Friday, January 13, 2012

On the Future of Capitalism: Growth, Income Inequality, and Political Polarization

In a recent article, On the Future of Capitalism: Trade and Income Inequality, the inevitability of income inequality in an advanced globalized economy was discussed. It was concluded that the spread in income between the wealthy and the poor would continue to grow unless appropriate social decisions were made to limit this increase. Thus we have a picture in which a healthy economy causes deleterious social effects. Recently several articles have appeared that have suggested that the inequality produced is not only harmful for the individuals affected, but it is also harmful to the economy as a whole. The problem then is converted from a moral issue to a fundamental economic issue.

Andrew G. Berg and Jonathan D. Ostry provided and article for Foreign Affairs with the provocative title: How Inequality Damages Economies. They claim that the data indicates a correlation between income inequality and the duration of economic growth cycles.

"Some years ago, we set out to understand what sustains long periods of high growth, or ‘growth spells.’ Other economists, notably Lant Pritchett, had come to realize that countries rarely enjoy a steady economic climb. Periods of growth are often punctuated by collapses and stagnation. Moreover, spurring growth is often not the hard part; even in the poorest regions, growth takeoffs are relatively common. The hard part seems to be keeping growth spells going."

"What stood out most in our research was that growth spells were much more likely to end in regions with less-equal income distributions. The effect is large. If Latin America, for example, could bridge half of its inequality gap with East Asia, its growth spells would last twice as long as they do now. Remarkably, inequality made a big difference in our results regardless of the other variables we included or exactly how we defined growth spells, a claim that we cannot make for the other factors seen as conventional drivers of good growth performance."

The authors do not elaborate on the mechanisms by which growth might be limited, but there is a suggestion that if the only way in which the lower paid sector of the population can participate in a growth in wealth is by borrowing, then the growth process can become self limiting. Recent history would support such a conclusion.

"ANDREW G. BERG and JONATHAN D. OSTRY are, respectively, Assistant Director and Deputy Director in the Research Department of the International Monetary Fund. The views expressed here are those of the authors and should not be attributed to the IMF."

In an article in Businessweek, David J. Lynch has a related article: How Inequality Hurts the Economy. Lynch references the same study results as the previous authors, but then goes on to provide other issues to consider.

Lynch suggests that as economies develop they become more dependent on an educated workforce, but the appropriate level of training or education becomes harder to attain for those who are falling behind in terms of income.

"Today, when the quality of the workforce plays a larger role in determining who prospers, many economists—including Federal Reserve Chairman Ben S. Bernanke—now believe that equality and growth are linked. As Branko Milanovic, a World Bank economist, wrote in September: ‘Widespread education has become the secret to growth. And broadly accessible education is difficult to achieve unless a society has a relatively even income distribution’."

Lynch presents a less-often considered view that capital markets can be harmed by income inequality. While markets are the playing field of the wealthy, broad participation by the population is required in order to provide the necessary cash flow for a growing economy. A perception that markets are rigged in favor of the few can hinder this required participation.

"Inequality is not just a problem for the have-nots. Barry Ritholtz, chief executive officer of the investment research firm Fusion IQ, says millions of potential investors may conclude, as they did after the Great Depression, that the market is a rigged game for insiders. Such seismic shifts in popular sentiment can have lasting effects. The Dow Jones industrial average didn’t regain its September 1929 peak of 355.95 until 1954. ‘You’re going to lose a generation of investors,’ says Ritholtz. ’And that’s how you end up with a 25-year bear market. That’s the risk if people start to think there is no economic justice’."

Lynch then reminds us of political and social issues that can be economically disruptive.

"As rich and poor drift apart, the constituency that favors redistributive tax and spending policies grows....Ultimately, unbridled inequality threatens social stability as rich and poor nurse their mirror-image resentments."

This latter statement reminds us that we are currently in the situation where redistributive options are being ferociously argued, resulting in exactly the sort of political gridlock that can be harmful to both society and the economy. There is a famous study that relates income inequality to political polarization. An article by Nolan McCarty, Keith T. Poole, and Howard Rosenthal has the obviously relevant title: Political Polarization and Income Inequality.

These authors derive a measure of polarization that considers the divergence of congressional voting patterns as they proceed from a bipartisan pattern to a highly partisan pattern. They compare this historical trend with the growth in income inequality as represented by the Gini index. The tabulation of the Gini number is the internationally accepted approach to quantifying income inequality. It is generally represented as a number between zero and one, where zero represents uniform income, and one is a state in which a single person has all the income. The Census Bureau provides these numbers for the US, although others also provide estimates.

The authors produced this chart to compare income inequality and political polarization

The authors describe this correlation as "uncanny." They do not suggest that this polarization is representative of a class conflict between the poor and the wealthy, but rather may have been triggered by the realignment of the parties that occurred in the 70s and 80s when the moderately conservative Republican Party captured the ultraconservative wing of the Democratic Party. The two sides have become increasingly divided over economic assumptions and economic policies over the years.

The chart above has been duplicated and extended to more recent times by others and the correlation continues to hold. Even the Great Recession seems to have not changed the environment much. As this table indicates, inequality dipped slightly at the height of the crisis, but then continued its climb upward—as has political partisanship.

As we are aware, the economic tumult has been accompanied by increased political tumult—with no end in sight.

The various sources quoted provide a credible picture of unfettered capitalism providing inherent mechanisms that will ultimately limit its effectiveness.

The more one studies the collaboration between corporations and government that defines capitalism today, the more one has to conclude that the current bargain must shift to one in which government plays a more active role.

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