Saturday, December 17, 2011

Income inequality and sustainable growth

Eduardo Porter points to the work of IMF economists Andrew Berg and Jonathan Ostry that questions the sustainability of economic growth in conditions of widening inequality. They argue that "sustainable economic reform is possible only when its benefits are widely shared".

They found that in high-inequality nations spurts of growth ended more quickly, and often in painful contractions. They find that a 10 percentile decrease in inequality (represented by a change in the Gini coefficient from 40 to 37) increases the expected length of a growth spell by 50 percent.

They also found that income distribution contributes more to the sustainability of economic growth than does the quality of a country’s political institutions, its foreign debt and openness to trade, the level of foreign investment in the economy and whether its exchange rate is competitive.

The graphic below highlights why widening inequality is a much greater cause for concern in the US

Extreme inequality and its rapid widening is especially bad for developing economies like India, which are even otherwise vulnerable to supply and demand-side business cycle shocks. As Porter briefly mentioned, such widening inequality has implications which go beyond economic stability. It threatens political stability and forces democratic governments down the slippery slope of political populism.

I am inclined to believe that the rapid explosion of competitive populism in India in recent years is in no small measure due to the rapid rise in income inequality and the perceived need for governments to placate increasingly alienated and disgruntled voters who have come to believe that they are being short-changed in the sharing of benefits of liberalization and globalization. As the inequality gap widens further, the propensity for competitive populism will only increase.

This creates a policy gridlock, a low-level equilibrium, from where governments find it difficult, fiscally constrained, to meaningfully address the critical issues that determine sustainable economic growth. Among other things, it contributes to the stifling of reforms and the weakening of governance.

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