Does Income Inequality Harm the Economy?

In relation to the growing inequality in income distribution in the U.S., I keep hearing claims that income inequality is economically harmful. But I keep hearing that from liberals without noticeable competence on economic matters, and I’m not noticing it from economists. Particularly I’m seeing it as a bald claim, with never a clear explanation of the causal mechanism by which income (or wealth) inequality causes economic harm.

But it’s an idea I’m willing to entertain, because I don’t know that it’s not true. So in the true spirit of intellectual laziness, instead of (or perhaps just prior to) researching it myself, I’d like to ask if anyone can point me toward explanations of how income inequality harms economic growth, particularly from economists, not social commentators (although I’d be curious to see their causal explanations as well).

I’ve got an excuse for my laziness. I’ve got a large stack of midterms to grade. First person to criticize me goes straight to the Bawdy Doghouse.

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About J@m3z Aitch

J@m3z Aitch is a two-bit college professor who'd rather be canoeing.
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19 Responses to Does Income Inequality Harm the Economy?

  1. D. C. Sessions says:

    I’m not aware of anyone outside of the lunatic fringe who would assert that some income (or wealth) inequality is a good thing, so let’s dispense with that particular strawman.

    I’m not quite so sure about the opposite extreme: everything owned by a very small group and everyone else without wealth or income. However, I’d like to think that the question, once posed, is pretty easy to resolve.

    Am I correct on those counts?

  2. Pinky says:

    Maybe I just don’t get it; but, my question is about what purpose the economy is supposed to serve.

    Maybe one of the experts could give a simple answer?

  3. D. C. Sessions says:

    I’m not aware of anyone outside of the lunatic fringe who would assert that some income (or wealth) inequality is a goodbad thing, so let’s dispense with that particular strawman.

    Sorry ’bout that. Editing error.

  4. D. C. Sessions says:

    Grrr. s/good/bad/

  5. James K says:

    I don’t recall anything from my lectures on growth theory that linked inequality of income or wealth to growth. If anything I’d suggest a common cause relationship whereby poor institutions (lack of rule of law, poor protection of property rights, excessive corruption and rent seeking) leads to low growth and inequality.

  6. Michael Heath says:

    I googled (in the Scholar search engine) “income inequality” and “economic growth” together along with some other search words, e.g., correlation. Here’s a sampling:

    the authors do not find a systematic link between growth and changes in aggregate inequality. They do find a strong positive relationship between growth and reduction of poverty.

    Cite: Deininger & Squire, A New Data Set Measuring Income Inequality, World Bank Economic Review (1996) 10 (3): 565-591. doi: 10.1093/wber/10.3.565 Link: http://goo.gl/sOFw4

    We present empirical results that show that inequality in land and income ownership is negatively correlated with subsequent economic growth

    Alesina & Rodrik, Distributive Politics and Economic Growth, the Quarterly Journal of Economics, May 1994 Link: http://goo.gl/V7T7f

    Forbes 2000 found a positive correlation between growth and inequality in the short and medium term. Her paper started with the assumption of a consensus perspective there was a negative correlation and that her findings challenged that notion. She notes that East Asian countries had low levels of inequality and high growth rates and that Latin American countries had high inequality and low levels of growth where these two differences which resulted in a new supply of studies of studying this correlation. She goes on to note that from ’95 – ’00 a certain approach led to a consensus view that there was a negative correlation.
    Citation: Kristin J. Forbes, A Reassessment of the Relationship between Inequality and Growth, The American Economic Review 2000. Link: http://goo.gl/2epHZ

    I’ve always assumed conditions influenced the existence and strength of the correlation, which could vary wildly, especially based on time frames. One example of a weak or positive correlation, contra American non-economist liberal assumptions, is the growth opportunities of primitive oil producing countries. Growth was rapid but normally only benefitted the tribe in political power.

    Does a developing country with a comparative advantage in labor costs require equality to grow? I doubt it in terms of the capitalists and technologists necessary to exploit their country’s advantage in labor (in the short and medium term), especially when capital and expertise can be imported. This was my experience in Mexico, Malaysia, and Hungary though not Taiwan.

    However I also assume that in the long-run, post-development and full employment economies do encounter a negative correlation. That relationship is necessary to maintain an adequate number of individuals politically willing to pay to maintain a social safety net and the increasing need for a more educated workforce as one loses their comparative advantage in labor costs. Consider Malaysia. Their proximity to Singapore (an Asian haven for capitalists and technologists while also a key logistics juncture) made them ready for exploitation as a low-labor cost manufacturing site, however Malaysia quickly exhausted their supply of cheap labor and the last time I was there in the early-2000s, were increasingly importing workers from Viet Nam and especially Indonesia while Thailand was also able to win business that would have previously been awarded to Malaysia. In order to maintain and grow their manufacturing base against a rising Viet Nam, India, and China; Malaysia needed to provide manufacturing services with a higher value-add, which requires more management and engineers and therefore more income equality.

    I don’t know if there is any empirical evidence which supports my experiences in these countries, the above was merely my observation doing business in these particular countries. [I’ve never done business in Viet Nam or India, I merely observed how these other countries reacted to their rise.]

    In terms of western civilization, I assume there is a strong negative correlation between income inequality and future growth in the long-run and that this relationship will strengthen as the number of developed countries grows. It’s also my observation that if you laid-out the worst possible policies given this assumption when considering the present and future, you’d find the GOP’s recent and current set of platform planks, in spite of the lessons we should have learned since the mid-1970s. From my perspective everything they’re doing guarantees more inequality and far worse growth. The only exception is Republican antipathy towards certain types of union behavior which I find justified. The more traditional unionists appear to deny reality just like conservatives do, only in this case it’s relative to the needed level of performance out of unions in certain industries and their performance relative to best practices which I find atrocious, e.g., education. Union members are not helped by the fact that politicians continue to avoid dealing with critical root cause problems whose harm is increasing at increasing rates, .e.g., health care costs and outcomes, aging population, increasing disequilibrium between educational attainment demands and educational results, domestic and foreign policies inconsistent with a global economy, especially in regards to taxes, budgets, energy, and immigration policies. One of the reasons I’m supportive of the current president is his recognition of these fundamental problems we’ve been observing since the mid-1970s which he’s been willing to attempt to take on relative to the extent Congress and his executive powers allow (Though not to the full extent possible, he is a pragmatic politician with a reelection coming up after all).

  7. D. C. Sessions says:

    Having taken three attempts to get around to “it depends,” maybe I should have just said that to begin with.

    * Income/wealth inequality that results in “too many” people so poor that they become unproductive (starvation, ill health, lack of education, lack of mobility, etc.) becomes economically disadvantageous. Examples include many feudal economies.

    * Extreme income/wealth equality in a subsistence economy practically guarantees that the economy remains a subsistence economy for lack of capital accumulation or time for anything other than survival.

    * Motivational psychology of wealth/income varies depending on the SES of the subject (hierarchy of needs): at the low end, economic motivation is primarily survival, shifting to a zero-sum competitive power game at the highest levels.

    * Motivation also shifts across generations: it appears to be heavily influenced by early experience. Those who become wealthy by upward mobility (e.g. Andrew Carnegie) tend to be motivated differently than those who inherit wealth.

    * This last suggests that the economic analysis of income/wealth disparity might be asking the wrong questions if it doesn’t distinguish between the nouveau riche and those who inherit wealth.

    * I’ll wrap this comment with a question: if income/wealth disparity is desirable as a productivity motivator, the slope of the curve becomes very important. If the return on effort is low for a large proportion of the population, there’s little net incentive to be productive (serfdom again.) That being so, what would an optimum distribution look like?

  8. James Hanley says:

    Thanks, these are great responses. I think I need to put Michel Heath on my payroll as a research assistant (do you qualify for financial aid, so I can get you in a work study position).

    D.C., just how much have you been drinking tonight? ;) Your last comment more than makes up for initial struggles.

  9. James Hanley says:

    Pinky, I would say that the purpose the economy is supposed to serve is to improve human material well-being.

    Let’s do as economists often do and assume for the moment a simple two-person world, just you and me, and neither of us has any contact with the other. Everything you need, you have to produce yourself. Everything I need, I have to produce myself. We may both survive, but neither of us will be particularly well-off.*

    Then one day I notice that you’re a better hunter than I am, but I’m actually a better gatherer. So I say, “Hey, Pinky, why don’t we make a trade, some of what I gather for some of what you hunt?” You agree, and so we both specialize. You stop wasting time gathering inefficiently and focus your energies on what you’re good at, hunting. I stop spending time hunting (badly) and dedicate myself to my specialty, gathering. And so between the two of us we actually are more successful in our hunting and gathering than we were before, and we trade our surpluses with each other, making each of us better off.

    Everything else follows from that simple beginning. However complex the details get–and they do get forbiddingly complex–the basic point is always that we’re trading in an effort to become better off.

    __________________________________________
    *Well, I know I won’t be. I’m ungenerously assuming you aren’t a superman capable of producing all your needs easily by yourself.

  10. Michael Heath says:

    D.C. Sessions stated:

    Motivation also shifts across generations: it appears to be heavily influenced by early experience. Those who become wealthy by upward mobility (e.g. Andrew Carnegie) tend to be motivated differently than those who inherit wealth.

    Ex-Gov. Mark Warner [VA], who was a successful entrepreneur prior to becoming a politician, once gave a talk where he lamented his observation that more recent generations from the higher American classes are far less ambitious and risk-averse in their careers. While Warner advocated more liberal immigration policies of the professional/educated class given their disproportionate propensity to start businesses, his point we should perceive our own collective lack of willingness to do this for ourselves is worth consideration and possible policy development.

    We’ve encountered what Warner observed in my extended family. My generation and older were far more willing to take business risks and do whatever it took to succeed where as our progeny secured a great education and got high-paying jobs with far less responsibility or risk.

  11. ppnl says:

    Errm, my problem with income inequality isn’t with growth so much as stability. Income inequality equates to inequality in political power. That political power can then translate to laws that serve the interests of that concentrated wealth. This causes an unending cascade of increasing income inequality. This may cause no real problem as long as the wealth at the bottom continues to increase fast enough to satisfy some expectations. But if economic reversals make that impossible then things can get ugly. Look at what is happening in Egypt and Libya now and think about that.

    Libertarians distrust government exactly because they see how wealth can capture government to serve its purpose. But one thing they may miss is that the power granted by wealth does not diminish as you diminish government. Wealth is and always will be power.

    Consider a metaphor from physics. When Einstein first developed his general theory of relativity he had a problem with it either exploding apart as a cloud of expanding gas or collapsing into a few black holes. He wanted to impose a cosmological constant to both allow concentrations of mass to form stars and planets and yet prevent concentrations of mass at a larger scale that threaten to reduce the universe to a few centers of gravity so powerful that they become massive black holes. It would act as a kind of anti-gravity that would kind of redistribute mass away from the bigger centers of mass.

    Liberals are like Einstein in that they fear the unending collapse of wealth and want a force to redistribute it. They want to impose a cosmological constant on the economy. There are plenty of reasons to distrust this. After all Einstein called his physics attempt the worst mistake he ever made. OTOH nobody knows exactly how our universe is balanced to allow stars and planets while preventing total collapse. And nobody knows what properties of an economy allow concentration of capitol to do stuff while preventing unending concentration of wealth.

  12. James Hanley says:

    ppnl,

    I fully agree that too much income inequality has negative political results (although unfortunately I don’t think we know where the tipping points are). I’m sure there are people who will disagree with that claim, but I think it’s fairly non-controversial. But I’ve been hearing this “income inequality harms the economy” claim lately, from disparate disconnected folks, so it has the appearance of a spreading meme, and so it’s got me curious about why it’s suddenly (or so it appears) sprouting, and whether there’s anything to it or not.

  13. ppnl says:

    Maybe when people start complaining that income inequality is hurting the economy that is a sign of a tipping point. After all it is just a cry that “my piece of the pie isn’t big enough anymore”.

    I doubt that the people of Libya know much about democracy. What they do know is that their piece of the pie isn’t very big and they have very little political power.

    Anyway the unrest is unlikely to make a healthy economy.

  14. D. C. Sessions says:

    D.C., just how much have you been drinking tonight?

    That would have been a lovely excuse, except that the first response was posted in the early afternoon when I was still guzzling coffee rather than the beer I just had (GMT-7 vs. GMT-5)

    NB: the “inherited wealth” issue isn’t exactly new. Teddy Roosevelt argued for the inheritance tax on the grounds that it created an incentive for inherited wealth to keep being productive vs. settling into a perpetual aristocracy.

  15. James Hanley says:

    There’s an old quip that the first generation earns the wealth and the second generation spends it. I have no idea how true it is.

  16. D. C. Sessions says:

    The British is “shirtsleeves to shirtsleeves in three generations.”

    The saying’s more likely true in the moderately wealthy. I know a few families where the story is playing out: Gen1 built up a moderately successful business which included owning a lot of cheap land. Gen2 sold the business but managed the land and turned it into money. Gen3 grew up well off, but didn’t really grow the estate all that much (and there were more of them.) Gen4 grew up lacking for nothing and had better things to do than manage their share of the estate. Gen5 is well off, but far from being as well off as Gen3 (my contemporaries.)

    I give them two more at most; there are too many of them now to live off of the earnings so they’re either consuming or diluting the capital.

    However, for really huge fortunes (Gates [1], Koch, Madoff) it takes more than a population explosion. Barring quiverfull rates of growth, money halfway well managed can grow faster between generations than population does. You have to actively spend the estate down or it’ll continue to grow faster than inflation, and sufficiently large estates simply can’t be spent on anything other than actively bad investments. That’s where the later generations actually benefit from being lazy: they leave a diversified portfolio to someone else and just spend their lives playing (as we see in so many old-money families.)

    Sometimes, as with the notable nobility of the English 18th and 19th century, their “play” contributes greatly to the world. Most often, not.

    [1] Notably, Gates (whom I generally loathe) is determined to leave his children very little of his fortune. We’ll see how that works out. IMHO that’s an estate-tax avoidance strategy that I approve of. (A page from the Rockefellers?)

  17. DensityDuck says:

    You might suggest that income inequality is like obesity. It doesn’t cause poor health, but it’s a result of practices that will eventually lead to poor health; and the more obese one gets, the more vigorously those practices are being followed.

  18. D. C. Sessions says:

    DensityDuck: Interesting analogy. Might be worth playing with a bit more.

    For instance, both arise from too much (FSVO “too much”) of something that’s necessary and in moderation are probably good: obesity gets you through the winter, income/wealth disparity we’ve discussed above. Both have some positive feedback properties when not checked. Other comparison can no doubt be drawn.

    As with all analogies, we need to bear in mind that the limitations as well: for instance, obese or not individuals are quite mortal. Each generation starts over on BMI and even though governments rise and fall, cultures continue organically. It takes a very, very large disruption (on the order of the Russian and Chinese multigenerational purges) to root out existing property regimes.

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