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The price of Inequality

published 16 January 2013 updated 16 January 2013
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We’ve all heard the old adage about the rich getting richer, and the poor getting poorer. It’s a saying that’s rung particularly true in much of the world over the last thirty years.  Statistics show that income inequality reached historically high levels, particularly in many OECD countries just prior to the financial crisis of 2008.  And that’s prompted some people to wonder whether rising inequality played a role in provoking the financial meltdown.

That suggestion of a causal link between inequality and the financial crisis might have once been dismissed as pure delusion by much of the economics profession. After all, if neo-classical economics taught us anything it is that inequality was a good thing, that rising income disparities merely reflect the efficient invisible hand of the market rewarding individual success and business acumen. As for the rest of us, well some small part of that wealth at the top we were assured “trickles” down.

But some prominent mainstream economists today are taking a second look at income inequality, with some important policy implications.

Last year, researchers with the International Monetary Fund – not the usual bashers of free market capitalism – published an intriguing report examining increases in income inequality and rising current account deficits in countries like the United States, Canada and the United Kingdom. (A current account balance is basically the difference between the value of a country’s exports and imports, its earnings on foreign investments and payments made to foreign investors, and other cash transfers).

While most economists agree that global current account imbalances played a major role in precipitating the financial crash, the IMF researchers went further and found that the common thread linking countries with large current account deficits was a steep increase in inequality.

How could this be?  After all, the poor don’t have direct access to international capital markets. Interestingly, the answer lies in the fact that rising inequality radically changed domestic consumption and savings flows. The rich got richer, but everyone else was forced to borrow and go deeper into debt to try to maintain their standard of living in the face of declining or stagnant wages. A good chunk of the lending came directly or indirectly from the rich through intermediary foreign sources. And it was this that pushed up the current account deficit.

To put these consumption and savings changes into perspective, consider this jaw-dropping example from the United States. In 1983, the top 5 per cent of income earners had 80 cents of debt for every dollar of income, while the remaining 95 per cent had just 60 cents of debt. By 2007, following more than two decades of neoliberal policies and rising inequality, the top 5 per cent held just 65 cents of debt for every dollar of income, while the remaining 95 per cent had seen their debt swell to $1.40.

Growth in the economy was maintained over this period, but only as long as the added savings of the increasingly affluent were funneled to support the consumption of those who were falling behind. And the price for this was increasing indebtedness that led to financial fragility, economic volatility, and eventually a crisis in public finances.

So what are the lessons to be learned from the study? The first is that the current preference by many governments for austerity measures may in fact make matters worse. Public spending cutbacks disproportionately hurt the poor and middle class. This threatens to widen inequality, push up debt and expose our economies to ever more volatility.

Austerity measures also ignore the scourge of unemployment we face, particularly amongst youth. For today’s young people in countries like Spain and Greece, long-term unemployment will translate into a lifetime of lost opportunities and income.  This too will drive greater inequality in the future.

And as some government’s cutback spending on education and training, they are in effect taking away from one investment that can help reduce inequality. Quality education can be a great equalizer if everyone has the opportunity. Education institutions can exacerbate inequalities when qualified students are turned away or when public schools suffer while private fee-paying schools flourish.

Finally, the evidence from the IMF research seems pretty clear. To put our economies on a more stable footing, governments must tackle excessive debt levels. They can do this immediately by providing debt relief. But more importantly, we need to seriously reduce income inequality. We can do this through tax reform, and by raising the incomes of the poor and middle class by strengthening collective bargaining.

It’s tragic to see many governments moving in precisely the opposite direction. It’s true that there were other factors behind the financial crisis. But if the IMF researchers are right, and I suspect they are, policies that promote greater equality might just head off an unwanted repeat of the financial meltdown of 2008.

The opinions expressed in this blog are those of the author and do not necessarily reflect any official policies or positions of Education International.