Impact of Inequalitay on Growth

It is a wise man who said that there is no greater inequality than the equal treatment of unequals. The worst form of inequality is to try to make unequal things equal.

Inequality is one of the most discussed political agenda in most of the countries in the world. On 14th June 2015, Hillary Clinton, the well-known democratic party presidential candidate to succeed Barack Obama as president of the United States, made inequality, the keynote of a dominant campaign speech. Pope Francis delivered an encyclical, a high-level Vatican pronouncement, which addressed the problems related to global inequality, among other issues on June 18th, and on June 15th economists at the IMF issued a study determining the reasons  and result of increasing inequality. The authors take into account that while inequality could be the reason of all sorts of problems, governments should be particularly concerned about its effects on growth. They evaluate that a one percentage point increase in the income share of the top 20% will pull down growth by 0.08 percentage points over five years, whereas a rise in the income share of the bottom 20% actually lifts up growth. But how does inequality impact economic growth rates?

It is believed that some inequality is needed to shoot growth. If there are no large financial rewards, risky entrepreneurship and innovation would refrain from expanding. In 1975 Arthur Okun, an American economist, debated that societies need to decide the mix of equality and efficiency, it is not possible to have perfect equality and perfect efficiency at the same time. While most of the economists keep on holding the view, the recent growth in inequality has aroused a new look at its economic costs. Inequality could hinder growth if those with low incomes suffer from poor health and low productivity as a result, or if, as evidence indicates, the poor struggle to finance investments in education. Inequality could also imperil public confidence in policies related to growth-boosting, like free trade, says Dani Rodrik of the Institute for Advanced Study in Princeton.
More recent work implies that inequality could lead to economic or financial instability. In a book published in 2010, Raghuram Rajan, governor of the Reserve Bank of India, debated that governments often reply to inequality by easing the flow of credit to poorer households. According to other recent research, American households borrowed massively preceding the crisis to reinforce their consumption. But for the increase in household debt, consumption would have languished as a consequence of poor wage growth. Economic eminences such as Ben Bernanke and Larry Summers feel that inequality may also help to the world’s “savings glut”, since the rich are less likely to incur the expense of  an additional dollar than the poor. As savings accumulate, interest rates fall, boosting asset prices, advocating borrowing and making it more difficult for central banks to manage the economy.
Concocting a response to rising inequality is treacherous, however. A part of the negative impact of inequality on growth can be accounted on poor government policies in extensively unequal countries. In Latin America, for instance, egalitarian pressure for excessive state economic control seems to lessen the average duration of growth spells. Yet in temperance, redistribution seems to have benign effects—perhaps by lessening the dependence on risky borrowing within poorer households. Over the past generation or two inequality has risen most in places where gradual policies, such as high top tax-rates, have been depleted. A bit more redistribution now might upgrade the quality and quantity of economic growth—and lower the demand for more aggressive state interventions later.


Anirvan Mukherjee
An article by:
Anirvan Mukherjee

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