Economic Inequality as Seen by Policymakers

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Since 19th century, the economists tried to identify and explain the major causes that lead to inequality but always obtaining a scarce consensus. The first was Marx in his book ‘The Capital) that pointed exploitation as the main cause, where people in upper classes get what they get by taking away from the bottom classes. The Duke William of Nassau, an Oxford economist, complained the rich classes to don’t appropriately consume. For Duke William was not the Marxist exploitation of labour, but an insufficient ‘top-down level’ consumption. While neoclassical economists used the marginal productivity theory to explain the phenomena where those at the upper classes only get what they add.

Joseph Stiglitz affirms that wages have grown less then productivity in the past three decades, a phenomena that could be better explained with neoclassical theory of marginal productivity instead of exploitation of Marx. The consequence is a weaker bargaining power of workers and unions. Moreover, unions’ inability to protect their members against the threat of losing the job has contributed to weakening their influence. In fact, in most of industrialised countries can be noticed a decline in union membership and power, particularly in the Anglo-Saxon countries and OECD Members.

Another factor that contributed to the increase of inequality are Central Banks policies that have an high focus on inflation and reduce worker’s bargaining power. Indeed, whenever worker’s wages increase, central banks tend to raise the interest rates that bring inflation with the result of “expanding unemployment and downward effect on wages”. At the same time, governments have been very superficial in enforcing laws anti-discrimination, a persistent aspect of market economies and highly present in labour and financial markets.

Paul Krugman compares two books published by Robert Reich: The Work Of Nations (1991) and Saving Capitalism (2015). In the first one, the author attributes the increase of inequalities to new technologies. The technology, indeed, was gradually eliminating repetitive jobs and was even making work based on personal interaction obsolete with the reduction of manual labour and an increase in demand for conceptual work. From this phenomenon, Reich predicted an increase in the salaries of graduate students from universities and a decrease in salaries for the non-graduated. According to Krugman, this theory has made a bad impression and no longer deserves to be taken seriously. In fact, the real wages of the mid-range have not only stopped growing faster than those in the low-range, but have even begun to slow down. At this point the other economists have also corrected their theory by arguing that technology has emptied the middle range rather than eliminating the low one.

Meanwhile, it has been noted that since 2000 that the salaries of graduated students also began to decline while those of the richest 1% were growing. Evidently this gap had nothing to do with education. But then what was happening? To explain the growing inequality, Krugman says that economists had abandoned the theory of new technologies starting to talk about power, in particular the market power, or the effects of ‘monopolies’ and ‘oligopolies’.

Saving Capitalism by Reich is an informative version of these new theses according to which the market power has strong repercussions on economic behaviour. According to statistical studies by Jason Furman, president of the United States Council of Economic Advisers, monopolies and oligopolies have been growing exponentially since the 1950s. In addition, inadequate antitrust policies and deregulation mean that monopolists can exercise their enormous power in determining the selling price of its products and the salaries of its employees, preferring to increase the dividends of its shareholders at the expenses of employee’s wages and investments in research and development.

“When, for instance, a monopoly succeeds in raising the price of the goods which it sells, it lowers the real income of everyone else. This suggests that institutional and political factors play an important role in influencing the relative shares of capital and labour”. Hedge fund legend Ray Dalio attributes the rise of global inequality also to financial crisis, that oblige central banks to keep financials asset prices at their near full capacity but increase wealth gap.

According to Dalio, ‘there are only two times in the history of this century where we had debt crises in which interest rates hit zero. And in both of those times, the central bank had to print money and go to a different type of monetary policy, which we call quantitative easing, and to buy financial assets. And that drives up, in both of those cases, the value of those financial assets and produces a recovery, but it drives interest rates down to zero or near zero, where they are around the world. And that buying of financial assets, has pushed up financial assets and driven the interest rates down to zero, so it’s caused asset prices to rise.’ This process creates a gap between the rich and the poor. Those that have more financial assets see those asset prices go up. And for various other reasons, a wealth gap has developed.

One of the most detailed research made by the IMF (Causes and consequences of Income Inequality: A Global Perspective. 2015), attributes to: global trends, technological change, trade globalization, financial globalization and redistributive policies as the main factors driving higher income inequality.

  • Global trends. In the last four decades, it’s a fact that new technologies have reduced the costs of transportation improving automation and communication. It helped to open new markets and spread growth opportunities in developed and developing countries lifting millions of people out of poverty. Despite this, inequality has also risen because the growth has been accompanied by ‘skill-based technological change’.
  • Technological change. New information technology brought an expansion of productivity and well-being, but has increased labour income inequality. This is because technological changes prefer capital and skilled labour to low-skilled and unskilled labour by ‘eliminating many jobs through automation or upgrading the skill level required to attain or keep those jobs’.
  • This phenomena have been proved by a research made by OECD in 2011, where shows that technological advantages have contributed to the rise of inequality in his member’s states over the last 25 years. Despite a large rise in the supply of highly educated labour, also emerging economies shows a similar trend of an increasing gap between high- and low-skilled workers.
  • Trade globalization. Despite trade has extremely high benefits and is a crucial engine for growth in many countries, nonetheless, is one of the main drivers of inequality. In fact, firms and MNSs in advanced economies highly adopt laboursaving policies and offshoring or outsourcing production that lead to a decline in manufacturing and raise skill premium with the consequences of reducing wages of unskilled labour in advanced countries.
  • Financial globalization. Financial globalization can ‘facilitate efficient international allocation of capital and promote international risk sharing’. At the same time, increased financial flows, particularly foreign direct investment (FDI) increase income inequality in both advanced and emerging market economies. One potential explanation is the concentration of foreign investments in sectors with higher skills and technology that increase the demand of workers with higher skills.
  • Redistributive policies. Despite governments in developed countries have used effective policies to reduce the inequality gap (taxing the richest and increasing retirement benefits). Anyway, the OECD data shows that income inequality gap between its members are widening. Cause of a declined taxation system with the results that corporations and households have a lower taxation.

Consequences: Why would widening disparities matter for growth?

Inequality affects growth drivers. J.Stiglitz believes that higher inequality lowers growth by depriving the ability of lower-income households to stay healthy and accumulate physical and human capital. For instance, it can lead to underinvestment in education as poor children end up in lower-quality schools and are less able to go on to college. As a result, labour productivity could be lower than it would have been in a more equitable world.

While, M. Corak finds that countries with higher levels of income inequality tend to have lower levels of mobility between generations, with parent’s earnings being a more important determinant of children’s earnings. Widening income disparities can depress skills development among individuals with poorer parental education background, both in terms of the quantity of education attained (for example, years of schooling) and its quality (that is, skill proficiency). While educational outcomes of individuals from richer backgrounds are not affected by inequality. “It’s not just about a wealth gap but also an opportunity gap. The issue is a global emergency.” Inequality leads to weak aggregate demand. The reason is easy to understand: “those at the bottom spend a larger fraction of their income than those at the top”.

Inequality of outcomes is associated with inequality of opportunity. When those at the bottom of the income distribution are at great risk of not living up to their potential, the economy pays a price not only with weaker demand today, but also with lower growth in the future. Every country’s long-term prospects are being put into jeopardy. Societies with greater inequality are less likely to make public investments, which enhance productivity, such as, in public transportation, infrastructure, technology and education. According to the IMF, inequalities will increase the possibility to have new financial crises, global imbalances and conflicts. Moreover, lead to policies that hurt growth and hampers poverty reduction.

  • Financial crises. A growing number of evidence suggests that rising influence of the rich and stagnant incomes of the poor and middle class have a causal effect on crises, and thus directly hurt short- and long-term growth. In particular, studies have argued that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation in mortgage-underwriting standards, and allowing lobbyists to push for financial deregulation.
  • Global imbalances. Higher top income shares coupled with financial liberalization, which itself could be a policy response to rising income inequality, are associated with substantially larger external deficits. These large global imbalances can be challenging for macroeconomic and financial stability.
  • Conflicts. Extreme inequality may damage trust and social cohesion and create conflicts discouraging investment. Conflicts are particularly prevalent where inequality makes resolving disputes more difficult. ‘More broadly, inequality affects the economics of conflict, as it may intensify the grievances felt by certain groups or can reduce the opportunity costs of initiating and joining a violent conflict’.
  • Inequality can lead to policies that hurt growth. In addition to affecting growth drivers, inequality could result in poor public policy choices.
  • Inequality hampers poverty reduction. “Income inequality affects the pace at which growth enables poverty reduction.” Growth is less efficient in lowering poverty in countries with high initial levels of inequality or in which the distributional pattern of growth favours the non-poor. Moreover, higher inequality makes a greater proportion of the population vulnerable to poverty.

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The IMF and many economists find the keys of inequality reduction in many factors. First of all is education. It can play an important role in reducing income inequality, as it determines occupational choice, access to jobs, and the level of pay, and plays a pivotal role as a signal of ability and productivity in the job market. From a theoretical perspective, the human capital model of income suggests that while there is an unambiguously positive association between educational and income inequality, the effect of increased educational attainment on income inequality could be either positive or negative depending on the evolution of rates of return to education (that is, the skill premium). Moreover, there can be opposing forces at play stemming from “composition” (that is, increasing the share of high-wage earners) and “wage compression” (that is, decline in the returns to higher education relative to lower levels) effects. Overall, the evidence suggests that the inequality impact of education depends on various factors, such as the size of education investments by individuals and governments and the rate of return on these investments. It is in this spirit that Raghuram Rajan notes “prosperity seems increasingly unreachable for many, because a good education, which seems to be today’s passport to riches, is unaffordable for many in the middle class.” J. Stiglitz finds in: taxation and macroeconomic policies and higher public investment the factors that could make inroads in the high level of inequality which now exists.

Taxation policies. The government of many countries can tax the income of the rich, and use the funds to finance either private or public investment; such policies reduce inequalities in consumption and disposable income, and lead to increased national savings.

Macroeconomic policies are needed that maintain economic stability and full employment. High unemployment most severely penalises those at the bottom and the middle of the income distribution. Today, workers are suffering high unemployment, weak wages and cutbacks in public services, as government revenues are less than they would be if economies were functioning well.

Higher public investment in infrastructures, technology and education would both revive demand and alleviate inequality, and this would boost growth in the long-run and in the short-run. According to a recent empirical study by the IMF, well-designed public infrastructure investment raises output both in the short and long term, especially when the economy is operating below potential. And it doesn’t need to increase public debt in terms of GDP: well-implemented infrastructure projects would pay for themselves, as the increase in income would more than offset the increase in spending. In most developed countries, public investments could be financed through fair and full taxation of capital income. So that those capitalists who save much of their income won’t see their wealth accumulate at a faster pace than the growth of the overall economy, resulting in growing inequality of wealth.

The IMF believes that tackling inequality is not only a moral imperative. It is critical for sustaining growth. They studied the economic impact of inequality since the late 1980s, since then, the IMF has conducted three waves of pilot studies on inequality topics in 43 countries around the world. From this studies they found their best policies against inequality.

Calibrating Fiscal Policies. As a government’s primary mechanism for redistributing income across populations, fiscal policies are key to addressing inequality issues. Recent work in Costa Rica, Guatemala, Honduras, and Togo focused on related topics.

Protecting Social Spending and Increasing its Effectiveness. Reallocating resources away from ineffective spending programs, such as on fossil fuel subsidies, to effective social spending programs such as cash transfers, can strengthen social assistance, and help counteract the negative impact sometimes associated with needed economic reforms. In Brazil, an IMF study of regional inequality documented the positive contribution of redistributive policies, namely the Bolsa Família program, to the decline in inequality. In Pakistan, IMF policy recommendations included increasing safety-net spending and consolidating some of the smaller, less efficient safety net programs into the well-performing Benazir Income Support Program. The IMF has also been working with countries to protect social spending—especially in health and education—and since 2010, minimum social spending levels have been included in virtually all low-income country programs.

Balancing Labor Market Policies. Work by the IMF staff reveals how differences between formal and informal workers in Colombia, ethnic and religious communities in Israel, regions in Brazil and Slovakia, and between workers in the United States, all contribute to income inequalities. In Poland, IMF staff advocated for policies that support structural transformation in the less developed eastern regions to reduce regional disparities and promote inclusive growth. A further study in 2015 focused on the relationship between labor market institutions and the distribution of incomes in advanced economies.

Managing Commodity Boom and Bust Cycles. Lower commodity prices threaten to reverse reductions in inequality and poverty in Bolivia, following a period of increased public spending funded by the last commodity boom. IMF staff developed a model to help the authorities analyze the driving forces behind the reduction of inequality and poverty, and determine which policies would best help retain these gains, while conducting needed fiscal consolidation.

Promoting Financial Inclusion. Limited access to financial services in rural areas of Ethiopia and Myanmar compounded issues of inequality following financial sector reforms. A recent IMF study looked at how countries can deploy complementary policies to offset any unfavorable consequences for inequality of pro-growth reforms in low-income developing countries.

Conclusion

The extent of inequality, its drivers, and what to do about it have become some of the most hotly debated issues by policymakers and researchers alike. In general, inequality is heavily influenced by many institutional and political factors, industrial relations, labour market institutions, welfare and tax systems, for example, which can both work independently of productivity and affect productivity.Inequality dampens investment, and hence growth, by fueling economic, financial, and political instability.

The evidence is that institutions do matter. Not only can the effect of institutions be analysed, but institutions can themselves often be explained, sometimes by history, sometimes by power relations and sometimes by economic forces left out of the standard analysis. Thus, a major thrust of modern economics is to understand the role of institutions in creating and shaping markets. The question then is: what is the relative role and importance of these alternative hypotheses? There is no easy way of providing a neat quantitative answer, but recent events and studies have lent persuasive weight to theories putting greater focus on rent-seeking and exploitation. A wide range of policies can help reduce inequality. Policies should be aimed at reducing inequalities both in market income and in the post-tax and-transfer incomes. The regulations of governments play a large role in determining market distribution in preventing discrimination, in creating bargaining rights for workers, in curbing monopolies and the powers of CEOs to exploit firms’ other stakeholders and the financial sector to exploit the rest of society. In most of the countries this rules have to be rewritten to reduce inequality and strengthen the economy.

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