8 May 2017

Inequality: A necessary evil or a real problem?

Charlotte writes:*

In 2006, Uganda experienced a record growth rate of more than 10 percent. Although we may be happy with this result, it is wise to consider that whilst this was happening, Uganda scored around 0.5 on the Gini Index, meaning that it was suffering from high levels of income inequality. Furthermore, it ranked 152th on the Human Development Index, suggesting that its population had low levels of development (i.e., low life expectancies and levels of education). I ask myself: Is economic growth paired with high inequality acceptable for a country?

Many scholars would say yes – to them, income inequality is seen as the necessary-evil to economic growth. A belief, which is grounded in a misguided trust in the existence of the Kuznets curve. The thought behind this idea, is the belief that entrepreneurs would not invest in an economy, if there are no prospects for “large financial rewards”. In this view, income inequality is needed as it creates the opportunity for the rich to get richer. Equality will, at some point, follow.

Yet, some scholars are starting to disagree with this line of thinking, as they realize that inequality can be expensive. To see why, let’s first carefully distinguish economic growth from equality. Economic growth measures the overall economic well-being of a market by tracking changes in a country’s GDP. Equality, on the other hand, looks at the distribution of resources, which are not necessarily material. Equality would also take into account, for instance, healthcare and education, which are excluded from a country’s GDP.

An emerging strand in literature is arguing, that this underlying inequality can harm the economic growth it, arguably, set into motion. A recent IMF study [pdf] found, in fact, that whilst an increase of 1 percent in income of the bottom 20 percent of people in a country, would lead to a 0.38 percentage point higher growth in the next five years, that same income increase of the top 20 percent would lead to a 0.08 decline in economic growth. The mechanisms at play are threefold. It is argued, that income inequality ((1) leads to political and economic instability with reduced investment as a consequence, (2) negatively affects the social consensus needed to deal with shocks, and (3) harms the poor’s access to healthcare and education, thus undermining human capital potential and labor productivity [pdf]. Therefore, non-inclusive growth can make a country’s growth spell unsustainable [pdf]. The underlying details to economic growth, which GDP does not reflect, thus matter.

In Uganda, we can clearly see the problems of non-inclusive growth. The economic growth in Uganda was largely driven by the expansion of some sectors of the economy, such as industry and services, whilst agriculture was mainly left behind [pdf]. However, it is exactly this sector that employs about 75 percent of the Ugandan population. This has meant that only a small part of the population is benefitting from economic growth. As a consequence, Uganda has experienced large political and economic instability, resulting in negative consequences to economic growth, such as capital flight [pdf]. It thus seems of little surprise that from 2006 onwards, Uganda’s economic growth has been inconsistent, going from high peaks to economic declines.

Bottom line: Economic growth may be a popular goal to strive for, but if it is not inclusive, then it can do more harm than good as large parts of the population are left behind. The resulting costs can make economic growth unsustainable.

* Please comment on these posts by students in my growth & development economics course. It really helps if you highlight unclear analysis, alternative perspectives, better data, etc.


Jan Joosten said...

Charlotte I enjoyed reading your well written blog post in economic inequality and growth. You nicely put forward the arguments for and against inequality given inclusive or elusive growth. You clearly highlight that for growth to be successful in the long term it must be inclusive. Personally however, I am less convinced by the three consequences of inequality put forward by the IMF report as they seem quit broad.

It seems to me that there is a tipping point at which inequality leads to said political and economic instability with reduced investment as a consequence, negatively affects the social consensus needed to deal with shocks, and harms the poor’s access to healthcare and education. Before this point is reached I am in agreement with the academic opinion that inequality is not necessarily a bad thing. With inequality one can argue that you remove incentive's for people to undertake economic activity to better their position. However, there seems to be little consensus about how much inequality is ‘healthy’ and at which point it becomes ‘unhealthy’ (ie. the tipping point)

Nonetheless, this is an extremely important debate as we have globally seen a rise in inequality (also in the ‘richer’ West), and can safely say that there has been a rise in political tensions, and fragmenting social consensus too. Only since 2008 have Western societies felt the day-to-day effects of economic inequality. Maybe this is a potential explanation for why it was not seen as a problem before; inequality only becomes salient when its negative externalities are tangibly experienced. Maybe its time to take heed to of the Dutch economic policy of the country with the richest poor, and the poorest rich.

Jori said...

I think this is probably one of the most important questions of the development in the 21st century. You explain the dilemma well and Uganda is an interesting case study to examine the impact of inequality on growth.

One aspect that is also deserves some attention is how equitable outcomes are reached. In other words, if we believe a country’s GINI should go down, how should this be achieved?

I can discern two specific ways: on the one hand there is redistribution and on the other hand there is inclusive growth. I think most people would agree that inclusive growth is a good thing. Since Uganda has high corruption levels, it would not surprise me if income gains for high earners would not just reflect their productivity, but also rent seeking. This means inequality does not create incentives for wealth creation. Rather, it is a reflection of underlying crony-capitalism and government corruption. Solving this problem might require breaking open the closed economic and political order, as well as creating incentive for human capital accumulation. Existing inequality probably stands in the way of this.

Redistribution raises some extra questions however. One problem is that for redistribution of be successful, there has to be wealth to be redistributed. This is problematic in countries like Uganda, since there simply is not that much wealth to go around. This is why Deng said “let some people get rich first.” The development of some parts of the population, at the cost of increasing inequality, would be better than shared misery. Secondly, sectors like rural agriculture are often very unproductive. Subsidising these lifestyles at the expense of urban wealth creation (which is what redistribution would do) would create incentives for the 75% of people in agriculture to remain in that industry, even if they could be more productive if they moved. This would mean redistribution could create a poverty trap, both for the rural class as well as the country as a whole.

This is not to say that redistribution could do no good, but rather that it is probably not a free lunch.

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