Economist Joseph Stiglitz has argued that excessive inequality is damaging the economy
How much inequality is necessary for successful economic performance? All but the most hardened egalitarian socialist would agree that some degree is inevitable. The leader of the UK’s Labour Party, Jeremy Corbyn, has suggested that there should be a maximum wage regulated by the state, alongside a higher minimum wage. Would this work? It could reduce inequality, but opponents will be quick to claim that it will damage incentives to work and stifle entrepreneurial initiative, even if it were enforceable.
Those on the political right often focus on the effect of individual incentives to work and invest when arguing that rising inequality is unimportant or at least that the status quo should not be meddled with.
Many governments since Thatcher and Reagan’s administrations of the 1980s made increasing inequality a deliberate feature of economic policy. They enacted legislation which weakened union influence and slashed tax rates for the wealthiest, in the name of improving incentives. The Laffer Curve is often cited as proof that cutting taxes will actually increase revenue due to falling tax avoidance and improved economic performance. The curve itself remains controversial, though you will not hear that from conservative supply-siders. One version of the curve holds that tax rates as high as 60% of income will maximise revenue, which is hardly an argument for further tax reductions, at least when starting from today’s rates.
Tax rates in many rich countries, particularly those on income, were certainly higher in the 1970s than they are today. They have often been replaced with taxes on consumption, which tend to be more regressive, so that public spending shares of GDP have not fallen a great deal, despite the best efforts of the right.
The argument that tax cuts for the richest and welfare cuts for the poorest improve incentives to work may be right if marginal rates are very high, but there is surely a limit to this. And even if it were the case, there may be greater economic and social benefits from the public spending which higher taxes can fund. Circumstances alter cases: it is not simply all about the taxes and there will be trade-offs involved.
Governments should focus on simplifying tax systems and reducing or eliminating avoidance and evasion. For the part of economic theory known as microeconomics, which focuses on the behaviour of individuals, such supply-side policies may be useful. But they are not the whole story when it comes to economic performance.
Macroeconomics addresses the behaviour of the economy as a whole. However, modern mainstream ‘macro’ starts from so-called ‘micro-foundations’, or assumptions about individuals. Macro is thus reduced to micro. There is little to be said about macroeconomic forces which are not reducible to individual behaviour, which is how macro began under the influence of John Maynard Keynes in the 1930s.
I would argue that there are indeed macro or ’emergent’ properties of the economy which have a powerful influence on individuals and are not reducible to the behaviour of the latter. Thus, categories such as aggregate demand or spending, and aggregate consumption, investment, saving, profitability and so on, may change despite the best efforts of individuals to alter them in some other direction.
When it comes to inequality, economists in the post-Keynesian tradition often argue that ‘excessive’ inequality has negative effects on aggregate demand and growth. It does this by concentrating income in the hands of the richest, who are least likely to spend it, as opposed to the poorest, who are likely to spend all the extra income they receive. Thus some degree of inequality may reduce aggregate consumption and weaken incentives for firms to invest in new capacity and create new jobs if demand for their products is growing more slowly. Policies to reduce income inequality could therefore strengthen consumption, investment and economic growth.
The above argument may not always hold. If the economy is constrained by a shortage of saving, then policies which increase inequality and increase aggregate saving, which is then used to fund investment, may have positive effects on investment and growth. This seems like a version of the ‘supply-side’ economics championed by many on the right, but it draws on macroeconomic rather than microeconomic analysis. Macro can trump micro when it comes to economic behaviour and performance.
From a political economy perspective, high levels of inequality can lead to political instability and a widespread sense of unfairness. Such factors are at least partly subjective, and will vary between societies. Depending on the balance of power between social groups and classes, policies which neglect rising inequality may or may not persist.
Political and social instability can undermine economic performance if they lead to widespread dissatisfaction with the status quo. Policies which redistribute income and wealth may thus be a preferable option which restore legitimacy to a (new or incumbent) government and lay the foundation for renewed economic prosperity.
Excessive inequality, even if argued for on economic grounds, may not be an option when political and social factors are taken in to account. Redistributive policies may be the least bad direction for the government to take, since the alternative, in the absence of political repression, would undermine the social basis of economic activity. Of course, history shows that the course of repression has been taken by numerous governments, but that is not an argument for its desirability.
Many economists have argued that today’s levels of inequality can be harmful to economic performance, even without considering the political and social consequences. They find particular support in the post-Keynesian camp, and for sometimes different reasons, among some on the left of the mainstream such as Joseph Stiglitz. Marxists tend to argue that it is all down to capitalism, cannot be avoided, and that we should therefore abolish the whole system. This seems to me to be too pessimistic, and could replace one bad with something worse. On other hand, in a dynamic socioeconomic system like capitalism, we will encounter trends and cycles as the outcome of the interaction between underlying economic forces, and particular sets of policies and institutions.
It may well be that the trend of rising inequality within many countries has reached its limit politically, and is also undermining economic performance. This is a dangerous cocktail, which has surely contributed to the rise of populism across the West, particularly in Europe. If populism leads to extremism, then policies which promote widespread prosperity could be in short supply. In the longer term, greater international cooperation which enables a new set of global rules and policies will be needed to underpin a rising and more fully shared prosperity. But further instability and economic conflict may be to come as some nations turn inward, ostensibly to appease nationalist sentiments.
The Political Economy of Development 
First read early in the morning. Thoroughly enjoyable. Great piece. Thanks for it.
Two passing thoughts: Pettis shows impressively just how important a “more equal” distribution of income (as a share of GDP) is in a balanced economic development.
What he also shows is that exploitation (e.g. financial repression) and high degrees of inequality (as witnessed in China) are not the prerogative of “the free markets” but typical appearances in state-led economic development.
Political power is a force in its own right and it tends to be particularly unbalanced where the state or socialist elites suppress democracy and other forces of civil society.
Second thought: concerning Europe, the political awakening of more and more people should not be reduced to “populism” (I am not saying you are reducing it to populism), and much of what is referred to pejoratively as “populism” is simply (long suppressed, still hard to effectively express) opposition to the politically correct status quo so much liked by the political and media elite. (Brexit is not populism – again, I am not suggesting this is what you are saying).
Even more importantly, when are people (including those among the non-regressive left) beginning to understand just how viciously anti-European the EU is – it is a veritable recipe for invigorating nationalism (and the danger of exaggerated nationalism), chauvinism (the mutual hatred of nationalities) and old feelings of national arrogance and rivalry in Europe.
As Pettis demonstrates brilliantly, much of what is considered mainstream and non-populist European thinking is in truth boisterously “populist/chauvinistic” – just listen to what German journalists, politicians, and many members of the public have to say every day about the inferiority of most Europeans vis-a-vis our marvellous national character. The problem of the EU is, these exemplary Europeans argue, that most members of the union simply aren’t German enough. (When did we hear that line of reasoning last time?)
The dangerous implications of the EMU(s economic dysfunctionality) are among the findings that economics has been helpful in discovering early on, but most economists are theologians, always eager to serve the incumbent “religious leaders”.
In my book, the apologists of the EU are a truly populist force, convincing millions of Europeans to support a system that is thoroughly damaging to their interests.
Thanks for this comment. I don’t think that state-led development necessarily leads to rising inequality. It can do, in China as you say and as I think Michael Pettis argues, but it need not. Pettis does argue that the China growth model worked impressively well for some time, as can be seen by China’s success, but that for perhaps the last decade, it has worked less well, and led to misallocated investment on a huge scale. Reform is now needed to raise the share of household income and consumption in GDP, and to reduce the investment share. It would seem that this will lead to slower but more equitable growth. Otherwise China could be heading for a ‘lost decade’ of slow growth.
Re the EU, it can’t be the case that the EU is intentionally anti-European, but it has failed to deal with the eurozone and refugee crises well and resurgent nationalism has been the result. If only Germany could stop preaching that their economy is so successful and that the southern peripheral members of the eurozone should all be like them by running trade surpluses (which is impossible). The German economy does seem to be rebalancing a bit, with consumption and imports growing on the back of stronger wage growth, but this needs to continue and even accelerate, which would benefit ordinary workers as well as the euro. Short of a fiscal union, it may be the only way the eurozone can survive. I am all for European integration but not in its current form, which as you say is damaging to the interests of ordinary people.