Inequality and the sustainability of growth

Inclusive Economy,Poverty & Inequality13 Mar 2013Jonathan Ostry, Andrew Berg

It is a big mistake to separate analyses of growth and income distribution. A rising tide is critical to lifting all boats. 

Events in recent years have (again) placed inequality at the topic of the economic policy agenda. From a widening recognition of the scale and implications of rising inequality in many developed countries, to the role inequality may be playing in the historical transformations underway in the middle east, to the challenge of managing difficult and necessary economic adjustments in Europe in a sustainable and inclusive way, inequality clearly matters.

Some time ago, we became interested in long periods of high growth (“growth spells”) and what keeps them going. The initial thought was that sometimes crises happen when a “growth spell” comes to an end, as perhaps occurred with Japan in the 1990s. We approached the problem as a medical researcher might think of life expectancy, looking at age, weight, gender, smoking habits, etc. We do something similar, looking for what might bring long “growth spells” to an end by focusing on factors like political institutions, health and education, macroeconomic instability, debt, trade openness, and so on.

Somewhat to our surprise, income inequality stood out in our analysis as a key driver of the duration of “growth spells”. We find that high “growth spells” were much more likely to end in countries with less equal income distributions. The effect is large. For example, we estimate that closing, say, half the inequality gap between Latin America and emerging Asia would more than double the expected duration of a “growth spell”. Inequality seemed to make a big difference almost no matter what other variables were in the model or exactly how we defined a “growth spell”. Inequality is of course not the only thing that matters but, from our analysis, it clearly belongs in the “pantheon” of well-established growth factors such as the quality of political institutions or trade openness.

While income distribution within a given country is pretty stable most of the time, it sometimes moves a lot. In addition to the United States in recent decades, we’ve also seen changes in China and many other countries. Brazil reduced inequality significantly from the early 1990s through a focused set of transfer programs that have become a model for many around the world. A reduction of the magnitude achieved by Brazil could—albeit with uncertainty about the precise effect—increase the expected length of a typical “growth spell” by about 50 percent.

The upshot? It is a big mistake to separate analyses of growth and income distribution. A rising tide is still critical to lifting all boats. The implication of our analysis is that helping to raise the lowest boats may actually help to keep the tide rising!

All this reminds us of the 1980s debt crises and the resulting “lost decade” of slow growth and painful adjustment. That experience brought home the fact that sustainable economic reform is possible only when the benefits are widely shared. In the face of the current global economic turmoil and the need for difficult economic adjustment and reform in many countries, it would be better if these old lessons could be remembered rather than relearned.

Our results raise as many questions as they answer. Most importantly, the immediate role for policy is not as clear as one would like. More inequality may shorten growth duration, but poorly designed efforts to reduce inequality could be counterproductive. If these distort incentives and thereby undermine growth, they can do more harm than good to the poor. One thing that would help us be able to say more about policy implications would be to know more about why inequality matters for growth. The economics literature has come up with several theories, including that inequality may:

  • reduce investments in education and health (“human capital”), because the poor cannot finance these investments or because divided societies may wish to provide fewer public goods;
  • lead to political instability that lowers investment;
  • generate political pressures that leads to financial imbalances, as the poor borrow to sustain consumption in the face of rising inequality, or to high redistributive taxes and subsidies that may themselves reduce growth through disincentive effects.

Clearly, which of these mechanisms is at play may make a difference for specific policy advice, and we need to work more on this question. Still, we cannot just wait for more research. For example, there may be some “win-win” policies, such as better-targeted subsidies, better access to education for the poor that improves equality of economic opportunity, and active labor market measures that promote employment. When there are short-run trade-offs between the effects of policies on growth and income distribution, the evidence in our paper doesn’t in itself say what to do. But our analysis should tilt the balance towards the long-run benefits—including for growth—of reducing inequality.

The views expressed in this blog post are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.