Two broad macroeconomic trends have dominated the global economy since the 1970′s. On the surface these two trends may seem contradictory, pulling us in opposite directions. But a deeper analysis of this contradiction points towards a single outcome. An outcome which would be devastating for the developed economies of the west, leading to third world levels of poverty in America, Europe and beyond, with all of the social unrest which that would entail.
Trend #1: Global Economic Convergence
A graph showing global economic convergence. Credit: Conversable Economics (click to visit)
In the twentieth century there was a big difference in wealth between the ‘developed’ world and the ‘developing’ world. Wealthy countries such as the those in North America and Western Europe had a much higher per capita level of GDP than developing countries, such as those in much of Africa and Asia. There was a sharp distinction between these two groups. But this sharp distinction is now being eroded, through a process which economists call ‘convergence’. According to Wikipedia convergence is defined as “the tendency for poorer countries to grow faster than richer ones and, hence, for their levels of income to converge”. The same Wikipedia page goes on to note that:
According to current research, global income inequality peaked approximately in 1970s when world income was distributed bimodally into “rich” and “poor” countries with little overlap. Since then inequality has been rapidly decreasing, and this trend seems to be accelerating. Income distribution is now unimodal, with most people living in middle-income countries.
In a guest post for The Economist Michael Heise expands on this, noting that the recent global economic crisis has only served to increase the trend:
At a global level, the prosperity gap between nations is shrinking, at least in relative terms. Whereas the financial crisis dealt a savage blow to financial assets of highly developed industrialised countries, average per capita wealth in emerging markets continued to grow. During the last decade, wealth growth in poor countries was roughly seven times faster than in rich ones. Furthermore, the number of people who can be counted as members of the global wealth middle class (per capita financial assets of between €5,300 and €31,600) has doubled since 2000 to almost 600m. These figures are taken from the Allianz Global Wealth Report which can be found here.
So global income and wealth inequality is shrinking; in a way this all sounds wonderful and quite utopian, in a socialist kind of way. But wait – inequality is decreasing? Then what about all of those articles we’ve seen in recent years lamenting how much wealth inequality has skyrocketed in recent years, leading to the growing fortunes of the infamous ’1%’ who control most of the wealth? I mean, what was that whole ‘occupy’ movement all about, if wealth inequality is actually decreasing, making the world more equal?
Trend #2: Rising Inequality Within Individual Countries
Since the 1980s, rich households in the United States have earned a larger and larger share of overall income. The 1 percent earns about one-sixth of all income and the top 10 percent about half, according to statistics compiled by the respected economists Emmanuel Saez of the University of California, Berkeley and Thomas Piketty of the Paris School of Economics. – New York Times
Source: Congressional Budget Office
In most countries around the world, the gap between rich and poor has been growing for years. According to a detailed OECD report on income inequality from December 2011:
Income inequality in OECD countries is at its highest level for the past half century. The average income of the richest 10% of the population is about nine times that of the poorest 10% across the OECD, up from seven times 25 years ago.
The U.S. Congressional Budget Office has also found a long term trend towards greater income inequality in America. Their report suggests that between 1979 and 2007, American incomes grew by 275% for the top 1% of households, 65% for the next 19% of households, under 40% for the next 60% of households, and just 18% for the bottom 20%. This finding is clear – not only are the top one percent taking the lion’s share of economic growth, but the increase in inequality can be seen across the spectrum.
Other studies have shown that the trend has continued, and may even have accelerated since then. One study found, for example, that 93% of the economic recovery following the global economic crisis went to the top 1% of households.
This divergence of incomes between the rich and the poor has not been limited to wealthy countries like America. Emerging economies like Brazil, India and Russia have created huge numbers of dollar millionaires and billionaires, but have made limited headway in tackling endemic poverty. Even communist China has been dramatically losing the battle against increasing inequality, and is now considered to be so unequal that it is at high risk of social unrest.
Economic Convergence + Rising Inequality = Convergent Inequality
Convergence, driven by globalisation and perhaps other factors, is eroding the income and wealth differences between countries. This convergence, however, does not mean that all people will converge on the same income, but rather that the same global inequalities of wealth previously seen between different countries will, in the future, be seen within individual countries.
Where is this leading? Unless there is some truly radical political action, or technological miracle, it is unlikely that the world will eradicate poverty. Similar levels of wealth and poverty will exist in the future as have existed in the past. But whereas in the mid twentieth century the wealth was concentrated in the developed world and the poverty in the ‘third world’, the trends outlined above show that we are moving towards a situation in which the wealth and poverty are both equally distributed across different countries. To put it starkly: first world wealth will be equalled within developing economies, while third world poverty will be seen within developed economies.
That is the end point towards which these two well established and long term trends are moving us. Of course that doesn’t mean we will continue all of the way to the end point. But such major macroeconomic trends, based on fundamental factors and well established over a period of decades, are very likely to prove incredibly difficult to change. What’s more, much of the world (ie the people living in the world’s poorer countries) wouldn’t want to change them and would strongly resist any attempts to do so.
High levels of wealth inequality negatively impact on economic growth. In a highly unequal economy the lower levels of society (in economic terms) cannot fulfill their potential. They become poorly educated, are unable to put their good ideas into action, and are demotivated by a system which seems to be against them.
According to Jonathan D. Ostry from the International Monetary Fund (IMF) “Growth becomes more fragile” in countries with high levels of inequality. Mr Ostry’s research suggests that increases in the gap between rich and poor since the 1980s may have knocked up to a third of the total GDP growth of the USA. This finding was echoed in an official IMF report published in 2011 which concluded that reducing inequality and increasing growth might be “two sides of the same coin” over the long term.
The OECD also described the “negative consequences” of income inequality on growth in a 2012 report.
The Organization for Economic Cooperation and Development this year warned about the “negative consequences” of the country’s high levels of pay inequality, and suggested an aggressive series of changes to tax and spending programs to tackle it
This factor does not apply to developing nations. Inequality caused by adding a few billionaires and a small middle class to a country which was previously almost entirely poor does not negatively impact growth – it has a positive impact because there are suddenly people with local knowledge who have money to invest. The negative impact of inequality only weighs down the advanced economies of the ‘developed world’.
Immigration has also been a substantial aggravating factor in recent years, and looks set to play an equal or larger role in the future. As the Scott Summer notes in The Economist, in reference to immigration,”It reduces economic inequality at the world level, but increases income inequality in America”.
For years big business has pushed against popular demands for stricter immigration control across the developed world, quite successfully arguing that immigration is necessary for economic growth. In many ways this is correct – its just that the economic growth it produces all goes to the top earners, while the bottom earners lose out. Business benefits from having access to workers who will perform unpleasant and unpopular tasks on a low wage. They benefit from an influx of semi-skilled and skilled workers who they do not need to pay to train (nor pay taxes for the state to educate to a high level). This boosts the profits of many businesses, but also serves to depress wages and reduce training and education opportunities for the lower pay grades who do not share in the company’s increased profits.
In addition, foreign workers may often send money home, or save money to return with themselves, thus accelerating the relative transfer of wealth from developed to developing economies.
With the free movement of people within the European Union set to expand to encompass more poorer European countries, Western Europe is braced for a new round of immigration from the east. At the same time President Obama is preparing plans to naturalize large numbers of illegal immigrants in the United States.
Risks to Social Stability
High levels of economic inequality induce a systemic risk of social unrest. This is especially true during times of acute economic stress – as can be seen now in countries such as Greece, where both political extremism and political violence have surged.
If the trends outlined above continue into the future, and I can find no reasons nor evidence to suggest that they will not, then the risk of social unrest driven by poverty and a sense of unfairness will increase, and continue increasing as long as the trends are maintained.
What’s more, if my analysis is correct, then at some point relative poverty will give way to absolute poverty across the developed world. The recent ‘global economic crisis’, which as the growth figures show was actually an economic crisis almost entirely limited to the developed world, appears within this context to be a manifestation of a broader trend. The developed world was living beyond its means – living on debt – and still is. This, along with incorrect credit ratings on bad debts, was the cause of the economic crisis.
Effectively we are currently acting as if we were wealthier than we actually are. It cannot continue for ever. At some point the budget has to be balanced and we have to live within our means, or our lenders will simply cut of the supply of loans.
To do this we have to either: get much richer, or spend a lot less money. So far the developed world has singularly failed to achieve high growth, and the mechanisms described above may suggest that it isn’t likely. That means we are already much poorer than it feels like we are. If and when reality kicks in (and it may not if we were to miraculously enter a period of high growth) it is the poorest who will be hit hardest.
The risks that people pushed further into poverty will turn to extremist politics, or rioting and social unrest on the streets, is high. Currently the extreme end of politics is divided between the extreme right – nationalists, and the extreme left – socialists, which are vehemently opposed to each other’s political philosophy. Both extremes are on the rise across the developed world and especially in Europe which has been the hardest hit by the economic crisis. Each of these extremes presents a set of solutions to the problems which developed economies are currently facing. The far left promises a way out of the problems stemming from rising inequality, while the far right promises a way out of the problems caused by globalisation and immigration. One possible danger which is worth noting, if only in passing, is the danger that these two extremes realise that their solutions are not mutually exclusive, but rather can be combined together into one broader and more complete solution. This happened once in the past. The combination is called National Socialism.
The primary mitigating factor is global growth. If the global economy keeps growing – which it currently is – then this presents an opportunity to reduce and perhaps eliminate absolute poverty before it reaches the developed world in its most extreme forms. This could be further boosted by the attainment of an ‘optimal inequality’ level between nations, in which a larger number of countries could afford to spend on good education, research, and other programs, thus increasing global growth beyond its current levels.
There is no real way to tell how quickly these trends will progress – whether we have a few months, a few years, or a few decades before we see third levels of poverty on the streets of America and Europe. This also makes it difficult to tell to what extent global growth will be able to mitigate the effects of the kind of economic convergence described here. In addition, rising inequality between the world’s richest and the world’s poorest may reduce the ability of global growth to reduce absolute poverty.