Inequality may lead to lower growth

One of the many interesting debates on India economy is role of inequality. Some say it has risen with others saying it has lowered thanks to high growth in last 7-8 years. While others say inequality is a natural outcome of a high growth process where it is survival of the fittest. So the well-educated and healthy get maximum advantage. This does not mean the growth process is wrong but state needs to work on the education, health care etc so that opportunities are shared by all.

The debate now is not limited to India (and other Emerging econs). It is a major issue in US as well with Raghu Rajan showing how inequality is one of the major causes of the crisis. This has led to some exciting debate in US as well amidst Tyler Cowen and all. Earlier research by Emmanuel Saez showed how inequality has been rising in US but was not really looked into. Now one is seeing some regular research flowing into the topic.

IMF economists in this paper look at this inequality and growth linkage. They say countries which are more unequal find it difficult to sustain growth. To put it other way, countries which manage to lower inequality tend to grow for a longer time.

This note focuses on the duration of growth spells—defined as the interval starting with a growth upbreak and ending with a downbreak—and on the links between duration and various policies and country characteristics, including income distribution. It turns out that many of even the poorest countries have succeeded in initiating growth at high rates for a few years. What is rarer—and what separates growth miracles from laggards—is the ability to sustain growth. The question then becomes: what determines the length of growth spells, and what is the role of income inequality in duration?

 We find that longer growth spells are robustly associated with more equality in the income distribution. For example, closing, say, half the inequality gap between Latin America and emerging Asia would, according to our central estimates, more than double the expected duration of a growth spell. Inequality typically changes only slowly, but a number of countries in our sample have experienced improvements in income distribution of this magnitude in the course of a growth spell. Inequality still matters, moreover, even when other determinants of growth duration—external shocks, initial income, institutional quality, openness to trade, and macroeconomic stability—are taken into account.

Findings are:

A key implication of these results is that it is difficult to separate analyses of growth and income distribution. The immediate role for policy, however, is less clear. Increased inequality may shorten growth duration, but poorly designed efforts to lower inequality could grossly distort incentives and thereby undermine growth, hurting even the poor. There nevertheless may be some ―win-win‖ policies, such as better-targeted subsidies, improvements in economic opportunities for the poor, and active labor market policies that promote employment. When there are trade-offs between potential short-run effects of policies on growth and income distribution, the evidence presented in this note is not decisive. But the analysis below does perhaps tilt the balance towards the notion that attention to inequality can bring significant longer-run benefits for growth. Over longer horizons, reduced inequality and sustained growth may thus be two sides of the same coin.

We have tried most of these win-win policies in India but have not really worked. The implementation of these programs is as crucial. This is where the problems are.. Another problem is estimation.  I think we need to first do a  serious estimation of the inequality. Has it increased or decreased? Research like this shows it has declined but going by the rise in social unrest, one sees a disconnect with the stats. We need to know proper facts here..

The authors in the IMF blog have more details:

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.

Liked this boat bit…

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