My interview with Goldman Sachs magazine Fortnighly Thoughts: Populism or plutocracy?

Branko Milanović is the visiting Professor at City University of New York Graduate Center and former lead economist at the World Bank’s research group, where he worked on the topics of income inequality and globalisation. He is the author of The Haves and the Have-Nots: A Brief and Idiosyncratic History of Global Inequality.

 

Hugo Scott-Gall: Is income inequality on the rise globally?

Branko Milanović: It is important to begin with a clear definition of global income inequality. The most commonly accepted use of the term refers to inequality in what all the individuals in the world earn, regardless of the country of origin. This form of global inequality has been slightly decreasing over the past 15 years or so. What is driving this decline is that large and relatively poor countries, particularly China and India, have been growing significantly faster than the rich countries, like the US. There are, of course, other countries apart from China, India and the US that feed into global income inequality levels, but this triangular relationship explains close to 50% of the variation in the recent decades.

Another definition that is also used to describe income inequality paints a contradictory picture and refers to developments on an intra-country basis, rather than a global level. On these terms, over the last quarter-century, there has been an increase in inequality in a majority of nations including China, US, Russia, UK and most of Europe.

In summary, by and large there has been an increase in national inequality levels, but if we aggregate populations from all countries, global inequality has slightly declined.

 

Hugo Scott-Gall: In practice, how do economists measure income inequality? And are there inherent difficulties arising from the quality of data?

Branko Milanović: There are two main methods employed to measure inequality, each with its own advantages and limitations. The first measures inequality using household survey data and the second looks at income concentration using filed tax returns.

Household surveys are used to get information on income levels from a sample of households, surveyed at regular intervals. These are produced by most countries. However, in some countries such as India and Indonesia, income surveys are not available and consumption surveys are used instead. These national surveys are then combined and adjusted for differences in purchasing power and prices between the countries in order to get a real worldwide distribution of incomes.

The second method draws on a country’s fiscal or tax data, and focuses on income concentration at the very top of the distribution.  For many countries, large segments of the population do not submit tax returns, and therefore capturing the entire distribution can be an impossible task. Fiscal data however are significantly more accurate at measuring incomes at the top percentiles compared to household surveys because rich people tend not to participate in surveys or underestimate their incomes. Obviously, the incentive to underestimate incomes exists in fiscal data too since such information provides the basis for taxation, but experience shows that, in rich countries at least, tax evasion is less of a problem among the rich than the sheer unwillingness to bother with surveys. Tax data are available for some two dozen countries only and they cannot be used to generate global statistics.    

It is also important to remember that focusing just on the top earners does not provide a complete picture of income inequality within a country. There are scenarios when there are income increases at the top and the bottom, but declines in the middle, and while the results obtained from top income shares only would imply further concentration of incomes, inequality measured by Gini coefficient might register a decline.  But over the past 30 years, in the US and elsewhere in the rich world, both top income shares and overall Gini have gone strongly up. So, the two methods come to the same result.

 

Hugo Scott-Gall: For countries that are rapidly developing, is higher income inequality a necessary consequence of growth?

Branko Milanović: From a historical perspective, there is evidence of a relationship between inequality and growth, drawing on periods such as the industrial revolution in the UK and the US. Inequality significantly increased during these growth phases. Peak levels of income inequality in the UK were reached around the 1870s, while in the US it was in the 1920s. The Kuznets curve, formulated in the 1950s, is based on the hypothesis that as an economy grows and industrializes, market forces at first drive increases in inequality, and after a certain income per capita threshold is reached, inequality begins to fall.

But the evidence has been mixed more recently. Although the Kuznets theory has not been rejected completely, it is perhaps too simple to conclude that inequality is a necessary condition that accompanies industrialization.  For sure, China’s growth phase has broadly conformed to this pattern as inequality has risen during the period over which real GDP per capita experienced a sixteen-fold increase (between 1980 and 2012). However, during Korea’s development phase, rapid growth was accompanied by reductions in inequality. So was it in Taiwan, which experienced land reform and equitable privatization after Japanese occupation.

The direction of causality between income inequality and economic growth, as well as whether the sign is positive or negative, continues to be one of the most hotly contested relationships in economics.  The Kuznets theory makes the case that the direction is from economic growth to the changes in inequality. But it is also possible to look at the reverse relationship, how inequality influences economic growth.

In the 1990s in particular there have been numerous studies that have looked at this relationship; some arguing that inequality has a positive impact on growth, while other found a negative influence. Classical economists would argue that there is a positive relationship, as those with higher incomes save more and these savings finance investment which lead to higher growth. At the other side of the spectrum, it is argued that inequality increases pressures for redistribution because with higher inequality there are more poor people and they have an incentive to vote for higher taxes simply because they gain more from social transfers than they pay in taxes. If you then also believe that higher taxes are bad for growth, there is a relationship from higher inequality to low growth. But neither of these approached found strong empirical support and this type of literature waned until very recently.

But now I believe this type of research has just begun to explore new options as a result of access to much larger pools of data, and economists’ understanding is becoming far more nuanced than 15 or 20 years ago. Analysis today is no longer limited to looking at the relationship simply between an overall inequality index like Gini and the growth rate, but at pin-pointing the variety of impacts that inequality might have on different segments of the population, i.e. poor, middle class and rich. It is in my way a much more promising way to look at the issue. It would also take us away from the inconclusive black-and-white approach to inequality. For some things, and up to a certain point, inequality may be good. For other things, and beyond a certain point, it  may be bad.

 

Hugo Scott-Gall: What role does ageing demographics play in increasing inequality?

 

Branko Milanović: Demographics certainly plays an important part. In general, an ageing population means increasing demand for social transfers that redistribute income from those who are employed to those receiving pensions – leading to a reduction in inequality. From an accounting perspective, unless this transfer is accompanied by an increase in productivity, there is a reduction in growth.

However, demographic shifts take place slowly and are constantly offset by many other elements impacting the labour market.  For example, in countries such as Spain where unemployment levels are close to 25%, a return to higher employment would obviously increase incomes and may reduce income inequality.

 

Hugo Scott-Gall: Have we reached levels of income inequality where society’s tolerance level is being tested?

Branko Milanović: Increasing income inequality eventually leads to political pressures, but at present, I do think that people’s concerns that it might lead to dramatic political changes are exaggerated. I do not foresee catastrophic events. However, I believe that the current situation has led to two problems, which I call the tale of the two P’s. Both elements can be found in all democracies, but have become more prominent and corrosive in recent years.

The first is plutocracy, some of whose features are present particularly in the US.  The need for politicians to fund future campaigns has been met by monies coming from special interests. These relationships have led to the politicians being beholden to lobbies. As we know from Adam Smith, special interests are special because they never have interest of a community, but their own only, in mind. This however is not a new phenomenon and was seen in the US even in the 1920s. It is just worse now.

The second risk is greater populism, and this has manifested itself especially in relation to immigration policies in Europe. The response by European countries has been emblematic of lower economic growth experienced after the financial crisis. Post 2008, stagnant or declining incomes in most countries were  not accompanied by an even distribution of the loss. For example, Mediterranean countries such as Greece saw real incomes at the top 1% experience minimal changes at a time when GDP decreased by 15%, and when the poor and the middle classes lost even more. As a consequence, there has been a tendency for political systems to assuage the middle class by using immigrants as a scapegoat. These are indeed difficult challenges faced by the countries that are adjusting to a slower growth environment, and if they are unwilling or cannot go after some of their own rich, they go after the immigrants. The US has been slightly different because it has a long history of immigration, and despite the fact that there is an anti-immigrant movement there, it is not been as sharp as the one in Europe.

 

Hugo Scott-Gall: Has greater transparency enabled by widespread access to the internet changed attitudes?

Branko Milanović: I'm not going to exaggerate the importance of smartphones in revolutions, but there are many examples where technology has played a role in raising awareness of the extremes in inequality. The revolution that took place in Tunisia was triggered by WikiLeaks, which reported on the spending habits and luxurious lifestyle of the now deposed leader, Ben Ali. Even though people would have been aware of his extravagance, there is a difference in impact from being told this as a gossip to being discussed and reported all over the internet.

 

Hugo Scott-Gall:   What are the solutions available to leaders of Western countries who may have been mandated by the population to address inequality?

Branko Milanović: Unfortunately, I do not have a very strong or original  answer to this question. For example, although more widespread and better education is not a panacea, it is certainly a policy that boosts economic growth and helps address income inequalities. A broader-based educational system equipping the population with a wider set of skills creates a more productive and flexible labour market (this is, I know, somewhat of a cliché but may nevertheless be true). Also, a more educated population reduces the premium that very highly skilled individuals receive which creates a win-win proposition for both growth and inequality.

Taxation is another tool, but its impact on growth is much more ambiguous. Implementing tax policy change is constrained by the fact that capital is very mobile, and for a single country or even group of countries such as the OECD it is a difficult task to accomplish single-handedly.  This has been the underlying hurdle which has scuttled proposals for worldwide taxation on capital or the Tobin tax levied on financial trading for example.

Also, there has been an ongoing debate in the US on increasing the minimum wage. The US minimum wage in real terms is below the level it was in the 1960s, whereas GDP per capita has increased by almost 2.5 times.

 

Hugo Scott-Gall: Countries and cities  that are highly specialised in specific industries can witness large differences in incomes across the population. Is wider income inequality inevitable under these circumstances?

Branko Milanović:  I agree that there are many economies located across the globe that are highly geared to a specific sector and have been especially successful in attracting global talent. For example, the state of California ranks as one of the most unequal states in the US, but it is incredibly successful at bringing together highly educated individuals, as well as people from different portions of the income spectrum including low-skilled. I do believe that high inequality in technologically driven or other successful economies is acceptable to the extent that it allows for movements up and down the income ladder, within and across generations. But absent that high mobility, high inequality which carries over several generations, eventually leads to marked inequalities of opportunity and that is certainly undesirable.

 

The world of the weird: r is greater than g and inequality is not increasing? Can it happen?

I was recently discussing Piketty’s book (yet again) with my friend Mario Nuti. I mentioned to him that I think it is possible to have the rate of return on capital (r) be greater than the rate of growth of income (g) and still have a non-increasing inequality—under the simplest possible conditions and within the very narrow confines of Piketty’s model. After I explained it, Mario encouraged me to publish it in a blog. So this is what I am doing now, essentially transcribing the notes I took while reading Capital in the 21^st century.

No, you don’t need to run away thinking that I will try to prove this by using a second-order  differential equation and a very fancy growth model (I would not know how to do it anyway). Not even by assuming (as we can) that while r>g holds, the distribution of capital becomes more equal and thus offsets, and possibly overturns, the pro-inequality effect of the rising capital share in total income. No, none of that. Much more simply; in effect, disappointingly simply… 

Just as a reminder: as we all know by now, r>g implies that the stock of capital is increasing faster than net income. Then, If the rate of return on capital does not fall proportionately (and Piketty thinks that it may not fall at all), the share of income from capital in total income will rise, and since capitalists are generally the rich guys, inter-personal inequality will increase too. So, that’s the basic story we all know. 

But now let’s go behind the mirror and assume that rate of return falls to 0 while the rate of growth of the economy is negative (a situation not too dissimilar from the one experienced by the Eurozone countries today). What happens then? Obviously, capital stock will not increase since net saving is zero. But capital/income ratio (Piketty’s β) will rise because income—the denominator—is going down. The share of capital income in total income (α)  will remain unchanged at zero.  Thus we can have (1) r>g, and (2) a rising β while—and this is strange—(3) α is constant. 

This is interesting because the general interpretation to which we are used, perhaps because we are used to living in or dealing with growing economies, is that r>g implies a rising β and a rising α. Not so in a declining economy. The last part does not hold. 

It is indeed a degenerate case, due the fact that α is bounded from below. But, as a general proposition, it is nevertheless true that we can have a rising β, a constant r, no change in the distribution of capital assets, and –surprisingly—a non-increasing share of capital, and presumably, non-increasing inter-personal inequality.

(To some extent, this issue goes back to Keynes’s great chapter in “The General Theory…” dealing with the special nature of money. It alone among all “commodities” has no “carriage cost”—decrease in value due to simple passage od time—so its lowest “own rate of return” is zero. If it could go below zero, there would be a decreasing capital/income ratio, negative α and a decreasing inter-personal inequality. The “paradox” to which we pointed out above would have disappeared.)

  

Why focus on horizontal inequality undermines efforts to reduce overall inequality

Goran Therborn in his important new book “The Killing Fields of Inequality” lists, among the three key puzzles of the past 30 years of social and economic developments, this one: Why were rich societies much more successful in reducing “existential” inequality between various  groups (blacks-whites; men-women; heterosexual-homosexual; immigrants-natives etc.) than in reducing overall income and wealth inequality? Actually, the very opposite happened: both income and wealth inequality increased substantially.

            A focus on “existential” or “categorical” inequality is what in the 19^th century Europe used to be called a radical position, associated with the post-1789 developments. Once all formal distinctions of class between clergy, aristocracy and people were abolished, there was, it was argued, no need to focus on the existing income differences. This view reached its peak under the French Third Republic when inequality was increasing by leaps and bounds, while formal equality was left untouched.  (The socialist position at the time was that formal equality is just the first step towards real equality which requires also the diminution of economic inequalities.) The same radical position holds fast and true today: once you see the world as primarily composed of various groups, you quickly slip into “identity” politics whose main objective is to equalize formal legal positions of the groups—and basically let everything else the same.

            According to Thorborn, that’s what the world has been remarkably successful in doing in the past 30 years. There are well-known and substantial advances in the equal treatment of different groups (listed above); there was also a strong push for “horizontal” equality, which is the term used in economics to indicate that on average there should  be no wage differences between men and women, blacks and whites etc. (that is, at  least no differences that cannot be explained by better skills or experience). The progress there, although not as substantial as in legal equality, has been real too.

            But the quasi single-minded focus on “existential” inequality was not always helpful, and I think in some cases was outright harmful, to the general reduction of income and wealth inequalities. The success in the latter would—I think it could be argued—also reduce income differences due to racial or gender discrimination. In other words, pushing for reduction of inequality in general would make lots of sense even if our primary objective is to reduce specific gender or racial income inequalities. But this is not how things worked out. Rather, the focus was on “horizontal” inequalities while the overall, general inequality was left to its own devices, namely was allowed to increase.

            The focus on “existential” inequality is wrong, in my opinion, for at least three reasons. 

            First, the emphasis of group differences quickly spills into identity politics, splintering  the groups that do have an interest in fighting for change. The joint front crumbles. The groups end up by caring just about the change in their own positions and become indifferent to the rest. I am unaware for example that gays or immigrants, once their objectives of legal equality achieved, have shown particular interest to fight for economic equality in general, be it in the United State or the world. Splintering has made people focus on their own complaint; once that complaint is solved, they are indifferent to the rest. 

            Second, the focus on “existential” inequality leaves the basic problem unsolved because the way it poses the issue is wrong. I noticed this in a recent discussion regarding legalization of prostitution.  For feminists, prostitution is a reprehensible activity that they would like either to ban, discourage through some ill-defined teach-ins of women, or curb its demand by  punishing clients who are predominantly males. Not only do these approaches just drive the problem underground without solving it, they are futile because the root case of prostitution is not addressed. The root cause today (and perhaps in history) is income and wealth inequality. There are many (mostly) men with huge incomes and there are many (mostly young) women with poor job prospects and no money. This drives prostitution nationally and globally (as in sex tourism). So,  the point is not to address gender inequality only (men vs. women) but its economic cause. Consider what would happen even if horizontal equality between men and women were achieved, a thing which, with higher enrollment and graduation rates among women than men, and rising number of rich women, man soon happen. The problem will simply become that instead of 90% of customers being men we shall have a “fair” and “gender-neutral” distribution of customers with 50% men and 50% women. Will such gender equality solve the problem? Obviously not: prostitution, a reprehensibly activity in the eyes of the gender-focused activists, will merely become gender-balanced.  Is this all they really want to achieve? No. But, of course, it reveals that the real cause of the problem lies elsewhere, in inequality, and that their approach is misdirected.

            Third, the emphasis on “existential” equality is politically easy because it is not serious. It faces no  real opposition from the right-wing politicians and conservatives because it does not affect the underlying structure of economic inequality and political power. Instead of fighting for meaningful general changes (e.g. increased vacation time for all, shorter work-week for all, more favorable working conditions for parents, longer maternity and paternal leave, higher minimum wage for all etc.)—the issues on which the success has been quasi nil, but which would cut into the profits and thus face a strong economic opposition from the businesses, proponents of the “existential” equality care only up to the point where legal equality is established. Strictly speaking, such equality is also in the well-understood interest of capitalists. We know at least since Gary Becker that, economically, discrimination is inefficient for those who practice it.  But general measures that improve the position of the employees will not of course please those who have economic power. So the proponents of “existential” equality stop midway again. Formal equality is surely a necessary condition for overall betterment, but it is not sufficient. A movement toward more generalized equalization of human condition requires not only legal equality but also substantively greater (income and especially wealth) equality.

            Their approach (“formal equality and then nothing”) is what Rawls calls “meritocratic equality”, the lowest level of equality where all participants are legally free to pursue whatever career they choose  but where their starting positions are vastly different. All those who care exclusively about “identities” do only that: they aim to place everybody on the same starting line, but do not care if some come to the starting line  with Ferraris and others with bicycles. Their job is done once everybody is on the same starting line. Case closed: just when the real issues begin.