Categories:Investments

Inequality a symptom not a cause

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The gap between rich and poor has increased significantly since the 1970s but, contrary to the argument put forward by Stewart Lansley, that is merely the effect of the economic crisis.

There is a growing school of thought that blames inequality for the economic crisis. From this premise it often goes on to argue that narrowing income differentials should be central to any successful recovery plan. This argument is based on faulty reasoning. Even if it is conceded that social inequality is problematic, it does not necessarily follow that it is the cause of the crisis.

I first touched on this discussion in Fund Strategy in January 2011 where I reviewed Fault Lines (Princeton University Press) by Raghuram Rajan. In his 2010 book, the Chicago university professor and former chief economist at the International Monetary Fund argued that the rise of income inequality was one of the causes of the crisis.

In Rajan’s view, the widespread stagnation of incomes had created an incentive for governments to expand credit and helped create the basis for the inflation of a bubble. My main criticism of the argument was that he failed to examine the relationship between the bubble and the real economy. I returned to this in a Fundweb blog post this January after Bill Gross, the managing director of Pimco, made a similar argument.

Now the debate has crossed the Atlantic with a piece by Stewart Lansley, a British expert on inequality, for a new think tank*. To assess the strengths and weaknesses of his case it is worth going through the main stages of the argument in turn. (Perspective continues below)

 

Lansley is right to argue that the British and American economies grew faster in the decades after the Second World War than more recently. I have often made the point myself. In many respects, (see my May 14 cover story), 1973 can be seen as the turning point rather than the 1980 that he suggests.

The period before the emergence of what is misleadingly called “neo-liberalism” clearly enjoyed better economic growth. The transition to a more overtly pro-business form of politics did not bolster economic performance. On the contrary, average growth slowed over that period. It is also true that inequality widened from the 1970s onwards. The gap between rich and poor is significantly greater now than back then (see graph, below).

 



It is at the next stage that Lansley starts to go seriously wrong. He suggests that because the widening of inequality preceded the emergence of the crisis, it must be its cause.

Pardon my Latin but this is what used to be called the post hoc ergo propter hoc (after this therefore because of this) fallacy. In other words, it assumes that because A precedes B then A must be the cause of B. A classic example of such a fallacy would be that since a rooster crows just before the sun rises, the crowing must therefore be the cause of the rising sun.

Lansley then puts forward two mechanisms that he claims account for a causal relationship between widening inequality and subsequent economic turmoil. First, as the gap between pay and economic output widens an increasing amount of demand is sucked out of the economy. In other words, relatively low wages mean consumption is lower than it would otherwise be.

Second, he argues that high levels of inequality lead to the emergence of asset bubbles. Eventually the bubbles tend to burst, with damaging consequences.

Although Lansley has identified many elements of the story correctly, the way he relates them to each other is wrong. In common with the rest of contemporary economics, he is blinkered to the importance of the real economy. He focuses so much on demand and consumption that he misses the primary importance of production.

The rise of many of the factors that Lansley identifies should be seen as a reaction to the slowdown of economic activity, rather than its cause. For instance, the rise of a more explicitly pro-business form of politics came about as a response to falling growth rates. In fact, it started to emerge even before Margaret Thatcher came to power in Britain and Ronald Reagan became the American president. Both the Labour government of 1974-79 and the Carter administration of 1976-80 were part of that shift towards a more business-friendly politics.

This underlying economic sluggishness also explains the huge increase in the importance of the financial markets. After 1973, firms increasingly preferred to invest in financial assets rather than reinvest in the production process. That is why business investment rates are much lower than they were and financial markets have become more important.

”The rise of many of the factors that Lansley identifies should be seen as a reaction to the slowdown of economic activity, rather than its cause”

This surge in speculative finance also helps explain the rise in social inequality. The remuneration gap has not widened, as many assume, mainly because of rising salaries among highest earners. Those with the highest incomes tend to get a high proportion of their remuneration from shares, share options and other forms of financial assets. That is why a surge in financial assets has coincided with widening inequality.

Even Emmanuel Saez, an economist at the University of California, Berkeley, who is regarded as on the left, has pointed out the correlation between asset prices and the incomes of America’s top 1% by income. That is why the incomes of the super-rich fell steeply from 2007 to 2009, with the stockmarket, before recovering sharply recently.

Whatever the desirability of egalitarianism, it should be conceded that inequality was not the cause of the recent economic crisis. It would be more accurate to see widening inequality as itself a symptom of more fundamental economic weaknesses.

* Stewart Lansley “Rising inequality and financial crises: Why greater inequality is essential for recovery” Think Piece, Class (Centre for Labour and Social Studies), May 2012.

 

Daniel Ben-Ami is a writer on finance and economics. His personal website can be found at www.danielbenami.com.

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