COLUMN-Does inequality help growth - or hurt it?-Chrystia Freeland

Thu May 16, 2013 2:35pm EDT
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By Chrystia Freeland

SAN JOSE, Calif. May 16 (Reuters) - One of the most urgent questions in economics today is the connection between inequality and growth. That is because one of the big economic facts of our time is the surge in income disparity, particularly between those at the very top and everyone else. The other big fact is the recession set off by the financial crisis and the consequent imperative to jump-start economic growth. Figuring out the relationship between these two tent-pole issues is therefore a good way for economists to spend their time.

There are two main and contradictory ideas about how that relationship might work. One is that inequality is the price of robust economic growth. If the private sector is thriving, the most successful capitalists will be getting very rich. Creating a system that allows - indeed, encourages - the best and the brightest to pull away from everyone else is how you shift your economy into its highest gear.

There is, however, another theory, and it has been winning adherents in the aftermath of the financial crisis. In this view, rising inequality is not a symptom of a fast-growing economy or an incentive that will help create one. Instead, too much income inequality crushes economic growth.

There are different arguments for why that might happen. One is that high income inequality creates an unstable system that is vulnerable to costly booms and busts. Another is that when too much of the income goes to the very top and not enough goes to the middle, spending slumps - how many yachts does a plutocrat need? - putting a brake on growth.

David Howell, a professor of economics at The New School in New York, has written a draft paper for the Center for American Progress, a progressive research group, that investigates the first argument. Howell argues that the United States and Britain have acted over the past three decades on what he calls the laissez-faire theory, that the equation of rising inequality and increasing gross domestic product is correct.

As Howell puts it, "the laissez-faire case for high inequality is grounded in the belief that growth in output and employment depends mainly on strong incentives to work and invest."

Howell tested that view by comparing the United States and Britain to their peers. He asked whether "compared to other rich countries, U.S. income inequality has paid off in relatively high growth." His answer: not particularly. He finds that "there is no simple correlation between our measures of growth and income inequality."   Continued...