Warning! Inequality May Be Hazardous to Your Growth

By Andrew G. Berg and Jonathan D. Ostry

Many of us have been struck by the huge increase in income inequality in the United States in the past thirty years. The rich have gotten much richer, while just about everyone else has had very modest income growth.

Some dismiss inequality and focus instead on overall growth—arguing, in effect, that a rising tide lifts all boats. But assume we have a thousand boats representing all the households in the United States, with boat length proportional to family income. In the late 1970s, the average boat was a 12 foot canoe and the biggest yacht was 250 feet long. Thirty years later, the average boat is a slightly roomier 15 footer, while the biggest yacht, at over 1100 feet, would dwarf the Titanic! When a handful of yachts become ocean liners while the rest remain lowly canoes, something is seriously amiss.  

In fact, inequality matters. And it matters in all corners of the globe. You need look no further than the role it might have played in the historic transformation underway in the Middle East.

The increase in U.S. income inequality in recent decades is strikingly similar to the increase in the 1920s. In both cases there was a boom in the financial sector, poor people borrowed a lot, and it all ended in huge financial crises. Did the recent financial crisis result somehow from the increase in inequality?

Some time ago, we became interested in long periods of high growth (“growth spells”) and what keeps them going. The initial thought was that sometimes crises happen when a “growth spell” comes to an end, as perhaps occurred with Japan in the 1990s.

We approached the problem as a medical researcher might think of life expectancy, looking at age, weight, gender, smoking habits, etc. We do something similar, looking for what might bring long “growth spells” to an end by focusing on factors like political institutions, health and education, macroeconomic instability, debt, trade openness, and so on.

Somewhat to our surprise, income inequality stood out in our analysis as a key driver of the duration of “growth spells”.

We found that high “growth spells” were much more likely to end in countries with less equal income distributions. The effect is large. For example, we estimate that closing, say, half the inequality gap between Latin America and emerging Asia would more than double the expected duration of a “growth spell”. Inequality seemed to make a big difference almost no matter what other variables were in the model or exactly how we defined a “growth spell”. Inequality is of course not the only thing that matters but, from our analysis, it clearly belongs in the “pantheon” of well-established growth factors such as the quality of political institutions or trade openness.

While income distribution within a given country is pretty stable most of the time, it sometimes moves a lot. In addition to the United States in recent decades, we’ve also seen changes in China and many other countries. Brazil reduced inequality significantly from the early 1990s through a focused set of transfer programs that have become a model for many around the world. A reduction of the magnitude achieved by Brazil could—albeit with uncertainty about the precise effect—increase the expected length of a typical “growth spell” by about 50 percent.

The upshot? It is a big mistake to separate analyses of growth and income distribution. A rising tide is still critical to lifting all boats. The implication of our analysis is that helping to raise the lowest boats may actually help to keep the tide rising!

The immediate role for policy, however, is less clear. More inequality may shorten growth duration, but poorly designed efforts to reduce inequality could be counterproductive. If these distort incentives and thereby undermine growth, they can do more harm than good to the poor.

Still, there may be some “win-win” policies, such as better-targeted subsidies, better access to education for the poor that improves equality of economic opportunity, and active labor market measures that promote employment.

When there are short-run trade-offs between the effects of policies on growth and income distribution, the evidence in our paper doesn’t in itself say what to do. But our analysis should tilt the balance towards the long-run benefits—including for growth—of reducing inequality. Over longer horizons, reduced inequality and sustained growth may be two sides of the same coin.

Stepping further back, all this reminds us of the 1980s debt crises and the resulting “lost decade” of slow growth and painful adjustment. That experience brought home the fact that sustainable economic reform is possible only when the benefits are widely shared. In the face of the current global economic turmoil and the need for difficult economic adjustment and reform in many countries, it would be better if these old lessons could be remembered rather than relearned.

42 Responses

  1. The comment about the “increase in U.S. income inequality in recent decades [being] strikingly similar to the increase in the 1920s.” is an error that arises from comparing two extremely different time series from Piketty and Saez. The prewar series is based on personal income. Total income,– the denominator of top 1% income shares –has been a rapidly shrinking share of personal income in recent decades because Piketty and Saez exclude ALL transfer payments (which were about zero in 1928). If 1928 and 2012 top incomes were both expressed as a share of personal income, the alleged similarity is clearly invalid..

  2. ‘The implication of our analysis is that helping to raise the lowest boats may actually help to keep the tide rising!’ -seems to contradict Kinsley below.

    “Assume people have earned their wealth if their contribution to society outweighs the contribution to their own pocketbook” – Michael Kinsley.

    Considering the power of lobbyists when it has come to setting tax policy, saying markets set fair wages and fair tax policies when left alone ignores WHY there is such high inequality in the US and why there will be higher rates of inequality as the housing market recovers.

    “Over the last 30 years taxes on the top margin and the über rich have dropped 50%. At the same time, income for the top marginal rates have gone up over 300 %. Ultra rich have seen their incomes go higher. While income for the working poor and middle class have gone up less than the rate of inflation.”

    Source: http://www.economynews.us/ayn-rand-approves-of-mitt-romneys-message-implies-author-edward-conrad/

  3. [...] new jobs, but increasing workers’ bargaining power might actually help to generate recovery. The International Monetary Fund – hardly a hotbed of lefties – has made a link between widening income inequality and [...]

  4. [...] new jobs, but increasing workers’ bargaining power might actually help to generate recovery. The International Monetary Fund – hardly a hotbed of lefties – has made a link between widening income inequality and [...]

  5. [...] recently came across IMF research (also here) testing whether income inequality negatively affects growth spells (periods of growth lasting at [...]

  6. [...] seeming to keep their hosts alive, has played havoc with the rest of us. Even the OECD and the IMF now seem to recognize to some degree that growing inequality of income (and between sectors of the [...]

  7. Dear Mr. Regulator,

    My bank charges me more because they perceive me as more risky, and I get it, can´t do a lot about that!

    My bank lends me less because they perceive me as more risky, and I also get it, can´t do a lot about that either!

    My bank lends me on shorter and tighter terms because they perceive me as more risky, c´est la vie, that´s life, got to accept it!

    But now my banker tells me I must pay him even more in interest to provide him with a competitive return on his equity, only because you, the regulator, authorized him to lend to those perceived as not-risky holding much less equity than when he lends to me.

    Is he right, and if so, why would you do a stupid thing like that? Why am I discriminated against and not given the same opportunity to earn him a good return on his equity?

    Honestly, I just don´t get it, as far as I know there has never been a bank crisis because bankers have lent too much to guys like me perceived as risky.

    Please?

    Sincerely,

    Your slightly risky but extremely helpful small businessman neighbor, and who, by the way, is trying hard to secure a future job for your grandchildren.

    Per

  8. nice job dad

    • Yes, it’s a nice job when the IMF releases a report telling us that inequality, while at first necessary to stimulate economic development, eventually limits it. Does that limitation occur when the offence to our basis senses of justice of inequality becomes too great?

      In the mid 18th Century, Adam Smith commented, in his “Theory of Moral Sentiment’, to the effect that moral sentiment is corrupted when we admire the rich and the great more than the wise and the virtuous. To me this suggests the mechanism by which inequality eventually limits economic development: the myopia of misconception and dishonesty that are the feedstuffs of unequal economic booms eventually become recognized and trigger their busts.

      The busts do seem to diminish inequality. But at what cost — to human misery and environmental degradation?

      What can IMF people do to help the wise and the virtuous become heard and recognized above the recklessly garrulous self-approbation of the rich and the great? What are the mechanisms of wise and virtuous economic development — development that doesn’t foul the environmental nest in which we all live and doesn’t corrupt our moral sentiments?

      • Angus, I agree of course on the “dangers arising from admiring the rich and the great more than the wise and the virtuous,” but that does not necessarily mean we can be sure about who were, and are, the wise and virtuous. Let me remind you that in that list, not long ago most probably, no, most certainly, the IMF would have included, very prominently, the Basel bank regulators.

  9. [...] the International Monetary Fund (IMF) recently posted on its official blog a story called "Warning! Inequality May be Hazardous to Your Growth" which states: Many of us have been struck by the huge increase in income inequality in the [...]

  10. I’m a little worried about the choice of model used in this duration analysis, particularly two things.

    1. Endogeneity seems to be assumed away. I’d try explicitly modeling for it.

    2. Unobserved heterogeneity nearly always exists and in duration models results in biased estimates. I recommend reading Heckman and Singer (1984) for a discussion of the issue.

    I’m a lowly grad student so take my comments with a grain of salt, but if you happen to know any duration model gurus (like Gerald van den Berg), you may want to consider running these issues by them. Stephen Jenkins is also good with duration modeling and has an interest in inequality and income distribution, so he may be a good person to contact as well.

  11. [...] same size of the pie. Which is obviously not the case. Growth with inequality, while still growth, is counterproductive to sustained growth. Japan and countries like South Korea, Taiwan, Singapore and Hong Kong all had growth with greater [...]

  12. [...] research shows that inequality can be counterproductive to sustaining longer-term growth. So, in increasingly turbulent global economic times, this gives added importance to promoting [...]

  13. [...] same size of the pie. Which is obviously not the case. Growth with inequality, while still growth, is counterproductive to sustained growth. Japan and countries like South Korea, Taiwan, Singapore and Hong Kong all had growth with greater [...]

  14. [...] But what’s wrong with inequality—really? The simple answer is that, as the middle and lower fifths of households share less and less of aggregate income, they lose the ability to buy goods and services at a rate that sustains economic growth. They are, after all, the majority of the population, and unless that majority is active in the economy, sooner or later it will fall into recession, long-term stagnation, or worse. Two IMF economists, Andrew Berg and Jonathan Ostry, have published a paper, “Inequality and Unsustainable Growth: Two Sides of the Same Coin?” (April, 2011), in which they argue that long-term growth and serious inequality do not mix well. They discuss their findings on the IMF blog: [...]

    • I ran a business for 20 years that was ultimately put out of business by people cheating the system and paying cash and avoiding taxes, insurances etc……but it is painfully obvious to me that what sustains any market is consumers with disposable cash to buy more than just the bare necessities. Hiring people who just barely get by puts the little funds they have into a distinct few hands. Assuming their boss makes a healthy profit still puts those funds from that operation into one set of hands, limiting anyone else in the market’s customer base. There are no such things as “job creators,” except for consumers with spendable incomes. No matter what you make or sell, if there is no one there to buy it, you’re out of business.

  15. [...] en LyD, “atentar contra el crecimiento y el desarrollo”. Por estos días, hasta en el Fondo Monetario Internacional están dispuestos a mirar la evidencia y cuestionar los dogmas del manual del curso de Economía I. [...]

  16. All of you fervent activists against (manmade) inequality… let me ask you a simple question.

    Current bank regulations have as a fundamental principle that of allowing the banks to hold much less capital when lending to those who are triple-A rated, than when lending to the small businesses and entrepreneurs who cannot even afford a rating, and who are anyhow paying higher interest rates.

    Do you believe this will increase or decrease inequality?

    • Your use of the word “inequality” is entirely appropriate in this context. Yet I wonder if sometimes we use this word when actually we would be clearer if we used the word “inequity”. It is inequitable that money is so easily available under the policies of the US and UK central banking authorities of quantitative easing because QE’s beneficiaries are people and/or organizations who have spare slugs of money to park and yet are choosing to use them to speculate in energy, agricultural products, housing/land, and rare metals, where they are causing price inflation that is painful to low-income people trying to buy the household essentials of food and fuel. See, for example:

      http://www.authentixcoaches.com/images/QE_Effect_on_Commodity_Prices_1104053.jpg

      The purpose of QE was ostensibly to prevent deflation and the job losses that would result from a deflationary spiral. Yet QE has been sadly under-effective in this objective, not because it has not be repairing the bank balance sheets that had tanked as a consequence of the financial sector’s own folly, incompetence, or dishonesty, or a combination of all three but because the central bank authorities have not been acknowledging the inequity of giving banks unequal access to the largesse of central banks’ QE policies.

      Basel III exacerbate this, as you have rightly said many times in many places and nowhere more consistently and cogently than in this forum. But until financial thinkers factor in the psychological concept of “birds of a feather flock together” and acknowledge how extremely dysfunctional and inequitable this psychological trait of ordinary human beings is in the financial sector, financial markets and the tools that the good people at the IMF advocate for regulating them, will continue to produce misery.

      Fortunately some intelligent departures from the current orthodoxy of devotion to the “free-market god of financial/economic simpletons” are introduced by creative and courageous people (outside the financial-political elite?) can deliver us from such evil. For example, capital controls, which Brazil has called for and to which Mr. Strauss-Kahn has given conditional blessing, are an obvious direction for the Fed and Bank of England to consider, along with a means to discriminate between speculation and investment.

  17. I hope the IMF considered the possibility of a spurious relationship between the two variables in question. It seems more likely that some third variable is related to both the shorter duration of growth and the inequality. There is no theoretical reason that I am aware of to suspect that economic inequality would affect economic growth.

    In a free market, compensation is a function of implicit bidding that goes on over a scarce resource, labor. The amount that a firm can afford to bid for a particular unit of labor is directly related to the relative value society places on a firm’s product, and therefore its use of the scarce resources for which it bids. If a firm miscalculates the relative value of a particular unit of labor in a particular pursuit, the profit/loss mechanism will discipline the firm. Therefore, in a free market system, compensation must necessarily be based on the value that an individual adds to the economy.

    There is no way, a priori, to determine that the ideal income distribution should look like. It depends on the distribution, relative scarcity and relative demand for various skills and abilities within the population. The ONLY way to measure this effectively is through a free market with private property, prices, and profits/losses (which are in essence the institutional components of a gigantic economic supercomputer.) It is, therefore, silliness to make normative pronouncements about income distribution within an economy.

    Silliness, that is, unless somewhat or something is monkeying with free market forces. It could be individual market participants who are manipulating the rules. A far more plausible explanation is that a far larger and more causally adequate entity, government, is toying around. Only a government can reward economic activity irrespective of the value it actually adds to the economy and therefore only a government can artificially distort the distribution of incomes in an economy.

    Of course, if you are ideologically predisposed to think that compensation should be based on intensity of labor or somesuch vague notion, then the above discussion will be completely meaningless to you. But I would suggest that it is long past time to put more faith in the albeit imperfect free market system. Like Democracy, it is the worst form of economic organization, except all other forms of economic organization that have been tried from time to time.

    • Daniel wrote: “But I would suggest that it is long past time to put more faith in the albeit imperfect free market system.”

      For over a decade the chief of the Federal Reserve put his faith in free markets. In testimony to Congress, he expressed himself surprised at the antics that market participants got themselves into after he and his fellow free-marketeers relaxed controls on credit markets.

      Has Daniel ever heard of psychology? Has he ever read a book on, for example, behavioural economics?

      The jungle is a free market system. Human animals left the jungle at least 500 generations ago. For good reason. But if Daniel is unconvinced of that, then he can challenge that any controls on free markets are necessary by volunteering to go and live in a pristine jungle for 12 months and, if he survives, to report back to us in this thread. Then we’ll know whether his post was authentic or merely the presumption of someone who finds the simplicity of free-market economics intellectually simple enough for him personally to grasp intellectually.

      • Asolutely! One could add that most (especially business-) economics are based on the axiom that people act rationally. But they don’t. And this is, why these models can’t demonstrate what is going on.

  18. Será que a política de “desigualdade social” aplicada no Brasil no ultimo governo, foi realmente eficaz. Os índices de pobreza diminuíram , mas o preço foi muito grande e sem uma melhor na Vida de milhões de pessoas. Os investimentos por outro lado diminuíram bastante na área de infra estrutura, esgoto sanitário, água, educação, creches. Se compra uma TV nova e é comum ver seus filhos brincando à beira de um esgoto aberto.Será que isso e realmente progresso.

  19. The rich have gotten much richer while just about everyone else has had very modest income growth. Some dismiss inequality and focus instead on overall growth — arguing in effect that a rising tide lifts all boats. Did the recent financial crisis result somehow from the increase in inequality? Some time ago we became interested in long periods of high growth growth spells and what keeps them going. The initial thought was that sometimes crises happen when a growth spell comes to an end as perhaps occurred with Japan in the 1990s.We approached the problem as a medical researcher might think of life expectancy looking at age, weight, gender, smoking habits etc.

  20. [...] distribuirea cât mai echitabilă a veniturilor. Nu o spun doar eu. O fac şi analiştii FMI, care stabilesc o legatura de cauzalitate intre durata de crestere economica si inegalitatea veniturilor. Andrew G. Berg, Assistant Director si Jonathan D. Ostry, Deputy Director in cadrul Departamentului [...]

  21. [...] authors in the IMF blog have more [...]

  22. The problem is the rich capturing a nominally democratic government, and using that government to transfer wealth upward, destroying the middle class of that country and the market naturally provided by them, and destroying any lasting prospects for growth.
    See, for example:
    http://sociology.ucsc.edu/whorulesamerica/power/is_our_tax_system_helping_us_create_wealth.pdf

  23. [...] If you would prefer a non-technical blog post by the authors of the paper/note, then have a look at this post on IMFDirect. [...]

  24. [...] Warning! Inequality May Be Hazardous to Your Growth [...]

  25. [...] any one unless they back it up with numbers. This time, I’m going to direct you to a study by the International Monetary Fund (IMF).  Just in case you don’t already know, the IMF  is not….  They’ve been soundly criticized by developing nations for exporting American-style [...]

  26. [...] any one unless they back it up with numbers. This time, I’m going to direct you to a study by the International Monetary Fund (IMF).  Just in case you don’t already know, the IMF  is not….  They’ve been soundly criticized by developing nations for exporting American-style [...]

  27. [...] a new study by the International Monetary Fund has found that higher rates of income inequality are strongly [...]

  28. [...] INTERESTING IMF analysis finds that growth spells tend to last longer in places with relatively low levels of income [...]

  29. From India’s reform experience, there is a debate raging on as to how to ensure effects of good growth percolating down into the bottom of the pyramid. Sustained high growth for long years without ensuring delivery of services and subsidies to those who deserve to be lifted from the choppy waters of existence is a daunting challenge the reformist-minded Congress party as a major partner in coalition government is facing now. It is yet to grapple with it, though it has been in power for the second five-year term uninterruptedly since 2004. All its steps to bring inclusive growth have not yielded the desired or desirable results since most of the intended benefits are not well targeted with the delivery mechanism woefully short of delivering to the right people. In a country where freebies are wasted due to shortcomings in the systems, it is time India took a few germane lessons in right earnest from Brazil to help ameliorate the dismal lot of its legions of the poorest of poor people across the country.

  30. [...] Now, thanks to Mark Thoma’s economist’s view blogsite, a study by two International Monetary Fund economists finds that widening income disparity appears to shorten periods of growth.   If during growth periods income gains unfairly or disproportionately fall to just a few, then those periods of growth come to an end more quickly.  Below is the article. [...]

  31. [...] Inequality and economic growth – IMF blog [...]

  32. [...] me of the inequality curve: Warning! Inequality May Be Hazardous to Your Growth, by Andrew G. Berg and Jonathan D. Ostry: Many of us have been struck by the huge increase in income inequality in the United States in the [...]

  33. Finally, the IMF is beginning to recognise the trends and real causes for social instability.

    For stable, sustainable growth (and societies) look no further than the economies of Scandinavia and some parts of Europe.

    As far as the lack of direction of fiscal policies required, it is not that the IMF is too ignorant to know what needs to be done but that it is too scared of saying them out loud.

  34. The more natural inequalities produces inequalities, the better for most, the more manmade inequalities produces inequalities, the worse for most.

    And don’t tell me you do not know the difference between natural inequality and manmade inequality.

    Natural inequality is what allows a Bill Gates and friends to come up with a Microsoft. Manmade inequalities are the patents awarded to a Bill Gates and friends, and which the society defends at its own costs.

    Manmade inequality is also like when the regulators order that lending to those who already are naturally charged lower interest rates, because they are perceived as less risky, should also benefit from generating lower capital requirements for the banks, because they are perceived as less risky.

    • Thanks, Per. The distinction you have introduced to this discussion — between man-made and natural inequality — is worth exploring more deeply in my opinion.

      Most people accept that some inequality is necessary and inoffensive. The “America of 1830″ described by Alexis de Toqueville and Gustave de Beaumont (both highly intelligent and inquisitive French lawyers from seemingly highly functional families) appears to have been, at least according to their eyes, almost perfectly OK with the inequality then existing.

      Today, when people in the advanced world and now much of the emerging economies are much better off than in 1830, it’s the equity of the inequality that is always in angered question. Few people, including this writer (and I gather also, from his interview with Stern, the IMF’s Managing Director), can credit that the compensation of the outstandingly highly paid is anything but a rip-off and that view not only triggers analyses to test the rationality of the inequity. It also triggers the imagination, articulation, and propagation of conspiracy theories that eat at the potential for coherence in the society viewing the outstanding compensation differences. One is tempted to think the theories and the emotions and eruptions of violence could become as bad as they did in India in the months after its modern birth and partition in 1947.

      In a future society people might well learn to assess and value the equality of different people’s emotional experience (which seems to me to be true equity — as distinct from legal equity). Then the need for capital to bridge the gaps of uncertainty as natural changes occur and innovations are tried would become far less than it has become today.

      In such a society one might even visualize a placard by Basel citizens that reads: “Go home BIS. The Basel framework at whose altar we once worhshipped is no longer needed!”. Was Basel onced spelled Baal?

  35. It’s not inequality that matters. It’s the level of the lower classes that matters. For instance, you can reduce inequality by taking away most of the money the wealthy have. This would do nothing for the poor however.

    The better way is not to worry about how much the rich have, but rather, worry about how little the poor have.

    That is why limits on deficit spending are so misguided, because such limits always impact the poor more than the rich.

    The problem isn’t inequality; the problem is the poor.

    Rodger Malcolm Mitchell

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 742 other followers

%d bloggers like this: