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This article aims to understand the relationship between inequality and growth better. In 1975 an American economist, Arthur Okun, stated that there was a trade-off between equality and efficiency.
Inequality is undoubtedly important, as, otherwise, the lure of large financial rewards, innovation and risky entrepreneurship would cease to exist. Nevertheless, inequality could hinder growth if “those with low incomes suffer poor health and low productivity as a result… [as well as threatening] public confidence in boosting policies like free trade”, according to the article. Government responses to inequality can also create a crisis; according to a 2010 book written by Raghuram Rajan, the Governor of the Reserve Bank of India (RBI), governments often respond to inequality by “easing the flow of credits to poorer households”. More about why this creates a crisis is explained in "Context".
Finding the exact relationship between inequality and growth can be challenging. While some studies suggest that inequality is just mildly bad for growth, others suggest that the nature of the relationship changes as poorer countries become richer. Still others say that, rather than the level of inequality, it is the trend in inequality that matters.
A research paper by IMF economists Messrs Andrew Berg and Jonathan Ostry in 2011 shows that perhaps it is the duration of growth spells that will give us the answer to the link between inequality and growth. They reckon that sustaining a growth spell is much harder than getting an economy growing. They also suggest that, according to the article, “when growth falters, inequality is often a culprit”.
Still others say that inequality is not a culprit but rather governments that tax and spend to try and reduce it. In another paper, Messrs Berg, Ostry and Charlambos Tsangarides analyse the separate effects of inequality and redistribution. They gather data about market income and net income in 173 economies. It is shown that in economies that redistribute heavily, their Gini coefficient is cut substantially. In economies that do not redistribute heavily, their Gini coefficient is cut considerably less. The paper shows that governments of more unequal countries redistribute more, and rich economies redistribute more than poor ones do.
While spreading wealth does not carry growth penalties – growth in income per person is not considerably less in countries with more redistribution – Messrs Berg, Ostry and Tsangarides suggest that redistribution may lead to shorter growth spells.
Inequality has more of a correlation with low growth, i.e. the higher the Gini coefficient, the lower the average annual growth. Therefore, redistribution that reduces inequality may boost growth.
Perhaps, the lesson to be learned is that reckless redistribution may harm growth, but sensible redistribution may help.
On the chart labelled “A little off the top”, there are two words in the legend: net income and market income. Net income is income after tax and transfers. To see a precise definition of market income, read the glossary in this S&P article, which I will be analyzing in a blog post soon.
1. In the third paragraph, the author states how “governments often respond to inequality by easing the flow of credit to poorer households. When the borrowing binge ends everyone suffers.” In fact, this is one of the main reasons for the 2008 financial crisis that stemmed from the US. On this note, it is worth mentioning that allowing sub-prime lending (easing the flow of credit to poorer households) is actually a means of redistribution by the government.
2. To read the IMF paper by Messrs Berg, Ostry and Tsangarides, click here.
3. Arthur Okun, quoted in this article, is well known for Okun’s Law, which details the relationship between a country’s unemployment and production. The relationship he observed is inversely proportional: increases in unemployment lead to decreases in production. To read more about this on Investopedia, click here.