The long-term economic impact of growing inequality

Inequality has been widening across the world. A recent ADB report expressed concern at the rapid rise in inequality in emerging economies and warned that it puts at risk the spectacular recent economic progress of these economies. In this context, Paul Krugman points to an exploration by Lawrence Mishel of the various causes of this widening inequality.  

Mishel attributes the growth in income inequality over the last 30 years in the US to three dynamics - rising inequality of labor income (wages and compensation), rising inequality of capital income, and an increasing share of income going to capital income rather than labor income. More specifically, he argues that divergence between pay and productivity can go a long way towards explaining this widening of income inequality,

Productivity growth has risen substantially over the last few decades but the hourly compensation of the typical worker has seen much more modest growth, especially in the last 10 years or so. The gap between productivity and the compensation growth for the typical worker has been larger in the “lost decade” since the early 2000s than at any point in the post-World War II period. In contrast, productivity and the compensation of the typical worker grew in tandem over the early postwar period until the 1970s.

He has two illuminating graphics that highlight the magnitude of its contribution. The first graphic illustrates the cumulative growth in productivity per hour worked of the total economy (inclusive of the private sector, government, and nonprofit sector) since 1948 and the cumulative growth in inflation-adjusted hourly compensation for private-sector production/nonsupervisory workers (a group comprising over 80 percent of payroll employment). Notice that after 1973, productivity grew strongly, especially after 1995, while the typical worker’s compensation was relatively stagnant.

The next graphic disaggregates the productivity-pay disparity from 1973 to 2011 by charting the accumulated growth since 1973 in productivity; real average hourly compensation; and real median hourly compensation of all workers, and of men and of women. This figure clearly shows the divergence, especially since the early nineties between productivity and different categories of compensation. In simple terms, the share of income received as wages by workers is disproportionately small when compared to the share received by the owners of capital.

In addition, he also finds that workers suffered from adverse terms of trade. In other words, the prices of things they buy (i.e., consumer goods and services) have risen much faster than that of what they produce (consumer goods but also capital goods).

I will leave Mishel to conclude,

Productivity in the economy grew by 80.4 percent between 1973 and 2011 but the growth of real hourly compensation of the median worker grew by far less, just 10.7 percent, and nearly all of that growth occurred in a short window in the late 1990s. The pattern was very different from 1948 to 1973, when the hourly compensation of a typical worker grew in tandem with productivity. Reestablishing the link between productivity and pay of the typical worker is an essential component of any effort to provide shared prosperity and, in fact, may be necessary for obtaining robust growth without relying on asset bubbles and increased household debt. 

Much the same forces are active across the world, including countries like India. The only difference is in its magnitude or severity. 

India Vs China - Labour Productivity

Ejaz Ghani's graphic clearly illustrates the much higher service sector labour productivity of India compared to China's similar advantage in the manufacturing sector over the 1991-2005 period.



He draws attention to the challenge for both countries to catch up in their weaker sectors,

"Services are more skill intensive compared to manufacturing, and so it creates fewer jobs. India now needs to develop its manufacturing sector to create jobs for the millions of additional workers who will join the labour force every year for the next two decades. China, on the other hand, needs to develop services and go up the value chain, from less skill-intensive to more skill-intensive activities. Developing services will enable China to avoid the inevitable middle-income trap, which is more difficult to avoid if it just relies on manufacturing as a source of growth."

Some observations on the Great Stagnation

An interesting article in The Atlantic by Derek Thompson where he highlights a deep productivity decline in the US economy.

He draws attention to the increasing deprivation of middle class Americans despite food, clothing, and entertainment getting cheaper and forming a smaller share of household budgets. He attributes this to the rising prices of health care, education, housing, and energy,

"You could say that everything is getting cheaper except for almost everything you need. We need places to live, energy to move, education to move up, and insurance to stay healthy. The productivity revolution isn't doing much to make those things more affordable. Even after decades of building up and building out, homes and apartments are still prohibitively expensive in our most productive cities. Adjusted for inflation, home energy costs doubled between 1967 and 2003, and continued to rise in the last ten years. The cost of medical insurance is growing faster than wages. Tuition and higher education fees are growing even faster."

The graphic below highlights how the rise in the prices of these items have far exceeded the general wage increases.



Thompson points to a graphic from a McKinsey report which shows that more than half of total productivity growth comes from computers and information technology and practically zero have come from health care, education, and housing. It is therefore no surprise that health and education have to keep hiring people to do the same job, even as elsewhere the same job is being done by far fewer people than earlier. The resultant pressure to keep prices up is therefore unexceptionable.



Health care and education are susceptible to Baumol's cost disease, where the wages of workers rise even in jobs that have experienced no increase of labor productivity since the wages of workers in other jobs which did experience such labor productivity growth have risen. He attributes the productivity weakness with health care and education to their inherent nature - both are local services that are labor intensive - and are therefore not amenable to any external competition.

I have three observations from this

1. Interestingly, this brings us to the issue of increasing productivity in both these services. How do we get the same teachers and doctors to cover more students and patients? How do we leverage technology to reduce the cost of service delivery in both these services?

All available evidence and experience of other sectors indicates that this can be achieved only through competition, direct or indirect. One, atleast some of these services should be outsourced or off-shored and technology leveraged to deliver the same or higher level of service, so that the cost of service delivery comes down. Or else, there should be direct supply-side competition in these markets. This can be brought about by direct participation of foreign teachers and doctors in the US labour markets.

Either way, there appears to be a strong possibility for convergence of interests between the developed and developing economies. As I had blogged earlier, immigration offers the greatest poverty eradication potential. The same immigrants also offer the best chance for America (and many other developed economies) to ward off the Great Stagnation's impact on their middle class. In the circumstances, labour mobility, atleast in knowledge-based fields like education and health care has the potential to be win-win trade for all sides.

2. The changing dynamics of deprivation from that caused by food, clothing and basic consumer durables, to one that is caused by the prohibitive cost of education, health, housing, and energy, has implications for many developing countries. In fact, in countries like India, as a generation of people emerge out of the traditional consumption poverty, they are set to face the poverty wall erected by these newer requirements.

As economies and jobs become more knowledge and skill-based, the college education premium (and more specifically those related to certain elite colleges) would rise, and if supply fails to keep up with demand, as is most certain to be the case if the prevailing trends continue, then access to education will be a major source of middle-class deprivation. In health care, since technology will improve and expand its scope but with a rising cost, affordability will emerge as a major problem.

Urban housing is already showing signs of reaching breakdown point, as affordable housing in most of our major cities is already beyond the reach of a large majority of the middle class. As economy becomes more energy intensive and people start using more of it, it will become untenable for utilities to supply energy at its current cheap and subsidized rates. This energy requirement will go beyond household electricity use to include fuel used for private vehicles and cooking gas. The share of income that gets spent on energy will only increase.

In view of all this, public policy has an important role in promoting the development of these sectors. Fortunately, countries like India have just about time to put in place these policies, before the real middle-class deprivation problem will materialize. Education will have to be carefully deregulated to attract greater private investments and government will have to dramatically increase its investments in secondary and higher education. Most importantly, policy will have to catalyze the development of a vibrant market for financing education.

The only way to sustainably and meaningfully address the problem of rising health care costs is to put in place a nation-wide health insurance system. This has to be complemented by substantial investments in public secondary and tertiary care facilities, which will provide the critical "public option" that is necessary to improve competitiveness and keep prices under control.

Housing will be a much more difficult challenge to surmount. In simple terms, urban immigration is simply much faster than anything that can be done to increase supply. The only way to address the supply-side is to deregulate urban planning regulations and permit massive vertical growth, while simultaneously providing the infrastructure to support that growth. Urban slums will have to go vertical. Government policy will have to catalyze the development of an adequate stock of affordable urban housing. Instead of the prevailing paradigm of urban home ownership, a more appropriate strategy would be for governments to themselves build and encourage private developers to construct these housing stocks which could then form the platform for a liquid and vibrant market for rental housing.

The requirements of energy is tied to purchasing power since both consumption of all energy sources will increase and their prices too will rise as subsidies get withdrawn. Consumers' pockets will face the impact of this twin effect. This cannot be easily mitigated with any one policy. Public transport facilities will have to improve dramatically, so as to minimize the reliance on private transport which will become increasingly expensive. Further, even if governments want to susidize people's energy consumption, subsidizing public transport may be one of the least distortionary and most effective means to do so. Piped gas will reduce many of the overheads and reduce the cost of cooking gas.

3. Derek Thompson argues that the middle class have been able to manage with relatively less problems though from 1970 to 2010 despite real earnings of middle class men falling 28% even as the real GDP doubled. This has been facilitated by people working harder (typical two-parent family worked 26 percent more hours in 2010 than in 1975) and the sharp increase in women entering the workforce and thereby nearly doubling family incomes. However, both these trends have now run their course leaving the middle class with nothing to fall back. In the circumstances, without higher wage growth, the deprivation will only increase.

This requires a more balanced distribution of the gains from economic growth. Inequality and the forces that have been responsible by accelerating its widening, need to be reined in. Or else, the middle class will face a hollowing out of their incomes, and income and social mobility will be increasingly constrained.

Widening income-productivity growth gap and inequality

I have blogged earlier about the concerns posed by widening inequality across the world. Conventional wisdom on widening inequality has attributed it to the explosive growth in incomes at the top of the distribution. It is argued that there has been a sharp increase in the returns on higher education, manifested in the spectacular incomes of financial sector workers and corporate executives. They claim that while incomes elsewhere have increased, it is just that those at the top of the pyramid have increased much faster.

This argument overlooks another important trend at the other end of the income spectrum. It now emerges, from the latest figures released by the BLS in the US, that changes in workers real hourly compensation has been lagging labor productivity growth. This effectively means that in relative terms, workers are getting squeezed from both side. On the one side, incomes of those at the top are exploding. On the other hand, their own incomes are not even keeping pace with productivity growth.



The graphic above, of growth of productivity and real hourly compensation in the nonfarm business sector, is striking for atleast couple of reasons. One, the gap between labor productivity and real wages of workers has been widening since the eighties. Two, even as productivity growth has been sharply rising over the past three decades, wage growth has remained small. In fact, even as productivity growth rate increased from nineties to the first decade of this millennium, the wage growth rate declined.

An excellent essay by BLS provides more interesting insights into the reasons for the widening compensation–productivity gap. This gap is a function of two trends - the growth rate of prices and the labor's share in output. If the price deflator rises faster than the income growth, then the purchasing power falls and the compensation-productivity gap grows. The same outcome occurs if the share of the total output accounted for by workers compensation falls.

As indicated earlier, the compensation-productivity gap has widened sharply since the eighties in the manufacturing sector, in a sharp break from the trend earlier.



The consumer prices have grown much faster than implicit price deflator of manufacturing output since early eighties.



Finally, labor's income share of manufacturing sector output has been in constant decline since the seventies.



Update 1 (7/3/2011)

From mid-2009 through the end of 2010, output per hour at US non-farm businesses rose 5.2% as companies found ways to squeeze more from their existing workers. But the lion’s share of that gain went to shareholders in the form of record profits, rather than to workers in the form of raises. Hourly wages, adjusted for inflation, rose only 0.3%, according to the Labor Department. In other words, companies shared only 6% of productivity gains with their workers. That compares to 58% since records began in 1947. Only in the recovery from the deep recession of the early 1980s, when inflation-adjusted hourly wages fell 0.4%, did workers do worse than they have in this recovery.

The Economist: Innovation helps poor and rich countries alike

The latest issue of the Economist features a special report on innovation and the global economy which is well worth a look. In it you will read about the efforts of India's Tata motors to produce a $3,000 "people's car" and small biotech firms that are figuring out ways to produce generic drugs without trampling on Western patents.

"With manufacturing now barely a fifth of economic activity in rich countries, the “knowledge economy” is becoming more important. Indeed, rich countries may not be able to compete with rivals offering low-cost products and services if they do not learn to innovate better and faster. But even if innovation is the key to global competitiveness, it is not necessarily a zero sum game. On the contrary, because the well of human ingenuity is bottomless, innovation strategies that tap into hitherto neglected intellectual capital and connect it better with financial capital can help both rich and poor countries prosper. That is starting to happen in the developing world."

Click here to read about how so-called "open innovation" is transforming the corporate attitude toward intellectual property rights (in the public realm this is often referred to as "policy transfer").

See this graph for a nifty visual of the relationship between innovation, labor, capital and productivity growth in the US.