The IMF Talks Inequality

The September 2011 issue of the IMF’s Finance and Development magazine takes a look at global income inequality (from the Editorial; link to the table of contents at the end of this post):

Haves and Have Less

WE used to think that overall economic growth would pull everyone up. While the rich might be getting richer, everyone would benefit and would see higher living standards. That was the unspoken bargain of the market system.

But now research is showing that, in many countries, inequality is on the rise and the gap between the rich and the poor is widening, particularly over the past quarter-century.

With taxpayers forced to pay for troubles in the financial industry in advanced economies during the global economic crisis, this discrepancy seems particularly galling to wage-earners who have seen their pay stagnate or worse. Inequality has started to attract more research by economists.

This issue of Finance & Development looks at income inequality around the world and how it matters.

The world has seen an unprecedented era of economic growth over the past decades, which has made people better off, on average. But overall the rich have done much better than the poor. According to the Organization for Economic Cooperation and Development (OECD), growing inequality breeds social resentment and generates political instability. It also fuels populist, protectionist, and anti-globalization sentiments. “People will no longer support open trade and free markets if they feel that they are losing out while a small group of winners is getting richer and richer,” says Angel Gurría, the OECD Secretary-General.

According to Branko Milanovic, a lead economist at the World Bank who wrote our cover article, the global economic crisis may have narrowed global inequality somewhat between people around the world because most emerging and developing economies continued to maintain strong growth.

IMF economists Andrew Berg and Jonathan Ostry say that inequality is counterproductive. In fact, a more equal society has a greater likelihood of sustaining longer-term growth. A good snapshot of the inequality issue is in our Picture This section, which draws on interesting results from the World Top Incomes database.

An awful lot of good reading here, with much relevance for Malaysia. For reference, our Gini number has been hovering in the mid-40s since the 1980s (about the global median), and before anyone asks, it’s about the same across all communities.

I’m especially taken by the article linking efficiency to inequality (excerpts):

Equality and Efficiency

Somewhat surprisingly, income inequality stood out for the strength and robustness of its relationship with the duration of growth spells: a 10 percentile decrease in inequality (represented by a change in the Gini coefficient from 40 to 37) increases the expected length of a growth spell by 50 percent. The effect is large, but is the sort of improvement that a number of countries have experienced during growth spells…

…Remarkably, inequality retains its statistical and economic significance even when we include many potential determinants at the same time, a claim that we cannot make for many of the conventional determinants of good growth performance, such as the quality of institutions and trade openness…

…One reasonably firm conclusion is that it would be a big mistake to separate analyses of growth and income distribution. To borrow a marine analogy: a rising tide lifts all boats, and our analysis indicates that helping raise the smallest boats may help keep the tide rising for all craft, big and small.

The immediate role for policy, however, is less clear. More inequality may shorten the duration of growth, but poorly designed efforts to reduce inequality could be counterproductive. If these efforts distort incentives and undermine growth, they can do more harm than good for 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 we have does not in itself say what to do. But our analysis should tilt the balance toward 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.

…and this is one is required reading (excerpts):

Unequal = Indebted

ECONOMISTS have long worried about the growing chasm between countries that borrow heavily internationally and those that dish out the loans. They call it global current account imbalances and, especially since the onset of the global economic crisis in 2007, there has been concern that global markets could be destabilized were there a run on the currencies of those countries that pile up huge deficits. That hasn’t happened, at least so far. In fact, the biggest borrower of all, the United States, is viewed mainly as a safe haven by lenders.

But there is another, domestic dimension to the pileup of international obligations. Domestic debt rises too and could reach unsustainable levels that could lead to domestic financial crises…

…An economic model can clearly illustrate these links between income inequality and current account deficits…

…The model assumes that the top group experiences a large and persistent favorable bargaining power shock that increases its share of the economy’s economic pie over an initial period of 10 years…

…Part of the top group’s response to the hike in its income is therefore to increase loans to the bottom group. This allows the bottom group to continue consuming the economy’s output even though it is earning a significantly lower share of income…

…As a result of the shock, our model shows a decline of about 9 percent in the real wage (relative to trend real wage growth), an initial increase in the domestic loan interest rate of 80 basis points, and an increase of almost 120 percentage points in the lower group’s debt-to-income ratio (see Chart 2, dashed line).

The increase in debt happens over the decades of below-trend incomes that result from the persistent shock…

…In reality, increases in income inequality are often followed by political interventions to prop up the living standards of the bottom group, whose real income is stagnating. This is generally done not by directly confronting the sources of inequality, such as declines in the collective bargaining power of the bottom group or shifts in the tax burden from the top group to the bottom group, but rather by promoting policies that cut the cost of borrowing for both individuals and financial institutions (Rajan, 2010). These policies include domestic and international financial liberalization, and they put additional downward pressure on current accounts.

As shown in the simulations in Chart 2 (solid line), a reduction in financial intermediation spreads leads to much lower lending rates, which draw more of the top group’s resources into financial rather than real assets. Initially this allows the bottom group to maintain a much higher consumption level. But in the long run it means the top group underinvests in real assets such as plants and machinery, and so the bottom group sees lower real wages over time. At the same time, debt-to-income ratios rise more strongly, as do current account deficits.

That sounds awfully familiar…and suggests Malaysia’s household debt binge might be better handled not with administrative measures or tighter monetary policy, but through looking at the real underlying cause – large and persistent inequality of wealth and incomes. Even if Malaysia’s level of inequality is no better or no worse than the majority of countries right now, could we do better socially, politically and economically with a less unequal distribution of income? More than possible, especially given the rise in global inequality generally since the 1980s (i.e. the current level of global inequality might be too high for long term economic stability and growth). The problem of course is what policies to pursue, for which there are no firm answers as yet.

Technical Notes:

Finance & Development, Volume 48, No 3, the International Monetary Fund, September 2011