Course Work -Economic Perspectives Final

7/28/2019 Course Work -Economic Perspectives Final

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Do we reduce inequality at the expense of efficiency, or let the poor get poorer and rich get

richer and focus on increasing our economic efficiency instead? This is a question that every

political institution should confront, and the evident trade off between the two has led to

continuous debates among economists for decades. An influential economist, Arthur Okun

stated, Theconflict between equality and economic efficiency is inescapable, while on

the other hand economists such as Piketty and Saez beli eve redistribution of income is

necessary to reduce equity at the expense of efficiency. Thus, with such contradictory

statements it can be seen that the cost of increasing GDP and the cost of a widening income

distribution is a serious issue; which is discussed at length in this essay, where the history of

the presence of inequality is traced back from the ancient world to industrialisation, testing

the impact that increasing efficiency has had on equity. Having analysed the proof and

causation of inequality, the consequences of increased efficiency is debated, then leading on

to the discussion of whether the government should intervene to reduce this cost of

inequality.

Inequality was an inevitable existence in the world even during the ancient world and middle

ages, better explained as the pre modern industrialisation era. This period boasted the

writings of some great men like the man of enlightenment, Jean Jacques Rousseau who

believed that ownership became the institutional basis of society which created economic

interdependencies dividing the population into classes, where the more wealthy were the land

owners who derived riches from the land either through subsistence farming, where the

surpluses brought income, or by large scale rental income being earned which was an idea

elaborated by David Ricardo. However, it goes back to the ancient world, where Xenophon

spoke about estate management and riches being accumulated from the rental income earned.

The diagram below illustrates the proof of the existence of inequality in the ancient world.


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Thus, inequality is not to be misinterpreted as a thing of the modern society, rather the notion

that inequality was the way of the world, originated from the beliefs based on religion which

dictated the workings of society back then. Religions such as Islam, Buddhism and

Christianity preached pro prosperity but anti greed. In other words, these old adages stated

that it was imperative that the poor existed in order to enable the rich to demonstrate theirvirtue. Even Martin Luther, a social r eformer in the 16thcentury claimed that an earth ly

kingdom cannot exist without inequali ty of persons.

This strong belief was instilled in some of the great economists who dictated many of the

workings of economics we follow today, for instance, Milton Friedman stated that greater

inequality would encourage people to work harder and improve productivity, whil e John

Maynard Keynes believed that it was precisely the inequality of the distribution of wealth

which made possible the vast accumulations of f ixed wealth and capital improvements

which distinguished the Gilded Age from all others. Thus, inequality may not after all be as

big a trade: off to efficiency as exaggerated, since based on the words of the ancient andmore modern economists, inequality was believed to be inevitable, incentivising, and a

necessary component to the industrialisation in the US.

Having discussed the presence of inequality in the pre modern era, we now move on to the

industrialisation era. This transformed and uprooted the lives of several, some for the better

and some for the worse. Was there an overall trade off in this period? The answer lies below,

but before that we first look at the data below proving the existence of inequality in the world

before industrialisation.


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As Islam developed there came about the creation of the world economy largely dominatedby the West which was a major shift in the history. With education and innovations together

with the discoveries of new lands occurring as a result, there was a spur of growth in many

countries. However, inequality was a growing phenomenon in the 18 th century, as countries

moved from agriculture to the secondary sector. This period of prosperity drove some classes

of the population to greater riches and a better lifestyle, while some other classes were driven

into poverty.

This can be explained by minority access to land and capital, i.e. several people had no rights

to land use for subsistence; most industries were located in urban areas, therefore, there were

substantial amounts of ruralurban migration adversely affecting the family life for some of

the poor who went in search of work. In addition, these workers faced very poor working

conditions in the industries as they were packed into slums, working very long hours adding

further misery to their poverty status.

However, the main source of poverty in this period was the dramatic increase in population

that set in after 1730, where the families high up in the distribution of income secured their

positions, as families involved in business increased their profit margins by investing more on

technology. The social hierarchy then became more rigid. The families in the lower end of

the income distribution were left to fend for their selves, the poor were driven to seek new

means of employment but the higher supply of workers created a downward pressure on the

wages leaving it at a mere subsistence level.


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To worsen the situation of equity, during the 1750s and 1850s the quality of goods

produced increased enormously and for the first time capital replaced labour to increase

efficiency but at the same time putting thousands out of their jobs, leading to a larger gap in

the income distribution. However this led to the Luddite Movements and the misery caused

by sweatshops to woman and children translated to the industrial revolution which is wherepoverty first became the cause of social up rise bringing into light additional evidence on the

trade - off of efficiency.


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Now, we shall consider the work of some influential economists. In line with the belief of

Adam Smith, that the ultimate goal should be increasing the wealth of the nation,the 17th

and 18th centuries likewise stimulated massive surges in the production of goods (indicated

below). However, this goal of increased efficiency alone was contested by Thomas More

who referred to this period of capitalism, as sheep eating men. He made this claim as theintroduction of enclosures in this period though increased the number of larger and more

productive capitalist farms, the number of peasants were reduced to the status of farm

labourers or more often displaced from their lands providing further proof that there existed a

trade - off between economic efficiency and equity. To accentuate this trade off, Thomas

Moore and Karl Marx as addressed in Das Kapital believed that these enclosures were

responsible for several social problems like stealing.


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Nevertheless, the 19thcentury was viewed as the progress of Enlightenment that continuing

growth and improvement was the destiny of human and natural life indicated in the theory of

Evolution by Charl es Darvin, and affirmed by Herbert Spencer(1820 1903). Further,

economic theory liberals like David Ricardo(1772 1823), John Stuart M ill(180673)

defended that free unregulated competition would bring continuous economic expansionand establish the universaljustice. This can be interpreted as perhaps that inequality is only

a small price to pay in the short run for a larger gain in the long run. Therefore could the trade

off merely be testing the patience of man or is it something that rather than being forgone

like in this period should be addressed? The answer is given below.

The relentless pursuit of the goal of increased economic efficiency, in terms of the old adage

introduced by Spencer in his system of synthetic philosophyi.e. the ceaseless devotion to the

theme of survival of the fittest has severe consequences in terms of increasing inequality.

It has resulted in people as a failure to compete due to inadequate skill, idleness, profligacy

and other factors like child labour and working conditions reforms demanded leading to the

formation of trade unions as early as the 19 th century. This may seem to be a good thing, but

as a topic argued back and forth by economists, when trade unions come into operation their

increased collective bargaining power is likely to reduce efficiency, as no longer could firms

use the carrotstick approach, instead inefficiency in the workplace may have to be tolerated

in terms of workers not being able to be fired always and the wage rate not always being

equal to the respective marginal productivity of labour. This is proof that when equity is

sought efficiency drops; whether this is a worthwhile cost is highly questionable.

Furthermore, it is believed that, labour market protections for low skilled workers would

have high egalitarian effects, (Blyth and Hopkin 2012).


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However, poverty issues do not stop there, as poverty increases with efficiency, crime is also

increasing continuously. This can be explained simply, man has strong survival instincts, if

they do not know and have no means to earn they would do the inevitable and steal to live.

Thus as the rich get richer and richer and the poor get poorer, crime and corruption in a

country increases as the poor have more incentive to steal from the rich, the black market

would become larger in terms of the amount of illegal activities undertaken by the poor toearn increasing, and thus overall efficiency would be affected again.

To elaborate, in line with the belief ofAdam Smith more resources are devoted to the

prevention of crime to protect the rich, and this can be seen as a waste of resources. Further,

the creation of the grey economy would make markets inefficient, in addition with tax

evasion social welfare would be affected and the resultant vicious circle of poverty would

only bring more harm to the economy.

Evidence of the impact of poverty on crime is illustrated below.


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The problems of poverty doesnt end with increasing crime, it extends further and beyond to

the more damaging political violence, for example; considering the industrialisation period,

the French Revolution in 1789 was definitely a demonstrative worry of poverty, which only

worsened efficiency as there were huge infrastructure destructions causing the GDP in

Europe to the lowest it has been, as seen in the Harvard review journal given among thereferences. However, we cannot be nave to imagine that this was merely a problem of the

past; the violence caused by poverty is seen in much of the Arab and Northern African

countries.

Thus, the cost of liberty leading the people was severe and brings into light the question of

whether efficiency can exist without equity? However the trade - off may not be as severe as

made out to believe since, Russell and Miller (1983), Taylor (1988) conducting research in

the Middle East, Asia and Europe discovered that there seems to exist poor evidence of

correlation between poverty and political violence. Nevertheless, as discovered by Fearonand Latin (2001) and Collier and Hoeffler (2000), GDP per capita is inversely related to

terrorism and thus impacts poverty. Therefore, it perhaps is more that political violence

affects poverty than the other way around.


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Another problem that poverty brings along is colossal emigration which has its own long and

global history. As people during the 19th century went in search of work to more welcoming

and richer lands with unexploited resources, countries with poverty lost out in terms of

international competitiveness to USA and Australia, as they would then face a lower labour

force and lower tax revenue.

However, in the modern era the countries receiving immigrants lose out as well, as illustrated

below where a negative relation is shown between U.S wages and immigration by skill

group; for every 10% increase in the number of immigrants, wages fall by 3.7%.

Lower growth rates may not be the only symptom of economic damage from inequality,

another could be macroeconomic instability. As stated byRaghuram Rajan the underl ying

cause of the 2008 American recession coul d be poin ted out to inequal ity, which echoed

John Kenneth Galbraiths writing in the 1950s that, bad distribution of i ncome was the

main cause of the Depression. To cement this, further evidence was discovered by Robert

Frank who believed that the spending of the rich affected the patterns of the near rich, and

David Moss found that the rate of American bank failures was highly correlated with thelevel of inequality. However, in contrast in Germany and especially China higher inequality

has encouraged saving rather than spending, and Anthony Atkinson and Salvatore Morelli

after researching on financial crises in 25 countries over the past 100 years found that there

was no correlation between inequality and macroeconomic disaster.


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Though the consequences of inequality are high indicating an evident trade - off between

efficiency and inequality, today it is more likely that efficiency and inequality are

complements rather than substitutes, as without equality incentives are created for crime and

revolution, the countrys labour force is risked to be driven away as seen in much of the

population poor Eastern Europe today, the aggregate demand is depressed leading to aneconomic contraction which would all in turn affect the welfare of the whole population

including the rich and in response economic efficiency. Thus it may not be possible to

achieve one without the other.

Having seen the consequence of inequality we shall now consider whether the governments

should intervene to correct this. An obvious answer would be yes, and seeing the diagram

below where government intervention in England has helped reduce inequality our answer

would be definite, however a discussion is necessary as detailed here.

Over the past two decades, inequality has tended to increase in advanced democracies. As

measured by the Gini coefficient, most of the OECD countries experienced increases in

income inequality from the 1980s to the mid 2000s. As stated by Piketty and Saez 2011,

I n some of these countr ies, the large shares of income growth went to the top 1% of the

income distribution, leading to pressure for redistributive policies to close the gap.Nevertheless, these demands to redistribute income to the poor were contested on the grounds

of reduced efficiency as a result of an ensuing deadweight loss that would occur, based on

Arthur Okuns leaky bucket hypothesis. Thus, redistribution by raising the tax rates was

thought to reduce incentive on investment for the rich and encourage low productivity from

the poor. Gary Becker too followed this belief as he stated that the bigger the state the

greater the distortion of private incentives.


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Therefore, our belief that governments should redistribute income to the poor and improve

the standard of living in the economy may be nave.Kuznets 1995 and Kaldor1958 together

with Fisher and Erikson 2007 cemented this belief that inequality had a positive impact on

investment and accumulation of capital. However, as we know with economics there is

always an opposing party, and in this case, Kenworthy 1995 believed that there was noempirical evidence on this trade off either at the national state level or cross nationally.

Furthermore, together with Kenworthy, Alesina and Rodrick 1994, Persson and Tabellii

1994, Petrotti 1996, Banerjee and Duflo 2003 believed that the egalitarian income

distribution and increased government spending were negatively correlated. Thus, based on

Barro 2000 and Forbes 2000 we can ascertain that the relationship is mixed at best.

However to conclude whether or not government intervention in the form of redistributive

spending does more harm than good, drawing on the recent research of Blyth and Hopkin

2012 seems the best idea. They shadow Okuns trade - off by stating that, market efficiency

has a positive yet curvilinear impact on income inequality, thus freer markets should bepursued by the institutions. This relationship is illustrated below.


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Government redistribution is a sensitive topic debated continuously, and as such we shall

consider the views brought forward by the Economist on how this affects the growing giants

of today: China and India, to cement the conclusion that freer markets are preferred to

institutional intervention. In these countries with the biggest income gaps increasing

inequality is more a function of the rigidities and rent seeking be it the labour laws in India orthe hukou system and state monopolies in China which creates distortions in economic

efficiency. In addition, though government spending has increased since the 1970s, the

modern transfers are less progressive and less growth promoting. Nevertheless, high income

inequality as seen in China and America today, would translate into high inequality in

opportunity for future generations possibly causing the poverty trap, thus slowing sustainable

growth in the future. Further, Gustav Marro and Juan Gabriel Rodriguez found that growth

was negatively correlated with inequality of opportunity but not overall inequality.

However, as illustrated below countries with high Gini coefficients had lower inter general

social mobility.

Thus, government spending rather than being directed at reducing income inequality could be

better directed at reducing inequality of opportunity, and a lesson should be learned from

countries such as Sweden that have sustained investment in public services which is highly

likely to prevent widening income inequality from reducing opportunity and Latin America

where investing more in education has proved to greatly improve social mobility. Thesecountries have thus shown that it is after all possible to have the best of both worlds.
http://econfix.files.wordpress.com/2013/01/great-gat-curve.png


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In conclusion, inequality matters for efficiency in all corners of the globe; one does not

need to look further than the role played by inequality in the global financial crisis or the

political violence issues in the Middle East hitting the headlines of social media daily.

Therefore, the notion that a higher inequality is both a necessary and sufficient condition for

increasing economic growth appears to be the uncontested truth, as discussed in the essay.

Evidence of this notion can be seen in China, which experiences some of the highest

inequality rates in the world that is believed to have enhanced its phenomenal economic

growth rates.

When considering the long run, according to Berg, Ostry and Zettelmeyer 2011, the trade

off between economic efficiency and equity may not exist after all, as sustained economic

growth cannot be achieved in the long run while having high levels of inequality. This is

accentuated by IMF economists, Andrew Berg and Jonathan Ostry in 2011 who discovered

that growth is more persistent in more equal countries, and that income distribution

mattered more for the length of growth spell s than either the degree of tr ade l iberal isation

or the quality of a countrys political institutions. This is evidence is illustrated below.

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Therefore, though according to Chaudhuri and Ravallion 2007, some inequality is

essenti al for ef fective functioning of a market economy and the incentives needed for

investment and growth, however too much would be destructive to growth. In addition,

concerning government intervention, if a government tries too hard, it would lead to lower

investment, less entrepreneurs and therefore lower living standards. Nevertheless the

implementation of policies such as better education made available for the poor, better

targeted subsidies and active labour market measures to improve employment would help

reduce the inequality of opportunity and thus reduce overall inequality.


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Regardless of the arguments made, the gap in the income distribution between the rich

and poor today in the 21st century is substantially much lower than a century ago or

even earlier, though quantitative measures tell us otherwise, as the calibre of goods

consumed by the rich and poor has changed greatly, as proved in the diagrams below.

Therefore if anyone has lost out it has to be the rich, proving our point that efficiency

and equity in the long run are both the sides of the same coin and it is after all possible

to have the best of both worlds.


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