Recent research and discourse on inequality has suggested that economic inequality is growing, may have harmful effects on economic growth, may be a sign of unproductive economic activity, rent-seeking or economic instability and is becoming a concern in political and civil society.

Economic inequality – the gap between the rich and poor in income and wealth –  has received extensive and continuing attention in public and academic discourse across the globe since the financial crisis.

It has entered the political mainstream, becoming the subject of scrutiny by global policymakers at events like the World Economic Forum annual meetings in Davos and intense civic mobilizations like Occupy Wall Street. In the United States, President Obama has called inequality “the defining issue of our time.” Political events with significant economic implications – such as the recent vote in Great Britain to leave the European Union – have been viewed as manifestations of risk associated with economic inequality.

Research has highlighted dramatic growth in inequality, especially in developed countries in the latter part of the 20th century. The attention received by Thomas Piketty’s Capital in the 21st Century, which highlights sharp spikes in wealth at the very top of the developed world’s economies, in addition to work by Piketty and Emmanuel Saez focused on the United States, helped spark popular focus on “the 1%.”

Investors have reason to explore how inequality shapes the world in which they invest because:

  • harmful levels of inequality cause, or are a sign of, low growth and financial instability;
  • channels of investment may help mitigate inequality;
  • the financial sector may play a particular role in generating harmful inequality;
  • the effects of inequality cause harm to the beneficiaries of investment that they represent or serve, both in the short and long terms.

In contrast to past conventional wisdom that there is an essential trade-off between equality and growth, one strain of recent research has argued that inequality can have negative consequences for economic growth (and that reducing it can therefore have positive consequences). These papers assert that in circumstances of excessive inequality, policies to promote equality can improve economic performance. 

“Our work built on the tentative consensus in the literature that inequality can undermine progress in health and education, cause investment reducing political and economic instability, and undercut the social consensus required to adjust in the face of shocks, and thus that it tends to reduce the pace and durability of growth.”

Redistribution, Inequality, and Growth, IMF

“For many OECD countries inequality is today at its highest since data collection started. This long-run increase in income inequality does not only raise social and political but also economic concerns: income inequality tends to drag down GDP growth, and it is the rising distance of the lower 40% from the rest of society which accounts for this effect.”

In It Together: Why Less Inequality Benefits All, OECD

This research is echoed in the UN’s SDG 10:

“While income inequality between countries may have been reduced, inequality within countries has risen. There is growing consensus that economic growth is not sufficient to reduce poverty if it is not inclusive and if it does not involve the three dimensions of sustainable development – economic, social and environmental.”

How much inequality is too much remains a difficult question to answer, and is clearly linked to particular economic, political and cultural circumstances, but this research has at least given investors cause to consider the question. James Galbraith suggests a biological metaphor: inequality is like blood pressure. When too high, blood pressure is a potential cause of harm to the body, and a potential sign of other troubling activity in the system.

Mechanisms by which inequality might harm economic growth

Reduced consumer demand

  • The wealthy tend to save more than other consumers, so wage stagnation and the resulting inequality may reduce the spending power of the poor and middle classes; in addition to reduced ability to save for retirement.

Increased economic instability

  • Inequality may drive bubbles, as those without economic resources take on debt for consumption.

Rent-seeking and political power

  • Concentration of wealth may lead to increased political power and influence, capturing economic rents at the expense of productive activity.

Exacerbation of social instability

  • As the gap between the haves and the have nots grows, so might social tension, and political and social instability. Inequality can even directly harm human well-being, being linked for instance to poor health outcomes, and reduced investment in education and development.

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    Why and how might investors respond to economic inequality?

    October 2016

Why and how might investors respond to economic inequality?