the notion that inequality is a crucial by-product of an economic environment that fosters entrepreneurship and hard work, and thus leads to higher growth. Is economic inequality a necessary stimulus for European economic growth or does it have a negative impact on output?

Assessing Inequality

It is very often the case that inequality leads to inequality of opportunities. This is especially so in the light of credit market imperfections, which are inherent in the education market.

In a perfect market, parts of the young population with incomes too low to pay for good education (secondary education, in particular) would be able to borrow money that could be paid off later. However, most young people have no collateral and equally no guarantee to pay back the loans, and are thus unable to finance their education. The logical consequence is a suboptimal level of human capital formation.

Human capital, though, determines the labour force’s productivity and has a big impact on a country’s growth rate – all the more so in today’s global environment, which is characterised by high rates of technological change and growing demands for a well-trained labour force.

Its Political Effects

Economic inequality can also have direct effects on the political economy: for example, the economic power of the rich implies some degree of political power at the detriment of the lower-income groups. As a result, legislation is influenced by the interests of the top-income group.

In his acclaimed book “The Price of Inequality”, Stiglitz shows that the wealthy are able to shape monopolies and create rents that favour their group’s interests significantly. These rents, which ultimately are market failures, will by their nature prevent a proper functioning of the market.

It is almost self-explanatory that market failures generally have a negative impact on growth and a country’s productivity. What’s more, these rents have increased sharply since the 1980s.

Recent OECD and IMF reports seem to support the existence of these negative effects of inequality. They find that there is a negative and significant effect of inequality on medium-term growth and, when spells of growth take place, they are shorter in countries of higher inequality.

Disentangling the Consequences

Nevertheless, pointing to these theoretical arguments and empirical findings to claim that inequality lowers growth and should therefore be reduced is equally hasty. Even if one believes that these empirical correlations between lower growth and inequality are in fact a causal relationship stemming from inequality’s effects – which some fiercely deny – it does not mean that inequality itself does not stimulate growth.

As alluded to above, the negative impacts of inequality only exist in combination with market failure or inappropriate institutions. The suboptimal human capital formation that results through inequality, for example, exists only because credit markets are imperfect. Equally, the wealthy are only able to create rents – and thus market failures – if institutions are not equipped to resist disproportionate economic influences in decision-making.

In short, economic equality needs to be disentangled from its institutional environments to make an accurate judgment about its effect on growth and related factors.

Defending Inequality

Inequality in itself seems to have few, if any, negative effects. As a study of 34 OECD countries shows, inequality has no negative effect on honesty, altruism and civic-ness, and only a negligible effect on tolerance. On the other hand, it does have a positive effect on people’s work ethic. Both the ‘carrot’ of financial rewards and the ‘carrot’ of symbolic rewards motivate people to work and leads to the economy to grow.

As such, it is not inequality in itself that has detrimental effects on growth, but the lack of social mobility. Social mobility, or intergenerational mobility, is described by the correlation of parents’ social and economic ranking and that of their children. It is precisely the lack of education opportunities and an unfair shielding of some income classes in society (as discussed above) that are the underlying problems of social immobility.

The Problems of Social Immobility

Although these failures in social mobility and their economic consequences are substantial, they can and should certainly be addressed by the state. With respect to credit market imperfections, this could mean state funding of education or state lending to provide credit to borrowers without collateral. Germany’s approach to free higher education and financial support for apprenticeships, for example, has proven extremely successful to stimulate growth.

Regarding the rent creation of the top-income (or top-wealth) class, more serious attention to monopoly powers and rent-seeking behaviour in the economy should be paid by policy-makers. Either that or a fairer design of the decision-making process that prevents the economically powerful from being also the politically most powerful might contribute to a solution.

This is not to say that these structural problems will be easy to solve. In fact, there is sufficient evidence which points to the difficulty of designing and implementing such policies without an adverse effect on incentives and growth. But it clarifies that a lack of social mobility will have negative consequences on a country’s output growth.

According to the above-mentioned, research pure economic inequality will not. On the contrary, given effective social mobility, inequality incentivises work effort, innovativeness and entrepreneurialism in a way that can contribute a stimulus to economic growth. This should be borne in mind before making overly hasty decisions.

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