Why should policymakers care about economic inequality?

The International Monetary Fund earlier this month gathered economic policy experts from around the world to discuss, among other important things, the rise in economic inequality in developing and developed nations alike over the past several decades. One panel focused directly on how to encourage more inclusive economic growth— a panel moderated by the executive director and chief economist of the Washington Center for Equitable Growth, Heather Boushey.

At the conference, she and I also released a new summary of the academic literature exploring this subject. Our report and the telling discussion among the experts in Boushey’s panel made note of the fact that it was long assumed economic growth led to less economic inequality but also that any economic policy efforts to alleviate inequality would necessarily slow economic growth. These views, however, were formed in an era before there was sufficient data to truly test this view.

As the data collection improved in the 1980s and 1990s, economists began testing this hypothesis. In an early survey of the literature, economist Roland Benabou at Princeton University in 1996 found that the vast majority of studies said high and rising inequality harmed economic growth. These papers used a variety of data sets, methods, and measures of inequality but still consistently found this relationship.

In response to this early literature, various economists explored the nuances of this relationship. University of Melbourne economist Sarah Voitchovsky summarizes much of this middle literature in a 2009 review, finding that there was substantial disagreement about the relationship between inequality and growth. Some studies showing that inequality may improve growth under certain circumstances. The muddle of this middle period in this economic literature has given rise to a newer narrative. Methodological differences appear to have driven the differences in the results, with later analysis finding that higher inequality can be associated with faster economic growth in the short term, but over time higher inequality is related to lower growth.

Recent work by International Monetary Fund economists Andrew Berg, Jonathan Ostry, and Charalombos Tsangaridis as well as by Roy van der Weide of the World Bank and Branko Milanovic of the City University of New York have robustly found a negative relationship between economic inequality for developed countries and within the United States, respectively. This most recent wave of studies will likely not be the final word on the relationship between economic inequality and growth. Furthermore, there is substantial work needed to understand how inequality affects growth. Research supports several plausible channels that could explain the relationship between inequality and growth. Some studies provide evidence that better human capital formation—workforce education and training—is the key way to reducing high economic inequality that in turn slows economic growth.

Other studies find that a highly skewed distribution of income and wealth depresses consumption in the economy, crimping growth and leading to unsustainably excessive borrowing. Recent research on the on the 2007-8 financial crisis also implies that high inequality may restrict access to credit that entrepreneurs need to build small businesses into big businesses. We have evidence for each of these findings, but more work is needed.

While there are many open questions about the relationship between economic inequality and economic growth, we hope the debate can move beyond why we should care to how do we fix it. As the United States drifts into a society with levels of economic polarization not seen outside of the developing world, policies that produce more equitable growth may be needed if we are to remain economically vibrant. Understanding how to craft those policies will be key in the coming years.

October 21, 2014


Economic Inequality

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