The Growth/Inequality Nexus

By Jac Laubscher, Group Economist / Consultant

1 August 2017

South Africa has been plagued by the twin problems of high inequality and low growth ever since the start of the democratic era. (It should by now be clear that the growth spurt of the early 2000s was due to a one-off international windfall and not because of any structural improvement in the economy.) If anything, the situation has worsened in recent years ̶ economic growth has virtually stalled while the surge in unemployment points to increasing inequality.

The skewed manner in which black economic empowerment is being pursued, with select individuals rather than the broad population benefiting, is also contributing to greater inequality. It has indeed been shown that the increase in inequality after 1994 is mainly the result of increased inequality among the black population, while inequality between race groups has declined.

If one accepts Thomas Piketty’s methodology as set out in Capital in the Twenty-First Century, lower growth will by itself exacerbate inequality because of a widening r – g gap, where g is the growth rate and r the net after-tax return on capital. However, the effect of lower growth may have been at least partially countered by subdued investment returns, especially on South African equities, depressing r. A low number for gwould imply slower wage growth as wages follow productivity, and simultaneously depress savings/wealth accumulation from earned income.

The relationship between economic growth and inequality works in both directions and is complex. On the one hand higher growth is essential for the alleviation of unemployment, which is the main driver of inequality (the Gini-coefficient for the employed has been estimated at approximately 0,4 compared with 0,7 for the population as a whole). On the other hand the extreme levels of inequality of the type South Africa is facing are holding back growth by preventing the full utilisation of the available human capital and limiting demand in the economy.

The standard response in describing the relationship between inequality and growth is to emphasise the importance of incentives for growth-supportive behaviour, especially when it comes to entrepreneurial activity. In other words, high (and rising) inequality in wealth must be accepted as the inevitable outcome of entrepreneurial success and dampening it would undermine positive incentives to the detriment of growth. Riches that result from own effort will in general be accepted by society as fair compensation for the effort put in, unlike, for example, inherited wealth. However, this is not the full story, with inequality depressing potential growth in the long run.

It has been shown that a high concentration of wealth can cause the inefficient allocation of capital, in particular if that wealth has been gained through rent-seeking behaviour, such as through the exploitation of political connections. Needless to say, South Africa has experienced more than its fair share of this kind of behaviour in recent times! An inefficient allocation of capital will by implication be to the disadvantage of total factor productivity and thus potential growth.

At the other end of the wealth distribution the lack of collateral among the asset-poor disrupts the normal operation of the credit function, with many people being shut out of access to credit. As a consequence of this, equality of opportunity is undermined in various ways. The accumulation of human capital by those at the bottom of the income and wealth distribution will be constrained, and entrepreneurs will find it difficult to get funding for their enterprises.

South Africa’s experience bears ample witness to the frustration caused by these constraints ̶ note the Fees must Fall initiative at universities and the frequent complaints of black entrepreneurs about the difficulties of obtaining finance from the formal financial sector. However, it is not only the affected individuals who suffer in the process, but once again the productive forces in the economy will also be hamstrung. Weak educational attainment and skills development will furthermore undermine the ability of the economy to remain at the technological frontier, to the disadvantage of potential growth.

In addition to the effect of inequality on economic growth, it can also result in greater fluctuations in the business cycle. Poorer people have a higher propensity to consume out of labour income than wealthier people (or a lower propensity to save, depending on how one looks at it). Wealthier people will in turn have a higher propensity to consume out of wealth (and a higher propensity to save out of income).

The result is that asset prices, especially stock prices, will play an important role in consumption decisions. Wealthy people tend to display pro-cyclical savings behaviour, viz. they will save more during periods of declining asset prices that will act as a further constraint on consumption expenditure, and likewise save less when asset prices are rising, adding to consumption expenditure.

Some of the volatility in asset prices will therefore be carried over into the real economy, causing the amplitude of the business cycle to increase. In an extreme situation, inequality could undermine financial stability by boosting loan delinquency among lower-income groups, pushing the economy into recession.

What is particularly upsetting of the dynamic described above is how South Africa has lost sight of the major challenges it faces. Instead of making progress in resolving these issues, South Africa is falling further behind. The world will not wait for South Africa to catch up, in particular not in the area of technological development. The distractions that are keeping us from focusing on the real challenges we face are costing us dearly.

References

Boushey, Heather, De Long, J Bradford, and Steinbaum, Marshall (eds.): After Piketty: The Agenda for Economics and Inequality. Harvard University Press. 2017

Brynjolfsson, Erik and McAfee, Andrew: The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. W W Norton & Co. 2016