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The Price of Growth

by Wilfred Herz Friday, May. 05, 2006 at 8:44 AM

In "1984," George Orwell warned that war would become a domestic necessity to divert the people from economic contradictions. Inequality may promote productivity but also undermines public spirit and social ochesion


The economy cannot advance without distinctions between poor and rich. However the economy is endangered if the social tensions are too great.

By Wilfred Herz

[This article published in: DIE ZEIT 14, 3/30/2006 is translated from the German on the World Wide Web,]

Redistribution does not sound neoliberal. “Distribution policy,” the economist wrote, “is an eminently important part of economic policy.” The “interest of social justice,” he urgently appeals to politicians, cannot be “taken seriously enough.” Sometimes one only sees wealth on the TV screen.

Walter Eucken, a law-and-order liberal, wrote these sentences that could be expected in speeches by Oscar Lafontaine or metal union head Jurgen Peters six decades ago –. He was a founder of the Freiburg school that developed the social market economy. He was everything but a redistributor. Still he was convinced that the incomes realized in the competitive economy must be corrected by the state and the differences between poor and rich kept within reasonable limits to promote justice.

Distribution policy and redistribution have been on the index for most politicians and economists for many years. The abstinence has its reasons: the empty public treasuries and the guiding principle of many economists that “inequality is the prerequisite for economic prosperity,” as Hans-Werner Sinn, president of the ifo-Institute formulates.

How great must be the differences of incomes and assets so the German economy can grow more vigorously and employ more persons? Is renunciation on justice the inevitable price Germans must pay for more economic growth? Couldn’t the losers of tomorrow be created with the losers of today?

The trend is clear. Incomes in Germany have already drifted apart for three decades even if the gap is wider in other European countries. According to the sociologist Richard Hauser, the development to more inequality in old Germany started “right after the beginning of mass unemployment in 1974” and was “only interrupted in short-term economic recoveries joined with a decline of unemployment.”

The contrast in assets between poor and rich is much greater than with incomes. The lower half of the population on the income scale earns 30.8 percent of the total net income while only owning 3.8 percent of the assets. The richest tenth pockets 22 percent of the net income but has almost half of the total assets.

The changes since the reunification have been “mainly at the edges of distribution,” as the five economic experts concluded in their 2004 report. Fewer regular full-time jobs, more part-time work, more precarious employment, mini-jobs and spread of the wage structure are registered on the bottom edge. That the wage increases have not equaled the inflation rate is not considered. Real wages are lower today than in 1991.

The exact opposite happens at the top edge. The “advance of income millionaires” was staged there, scandalizing the union-friendly Hans-Bockler foundation. In 1995, eight German corporations had CEOs with salaries of over a million euros. In 2003 there were nearly ten times as many. The executives in the 30-Dax businesses, the heavyweights of the German economy, doubled their earnings within six years.

One contradiction in the argument is very strange. For the lower incomes, employers justify the pressure on wages with the competition intensified by globalization and European liberalization. The same argument is used with the top incomes in an opposite way. The enormous increases are justified – even though a functioning competition would force down all incomes including the incomes of the bosses.

German executives cite top earners in the US as a standard of comparison since they are paid far more extravagantly. Low wage competition from the East threatens the managers – like some of their subordinates. If a manager in Germany earns 247,000 euros, international corporations pay managers of their branches only 74,000 euros in Tschechnya and only 66,000 euros in Hungary. Thomas Straubhaar, president of the Hamburg World Economic Institute explains the development of manager salaries as follows. “Managers are a comparatively scarce asset.” Scarce goods, according to a basic rule of the economy, are now more expensive.

What does justice mean in income distribution? The announcement of executive salaries in the millions regularly sparks off a justice debate – particularly when employees are dismissed or wages of personnel are cut at the same time. “Self-confident citizens,” the sociologist Ralf Dahrendorf explains, regard it as “unbearable when the asses- and income gap diverges more and more. These are typical excesses of a dynamic period.”


Politicians claim to worry about their possibilities for justice but refuse a precise definition of the practical meaning of justice. “All definitions of justice,” the senior leftist SPD Erhard Eppler admits, “remain abstract” and therefore “can be interpreted and manipulated.” All those who proclaimed the motto “What creates work is social” often meant “creating work by offering optimal conditions for global capital: low taxes, no protection against unlawful termination, negligible social security contributions, weak unions and poor wages.” Practically this means: “What was long regarded as socially unjust is socially just.”

Since time immemorial, economists have shirked from exact statements about justice. For hem, justice is not a standard. Instead they measure equality and inequality by income distribution. “Pay in the market economy” occurs “according to the principle of scarcity, not according to the principle of justice,” ifo-head Sinn explains. Therefore economists have left the answer about what is just to sociologists and philosophers. The economy concentrates on becoming more efficient and thus rich, trusting that a “rising tide lifts all boats,” as the American Nobel Prize winner Paul A. Samuelson wrote.


Is increased inequality a bad sign for social cohesion but a good sign for the economy? “A great spread of incomes is connected almost invariably with rising economic growth,” said Thomas Straubhaar of the Hamburg World Economic Institute. However this says nothing about cause and effect as the economics professor Roland Schettkat explains. Does the economy grow because the income differences increase or do income distinctions becomes greater because economic growth increases?

“Incentive pay as stimulation” is undisputed as Eucken wrote. Whoever accomplishes more on the job should be paid more. According to the firm belief of economists , the person strives to accomplish more – and this benefits the whole economy. Whoever has a desired vocation – usually the better trained in a high-tech economy – can demand a higher pay. On the other hand, a harsh wage competition threatens the poorly trained, from t he host of German unemployed or from countries where employees are paid miserably – through immigration, production outsourcing or imports.

Whether a greater inequality in distribution of income makes an economy more efficient and more productive is very controversial today among economists. The economist Nicolas Kalder defended this thesis in the middle of the 20th century. According o his argument, the rich had a higher savings rate than the poor and higher savings rates led to greater total economic output and thus greater economic growth. At the same time the Nobel Prize winner Simon Kuznets developed the Kuznets curve: the inequality of incomes first increases when an economy develops but then decreases – upon reaching a high state of development. However the Kuznets curve is hardly true for industrial countries.

Twenty years later the American Arthur Okun in his book “The Big tradeoff” described the conflict of goals between economic efficiency and just income distribution. In 2002 the American economist Kristin J. Forbes after evaluating data from 45 countries concluded, “A short-term and medium-term increase of income inequality has a significant positive relation to subsequent economic growth.”

In the meantime, many research projects deny this connection or prove the opposite. At a meeting of the Austrian National Bank three years ago, the Swiss scholars Retio Yoelimi and Josef Zweimueller declared only “very slight empirical evidence indicates that greater inequality is favorable for long-term economic growth.” In a paper of the World Bank years before, the idea was defended that excessive distinctions between poor and rich could “hinder economic growth.”

Beatrice Weder di Mauro, one of the five economic experts and the Mainz economist Mathias Oschinski presented another variant. Income distribution is hardly revealing. However inequality in ownership of assets is “negatively correlated with economic growth.” This is not a good sign for Germany since assets are distributed far more unequally than income.

In the long run, intense inequality is a poor breeding ground for growth. The larger the group of the poor with little income or assets, the more serious become the risks:

· With little income, the means for defraying the costs for one’s own education or the children’s education are lacking. Inequality for the next generation is fixed as the Pisa study shows. With great dispersion of income, “little is invested in human capital” (Schettkat) because whether the spending will be later worth the effort is uncertain. From an economic perspective, the potential is not exhausted since talents remain unused.

· Whoever has only little cannot build his or her own firm. He cannot obtain any credit or only a credit at high interest. Thus the chances that more people could become independent and create jobs for others, not only for themselves remain unused.

· When the gap between poor and rich becomes too great, the threatening distribution conflicts could harm economic growth. These conflicts could be carried out in politics in that unaffordable demands are obsequiously fulfilled for election votes. The conflicts around wages could also become sharper in the businesses.

· The danger of protectionism grows when wages fall on account of cheaper foreign competition. Victims of liberalization could force politicians to screen off the economy – even though the economy altogether profits from open borders.

· A higher criminality as a result of polarization can lead to higher costs to secure one’s prosperity and personal protection. Some regions in the United States are already warnings.


In addition, Claus Schaefer from the union-friendly WSI points to short-term consequences of unequal income distribution: “Private incomes needed for consumption will be considerably weakened and incomes not needed for consumption will be strengthened.” In the last years, this had a negative effect on private demand and economic growth.

International experience proves that both ways are entirely possible. An economy can attain higher growth rates with greater inequality and with a more equal income distribution. Four economic models are practiced in Europe – with different success – according to a background paper written by the Belgian economist Andre Sapir for a meeting of European Union economics and finance ministers in the fall of 2005.

According to Sapir who also advises the EU commission, the Scandinavian and continental countries including Germany have more equality. More inequality prevails in the Anglo-Saxon and Mediterranean countries. However the Scandinavians are equal to the Anglo-Saxons in economic efficiency while the continental and Mediterranean countries are lower. The right mixture of taxes, social transfers, job protection, unemployment insurance and education policy is crucial, not the distribution of incomes. The Mediterranean states should orient themselves in the Anglo-Saxon model while Germany and its neighbors in the West should imitate the Nordic states, the economist recommended.

The social consensus, not only alleged economic pressures, decides whether the polarization of incomes in Germany should be promoted or curbed. Germans could avoid a deeper split in society and reduce the distance between poor and rich if they realized further reforms: a reorganization of the tax system including social security, stronger work incentives for the unemployed – at best through a negative income tax – and more money for education, for instance education vouchers for low-income persons as the economist Straubhaar emphasizes. Germans must become as innovative as Scandinavians if they want prosperity for everyone in the future.

Despite globalization, EU-expansion and technical progress, what John Stuart Mill, one of the classical authors, wrote in the middle of the 19th century is still true: Many economic laws could have “something of the character of physical truths. Nothing voluntary, spontaneous or arbitrary is found with them.” This is not true in distribution. “Distribution is the work of human arrangement alone.”

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