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Inequality and the Economy of Exclusion

Inequality and the Economy of Exclusion

Last updated on: January 27, 2014 at 12:24 pm by Morning's Minion

Inequality and the Economy of Exclusion 2014-01-27T12:24:00-05:00 Morning's Minion

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There can be little doubt that rising inequality is one of the defining economic issues of our time. From a fairly fringe concern a few years back, it has now risen to the very top of the agenda. In part, we owe this to the passionate and prophetic voice of Pope Francis. In this short blog post, I want to explore the issue of inequality, and make the economic case for Pope Francis’ claim that inequality lies at the root of exclusion.

Patterns of rising inequality

Let me start by describing the problem of rising inequality.

If we look at the most standard measure of income inequality, the Gini coefficient, we can see it rising in 17 of 22 OECD countries since the mid-1980s. This is most pronounced in Anglo-Saxon countries like the US and the UK, we are also seeing upward ticks in traditionally low-inequality countries like Germany, Denmark, and Sweden. The OECD also found that the tax-transfer system has become less effective in reducing inequality in about half of OECD countries.

The Gini is out of the bottle in other places too. In China, it jumped severely from a low of 30 in the 1980s to 45 by the first decade of this century—reflecting a fast-paced but non-inclusive pattern of economic growth. The most unequal parts of the world remain Latin America and sub-Saharan Africa, with Ginis well north of 50.

Overall, seven out of ten people in the world today live in countries where inequality is on the rise.

Using fiscal data, Thomas Piketty and Emmanuel Saez have shown a similar pattern of rising inequality in the advanced economies. Most famously, they showed that the income share of the top 1 percent in the US, at almost 20 percent, is back to where it was on the eve of the Great Depression—after a long period of compression and relative equality from the 1940s through the 1980s. And since the crisis of 2008, 95 percent of the income gains went to the top 1 percent, while the middle class lost and the poor lost a lot.

Is this just a US phenomenon? Not quite. Recent research by Alvaredo, Atkinson, Piketty, and Saez shows that it is really a broad Anglo-Saxon trend. From 1980-2007, they show the top 1 percent income share rising by 135 percent in the United States and United Kingdom, 105 percent in Australia, and 76 percent in Canada. In contrast, the top income shares in continental Europe are not much different today than where they were in the late 1940s. Clearly, two groups of countries chose two very different paths.

This is the evidence from Gini coefficients and from top income shares. We can also look at evidence in a third area—wages. Looking at evidence from the ILO, we find more evidence of rising inequality, this time through the compression of real wages.

The ILO finds that the labor share has fallen over the past two decades in 26 out of 30 advanced economies. Across these countries, labor productivity has also risen faster than wages—more precisely, average labor productivity grew more than twice as much as average wages since 1999. So workers are getting more productive, but also getting a smaller share of the pie, while capital is winning big. Again, at least in terms of distribution, the economy is looking more and more like it did in the days before the Great Depression.

Sifting through the evidence, I think we can make some broad conclusions. Rising inequality reflects tensions at both ends—a stagnation in real wages for the middle class and the poor, and from runaway income at the very top. The latter phenomenon is particularly associated with the Anglo-Saxon economies and could reflect financial sector dominance.

Many explanations have been put forward to explain these trends: technological change favored high skills, rampant globalization, the declining bargaining power of labor, the financialization of the economy, and diminishing minimum wages. All of these factors probably have some role to play.

The point of this essay, however, is less to figure out how we got here, and more to ask whether it is something we should care about or not.

Does inequality matter?

So, should we worry? Some would say no. A classical economist, for example, might argue that there is nothing wrong with some people doing better—sometimes much better—than others, as long as the overall economic pie is getting bigger, and as long as nobody is being made worse off. For Catholic social teaching, though, this utilitarian approach is clearly inadequate.

Some others might argue that while a poor distribution of income is something we should care about, the focus on rising inequality within countries obscures the progress made in reducing inequality between countries. But when we think about it, this doesn’t really make sense. Global inequality is still stunningly high, and has not changed much over the past few decades. And the fact that China and India are doing better cannot be an excuse to ignore the fire raging in your own backyard.

But even within Catholic social teaching, the case for caring about inequality is not cut and dry. Some claim that the Church’s long tradition focuses much more on meeting the needs of all, and less on whether some people are richer than others. Along similar lines, some would claim that inequality on its own is not troubling—it only becomes troubling when denies opportunities for the poor to flourish. People like Dan Finn and Andrew Yuengert have made arguments like this.

I believe this is certainly true, but—before going further—I should point out one area of inequality that we should care about in its own right—the decline of real wages. Based on the core principles of distributive justice and the universal destination of goods, Catholic social teaching has always stressed the importance of a living wage, the dignity of work, and the rights of workers.

This means that wages should be sufficient to provide the workers with a decent living for themselves and their families—a living wage is the best route toward the universal destination of goods in the modern economy. More than that, the priority of labor over capital suggests that wages should rise with productivity, and profits should come after wages in priority—exactly the opposite of what has been happening. Going even further still, Catholic social teaching calls for workers to participate in the ownership of business and to share in its profits.

So clearly, the current state of affairs is unacceptable. This is an important direct reason why we should care about inequality.

Beyond that, we should care about inequality because it leads to an economy of exclusion. It prevents people from fulfilling their potential and hinders human flourishing.

Indeed, I would go further and argue that inequality, by its very nature, has exclusion built into its DNA.

Inequality lies behind economic exclusion

Those who downplay inequality frequently invoke the idea that what matters is not equality of outcomes, but equality of opportunity. At some level, this makes sense. But what it misses is that there is a direct correlation between these two types of exclusion. The evidence shows clearly that social mobility is far more stunted in more unequal societies.

In what he coined the “Great Gatsby curve”, Alan Krueger showed a remarkably strong relationship across countries between inequality and intergenerational mobility. In more unequal countries—such as the US or Argentina—the poor stay poor and the rich get richer across generations. There is far more mobility in more equal countries. This is something people like Michael Novak refuse to acknowledge, with their blind faith in the increasingly-out-of-reach “American dream”.

Putting it simply, inequality prevents people from fully participating in the economy and from developing their true potential. We all know that participation is a key tenet of Catholic social teaching, and a lack of participation is synonymous with economic exclusion.

There are many reasons for this kind of exclusion. In more unequal societies, it is harder for the poor to get access to decent education, decent health care, and acquire finance or decent skills. In more unequal societies, the rich are more likely to dominate the political system, and enact policies to protect their privilege.

It is useful here to look at Latin America, where rampant inequality goes hand-in-hand with extractive politics and extractive institutions—where elites protect their own positions by closing the door of opportunity and inclusion to others. This is a major theme of Daron Acemoglu and James Robinson’s highly influential Why Nations Fail.

Some might argue that this kind of static “extractive inequality” is different from the more dynamic “Darwinian inequality” of the Anglo-Saxon countries, which relies far more on market forces. There is certainly some truth this to this. Just compare the richest man in the world, Mexico’s Carlos Slim, with the second richest, the US’s Bill Gates. Slim made his money from cozy connections and vested interests, while Gates made his money from genuine innovation.

Yet we should not push these distinctions too far. As any society becomes more unequal, vested interests are bound to assert themselves. In the US, we see this with the financial sector. Over the span of three decades, it pushed for far lighter oversight and far lighter taxation, leading to an explosion in both rewards and risk.

More generally, alongside rising inequality in the US, elites have managed to dominate the political system and shape policies in a way that benefitted them personally—think about the declining real minimum wage, the attack on collective bargaining rights, the rollback of regulations, the erosion of the social safety net, and the upward redistribution of income through the tax system. As a particularly egregious example, consider the tax advantages enjoyed by unearned income over earned income, a direct result the dominance of politics by monied interests.

In the US context, this is the theme of Jacob Hacker and Paul Pierson’s enlightening book, Winner-Take-All Politics. It is a sure sign that inequality in the US is becoming more extractive. This is one reason why I believe that rampant inequality, by its very nature, has exclusion built into its DNA.

Inequality leads to a more unstable and less sustainable economy

This all has an important side effect—it makes economic growth more volatile, less sustainable, and it increases the likelihood of economic crises.

Again, a look at Latin America over the 20th century is valuable. Because of elite dominance, we saw waves of populism and repression, progress and regress, crescendo and crash. The region seemed stuck in an endless cycle, and the advent of liberal economic policies over the last few decades proved—in the absence of a better distribution of income—incapable of providing an escape.

More broadly, we have empirical evidence that growth is more durable and sustainable when the distribution of income is more equal. East Asia is more equal than Latin America, which explains a lot why this region was not trapped in the same cycle. Of course, as inequality starts to rise in East Asia, there could be trouble down the line.

The reasoning is clear—more equal economies are more inclusive economies. People have better health, more education, and better access to finance. There is more investment in public goods, in infrastructure, in safety nets. There is better governance, with less protection of elite interests. With people having more of a stake, there is more political and economic stability and less violence.

Despite what libertarians say, it goes far beyond the mere protection of property rights.

Fundamentally, economies can only expand in a durable and a sustainable manner from a broad middle, not from a narrow top. The only lasting prosperity is shared prosperity. An imbalanced top-heavy ship is likely to topple at the slightest wave.

Let me delve a bit deeper on the economic stability point. It is no accident that levels of inequality in the Anglo-Saxon world peaked on the eve of the two greatest economic crises of the last hundred years—the Great Depression and the recent global financial crisis. In both cases, the financial sector broke free of restraints and ramped up debt and leverage dramatically. Instead of serving the productive economy, it lined its own pockets. Of course, this model proved unsustainable and it all came crashing down—with the poor left to pick up the pieces.

History teaches us a basic lesson: periods of economic crises tend to be associated with periods when the financial sector is less constrained. On the other hand, the period after the Second World War through the Reagan era was one of the most stable—and regulated—in history.

It is also no accident that the countries in Europe facing the most economic stress over the past few years are the most unequal countries—countries like Ireland and the UK with American-style “Darwinian inequality” and countries like Greece and Portugal with Latin American-style “extractive inequality”.

All forms of inequality make the economy more vulnerable, and the poor are always on the front line.

Inequality erodes trust and social capital

Let me get to the heart of the matter: an inclusive economy runs on social cohesion and trust. Increasingly, economists are realizing the importance of social capital—those networks of solidarity, reciprocity and trust that bind society together, making it stronger and healthier.

It should come as no surprise that more unequal societies tend to have lower levels of social capital, and hence lower levels of social cohesion. It should also come as no surprise that in the US, trust and social capital have been diminishing over the past few decades, a trend noted for a while now by political scientists like Robert Putnam and Francis Fukayama.

This decline in social capital directly maps the rise in inequality. Again, this should come as no surprise. As people drift apart in incomes, opportunities, and lifestyles, they will also drift apart in terms of social networks, shared interests, and common goals. The social glue that binds society together will start to come undone. Civic virtue will be replaced by a mentality of self-absorption and individualism.

We saw this clearly with political trends—monied interests increasingly used the political system to steer policy toward their own narrow advantage, rather than the common good of all citizens. Political rhetoric became increasingly inflamed, with emerging narratives of “two nations” and “makers versus takers”. Instead of common citizens in need of help, the poor were increasingly seen as undeserving. They were simply not “seen” at all. They became the “other”, and the “other” is easy to marginalize and demonize.

At the other end of the scale, low social capital can lead to a culture of dependency. With no real sense of belonging or connection to wider society, people are inclined to cast civic virtue aside and retreat further into enclaves of marginalization. And so the backlash intensifies—it becomes a vicious circle.

All of this is made worse by the tragic history of race relations in the US. For obvious reasons, trust has always been lower among minorities, especially African Americans, and they continue to be systematically excluded, marginalized—and even oppressed. Rising inequality will make this worse, and could easily reverse any precious gains made in the postwar period.

Speaking of race, it is interesting that conservative social commentator Charles Murray is alert to many of these issues, at least among white people. He talks about a great “coming apart” over the past few decades, in which the elites live lives than have less and less in common with their working class compatriots.

What he is really describing is the eroding social capital that comes with rising inequality and declining economic opportunities for the working classes. Murray, however, cannot see this point—he focuses exclusively on the cultural sources of malaise. But he is certainly right to point to the pressing social problems that are increasingly a matter of class and not just race—crime, illegitimacy, drug abuse, joblessness.

I believe that inequality lies at the root of many of these problems. As British historian Tony Judt put it, “inequality is corrosive…it rots societies from within…it illustrates and exacerbates the loss of social cohesion…[it is] the pathology of the age and the greatest threat to the health of any democracy”.

This is not just an abstract claim. In their influential book, The Spirit Level, Richard Wilkinson and Kate Pickett demonstrate that inequality erodes trust and affects a wide variety of economic and social indicators—including infant mortality, life expectancy, criminality, the prison population, mental illness, unemployment, social mobility, educational attainment, obesity, malnutrition, teenage pregnancy, child well-being, illegal drug use, violence, economic insecurity, personal indebtedness, and anxiety.

Now, some researchers have criticized the sweeping claims of Wilkinson and Pickett, but they put up a good defense of their work. The important point is that excessive inequality depletes social capital, leading to societal disharmony and dysfunction.

The centrality of social capital comes through clearly in Pope Benedict XVI’s Caritas in Veritate, when he argued that human relationships of friendship, solidarity and reciprocity must underlie all economic activity. Without social capital and trust, we will not be able to achieve the kind of reciprocal fraternity needed for markets to function with justice and with charity.

Back to Pope Francis…

It is good to conclude with Pope Francis, who put it so well and so succinctly when he said that “inequality is the root of social ills”. This is because it burns the bonds of solidarity and fraternity that must guide economic life. It leads to an economy where the few are inside the room, and the many are locked outside.

Given the barriers between peoples, and lacking any real encounter with the other, the natural response is indifference—and in a globalized world, a “globalization of indifference”. As a result, as Pope Francis puts it, “we end up incapable of feeling compassion at the outcry of the poor…as though all this were someone else’s responsibility and not our own”.

The first priority must be to overcome poverty and meet peoples’ basic needs, which is a strict requirement of justice—and the best way to achieve this is through a living wage.

But it must also go beyond this, toward a full-fledged economy of inclusion. Throwing some leftovers from the table is clearly inadequate, as this ends up treating the people themselves as “leftovers”. In our modern economy, we must invite everyone to sit at the same table and feel part of the same family. Only then can we all flourish together.

This is not just an economic issue or even a social issue. It is an theological issue and a moral issue that gets to the very heart of who we really are—relational persons rather than autonomous individuals, who find meaning in social life and encounter with others, especially the poor.

What does all of this mean for policy? It means, in the words of Pope Francis, that we need to tackle the “structural causes of inequality”. From a policy perspective, finding ways to achieve a more harmonious distribution of income must be central to our concerns. The poor can wait no longer.

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