Inequality: what so much has been and will be ultimately about.

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Aliaksei Mukhachou's picture

Inequality: what so much has been and will be ultimately about.

Past several weeks have shown that there will be no easing to the demonstrations against the European austerity any time soon, at least not in Spain. Different parties offer a wide array of potential scapegoats. You can choose to blame it all on Greece, Germany, Fed, debt burden, bankers or Chinese. But it seems that not many leaders want to take a wider perspective.

 Last three decades saw the world become a more equal place. The developing nations have been reaping the benefits of international trade and now their median incomes are closer than ever to those in the developed world. Citizens of the industrialized countries, however, find themselves more divided over the paycheck size than at any point in time after World War II. According to the OECD, Germany, the US, Spain, Portugal, Japan, Canada and almost every other member state saw their Gini coefficients steadily rising since the ‘80ies. The recessionary rise in unemployment has accelerated this trend with the real median income of American households stagnant since 1998 and the jobless slowly slumping into poverty while the top earners have been able to capture most of the post-crisis income growth.

Joseph Stiglitz, Raghuram Rajan, Nouriel Roubini, Kenneth Rogoff and a number of other economists have called attention to the harmful, self-reinforcing nature of excessive inequality and stressed the necessity to curb the broadening wealth gap. But why do we have to care about income and wealth inequality in the first place? And if it is harmful, will the developed nations be able to come to an elegant solution?

Turning to fundamental theory to answer the first question is not a particularly good idea, as there is no straightforward way to define equitable wealth distribution in positive economics. The Pareto-efficient resource allocation within the framework of the fundamental theorems of welfare economics implies that in ideal free-market conditions a competitive equilibrium should eventually be achieved and resources will be allocated in the best possible way. This framework, however, gives no tools for understanding if and how inequality may affect the size of the pie, especially when the model’s behavior is distorted by market irregularities. Because of that, tolerance for inequality remains a question of norms and values of a society.

In many individualistic countries, most notably in the United States, people share sympathy for the glamour of the extremely rich and a popular belief exists that inequality fosters competition, achievement and progress. Contrary to this philosophy, a large volume of research indicates that a variety of mechanisms may positively link income equality and economic effectiveness. One recent publication I should mention is a paper by Aizenman and Jinjarak (2012), who examined cross-section country data to find that inequality strongly correlates with lower tax bases and higher sovereign spreads. Moreover, their research finds that a wide income gap also boosts resistance to tax reforms and polarizes political parties, making fiscal policy inflexible in the times of crisis. Other studies link inequality to erosion of human capital, loss of competitiveness, lower social cohesion, unhealthiness and fall in aggregate consumption.

How do societies address this issue then? Recent Latin American and French experience shows that even in the 21st century a common reaction is a shift to the left. This shift can be more subtle when the existing political parties promote income redistribution agenda via fiscal action, such as tax cuts for the poor, tax hikes for the rich, subsidies and unemployment benefits. Naturally, these measures are necessary in times of crisis to compensate for the system’s inefficiencies and give the unemployed a chance to find an appropriate job and preserve their skills.

However, such activism does not always serve the nation’s best interests in the long term. Redistribution is often used only as a symptomatic treatment as opposed to structural reforms. For example, Greece, through active governmental sponsorship, had its Gini coefficient slowly edging down over the last three decades – but eventually ran out of the borrowing capacity. Other European nations also focus on welfare, but the ever growing burden of public debt is taking its toll. Imposing Robin Hood taxes in this case does not create a system that could be sustainable in the long run. Moreover, the costs of progressive tax systems still apply. As Prime Minister Cameron noted in his address at the WEF in Davos, rich French emigrants are always welcome in London.

When political will for redistribution meets opposition, the result can be even more destructive. And that relates not only to paralyzed parliaments but also to hastily made compromises, argues Raghuram Rajan (2010) and Kumhof and Rancière (2011). From their perspective, the subprime bubble was fueled by subsidized mortgages that made housing available to low-income borrowers. Debt sponsoring may have seemed like a good wealth equalization idea at first, but the financial implosion of 2008 proved otherwise.

To sum up, while necessary in some form, taxing the rich and giving to the poor is fraught with risks. A nation should not rely excessively on wealth transfers and must instead focus on the root causes of inequality. In their 2007 report, Goldman Sachs find that the share of wage income (the main factor behind inequality in the G3) has been falling primarily due to cross-border job flows and growing redundancy of unskilled labor with technological change. Addressing these challenges will require a comprehensive reform of the education system and the labor market. Here one should mention that Denmark, being one of the most egalitarian states, also enjoys one of the most successful labor systems.

But would an unemployed voter favor financing of a job centre over monthly benefits? And would a middle-class working husband prefer taking classes in a continuing learning center over job security legislation? And will he vote for an inheritance tax reform to finance public schools?  Myopic, self-defeating selfishness, coupled with the political incentive structure with a short horizon makes passing of the much-needed equal opportunity laws far less likely without truly visionary leadership. Governments will not be able to solve a problem that spans generations if a far-reaching strategy to normalize income distribution and wealth accumulation is not designed and supported by the population.  

Unfortunately, none of the afflicted countries seems to be concerned with making any comprehensive reforms. What we observe is political partisanship, austerity in indebted countries, cuts in public education budgets and calls for Robin Hood fiscal measures. Unless the developed nations declare the equality of opportunity a top priority of their political and economic agenda, we will see more social volatility, economic imbalances and structural fragility in the coming decades.

Or you can blame Obama.

References: 
  1. Joshua Aizenman, Yothin Jinjarak, "Income inequality, tax base and sovereign spreads", NBER Working Paper No. 18176, 2012
  2. Goldman Sachs, Global Economics Paper No: 158, July 6, 2007
  3. Michael Kumhof, Romain Rancière, "Inequality, Leverage and Crises", IMF working Paper 10/268, 2011
  4. Raghuram G. Rajan, "Fault Lines: How Hidden Fractures Still Threaten the World Economy", Princeton University Press, 2010
  5. Kenneth Rogoff,"The Inequality Wildcard", Feb. 4, 2011, available at http://www.project-syndicate.org/commentary/the-inequality-wildcard
  6. Nouriel Roubini, "The Instability of Inequality", Oct. 13, 2011, available at http://www.project-syndicate.org/commentary/the-instability-of-inequality
  7. Joseph Stiglitz, "The Price of Inequality", Jun. 5, 2012, available at http://www.project-syndicate.org/commentary/the-price-of-inequalit