For decades, income distribution was ignored by a policy consensus that favoured free markets. Research on income inequality is challenging that view.

The pursuit of free markets has commanded a consensus among policy-makers for over three decades now. Since the 1980s, countries have been increasingly introducing competition in various spheres of economic activity. At the same time, globalization is also expanding, buoyed by technology (the “fourth industrial revolution”), deepening cross-border financial integration, and the declining role of the state.

The motivation for “free-market” policies — many of which are key aspects of the Washington Consensus (a set of economic policy prescriptions advocated, inter alia, to restore economic health to crisis-hit economies) — has been to deliver strong growth and macro-economic stability. These substantial benefits, however, have not been equally shared: median incomes have stagnated in the US and in many other advanced economies; the labour share of income (the part of the economy that comes from wages) has steadily declined in many countries; and within-country income inequality has increased in almost all advanced economies and in several emerging markets.

Here I argue that greater attention should be paid to the consequences that economic policies have for income distribution (inequality). The reasons are four-fold.

  • First, excessive levels of inequality are bad not only for social and moral reasons but also for growth and efficiency: higher levels of inequality are associated, on average, with lower and less durable growth. Hence, even from the perspective of the goal of fostering growth, attention to inequality is necessary.
  • Second, high levels of inequality may lead to latent social conflicts that ultimately translate into political backlash against the pursuit of free market polices, including globalization.
  • Third, the fear that income redistribution would have an adverse impact on growth turns out to find little support in the data — implementing policies to reduce excessive inequality tend on average to support growth (by reducing inequality) rather than retard growth.
  • Fourth, many policy choices made by governments have a direct effect on inequality outcomes. Hence, inequality outcomes are not, as is sometimes argued, exclusively due to technological changes (such as robotization or digitalization) and other global trends that are beyond the control of any one government.

While the pursuit of market-friendly policies is desirable to ensure an increase in average living standards, the consequences of these policies for the distribution of income within an economy should be recognized and addressed, from the outset, through better policy design, and through redistribution when appropriate after policy implementation.

The dominant economic policy narrative

The notion that economists should worry more about growth than about its distribution has a long tradition, going back at least to economist Joseph Schumpeter in the 1940s, who noted that the benefits of growth could be expected to trickle down to even the poorest. Though academic debates rage to this day, by the 1990s policy-makers had converged on the broad policy ingredients they felt were needed to foster growth. This consensus — the so-called Washington consensus — was summarized by John Williamson and rested on (1) macro-economic discipline (particularly fiscal discipline); (2) structural reforms, particularly deregulation of markets and privatization; and (3) globalization — liberalization of trade and inward foreign direct investment. Though opening up to all manner of cross-border financial flows was not part of Williamson’s list, it became an important pursuit of policy-makers over the subsequent decades.

Along with the emphasis on growth, caution about worrying too much about distribution became embedded in academic and policy circles. As Robert Lucas famously noted: “Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.”

There are two reasons for this disregard of distribution. First, the assumption is that markets for the most part work well in giving people their just rewards for their work. Over-ruling the judgment of markets is thus unfair and unnecessary. Second, efforts to redistribute may themselves undercut growth. Even if inequality is considered undesirable for some reason, using taxes and transfers to lower it may be the wrong remedy.

A needed focus on macro-distributional linkages and inclusion

My own work strongly suggests that there is a strong negative relationship between the level of income inequality in a given period and economic growth over the subsequent period. Typically, on average, high initial inequality portends lower growth in the ensuing decade. Similarly, higher levels of inequality are associated with more fragility (less sustainability) in economic growth. That is, high inequality is strongly associated with a shorter duration of growth. Again, on average, countries with high initial inequality will see periods of healthy growth that are shorter and more likely to be cut short by a recession or depression. This is especially important for developing countries whose quest to “converge” with industrialized nations in terms of income per capita depends on sustaining periods of healthy economic growth over many years, indeed decades.

There is a direct economic cost to inequality in terms of lower and less durable growth. Hence, even if growth is the primary goal, inequality cannot be ignored.

While this evidence is suggestive it is not conclusive, given the need to control for other factors that drive growth processes. To get closer to causal relationships, my colleagues and I pursued extensive econometric modelling of the level and sustainability of growth. The results strongly bear out the preliminary indications from the data. If one controls for a range of plausible determinants of the level of economic growth and the duration of growth spells, inequality remains a robust determinant. In summary, there is a direct economic cost to inequality in terms of lower and less durable growth. Hence, even if growth is the primary goal, inequality cannot be ignored.

The notion that redistribution is a cure that is more harmful than the disease (excessive inequality) it is trying to address also finds little support in the macro-economic data over the last several decades. As I argued elsewhere (Financial Times March 2014), the things that governments have done to redistribute (through progressive taxation for example) have not, on average, inflicted a big growth cost on economies, and the resulting improvement in equality that redistribution engenders has itself been highly protective of growth.

External financial liberalization

It is an important notion in economic theory that the free flow of capital, or financial flows across borders, foster economic efficiency. They allow the international capital market to channel world savings to their most productive uses across the globe. Developing countries with little capital can borrow to finance investment, thereby promoting their economic growth without requiring sharp increases in their own savings. All this should contribute to higher growth. At the same time, there is a general consensus that greater openness to foreign financial flows is a driver of higher financial and economic volatility in many countries, raising crisis vulnerabilities.

From an empirical point of view, demonstrating the growth benefits of financial openness has proven difficult. Indeed, the empirical evidence has typically found that, on average, the growth benefits of opening up to foreign flows (financial globalization or liberalization) are small to negligible and are rarely statistically significant.

A defining characteristic of post-liberalization episodes is the presence of repeated boom-bust or surge-crash episodes — think of the Latin American debt crises in the early 1980s or the Asian financial crisis in the mid-late 1990s. Capital inflow surges amplify financial and macro-economic vulnerabilities during the surge phase. In recent work, my colleagues and I classify episodes according to whether they end in a crash or a soft landing, and associate the outcome with shifts in global conditions, as well as with domestic factors and policy responses over the surge episode. Importantly, about 20 percent of the time, surges end in financial crises, of which one-half are also associated with large output declines.

Designing liberalization in a way that does not compromise macro-economic stability and limits the risk of crises is crucial to enhancing its macro-economic benefits while mitigating inequalities.

While the impact of technology and trade on inequality has been studied extensively, much less attention has been paid to possible impacts of opening up capital markets to foreign flows. Our results on this score suggest that capital account liberalization has typically led to an increase in the Gini coefficient of about 0.5 percent in the short term (one year after the change in liberalization), with slightly larger effects over the subsequent couple of years.

In summary, this work suggests that lifting restrictions on capital flows across a country’s borders has been associated with limited growth benefits but significant distributional consequences. It also suggests that designing liberalization in a way that does not compromise macro-economic stability and limits the risk of crises is crucial to enhancing its macro-economic benefits while mitigating inequalities.

The field of macroeconomics was born in the aftermath of the Great Depression of the 1930s, when aggregate incomes fell by 25 percent in some countries. Avoiding such a decline through the use of monetary and fiscal policies became the central policy concern of macro-economists. Over the past three decades, a consensus has emerged, with a focus on openness to foreign trade and capital, fiscal discipline, and deregulation. Other than a concern with reducing poverty, concerns around the unequal distribution of growth have largely been ignored in this consensus.

Macro-economics is now reconsidering this consensus. My research contributes to this endeavor, with several important results. First, inequality is detrimental to growth, hence it is important, even if one’s interest is solely in aggregate outcomes. Second, redistribution has not been harmful to growth, which negates worries that redressing inequality would itself hurt overall outcomes. Third, most economic policies — including policies with respect to external financial openness — pose efficiency/equity trade-offs that need to be factored in at the policy design stage.

Since the Great Recession, much attention has been paid to understanding the links between finance and economic growth, given the origins of the global financial crisis that began a decade ago. Broadly speaking, the same attention needs to be devoted to the linkages between income distribution and economic growth, as well as to the exclusion of large parts of the population from the benefits of increased growth.

The views expressed here are those of the author and should not be attributed to the IMF.

This article is part of the special feature Inclusive Growth in an Age of Disruption

Photo: Shutterstock, by Life In Pixels.

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