01/21/2013 09:34 am ET Updated Mar 23, 2013

Does Inequality Stifle or Promote Growth?

Sunday's New York Times features two different views on the impact of inequality on growth. In a magazine pieceI wrote about earlier in the week, Adam Davidson frames the question in the traditional way: a modern economy can have faster growth or less inequality, but it can't have both. We need to decide, he asserts: "What do we value more: growth or fairness?"

Joe Stiglitz disagrees, arguing that "inequality stifles, restrains and holds back our growth." used to be that we asked how much growth we would be willing to sacrifice for a little more equality and opportunity. Now we realize that we are paying a high price for our inequality and that alleviating it and promoting growth are intertwined, complementary goals.

Who's right? Is inequality negatively (Stiglitz) or positively (Davidson) linked to growth?

It's true, as Stiglitz suggests, that Davidson's view of the tradeoff is "old school" and no longer widely believed by economists who study the issue. A simple look around the globe at advanced economies with much narrower income and wealth distributions and growth rates at least comparable to our own (e.g., Scandinavia) began to raise eyebrows re the traditional view, and subsequent analysis found little support for it.

As the OECD recently noted, "Despite a vast theoretical literature on the link between inequality and growth, no consensus has emerged and the empirical evidence is inconclusive."

Why might you expect inequality to be positively correlated with growth? Because many economists and the policy makers who listen to them believe that interventions and institutions that push back against inequality distort market signals and thus dampen growth. Unions and minimum wages, for example, are thought in this context to interfere with market-driven wage setting. Same with anything that protects domestic industries from foreign competition.

There's a lot obviously wrong with this view, not least of which that it ignores the power dynamics that shape both political and market outcomes. Those who lobby against unions, minimum wages, and industry regulation don't do so because they seek clearer market signals. They do so to claim a larger slice of the pie, and they've been extremely successful.

As Stiglitz puts it:

Market forces don't exist in a vacuum -- we shape them. Other countries, like fast-growing Brazil, have shaped them in ways that have lowered inequality while creating more opportunity and higher growth. Countries far poorer than ours have decided that all young people should have access to food, education and health care so they can fulfill their aspirations.

Our legal framework and the way we enforce it has provided more scope here for abuses by the financial sector; for perverse compensation for chief executives; for monopolies' ability to take unjust advantage of their concentrated power.

True dat. Yet, as the OECD finding suggests, there's not much evidence for causality going in the other direction -- from higher inequality to lower growth.

That doesn't prove Joe wrong. He lists a number of common-sense linkages, as did I in this post from a while ago. I'm working on a longer paper on the topic but so far, I'm finding the empirical inconclusiveness that the OECD notes. Why might that be?

It's of course possible that no relationship exists, but I think the problem has more to do with big timing and thus big signal-to-noise challenges in the measurement. For example, one potentially important pathway by which inequality may lower growth is through diminished quality of labor inputs. That's a fancy way of saying that young, economically disadvantaged kids faced with lousy education opportunities will be less productive in the workplace years down the road. But if that occurs, it does so with a 15-or-so-year lag, and there's a lot else going on in the economy in those years.

On the other hand, some aspects of the Stiglitz version of inequality/growth relation seem inarguably clear. Financialization of markets, the underpricing of risk, and the inflation and implosion of massive asset bubbles seems clearly and recently correlated with more inequality and our protracted recession/growth slog.

For now, I'd say the important things are to a) not subscribe to the traditional tradeoff view as per Davidson, as it leads to false and economically harmful policy choices, and b) promote policies that are both pro-growth and likely to help reduce inequality and particularly immobility, like quality pre-school and access to higher education by those on the wrong side of the inequality divide.

At the end of the day, our historically high levels of economic inequality may or may not be found to be causally linked to worse growth outcomes. But either way, as long as inequality is blocking opportunity, keeping working families from benefiting from the growth they themselves are helping to create, and violating the social contract and the basic American value that hard work should pay off, it's a huge freakin' problem.


This post originally appeared at Jared Bernstein's On The Economy blog.