Hollowing Out: Income inequality and income distribution

Today’s post is going to be short. The theme is income inequality. My thesis on this has been that globalization is a net transfer from the developed economy middle class to developed economy elites and the emerging market middle class. I have some evidence to support that thesis.

Imagine, it is 1975 and you are the owner of capital, paying your workers a decent wage. But then the economy goes global, with the availability of cheap labor in emerging market, and then the opening of China and the integration of the eastern bloc into global trade. You have a choice. You could continue to pay developed economy workers their salary or you could offshore some of those jobs, cut prices and keep whatever increased profits accrue from this strategy.

The key here is that, unlike in economic theory, you and your competitors are not small firms operating as price takers in a perfectly competitive market. You do have sway over your customers and suppliers and so your reduction in price does not lead to an industry-wide price decline that bids away all excess profit. What you have effectively done is reduce costs by offshoring and dividing the spoils between American consumers, foreign workers and yourself. All of the gains from offshoring do not go to American consumers in the form of reduced prices. Rather, some of the gains from reduced costs are transfers of income between different groups within the US and across borders globally.

The most recent data bear this thesis out. Take a look at this chart.

Branko Milanovic’s “Global Income Inequality by the Numbers: in History and Now” produces this outcome. Bryan Caplan notes the following from Milanovic based on the data:

What parts of the global income distribution registered the largest gains between 1988 and 2008? As the figure shows, it is indeed among the very top of the global income distribution and among the ’emerging global middle class’, which includes more than a third of the world’s population, that we find most significant increases in per-capita income. The top 1 per cent has seen its real income rise by more than 60 per cent over those two decades. However, the largest increases were registered around the median: 80 per cent real increase at the median itself and some 70 per cent around it. It is between the 50th and 60th percentiles of global income distribution that we find some 200 million Chinese, 90 million Indians and about 30 million people each from Indonesia, Brazil and Egypt. These two groups – the global top 1 per cent and the middle classes of the emerging market economies – are indeed the main winners of globalization.

The surprise is that those in the bottom third of global income distribution have also made significant gains, with real incomes rising between over 40 per cent and almost 70 per cent. The only exception is the poorest 5 per cent of the population, whose real incomes have remained the same. This income increase at the bottom of the global pyramid has allowed the proportion of what the World Bank calls the absolute poor (people whose per-capita income is less than 1.25 PPP dollars per day) to go down from 44 per cent to 23 per cent over approximately the same 20 years.

But the biggest losers (other than the very poorest 5 per cent), or at least the ‘nonwinners’, of globalization were those between the 75th and 90th percentiles of global income distribution, whose real income gains were essentially nil. These people, who may be called a global upper middle class, include many from former communist countries and Latin America, as well as those citizens of rich countries whose incomes stagnated.

This very much fits with the narrative presented above. It is a case of globalization not offering a situation in which the tide lifts all boats. Rather, globalization has meant a secular stagnation for the developed economy middle class, income inequality in developed economies and a rise in the income and wealth of emerging markets.

Yes, everyone sees some gains in income. But for the developed economy middle class, it is truly stagnation. Think about this in the context of income inequality as presently framed. What are equitable policy solutions? And what is the political outcome if no ‘solution’ is found?

My take here is that when broad swathes of the richest countries in the world see their income stagnating as their debt rises dramatically, you have the makings of political upheaval if and when cyclical downturns occur. That is what the great financial crisis was all about. Now, interest rates are at record lows, so the higher household debt loads are more easily supported by stagnating income. But in a downturn, this will change and debt stress will increase, forcing another bout of deleveraging and the attendant financial and political upheaval.

I don’t know what the solution is but it is clear that while the huge reduction in poverty in emerging markets is a positive outcome, the stagnation in the west puts globalization as practiced under threat. Personally, I don’t think the underlying causes of the Great Financial Crisis have been dealt with. They have receded somewhat but they are chronic and will become acute when we have another downturn. Secular stagnation in developed economies is real and it will be a big political issue for years to come.