Warning! Inequality May Be Hazardous to Your Growth

IMF Blog, April 8, 2011

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Income inequality has risen sharply in the United States over the past thirty years: the rich have gotten much richer while most households experienced very modest income growth.
The authors reject the view that overall growth alone suffices ("a rising tide lifts all boats") and illustrate inequality visually: imagining a thousand boats with boat length proportional to family income.
Inequality matters for growth duration: high income inequality is associated with a higher probability that long periods of high growth (“growth spells”) will end.

Illustrative comparison of U.S. income distribution changes:
- In the late 1970s, the average boat was a 12 foot canoe and the biggest yacht was 250 feet long.
- Thirty years later, the average boat is a slightly roomier 15 footer, while the biggest yacht, at over 1100 feet, would dwarf the Titanic.
Historical parallels:
- The increase in U.S. income inequality in recent decades is strikingly similar to the increase in the 1920s; in both cases there was a boom in the financial sector, heavy borrowing by poor households, and an eventual huge financial crisis.
- Inequality may have contributed to large upheavals, including political transformations in the Middle East.
Quantitative results from the authors’ analysis of “growth spells”:
- Closing half the inequality gap between Latin America and emerging Asia would more than double the expected duration of a “growth spell”.
- A reduction of the magnitude achieved by Brazil from the early 1990s through focused transfer programs could increase the expected length of a typical “growth spell” by about 50 percent.
Robustness:
- The effect of inequality on growth-spell duration appears large and persistent across alternative model specifications and definitions of “growth spells”.
Caveat:
- Income distribution within a country is generally stable most of the time, though significant shifts do occur (examples cited include the United States, China, Brazil).

Channels discussed or implied:
- Inequality may foster financial booms and borrowing by poorer households, increasing systemic vulnerability to crises.
- Unequal distribution may undermine the durability of growth even when other favorable conditions (political institutions, trade openness, health, education) are present.
Comparative importance:
- Inequality is placed alongside established growth determinants such as the quality of political institutions and trade openness in the “pantheon” of growth factors.

General principle:
- Analyses of growth should not be separated from analyses of income distribution; reducing inequality can promote sustained growth.
Short-run vs. long-run trade-offs:
- The immediate role for policy is unclear because poorly designed redistribution could distort incentives and undermine growth, harming the poor.
- When short-run trade-offs exist, the authors’ evidence does not prescribe a definitive policy choice but tilts the balance toward considering long-run benefits of reduced inequality.
Potential “win-win” measures the authors identify:
- Better-targeted subsidies.
- Better access to education for the poor that improves equality of economic opportunity.
- Active labor market measures that promote employment.
Historical lesson:
- The 1980s debt crises and the resulting “lost decade” demonstrate that sustainable reform is possible only when benefits are widely shared; similar considerations should guide adjustment and reform in the context of current global economic turmoil.

Source: Andrew G. Berg and Jonathan D. Ostry, April 8, 2011

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