Inequality and Growth: Challenges to the Old Orthodoxy by Erwan Quintin and Jason L. Saving

Federal Reserve Bank of Dallas
Economic Letter—Insights from the Federal Reserve Bank of Dallas
http://dallasfed.org/research/eclett/2008/el0801.html

Discussions of how best to alleviate poverty often center on the relative merits of policies that boost growth and those that promote redistribution. If greater inequality allows economies to expand faster, or if it’s an inevitable consequence of pro-growth measures, the two principles seem incompatible. Under such a scenario, societies seeking rapid growth rates have to forgo redistribution from rich to poor. Conversely, choosing a high degree of redistribution implies the decision to accept lower growth rates.

If, on the other hand, inequality impedes growth, these principles aren’t only compatible but may, in fact, reinforce one another. François Bourguignon, the former World Bank chief economist, wrote: “If one interprets literally the potentially negative relationship between inequality and growth, then redistribution would enhance growth. It would then be sufficient to have at one’s disposal policy instruments to guarantee that growth is pro-poor—i.e. that it reduces inequality—for a virtuous circle to start and lead progressively to faster growth, declining inequality, and accelerated poverty reduction.”<1>

The question of whether inequality impedes or fosters economic growth once seemed largely settled, with traditional economic theory focusing on inequality’s beneficial effects on saving, investment and incentives. In the past two decades, however, research has identified new channels between inequality and growth, suggesting a more subtle relationship than the one advanced by earlier theorists.

The new work doesn’t refute many of the important insights of classical economics, but it points out that inequality can have disruptive effects on resource allocation in economies where markets function poorly. Inequality, therefore, is more likely to be harmful in countries with weak institutions for the exchange of goods, services and money. This confirms the idea that improved market institutions are a key condition for economic success.

Trade-offs between inequality and growth aren’t merely theoretical matters. They’re crucially important not only for policymakers who shape their countries’ safety nets but also for monetary authorities seeking to understand potential growth rates and make more informed policy decisions.
MORE ARTICLE WITH GRAPHS AT LINK



Economic Letter is published monthly by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

Articles may be reprinted on the condition that the source is credited and a copy is provided to the Research Department of the Federal Reserve Bank of Dallas.

Economic Letter is available free of charge by writing the Public Affairs Department, Federal Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX 75265- 5906; by fax at 214-922-5268; or by telephone at 214- 922-5254. This publication is available on the Dallas Fed web site, www.dallasfed.org.