Thursday, May 8, 2014

Inequality, Redistribution, and Economic Growth

Thomas Piketty is the author of a wildly popular book on economics—yes, economics! In Capital in the Twenty-First Century he summarizes years of research into economic history. Based on data extending back to the French Revolution, he was able to conclude that capital (wealth) tends to grow faster than the economy as a whole, thus leading to increasing inequality. The only period in which growth was significantly higher than the mean was in the period after World War II when so much capital that had been destroyed by two world wars and a worldwide depression had to be rebuilt. It is this era of abnormality that most economists have viewed as the norm. Piketty sums up the history of economic growth:

"The key point is that there is no historical example of a country at the world technological frontier whose growth in per capita output exceeded 1.5 percent over a lengthy period of time. If we look at the last few decades, we find even lower growth rates in the wealthiest countries: between 1990 and 2012, per capita output grew at a rate of 1.6 percent in Western Europe, 1.4 percent in North America, and 0.7 percent in Japan. It is important to bear this reality in mind as I proceed because many people think that growth ought to be at least 3 or 4 percent per year. As noted, both history and logic show this to be illusory."

Inequality grew and produced fantastic accumulations of wealth leading up to World War I. After World War II, inequality fell and growth was high. Now we seem to be reverting to the norm as growth slows down again and inequality is seen to be increasing back to pre-World-War-I levels.

The obvious conclusion is that inequality will grow until some catastrophe occurs or some policy intervention is accomplished. This notion is disconcerting to conservative economists because it is inconsistent with their political beliefs. Consequently they feel they must discredit Piketty, not on the basis of his analysis, which appears unassailable, but on the basis of his politics— he writes favorably about the need for redistributive policies.

An article appeared in The Economist that addressed the conservative complaints: Piketty fever: Bigger than Marx. The assault begins by accusing Piketty of "immodesty."

"The book has attracted much criticism, however. The most common complaints fall into four broad categories. The first concerns Mr Piketty’s tone, beginning with the title. A deliberate allusion to Karl Marx’s magnum opus, it suggests both immodesty and an innate antipathy to markets. Some critics object to Mr Piketty’s use of words like 'appropriation' to describe the rising share of income going to the rich. Writing in the Wall Street Journal, Daniel Shuchman, a fund manager, fumed at the book’s ‘medieval hostility to the notion that financial capital earns a return’."

Much of the criticism is aimed at attacking the conclusion that two centuries of history are relevant to our future. Current wealth is not the same as past wealth, is one such claim. People who are wealthy today will not be smart enough to protect their wealth and propagate it into the future is another theme.

One of the claims against Piketty and the need for redistribution of wealth is that redistribution will somehow inhibit economic growth.

"Mr Piketty glosses over the question of whether attempts to redistribute wealth will weaken growth."

There is a new study issued by the IMF—hardly a bastion of liberal thinking—that attempts to put those concerns to rest: Redistribution, Inequality, and Growth by Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides. They have been studying the effects of inequality on growth and concluded from earlier work that inequality was harmful to economic growth.

"In earlier work, we documented a multi-decade cross-country relationship between inequality and the fragility of economic growth. Our work built on the tentative consensus in the literature that inequality can undermine progress in health and education, cause investment-reducing political and economic instability, and undercut the social consensus required to adjust in the face of shocks, and thus that it tends to reduce the pace and durability of growth."

All developed countries redistribute wealth to a certain extent. An article in The Economist provided this fascinating chart:

This compares the standard measure of inequality of income, the Gini coefficient, as calculated using as-earned income (market inequality) and income after taxes and redistribution (net inequality). Most of the countries listed have similar market inequalities, but differ in the net inequality due to differing redistribution policies.

The IMF study wishes to determine if those more highly redistributive policies act as a hindrance to economic growth. Examination of historical data led to these conclusions:

"First, more unequal societies tend to redistribute more. It is thus important in understanding the growth-inequality relationship to distinguish between market and net inequality."

"Second, lower net inequality is robustly correlated with faster and more durable growth, for a given level of redistribution. These results are highly supportive of our earlier work."

"And third, redistribution appears generally benign in terms of its impact on growth; only in extreme cases is there some evidence that it may have direct negative effects on growth. Thus the combined direct and indirect effects of redistribution—including the growth effects of the resulting lower inequality—are on average pro-growth."

The emphasis is that of the authors of the report.

And so another economic assumption cherished by politically conservative economists bites the dust.

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