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Rising inequality poses a political and economic menace

Michael Collins, Investment Commentator at Fidelity

China’s now-disgraced ex-politburo member Bo Xilai revealed one of China’s most sensitive pieces of information just before he was ousted from his leadership role last year. No, it wasn’t a military secret, some diplomatic manoeuvre, nor some political machination. It was just a number, but one that rattles China’s regime.

Bo told journalists a year ago where China’s Gini coefficient stands. This measure of income inequality named after its inventor, Carrado Gini of Italy, is at 0.46 for China and if only a few people are wealthy “we have failed,” Bo said.1 China’s ratio has shot up from about 0.3 in the early 1990s to beyond the 0.4 level that is often taken as the marker where inequality leads to social unrest. With the index, zero represents perfect equality and one stands for perfect inequality – as in the richest hog all.

The rise in inequality is a common flaw of most of the developed and developing societies that have thrived under free-market economic reforms in recent decades. The beliefs of unbridled capitalism generally hold that free trade and unfettered exchange promote prosperity, that markets and private enterprise are efficient and that government interference, in the form of higher taxes, regulations, subsidies or welfare transfers, generally stifles wealth creation.

In practice, the reign of free-market beliefs has meant that governments favoured capital over labour at a time when new technology and the globalisation it enabled eroded the bargaining power of the semi-skilled and unskilled. The highest marginal income-tax rates were slashed (from 70% in the US in 1980 to 39.6% now) while other taxes that hit the rich hardest (such as those on capital gains and inheritances) were reduced. Fighting inflation took priority over reducing unemployment. Restrictions were removed from finance and big business, as a drive to maximise shareholder value reigned, while organised labour was hobbled through regulation and outsourcing. Government assets were sold, often cheaply, and generally became the basis for privately owned monopolies.

Free-market apologists say that the extra wealth created by liberal economic policies trickles down to the masses. Everyone, more or less, is better off these days, if measured by how GDP per capita has soared worldwide over the past three decades. But many people don't feel better off because they aren’t relatively better off. That’s why it’s not just Chinese authorities fretting about the political and economic costs of rising inequality these days. Governments everywhere are jolted by the image conjured by the Occupy Wall Street movement – that the overlooked 99% are angry.

Investors may find to their cost that fighting inequality could become one of the defining political issues of the upcoming era. They will need to factor political risk into their decisions as authorities are under pressure to switch their focus from growing wealth to worrying more about how wealth is shared.

Long-term threat

Authorities are in a bind; fighting inequality disrupts wealth creation, but they need to battle rising inequality because it has direct economic costs and, more tellingly, produces political consequences that create economic liabilities. The Asian Development Bank rates the “startling rise” in inequality as developing Asia’s greatest long-term economic threat. The bank estimates the Gini coefficient in developing Asia has jumped from 0.38 to 0.47 over the past two decades – as in nearly 20% of total income went to the top 5% in most countries.2      

One political consequence of inequality that turns into an economic liability is that it creates a feeling that everyone is only out for themselves. This impression undermines the social cohesion that lubricates economies and societies. As people become more fearful, selfish and insecure, corruption flourishes, crime jumps, anti-social behaviours increase, labour unrest stirs and legal disputes tied to commerce rights rise. When people feel they no longer live in a fair society or one where they have much opportunity they will eventually react. Heightened crime in Spain where youth unemployment is 50%, riots in Athens and strikes in Italy over austerity measures and mass looting by the impoverished in the UK in 2011 are signs of have-nots getting fed-up with the haves. Rising inequality could retrigger the violent labour unrest that disrupted many countries in the 19th and early 20th centuries, until labour reforms were enacted on minimum wages and basic conditions. In South Africa, where the Gini coefficient at  0.57 shows the country has one of the world’s biggest wealth gaps, police in August killed 34 striking workers and injured 78 at a platinum mine owned by Lonmin of the UK, a week after miners killed three company officials and two police.

Inequality, when combined with economic hardship, is the essential ingredient for uprisings that topple governments. Inequality played a role in nurturing the upheavals that have swept across north Africa and the Middle East since 2010. Similar revolts are what China’s ruling Communist Party fears most. The Chinese government concedes that tens of thousand of “mass incidents” of unrest occur each year, which can range from a few people reacting to an official decision to everyone in a village protesting as happened at Wukan in southern China in December 2011 after communal land was sold to developers. China’s rulers fret that somehow these incidents will coalesce into a nationwide revolt as the quasi-religious Taiping Rebellion did in the 1850s and 1860s at the cost of 20 million lives.

Feeding the extremes

A second economic liability created by the political fallout from inequality is that the resentment against economic injustice – epitomised by globalisation – nurtures an environment ripe for populist policies. Democracies are especially prone to this political backlash that undermines economic efficiency. The rise of Pauline Hanson’s One Nation in the 1990s and its associated economic nonsense (recall its proposal for lower interest rates for rural areas?) stemmed from lower-paid workers feeling excluded from Australia’s rising prosperity.

In Europe, extremist parties from the left and right are gaining popularity by pledging to re-nationalise industries and to shut out foreign bond speculators and cheap Chinese imports. (Far-right parties in Europe are anti-globalisation, anti-finance and anti-foreign including anti-EU, which helps them blend with the left. Far-right parties in the US are anti-government but for market fundamentalism, so implicitly support policies that promote inequality.) In the just-held Italian election, populist candidates, Silvio Berlusconi’s coalition, and comedian Beppe Grillo’s anti-establishment movement, scored a combined 55% of the vote in the lower house, while the incumbent technocrat Mario Monti’s coalition received just 11%. (Pier Luigi Bersani’s centre-left alliance gained 30% of the vote, giving it control of the lower house via bonus seats for coming first.) In the first round of France’s presidential election in April last year, pro-protectionist candidates from the extreme left (the Communist-backed Jean Luc Mélenchon) and the hard right (the National Front’s Marine Le Pen) attracted one in three votes, even though the mainstream candidates chased these voters with protectionist platitudes. The rise of pro-protectionist or anti-free market, nationalistic parties across Europe is one of the biggest impediments to the banking, fiscal and political integration that would help the eurozone escape the economic mess caused by the euro’s flaws.

In the Americas, more than a touch of populism lay behind the Argentina’s decision in April last year to nationalise the 51% of the national oil and gas company YFP that belonged to Spain’s Respol, after the possibility arose that Respol might sell the company that controls Argentina’s energy assets to China’s Sinopec. In the US, where the Gini coefficient stands at 0.38, the idea that the rich are robbing the rest even twisted its way into the primary campaign of the free-market, shrink-the-government Republican Party.

Worst offenders converted

A third political threat from inequality that carries economic costs is that the concentration of economic power can undermine democracy because it gives the mega rich too much political power. As the wealthy use this muscle to expand their economic interests (via, for instance, subsidies or anti-competitive moats around their assets), the core political institutions of society are eroded. Rule of laws, fundamental rights, open debate and the electoral process are often diminished. In Russia, the tainted sale of public assets created an oligarch class of billionaires, which now directs public policy in its interests. In the US, the wealthy’s control of the political system has only increased since a 2010 Supreme Court ruling effectively allowed unlimited spending on elections by individuals and companies.

Lastly, inequality imposes direct long-term economic costs because unequal societies prove to be faulty and inefficient economies. When too much income and wealth gushes to the top, the middle and lower classes are incapable of marshalling the purchasing power needed to fan sustainable economic growth. The lack of aggregate demand tied to the perennial inequality of Latin America, where the Gini coefficient is 0.52, has retarded these countries economically as well as politically. Another way inequality undermines economic growth is that people don’t work as hard if they feel they are not rewarded properly. A third way is that inequality directs activity towards acquiring government-sanctioned monopolies rather than innovation.  

Governments talk about tackling inequality, though many are too swamped by more acute challenges to impose decisions that may have pose a short-term threat to efficiency. US President Barack Obama has made fighting inequality a priority in his second term, though Republicans oppose his plan to boost the minimum wage by 24%. Perhaps more-stable Asia will make the most immediate progress on levelling the gap between rich and poor. In February, Beijing released a 35-point anti-inequality plan to lift as many as 80 million people out of poverty by 2015. It included plans to lift minimum wages and force state-owned companies to return more profits to the public. Even in anything-goes Hong Kong where the Gini coefficient stands at 0.54, the new leader Leung Chun-ying has promised to pull away from the model of “small government, big market” to help the less-well-off.  On February 27 when announcing his first budget, Leung boosted spending on welfare by 31%, earmarked US$2 billion for a  fund to lower poverty and gave about 400,000 elderly an allowance.

Solutions to reduce inequality will no doubt involve higher taxes on the rich and capital gains and the closing of tax loopholes that favour the wealthy. Government will need to spend more on education, health, public works and welfare payments. Policymakers may raise minimum wages, tilt employment laws more towards labour and tighten anti-competitive regulations. It makes economic sense for governments to take up these and other ideas to combat inequality. Self interest will demand that they do anyway for that’s where the centre of politics lies, even if attempts by the rich to preserve their status polarise society at the same time.

Gini coefficients come from various OECD reports and the Asian Development Bank unless stated otherwise. For the record, Australia’s Gini coefficient is 0.30.

1 Bloomberg News. “China’s Gini coefficient has exceeded 0.46, Bo Xilai says.” 9 March 2012
2 Asian Development Bank chief economist Changyong Rhee quoted in “Unfair growth” release issued by the Asian Development Bank on 11 April 2012.

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