Economists are struggling with this classic problem that lies at the heart of IMF policy
Recent work has suggested that growth in GDP and in productivity may also be slowed by inequality
Prominent economists from the International Monetary Fund have raised eyebrows recently by questioning the virtues of neoliberalism. An article in the Fund’s quarterly magazine entitled “Neoliberalism: Oversold?” was a source of surprise for two reasons.
First, it questions aspects of long-established policy orthodoxy. Second, neoliberalism is usually deployed as an epithet by those who decry IMF policy prescriptions as destructive and unjust. The use of the word is deliberately attention-seeking and has provoked some on the left to characterise the Fund article as a full-scale recantation.
It is far from that. On the substance, the standard IMF model for sound policy favouring growth and development is also referred to sometimes as the Washington Consensus, a phrase introduced into policy discussions in the late 1980s by John Williamson.
The core elements of this so-called consensus call for liberal trade and investment policies, fiscal discipline, market exchange rates, subsidisation limited only to social support policies, private ownership, secure property rights and minimal regulation.
Packages along these lines have taken hold in many economies. With some important exceptions, they are considered essential to economic progress among a broad community of policymakers.
Now the IMF has come along and given qualified succour to critics of the orthodoxy. These are welcome adjustments. They essentially focus on two issues, one fairly narrow and the other more fundamental. The narrower ground relates to capital account openness.
For many years the IMF argued strenuously for the virtues of fully open capital accounts. Governments in this part of the world will remember this particular fixation from the Asian financial crisis of the late 1990s. A more nuanced approach distinguishes between foreign direct investment that can contribute to the real economy and knowledge transfer, and short-term, speculative capital flows.
The latter have been associated empirically in developing and emerging economies with volatility and financial crises that can cause severe economic contraction.
The second criticism of a neoliberal stance relates to austerity, or the role of fiscal consolidation. In the face of accumulated debt, an austerity orientation will seek to generate fiscal surpluses largely by cutting government social spending. The alternative to austerity is the Keynesian solution of stimulating output, such that an economy can grow its way out of debt over time.
This debate will be familiar to anyone following the tortuous twists and turns of the Greek crisis.
The most significant aspect of this policy debate is its implications for income distribution and inequality. Income inequality has been growing in many parts of the world in the past two decades. It has become a scourge, threatening social and political stability.
Many mainstream economists have been reluctant to address this problem, since the intellectual arsenal of neoclassical economics has nothing to say about income distribution. The standard microeconomic approach to optimal efficiency has nothing to say about how the cake is cut.
All it says is that the cake has become as large as it can be in an equilibrium state when nobody can be made better off without someone else being worse off. Critics of the neoclassical focus abhor what they see as an ethical vacuum.
The only problem with that kind of outrage is that nobody can convincingly benchmark the desirable level of equality in a society. In any society that is essentially an ethical variable, even though it is at the core of perennial struggles among interest groups. Neglect of income distribution on grounds of technical indeterminacy is not defensible. Political discourse is indispensable.
Empirical studies have shown that both full capital account openness and austerity exacerbate the maldistribution of income, so moving away from obsessive obeisance to dogma here is highly desirable. And excessively skewed income distributions have also been associated in a number of studies with a poorer growth performance. Recent work has suggested that growth in GDP and in productivity may also be slowed by inequality.
This leads us inexorably to the conclusion that governments and their citizens should care more than most of them do about inequality on practical economic grounds as well as for ethical reasons.
Patrick Low is a vice-president of research at Fung Global Institute