Should we worry about inequality?

In my lasts posts I have tried to explain how Governments have been applying wrong policies in order to tackle the New Great Depression that we are living. But in this post I will not be covering this topic, not as main point at least, in this case I will try to show if do we have to worry about growing inequality.

In the wake of the financial crisis, many economists and political experts, especially this last group not difficult to guess why, are arguing that growing inequality threatens growth. This analysis has been shown in the last report of the World Bank; Inequality in Focus released this April 2012, which shows that in the last few years inequality had worriedly grown. In this point one may argue that this is just a result of the financial crisis so when global economy surpass this stage things will restore normalcy, but this approach will be completely wrong as inequality have been growing since the last 20 years. The best indicator to bring numbers to the table in this field it is the Gini index, which measures income distribution inside different societies; the index is based in a number from 0 to 100, 0 means that income is perfectly distribute and 100 completely the opposite so that one person captures all the income.

The results of this table, extracted from the research work done by Ortiz and Cummins, prove the conclusion that growing Inequality is not a fact that we can directly link to the Financial crisis since it has been grown substantially before the crisis, for example Inequality during the period from 1990 to 2000 has grown more than in the period comprised between 2000 to 2008.

To further demonstrate the evidence that income inequality had been growing since the last quarter of the XXth century and the begging of the XXIth I am using another graphical support. In this case, the graph shows the share of income that the people on the top 1% and the top 0.1% are getting from 1918 to 2010 in the USA.

As we can appreciate in the graph, since 1970 the share of total income held by the top 1% earners have risen from 10% to almost a 20%. This tend has not happened in any other moment of time shown in the graph; using as reference the same temporal fraction that in the example cited previously (40 years).

At this point, where growing Inequality has been consistently proved, the next question will have to be if we have to worry about it or it is just a phenomenon that it is normal in growing economies.

In one side you might find the typical arguments embraced by most of the left wing political parties stating that when economy growth but inequality also grow, the richer are capturing all this growth, so that the lower classes are getting even poorer and obviously this will hurt growth in the long run because it will reduce economic mobility, meaning that the lower classes will not be able to catch up the higher ones. And this is going to happen from their point of view because this inequality will reduce workers motivation and effort and as consequence it will lower productivity. For them, it will also reduce high school education between lower classes (reasoning mostly applicable in countries where education is really expensive such USA or UK), as they will need big loans in order to afford their college education with all the negative effects this will suppose as we will be loosing a lot of talent, that of course, it is out there.

These arguments may sound plausible but in fact they lack a crucial fact, which are figures. These statements are as easy to say as the ones made by the other side. Stating that growing inequality is positive because it rightly allocates the incentives as people know that only by working much harder and taking more risks maybe there will be able to reach the top income earners; the self-made argument basically. Another argument it is that growth brings more inequality because it is a natural effect, people who are rich get richer in a faster path than poor people start being less poor, so in the long run the whole population will be in a better situation.

So at the end, do we have to worry about inequality or not? Clear empirical evidence in this economic field has not even been reach but the answer might be yes but not for what most people tend to think that inequality is bad. The problem has nothing to do with the fact that inequality allocates wrong incentives regarding work effort and productivity or that reduces growth because high income earners consume less than middle classes and they save more and consequently it reduces the overall growth (Spain can be used as a powerful example that saving is necessary). The main problem with inequality according to the research done by Berg and Ostry in this paper is that inequality is a main driver of economic growth in the long term, or at least we can say that higher inequality is associated with lower periods of growth. The main explanation given by the authors of the paper is that more equal societies have more stable and efficient governments that when a shock affects the normal trend of economy, which is growth, they can react faster and better with the positive effects this usually have for the economy. As the authors say in the paper: “growth is easy to start but hard to keep going”, and to keep going inequality is not a positive a fact. In this last graphical support we can appreciate how the duration of growth is reduced as inequality rises.

In a future post I will be talking about the main drivers of economical growth in the long run, but I would like to advance that have nothing to do with running a big amount of deficit, tax loopholes or over regulating the labor market.

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