Inequality and Instability: A Study of the World Economy Just Before the Great Crisis

Plugging the income gap could prevent another economic landslide, discovers Stewart Lansley

June 28, 2012

Does inequality trigger instability? This ought to be one of the burning issues of contemporary economics. Yet until recently the question of the relationship between growing income gaps and financial crises has been largely ignored by the bulk of the economics profession.

The default view is that the two are unrelated, and that the rising concentration of income at the top since the 1980s in both the US and the UK, and more belatedly elsewhere, has played no part in recent financial and economic turbulence, or in the 2008 crash, or in today's lack of recovery.

But gradually that view is being challenged. James Galbraith, son of John Kenneth Galbraith, who has been working for years in what he has described as the "backwater" of inequality research, is one of a small but growing band of economists who put inequality at the root of the crisis. His new book is a multi-layered work of scholarship. A key pioneering contribution is Galbraith's assembly of a wealth of new data on inequality for individual countries. This greatly expanded database helps to overcome the limitations of existing measures and produces a larger body of data for testing economic relationships than previously has been possible.

Galbraith uses his dataset to test some of the claims of the current economic orthodoxy. One of those tests applies to the relationship between the pay gap and employment levels. The standard view - and one that has had a big impact on policy - is that narrow pay scales lead to higher unemployment; that, by sacrificing incentives, countries opting for greater equality must settle for a smaller cake.

This belief has been used to justify liberalised employment laws - with weaker levels of job protection and unionisation - adopted in the US, the UK and increasingly parts of continental Europe. Applying his new data to Europe, Galbraith finds this belief to be false: "measures to reduce the inequality of European wages", he concludes, "would help reduce chronic unemployment on average". This "is quite the opposite of the common view that Europe needs more pay inequality rather than less".

Galbraith also challenges widely accepted explanations - a mix of globalisation and rapid technological change - for the past three decades' growing income gap. His study pins the blame largely on the growing muscle of the global finance industry, and on the impact of the explosive growth of credit generated by an expanded, less regulated Wall Street and City. The data, he argues, "give no support to the vast outpouring in the professional literature that changes in inequality are based on...a 'race between technology and education'".

The book's strength lies in a series of distinct micro-studies; detailed pieces of individual analysis that examine several elements of mainstream economic thinking, especially those around the idea that nations can have greater equality or greater efficiency, but not both. Although it is hardly easy going for the non-specialist reader, the policy and political implications of much of its evidence are profound.

The mainstream view holds that we must live with greater inequality if we want faster economic progress. If Galbraith is right - and his views will stoke plenty of counter-argument - we need to tear up many strands of dominant economic thinking and substitute the wholly new idea that we can have it both ways: greater equality along with stability and economic health. Now that should get plenty of economic common rooms, and political advisers, talking.

Inequality and Instability: A Study of the World Economy Just Before the Great Crisis

By James K. Galbraith

Oxford University Press 336pp, £18.99

ISBN 9780199855650

Published 3 May 2012

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