Inequality in the OECD: causes and policy responses

Inequality has become a ‘big’ topic in recent years, of concern both to economists and the public at large. This is exemplified by the popularity of Thomas Piketty’s Capital in the Twenty-First Century, and many other works. I have written on some of these studies here.

They continue to be churned out: in the July issue of the heterodox Cambridge Journal of Economics, Pasquale Tridico of Roma Tre University analyses the determinants of income inequality in 25 OECD countries between 1990 and 2013. He finds that ‘financialisation’, increased labour market flexibility, the declining influence of trade unions and welfare state retrenchment have been key to its rise.

When other factors such as economic growth, technological change, globalization and unemployment are taken into account, the above four causes remain important, and, to the extent that they can be changed as a matter of policy, they can mitigate inequality without harming economic growth. They are therefore not the full story but, for example, the negative effects of rising unemployment on inequality can be reduced if there is a strong social safety net in place.

The author puts financialisation at the heart of his explanation:

“[I]nequality is boosted by financial development, credit consumption and the financialisation of the economy, which allows for an expansion of debt (both public and private), the compression of the wage share through the downsizing of the workforce and distribution of profits among shareholders, flexible labour markets and the reduction of the welfare state, which increases income vulnerability and reduces worker purchasing power. This…is more a long- to medium-term perspective where institutions change, a transformation of the structure of the economy occurs and the relationship between capital and labour takes new forms.”

Financialisation, or the ‘rise in financial claims and incomes with respect to the real sector’ of the economy, has proceeded to varying degrees in the OECD club of rich countries. It has tended to go further in Anglo-Saxon nations such as the UK and US, and less so in continental Europe. This is exemplified by the rise of shareholder capitalism and the importance of dividend payments.

Many authors have argued that pressure to keep dividend payments high has exerted downward pressure on wages so that profits have increased, while investment has not, at least compared with the decades prior to those in the study. It has also created pressure for labour markets to become more ‘flexible’, meaning that worker protections have been reduced via deregulation. Once more, the Anglo-Saxon economies have led the way:

“Labour flexibility has increased almost everywhere in Europe and in advanced countries over the past 20 years. However, some countries, such as Austria, Belgium, France and Germany, have retained more rigid labour markets. Other economies, such as Denmark, Sweden, Finland and the Netherlands, introduced higher levels of flexibility along with higher levels of security. Countries such as the USA, UK and Ireland increased (or maintained) their already very flexible labour market. Finally, Mediterranean countries such as Italy, Spain and Greece and most of the former communist economies in Europe combined very hybrid situations (of liberal and corporative elements) with an increased level of labour flexibility.”

In general, these trends have shifted bargaining power towards capital and away from labour, while failing to generate and sustain faster economic growth. One might argue that economic performance would have been even weaker without these changes, but today even the IMF is arguing that high inequality is associated with lower growth, and that there is no ‘big trade-off’ between lower inequality and economic growth and efficiency.

Indeed, it is a popular view among heterodox economists that financialisation and rising inequality increases financial instability and played an important role in causing the Great Recession.

Stagnant or falling wages for those at the lower end of the distribution reduce consumption since poorer workers spend a larger share of their income than richer ones. Weaker growth in consumption will in turn weaken aggregate demand and can only be countered by higher consumption by the rich, or increased borrowing among the poor. In many countries, the latter rose faster than their incomes, a trend which proved unsustainable.

Once consumers, on a large enough scale, begin to use their income to pay down debt rather than spend, aggregate demand will fall or stagnate, leading to recession and a weak recovery, as has been demonstrated over the past decade.

Among the rich countries, rising inequality and weak consumption led to two broad responses: a dependence of economic growth on rising debt, particularly in the more financialised economies such as the US and UK, or on rising net exports in countries such as Germany. These imbalances and their consequences remain a key part of our unfolding global economic story.

Higher inequality is also surely proving to be a problem beyond the economic sphere, in that it can undermine social cohesion and the foundations of democracy at the national level. If wages stagnate for the majority of ordinary workers, while they continue to rise for those at the top of the distribution, despite fairly sluggish economic growth, it is unsurprising that those left behind will call into question the legitimacy of the structure of the economy and society.

What of the policy response? The author cites Dani Rodrik’s point that, even if factors such as free trade and globalization more broadly have produced rising inequality within countries, such trends can be countered by strengthening particular domestic institutions.

This might involve boosting certain kinds of worker protections, reversing cuts to the welfare state and social spending, promoting trade unions as stronger social partners with business and reining in the influence of the financial sector. In this way, the inclusivity of growth could be increased without harming competitiveness.

Such policies may seem counterproductive from a neoliberal perspective, as they reverse the very ‘reforms’ implemented from the 1970s onwards to varying degrees across the capitalist world, intended to revive profitability and restore competitiveness and growth.

But if higher profitability, achieved at the expense of reasonable equality, has not produced a concomitant rise in productive investment, but simply a rise in consumption among the richest members of society, or an increase in unproductive investment, an unsustainable burden of debt and financial bubbles, then something is amiss.

As mentioned above, these policies have proceeded to varying degrees in different countries, and there seems to be no obvious relationship between their extent and subsequent economic performance. But large rises in inequality and the potential social division to which they give rise may well undermine the legitimacy of the political status quo, with unpredictable and sometimes damaging policy responses.

These considerations surely give rise to a more complex picture than a simple binary right-left axis of policies. To depart from the conclusions of the article, some neoliberal reforms may have improved performance, while others have been unnecessary, in that they increased inequality without improving performance.

At the same time, political instability and disaffection can influence economic policy and performance, so that certain policies promoting greater equality may be a ‘second best’ outcome in pure economic terms, but avoid the longer term damage arising from a continued neoliberal assault on wages and workers’ rights and protections.

As mentioned already, increased labour market flexibility has been achieved in certain European countries, while trade union power and influence, and welfare and social spending, have remained relatively high, reducing the impact on overall inequality and insecurity.

Overall then, these issues remain controversial and are worthy of continued study. But if even the IMF now supports policies to reduce inequality, politicians must craft responses which do so while sustaining prosperity in its widest sense.

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