‘Nowhere is there a principle which is right in all circumstances, or an action that is wrong in all circumstances.’
The header, and following quote, come from the book of Lieh-Tzu, an ancient Chinese book of Taoist fables, and neatly summarises a point that I made in a previous post, that one set of economic policies can be effective in one context, and fail or be less effective in a different context. The policies of the political right, or the policies of the political left, can both be successful in promoting the prosperity of a nation in different circumstances and it is dangerous to become rigidly attached to one set of policies or even an ideology or set of beliefs about society.
This point has been well made by the economist Michael Pettis, who blogs here. I find his many of his posts very insightful, as he tries to steer clear of ideology and remains flexible intellectually. He pointed out that both rising and falling inequality of incomes and wealth in an economy can be associated with improved economic performance. Policies which deliberately promote, or at least are indifferent to, rising inequality, as were carried out by Thatcher and her successors in the UK in the 1980s and 1990s, and Reagan in the US during the same period, are associated with the political right, while policies which aim to reduce inequality tend to be associated with the political left.
During the post-war period up until the 1970s, policies aimed at promoting full employment and narrowing inequality, were deemed to be important in terms of their effect on economic growth and the prosperity of nations across the west. The confluence of high inflation, slowing income and productivity growth, and rising unemployment led to a political crisis in many countries, and a swing to the new right which, in the UK for example, led to the abandonment of the post-war consensus and the emergence of a neo-liberal policy agenda. Despite the unprecedentedly strong economic performance of the industrial countries in the 1950s and 1960s, the promotion of equality via state intervention was held to be responsible to the deteriorating performance in the 1970s. Tax cuts, deregulation and privatisation were implemented during the 1980s and after, and in many ways, the neo-liberal agenda worked, although there were significant downsides to the policies, especially for the poorest in society. Inequality rose, and the richest became substantially richer. It was believed that by liberating those at the top of society in particular, that the wealth thereby created would ‘trickle down’ to those at the bottom.
In the UK, macroeconomic management or the management of aggregate demand and the economic growth cycle, was poor, due to the adherence to the monetarist doctrine and exchange-rate targeting, but it is arguable that the supply-side reforms mentioned above, after some time, did work, as UK productivity growth improved relative to other economies in the decades that followed. Many on the left have been in denial about this, because they disliked the painful increase in inequality and poverty that seemed to be necessary to promote it. The situation in the US has been similar, with rapidly rising inequality and poverty, alongside improved productivity growth, especially in the 1990s once the IT revolution started to have an effect on company behaviour.
In the aftermath of the Great Recession, the pendulum of popular opinion has begun to swing towards the notion that relatively high inequality has been partly to blame for the excessive growth in private debt which, when it started to go in to reverse, has been part of the story of the recent poor economic performance across the west. Popular, although apparently largely unread, books such as Thomas Piketty’s Capital in the Twenty-First Century, document and criticise the inequality of incomes and wealth that are the product of the current political economy we are living through. Whether or not inequality is wholly or partly to blame for the Great Recession is beyond the scope of this post, where I will stick to the relevant theoretical issues surrounding inequality and economic performance.
So what effect could inequality have on economic performance? Our economies have lived through periods of both rising and falling inequality, and have continued to grow under both set of circumstances. It should be noted that the ‘Golden Age of Capitalism’, as it has been called by many, especially on the liberal left, was during the 1950s and 60s, when the growth in prosperity across western economies was more rapid and more widely shared than in the decades before or since. Many Keynesians and other liberals look back on this period with some fondness, searching for historical lessons and wondering whether we could achieve a similar performance again. There were probably factors other than simply relatively low inequality that contributed to this success, but that is a matter for another post.
Michael Pettis, mentioned already, has suggested that under certain conditions, rising inequality may be necessary to improve economic performance, while under others, lower inequality may become important again. He highlights the role of consumption growth for the economy as a whole, as stimulating investment, when firms decide to invest in new capacity to meet rising demand. The trickle-down effect that the political right favour may work if there is a shortage of savings in the economy, needed to fund the investment which helps to drive growth. Since the richer members of society will tend to save more of their income (they have a higher propensity to save) than the poorer members, who will spend most or all of their income, an increased inequality of incomes will tend to promote higher saving. Assuming that this is used to fund private investment which should grow the economy, this is one route by which policies which promote or allow a higher degree of inequality could improve performance.
If, on the other hand, as is possibly the case in some western economies like the US and UK at the moment, the constraint on private investment is not a shortage of savings, but a too-slowly growing consumer demand which is needed to encourage private investment as described above, then a policy of reducing inequality of incomes will boost the potential spending of the poorer and reduce the saving of the richer members of society, due to their different propensities to save and spend. As the poorest become richer, their higher propensity to spend out of their income than the rich will boost consumption, if this is what is needed in the economy, and this will stimulate private investment, which will grow the economy faster than otherwise. This is the argument of many on the left today, and may well be valid. In this situation, the economy could be termed ‘wage-led’, in which boosting the share of wages will simulate faster growth. If the economy is more ‘profit-led’, boosting savings and profits and lowering wages for the economy as a whole will help to promote investment and more rapid growth. The economy could well operate with a mixture of the two, and which law predominates could also change, but this is also a topic for a future post.
Those on the right often talk about the importance of economic incentives: allow the rich to get richer and they will work harder; allow the poor to get poorer and they will also work harder so that they have more incentive to get a job and try to match the richer individuals. The ideas of Pettis, described above, have focused on the macroeconomic effect of changing degrees of inequality. Individual incentives are important, but they can be influenced and often overwhelmed by larger economic forces operating at the macroeconomic level, or that of the economy as a whole. Thus changing income distribution can affect the behaviour of savings and investment, consumption, wages and profits, and from there the overall growth in productivity and incomes and thus the prosperity of a nation.
The illustration above shows how both neo-liberal or more right-wing policies, which aim to promote prosperity through increased inequality, and social democratic policies, which aim to promote it by doing the reverse, can both have their place, depending on other factors. I have ignored political or popular influences on these processes, but the story described above shows how a different economic context can change which policies will be effective in promoting national prosperity. Both right and left can be right in different situations, as the world is more subject to change than those who peddle various ideologies like to think.