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Growing Inequality Harms the Political Economy

by Stefan Trappl and Branko Milanovic Thursday, Aug. 04, 2016 at 10:33 AM

Neoliberalism and finance market capitalism encourage creating money out of thin air, exploding inequality, precarious work and environmental destruction. Wages are not only a cost factor but an important demand factor leading to either investments or social blight.


By Stefan Trappl

[This article published on May 6, 2016, is translated abridged from the German on the Internet, http://blog.arbeit-wirtschaft.at.]

"The gap between poor and rich widens"

This headline appeared again and again in the media in the last years. This blog article discusses why different perspectives are necessary and why the increasing concentration of wealth in the hands of a few will harm the whole political economy.

In the last years, the theme "inequality" has increasingly been in the limelight of political economic discussions. The effect of "increasing inequality" on "political-economic development" is very controversial. There are several reasons for this from an economic perspective.

Firstly, "inequality" only plays a subordinate part in standard political-economic theory. Most economists are simply not interested in distribution questions or do not consider inequality in their models.

On the other hand, renowned economists like the two US Nobel Prize winners Joseph Stiglitz and Paul Krugman have taken up the theme. The increasing income concentration, the above-average rise of mammoth incomes compared to medium and low incomes was decried again and again.


Secondly, the problem of inequality is defined very unspecifically. How can inequality be best expressed? Seen historically, inequality was geared to functional income distribution up to the middle of the 20th century. Distribution of national income was geared to the factors capital and labor, the distribution between capitalists and the working class, to express the theme "ideologically." Since the second half of the 20th century, the focus has been more on personal income distribution, the distribution of incomes to individual persons or households irrespective of the origin of the income (work income or capital income). Moreover, income distribution and wealth distribution must be distinguished. In my research activity, I have focused on analyzing income distribution.

A very practical problem arises because of this lack of clarity. For decades, the economic discussion suffered in that convincing data was hardly available. Data hardly existed to support points of argument even after agreeing on how inequality should be defined.


The publication of top income data records brought a swing in the distribution debate. Firstly, records were now available that allowed statements on the long-term development of personal income distribution and secondly because the personal income distribution was established as the measure of "inequality"…


…Complete income equality – every person in a political economy receiving the same income irrespective of output – cannot be desirable in macro-economics. In this case, incentives for achievement, innovation, and acceptance of business risks are completely absent. Optimal distribution of income must lie somewhere in the middle. The two extreme cases never occur in reality. But in my opinion – and many leading economists agree – income concentration in the last decades has reached an extent that is "unhealthy" in many regards for the development of a political economy.


What is an "unhealthy income concentration"? The income distribution theme can be seen from three different perspectives:

from an ethical perspective: What income distribution is "just"?

in social science: What income distribution is ideal from a social perspective?

In economics: What income distribution is desirable purely economically?

The first two points should be discussed. Questions about "just" income distribution are very explosive. Discussions mostly move in a rightwing populist way between slogans like "grasshopper capitalism" versus "envy debate"… A 2013 study of the Johannes Kepler University [1] shows the richest 10% of Austrians have nearly 70% of all wealth. In relation to income distribution, a WU study demonstrates income concentration in Austria has risen since the middle of the 1990s… On the other side, very extensive transfer payments redistribute income to groups of persons who would fall by the wayside in a pure market economy according to a HIS study in Austria. The top quarter of income earners, according to Statistics Austria, pay over 80% of all wage- and income taxes. Economists agree the factor labor is taxed too highly compared to wealth in Austria.


The question what distribution is "just" can not be answered definitively.

The second question what wealth- and income distribution would be optimal from a social or social science perspective is secondary. Society must ask whether the most talented young persons enjoy the best education or rather those young ones who had the luck of being born in better-off families. Studies suggest the second is often the case. Children of academics have a three-time greater likelihood of studying at the university than children from anti-education sectors. In a 2011 book, Ingolf Erler summarized this as follows: In what family a child was born cannot be indifferent in any society. Social origin has a greater influence on education in Austria than in most western industrial countries. Whether an increasing wealth- and income concentration does not lead to social tensions or higher rates of criminality can also be questioned. Richard Wilkinson and Kate Pickett emphasized this thesis in their book. Increasing income concentration in the end also harms the top income earners since even top earners do not want to live in any country marked by criminality and social tensions. The question of income- and wealth distribution will mark the next years and decades in socio-economic and socio-political regards. More and more young persons are exposed to the problem of unemployment in industrial states and feel a lack of perspectives.


Unlike older generations that mostly had secure stable jobs, younger generations see themselves exposed more and more to precarious job situations. Financing one's own home from one's own means is a long way off today for most you9ng persons at least in urban areas. The feeling of not being able to gain prosperity through one's effort is widespread in the younger generations. That kind of certainty is caused above all by the current wealth concentration and cannot be conducive for the achievement readiness of a whole young generation! Joseph Stiglitz recently publicized this view.


The third question is how increasing wealth- and income concentration affects economic development.

As mentioned, personal income distribution hardly plays any part in predominant neoclassical economic theory and is ignored in economic models. The question how and whether an unequal income- and wealth distribution influences economic growth is connected with how total economic consumption and investments depend on that distribution.

While neoclassical writers see no negative effects of an unequal income- and wealth distribution hampers economic growth to more progressive schools including Keynesians and post-Keynesians. This is because receivers of low incomes spend a greater share of their total income on consumption than persons with higher incomes. Receivers of very low incomes often spend 100% of their income on consumption and would consume more with higher incomes. Very high incomes frequently save additional incomes since they can satisfy all their needs without the additional income. As a result, consumer demand is highest with the most equally distributed income. Neoclassical authors argue the higher savings rates of higher earners leads to more investments for future production. That is only restrictedly true.

Firstly, a large part of that additional savings capital flows into pure financial investments and only a certain part actually go to future production. The other parts only serve speculation. Secondly, increased income and wealth concentration leads businesses to invest less and less in building production sites. Broad parts of the population find themselves in the acute economic situation where the economy is marked by low growth while income concentration increases (the real income of vast population sectors falls) and less and less can be achieved. Why should there be an investment in new production sites?


An economic study of the University of Vienna shows investments in real means of production stagnate in Austria. This is referred back primarily to the alleged declining attractiveness of "industrial location Austria." An OECD study documents that falling real wages primarily of the lower income sectors lead to investment unwillingness of businesses. Thus the growing income- and wealth concentration has probably reached a level that impedes economic growth.

At the same time, there are research projects that ask why the increasing gulf between poor and rich is negative from an economic view. Renowned economists like John Kenneth Galbraith and Joseph Stiglitz see this chasm as one of the main reasons for economic crises.


According to a recent study, personal income concentration increased in the US before the two massive economic crises of the last hundred years, the "Great Depression" (1929-1933) and the "Great Recession" (since 2007). The development of the top income's share was familiar in direction, absolute percentages, and relative changes. For the time before the "Great Recession," the study shows the top income share rose strongly everywhere in industrial states. The study included data on the ten leading industrial states. In another study, whether a causal connection exists between rising income concentration and crisis likelihood was analyzed. Altogether regressions occurred. As income concentration increases, the risk of an economic crisis rises –, particularly in Anglo-Saxon areas. In these states, consumption is increasingly financed through credits. Lower income sectors in these countries try to counter the increasing chasm through credit-financed consumption.


In these states, particularly the US, economic growth is comparatively high despite mounting income concentration. However, these states tend to high crisis susceptibility. Financing personal consumer desires of broad sectors of the population through credits is not sustainable.

Summary: Ethical and social science problems of increasing wealth- and income concentration are often discussed and just as often dismissed as an "envy debate." The question whether higher income concentration has a negative effect on total economic development is an interesting new discussion subject. On account of the long time of poor data, this question will be first academically investigated in a few years. Recent studies suggest opposing higher income concentration with political-economic measures is sensible for purely economic reasons.


By Branko Milanovic

[This article published on February 24, 2016, is translated from the German on the Internet, http://blog.arbeit-wirtschaft.at.]

Many politicians obviously believe the inequality theme is finished as soon as the economy grows again. That could turn out to be an illusion. The development of the last decades has already led to far-reaching changes – necessitating a stronger medicine.

The inequality theme seems only an ephemera or flash in the pan for most moderate politicians despite the unprecedented attention given income- and wealth inequality in the US presidential campaign and in several elections in Europe. I think they believe people forget the talk about inequality and let everything return to the state 20 years ago as soon as the political economies realize robust growth rates of at least 2 to 4% per year and unemployment falls below 5% (or in single digits in Europe).

In my opinion, this is an illusion because it ignores the structural changes in societies that originated in the last 40 years through the long, continuing process of increasing income- and wealth inequality. Aggregated indicators like the growth rate of a political economy (which is nothing but the growth rate of income…) lose their significance that they normally have in economically homogeneous societies amid radical structural changes like the process that occurred in Latin America in the 20th century.

Three structural changes will be explained here: the "disarticulation" of many western societies, the political influence of "Big Money" (plutocracy) and unequal opportunities.


The term "disarticulation" was used by the Dependency literature of the 1960s and 1970s to underline both the divergence of interests and the different positions in the international division of labor of different classes in the developed world. On one side, there was an indigenous elite that was joined in the world economy both through the production side (as highly trained workers or capitalists) and through consumption (as consumers of international goods and services). Then there was the majority of the population that produced and consumed locally and had no connections to the world economy.

Nowadays the situation in rich countries like the US is similar. There is an elite (whether the notorious 1%, 5% or 15%) who are completely hooked in the world economy and live and consume globally. Then there is a shriveling middle class whose income has stagnated for 30 to 40 years and who are tied to the world economy in a negative way. Because of competition with poorer countries or migrants, the middle class lives in permanent anxiety of job- or income loss.

More strongly than the lower class of income distribution, the middle-class forms is that group that can more easily be won by Donald Trump's protectionist speeches. I do not say whether their expectations can ever be fulfilled in a globalized economy or not. I only point to the deep uncoupling of the interests of the top from those of the middle class, a breach that arose through globalization and increasing income inequality.

When the economic interests of these two groups are so different, it will be hard to speak of a "national economic interest." Rather the divergence of interests reflects a number of other divergences in life organization, observation of politics or cultural desires. That is the first structural gap.


The second consists in the extension of the first in politics. The significance of "big money" in politics always important in the US has multiplied again. The intense increase of income inequality brought greater political power to the rich even without these facilitating court decisions (and these decisions could be regarded as endogenous for the process of income differentiation).

Greater concentration of economic power means there are fewer persons with sufficient funds to support politicians and political interests that please them or (more probably) are profitable for them. Thus the concentration of economic power logically leads to a concentration of political financing. Ultimately the influence on politics merely reflects unequal economic power. This again leads to political divisions that favor the elite economically and to a further deepening of economic differentiation as several political scientists have already explained (Benjamin Page, Larry Bartels, Jason Seawright and Martin Gilens "Affluence and Influence").


The third structural change that arose through the income inequality – unequal opportunities – is transferred to the next generations and does not simply only end in an actual income inequality. The chances of children from rich parental homes and those from poor families differ enormously.

Similar to Latin America, this spread includes access to education and is not limited to inherited wealth. The growing importance of private education reinforces this trend. This is also true for family relations and networks which are often decisive for success.

These structural inequalities will deepen and not disappear when the economy returns to its long-term growth path. Higher growth rates and lower unemployment could occur before these structural fractural lines become very strong since growth can cover up these differences. But growth alone will not be enough when the structured divisions are deep (we can see this in Latin America).


An analogy from medicine is helpful. A common cold can be healed by lying in bed and drinking liquids. Step by step we return to our past condition. But strong medicine is necessary if the cold lasts a while and develops to a more serious sickness – and this happened with the long process of inequality with the political community…

A politics for greater justice is not a waste of resources but rather an investment – perhaps even the prerequisite for future growth.
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