Bush's new economist has a curious prescription.

Bush's new economist has a curious prescription.

Bush's new economist has a curious prescription.

Moneybox
Commentary about business and finance.
May 23 2003 6:15 PM

Dr. Inequality

Bush's new economist has a curious prescription.

Last week, Kristin J. Forbes, a young Massachusetts Institute of Technology economist, was named to President Bush's Council of Economic Advisers. Professor Forbes has an impressive résumé,but one can't help but think that one article in particular helped put her over the top.

In her most prominent journal article, which appeared in the American Economic Review in 2000, Forbes concluded that "in the short and medium term, an increase in a country's level of income inequality has a significant positive relationship with subsequent economic growth." In other words, after employing various forms of regression analysis and crunching scads of data, Forbes presciently affirmed what President Bush and the Republicans who control Congress have long implied but never said: If you want to put a jolt into the economy, fix fiscal policy so that it widens the gap between rich and poor. By reducing marginal rates and cutting taxes on dividends, that's precisely what the most recent gimmick-laden tax bill will likely do.

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But Forbes—who appears to be no relation to the better-known Forbes family of income inequality advocates—is an academic economist, not a think-tank jockey. Her argument, although easily caricatured, has less to do with partisan politics and more to do with an ongoing academic debate about the relationship between economic inequality and growth.

In the middle part of the 20th century, the prevailing presumption was that income inequality was good for growth. Putting more money in the hands of the rich, who saved more, would provide economies with the means to finance investment. Under the schemas of influential economists such as Keynes contemporary Nicholas Kaldor and Nobel Memorial Prize-winner Simon Kuznets, governments faced a tough choice in devising fiscal policy. They could either spread income out more evenly, which would harm growth, or stimulate greater growth by fostering greater inequality.

In recent decades, the accumulated knowledge about how economies performed in the post-World War II era started to undermine this view. Countries in East Asia—Japan, Korea, Singapore, etc.—charted impressive growth over long periods, even as the distribution of wealth remained relatively equal. And regions in which income inequality was both massive and stubbornly persistent—i.e., Africa and Latin America—were perennial laggards. Indeed, the very structures that calcified income inequality—dynastic landholding, corrupt governments, lack of investment in public education—seemed to militate against growth.

In the 1990s, a wave of empirical research found that, in fact, countries with high inequality over a long period of time have low growth. This paper by Harvard professors Alberto Alesina and Dani Rodrik is a good example of such work. When there's a lot of inequality, the median voter will be poor. As a result, populist backlash will pressure the government to enact redistributionist policies and tax capital, thus hurting investment and stunting growth. (See under: Venezuela.)

Forbes' article uses new data and different methodology to poke (tentatively) at this conventional wisdom. Alesina and Rodrik—and many other researchers in the 1990s—took a "cross-country" approach, examining the relative economic performances of high- and low-inequality countries over time. But Forbes chose instead to look at the performances of individual countries over time and investigate whether there was a correlation between periods of higher or lower inequality on the one hand and periods of higher or lower growth on the other. Of course, it's possible that the relationship she detects between growth and higher inequality is more coincidental than causal. As New York University economist Bill Easterly put it: "It's more likely that what she was finding was that there are long waves or business cycle waves—maybe during booms, inequality rises, and during recessions, inequality falls."

Forbes—whose dissertation committee included the avowedly anti-Bush economist Paul Krugman—says she isn't certain about the meaning of her results. She notes that "the relationship is far from resolved" and that it is "too soon" to reach "any definitive policy conclusions." Unfortunately, the Bush administration and its Republican allies suffer no such compunctions.