Sunday, January 30, 2011

Why Inequality Matters

Adam Smith wrote in his 'Theory of Moral Sentiments' (1759): "This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments. That wealth and greatness are often regarded with the respect and admiration which are due only to wisdom and virtue; and that the contempt, of which vice and folly are the only proper objects, is often most unjustly bestowed upon poverty and weakness, has been the complaint of moralists in all ages."

One can argue that foolish admiration for wealth has always existed. We have an emblematic illustration in Italy's recent history. Conversely, people may regard this as unfair and will rebel against worship and power as shown by protests in Tunisia, Egypt and other Arab countries.

But the significance of this is more profound. Inequality is not a fatality; it is the product of savage capitalism. Many economists sympathise with the idea that governments should do something to reduce inequality, but this is often a wishful thinking or just a moral inclination. The fact is that inequality matters and governments should act to address this issue. This view is also shared today by many institutions which had always defended free market ideas.

In a 2009 report*, Angel Gurria, the OECD secretary-general warned of the dangers posed by inequality and the need for governments to tackle it: 'Growing inequality is divisive. It polarizes society, it divides regions within countries and it carves up the world between rich and poor. Greater income inequality stifles upward mobility between generations, making it harder for talented and hard-working people to get the rewards they deserve. Ignoring increasing inequality is not an option". 

More recently, D.Strauss Kahn, the IMF managing director and a former socialist finance minister, warned about "a large and growing chasm between rich and poor - especially within countries" and argued that " inequitable distribution of wealth could "wear down the social fabric". He then added: "More unequal countries have worse social indicators, a poorer human development record, and higher degrees of economic insecurity and anxiety". This marks a radical shift in the IMF discourse.

However, the Economist (January 22) asserts that inequality matters "most because of brands and status competition" and that "such concerns could seem peripheral compared with global woes such as poverty", In previous years it has asserted a similar critique focusing on the fact that income inequality is not reflected in consumption inequality. This is a fallacious argument as consumption does not increase dramatically in high income groups.

A reason for the revived interest for these issues is the rise of inequality as measured by the Gini coefficient which runs from 0 (everyone has the same income) to 1 (one person has all the income). Most countries range between 0,25 and 0,6. The Gini coefficient has been rising steadily since the 80s. Latin America has the world's worst income inequality, but it has fallen in Brazil more than five points since 2000 to 0,55. In the US, it rose from 0,34 in the mid-80s to almost 0,40 in the past decade. In China, it grew even more, from under 0,3 to over 0,4. Overall, higher growth in the so-called emerging countries does not necessarily lead to a reduction in income inequality.

Furthermore, there is no consensus on the causes of inequality. One simple explanation is that the wealthy are getting wealthier. Several studies examined the distribution of income in the US with rather converging results. A study from the Economic Policy Institute** in Washington found that the top 1% of the population earned ten times more than the rest at the end of the period and 20 times more at the end.

Some economists have argued that income inequality is not significant since it only means that the rich are gaining more income than the rest. But the picture is that the richest Americans are gaining so much of the  US total income that there is not enough left over for most families to see any possibility of increase of their real incomes. These patterns of extremely uneven income growth contrast to the period between 1947 and 1973 when income growth was distributed roughly equally across income classes, with the poorest 20% of families seeing income growth at least as fast as the richest 20%. 

The other argument put forward is that poverty matters rather than inequality. In other words, governments do not pay attention to the rich and even grant tax cuts for the richest as long they can devote (scarce) resources to reduce poverty. That view was shared by conservative governments as well as the new Labour in the UK. In fact,  poverty and income inequality are often interlinked. In the US, most poor people  have a car but they cannot afford medical care and even enough food or give to their children a decent education. The issue is not the disparity of status which matters, i.e.  how many 'positional goods' people can buy to increase their social status, but access to public goods such as healthcare or education.

Income inequality is the issue to focus on in today societies. The growing chasm between the rich and the poor has never been so big - those that continue buying diamonds and luxury cars and those (increasingly) who have barely enough to buy food. We would have to go back to the Great depression of the 30s to find similar income inequality. This is intolerable not only from a moral perspective, but from an economic one because the system will break down if demand continues its collapse. There are no simple remedial solutions, but there should be a political will to engage in building a fairer society. It will also be more efficient economically.

* OECD, Growing Unequal? Income Distribution and Poverty in OECD Countries, 2009

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