Capitalisn’t: Global inequality and convergence

Dec 05, 2018

Sections Economics

In the first part of a two-part look at global inequality, Capitalisn’t hosts Kate Waldock and Luigi Zingales talk about the upside of globalization: a decrease in income inequality between countries over the last few decades. How much of this can be attributed to China, and what was the secret to its success?

Luigi: Hi, this is Luigi Zingales at the University of Chicago.

Kate: This is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

In the last two episodes, we discussed populists in Brazil with the victory of Bolsonaro, and with Yascha Mounk about populists all over the world. Yascha was one of the many people saying that the reason why we see this explosion of populists all over the world today is because of an increase in inequality.

What we want to do now is actually analyze how much truth there is in this allegation. In particular, what is the impact that globalization has on inequality?

Kate: There are many different ways in which you can think about globalization and inequality. One major distinction is between within-country inequality and across-country inequality. If a bunch of countries are converging to one another, poorer countries are being lifted out of poverty, you can think of that as a reduction in across-country inequality. 

Luigi: The second thing we have to be aware of is that globalization is not necessarily a recent phenomenon. If we look at the last two centuries, there have been two major waves of globalization, one that took place between 1818 and World War I, and the second one that started in the 1980s and is continuing today. In both cases, we saw a similar pattern of increased inequality within the Western world. The difference is more what happens at the global level about inequality across countries. 

What we’re going to do in these two episodes is focus on the recent wave of globalization, because, number one, it’s recent and more interesting, and, second, we have better data to analyze. But you have to keep in mind that some of the stuff that we say today has some historical background.

Kate: On today’s episode, we’re going to focus on the rosier side of the picture, which is how there’s some evidence that across countries, inequality has been improving, and, in particular, a lot of people have been lifted out of poverty as a result of globalization. But on the next episode, we’re going to focus on the darker side of the story, which is that within a lot of Western countries, there has been a big inequality problem. 

I think part of the reason people are so mad about inequality is because of statistics like, just eight men in the world own the same amount of wealth as 3.6 billion people living in poverty, which is half the population of the planet.

Luigi: Are you angry because they’re men, or because there are only eight?

Kate: Both. A little bit more that there are only eight, but the fact that they’re men doesn’t thrill me either. 

Luigi: This is not just a statistical issue. I think it is a philosophical issue. What do you care about? Why do we care about inequality? 

I think that the reason why we care about inequality is because there is a tail of the distribution that is extremely poor. There is a tail that cannot arrive at the end of the month, cannot feed the kids, and so on, so forth. If that tail can improve dramatically, I think the world is a better place. 

If the guy that used to buy a mansion can now buy two, that’s not a problem for me as long as more people can go to school, more people are not starving, more people are middle class. Definitely, we have seen that in the last 30 years.

Kate: Yeah, I do think there’s a distinction between talking about reductions in poverty and talking about changes in inequality. There have been reductions in poverty. I think at the global scale there’s no doubt about that. 

But at the same time, there’s confounding factors there, too. Most of that is driven by China, for example. China’s poverty rate fell from 85 percent to 16 percent between 1980 and the mid-2000s. That was a huge driver of this reduction in poverty.

Also, another thing that confounds our measurement of global inequality is that rich people tend to not really report their incomes. If we’re not really counting how much richer rich people have gotten, then the numbers look rosier than, I think, the truth.

Luigi: Let’s put some structure to the discussion here. I think that the World Bank defines somebody as poor if the person can spend less than $1.90 a day and defines somebody as middle class if you can spend between $11 and $110 per day per person. Now, these dollars are adjusted for differences in what is called purchasing power, the ability to buy different goods in different places, and they are adjusted for time, so for inflation.

But, so, if you think about 2011 dollars that are not too different from 2018 dollars, in 1981, 42 percent of the world was poor. Now, it’s less than 10 percent. 

You’re right, Kate, that much of this reduction took place in China. The number went from 660 million people to now 25 million, but, also, India, and part of the rest of the world. In addition, there has been an increase of people who consider themselves middle class. 

I think that the other month there was a celebration that most of the world, slightly more than 50 percent of the world today, can be considered middle class by this standard. This is a remarkable success, and I think that globalization and capitalists are responsible for this success.

Kate: How do you measure inequality? If everyone’s wealth doubles, then, according to the Gini coefficient, inequality didn’t change. Also, if you’re looking at a poor person’s wealth doubling versus a rich person’s wealth doubling, I think that the rich person got better off, and, so, actually, inequality increased.

Luigi: I think this brings us to, why do we care about inequality? If the concern about inequality is envy, that you are jealous that some people make more than you and can buy more mansions than you can, I think that measuring on an absolute basis might be relevant. 

But if we are concerned about people who are left behind, people who cannot afford a decent living, people who cannot send their kids to a decent school, I think what we care about is the fact that the lower tail of distribution is improving dramatically its standard of living. In that sense, a relative basis is fine and captures that very well.

Kate: I don’t think that the concern with rich people getting richer at the same time that poor people are getting poorer is just poor people being jealous of rich people. I think that the concern is that if rich people double their income at the same time that poor people double their income, that makes rich people relatively more able to influence the political system. It makes rich people relatively more able to distort the playing field in favor of their own children. 

Yeah, I think the jealousy thing matters, too. It foments political unrest. I think there are reasons to be concerned about inequality on an absolute basis.

Luigi: I think that the point you’re raising about the influence in the political system is very important and should be taken very seriously. But if you keep that aside for a moment, and I’m not saying you should always keep it aside, but if you keep it aside for a moment, what we care mostly about is inequality of consumption. Inequality, if you want, of utility, of welfare.

We know that marginal utility of money is decreasing. If I go from making $1 a day to making $3 a day, my utility goes up tremendously. If I go from making $1 million a year to making $3 million a year, of course, my utility goes up, but not in any possible form or shape in the same degree. 

I think that the standard measures that look at the relative distribution of income are useful measures, and, by those measures, the last 30 years have been very good years in terms of decreased inequality.

Kate: I don’t even agree with that. Even if we’re just looking at relative measures, one of the most popular studies of the decrease in global income inequality is by these two guys named Lakner and Milanovic, where Lakner is at the World Bank, Milanovic is at CUNY. They find that the global income Gini coefficient has fallen from 0.722 in 1988 to 0.705 in 2008. 

First of all, 0.722 to 0.705 is not a massive decrease, and that still indicates a pretty high level of inequality. Then, also, here I think it’s important to talk about how much that increase in global income is attributable to just one country, China.

According to those same World Bank statistics, between 1981 and 2005, if we look at the number of people who are living below $2.50 per day, and we exclude China, then the number only dropped from 50 percent to 49 percent. Yeah, I’m bumping the number or the definition of poverty up by a little bit, you said $1.90, I’m saying $2.50. But really, I don’t think there’s a huge difference there. If we exclude China, there’s barely been any change. 

It’s not to say that we should be sad about that, because there’s a huge number of people living in China, and they’ve become much better off. But I also don’t think that this necessarily tells us anything about global trends.

Luigi: First of all, it is not just China. Also, India did remarkably well—not as well as China, but I think it’s important. It is true that China is the big outlier. I think it’s worth understanding why China was able to make it. 

I think that the turning point in China was the Deng Xiaoping reforms in the early ‘80s, when China de facto abandoned a communist regime, where even the land was in common, and started to recognize private property and allow some form of private enterprise. It was not initially very diffused. It was only in some economic areas. But then, this spread in a larger and larger part of the country. 

The other major turning point is when China joined the World Trade Organization at the turn of the new century. This is really a turning point, because China accepted many rules of the economy, the world economy, and entered full term into the global economy in global trade. I think that it benefited tremendously from the transfer of technology and money coming in and being invested in China, foreign money coming in.

Kate: There’s this open question as to why did manufacturing jobs go to China and not South Africa or Indonesia. I think the answer to that is a difficult one, because there’s a couple of different potential solutions. One is that it has to do with government institutions. There’s a single party in China. Maybe there’s cooperation problems if you’re working with a democracy, where there’s changes in party control, and you’re not really sure what the next regime will be. For Western countries moving plants, for example, to other countries, it was easier for them to work within a single-party system. That’s one of the explanations.

Here, Amartya Sen, a Nobel Prize-winning economist, has weighed in on the issue, and he believes that it has much more to do with education and health. If you look at the educational statistics between China and India, for example, in 1990, only 45 percent of the adult Indian population was literate, whereas it was 80 percent for China. Life expectancy was also significantly higher in 1990. 

This is why American manufacturing companies would want to relocate their factories to a place like China, where they knew that it was easier to train the population, because so many people were literate, and, also, they didn’t have to worry as much about low life expectancy, about having to deal with issues like disease and famine.

Luigi: But I think that I will divide the problem into two. There are the first 20 years of Chinese expansion from 1980 to 2000, and, then, there are the next 20 years, from 2000 to today. 

In the first 20 years, I think that the secret is very simple. It is starting low. China was completely mismanaged. Agriculture was very, very low productivity, in part because there was no private ownership of land.

We have seen many countries having a very high level of growth succeeding in getting the agriculture from the Middle Ages to the 20th century. Even Italy after World War II had 20 years of 7 percent growth, which is hard to believe today, but it is a combination of a rapid movement from agriculture to industry.

Now, the more interesting question is, what happened in the next 20 years? Because, while it’s easy to go from a low-level agriculture to productive agriculture, it’s much more complicated to move from being a middle-income country to being a more-sophisticated country. 

Here, I have to say, it’s not just China that did it. If you look at Korea, Taiwan, Singapore, Hong Kong, what we used to call the Asian Tigers, they all succeeded in this in a remarkable way. 

They all share some common features. One is an emphasis on education, as you mentioned. The second was a pretty good rule of law, even if in China certainly much less than Hong Kong. I think that those two things are quite crucial to the success of the economy.

Kate: I think there’s an interesting debate to be had here about what we mean by good rule of law. There’s good rule of law for the people. That means democracy. That means voting rights. That means liberalism in the sense that there are civil liberties and people have free speech. But there’s also good institutions for business and capitalism. 

I think the latter is really what united what you call the Asian Tigers. Even though China’s a communist country, at least de jure, it had a lot of the similar business-friendly institutions that Singapore and South Korea did.

Luigi: Yeah, I think it’s quite important especially to motivate foreign investments that if you set up a plant, this plant is not expropriated by the local authorities, or even if it’s not expropriated, if the working conditions, the regulation is changed ad hoc to make your life worse, or if they try to extract gigantic bribes for you to work there. 

While Korea, China, and Taiwan are not in any way perfect from the corruption point of view, they are certainly better than Latin American countries or African countries or even India, for that matter.

Kate: I think that’s a huge point. I think it’s really the corruption problem at the local level and the everyday level that impedes business formation and growth.

Luigi: I think a point I would like to get across, because it’s often forgotten, is many economists or even policymakers think that if you just have markets, they will do wonders. But markets need infrastructure, legal infrastructure to work. The legal infrastructure must be supported by a competent state. 

China has a long tradition of a competent state. I think that even Korea, et cetera, they do. I think in my view that helps forming a competent state to run a modern economy. In a lot of other countries, this tradition does not exist, and that makes it much more difficult.

What makes a country rich is not how much gold is there. It’s not how many buildings are there. It is the ability of the people working there to be very productive, to produce a lot per hour of work. 

Labor productivity is what drives the wealth of nations in the long term. The fact that China increased tremendously the number of people out of poverty meant that China had a tremendous increase in labor productivity over this period.

Kate: I really hate to have to talk about this, because I don’t want to have to nerd out on this show, but it’s a little bit hard to talk about global growth without introducing this model called the Solow growth model, which is pretty important to understanding economic development. It’s named after Bob Solow, who won a Nobel Prize for this idea. 

The two ideas behind the Solow growth model are that if you go from having just a little bit of capital—by capital I mean machines and plants and stuff—if you go from having just a little bit to more than just a little bit, that actually leads to a big increase in output, or a proportional increase in output. Whereas if you have a ton of machines and a ton of plants already, and then you increase them by that same amount, the relative increase in output is lower. 

What I’m trying to explain is this idea of the declining marginal product of capital. Going from a low level to an intermediate level, you gain more than going from a high level to an even higher level. 

One thing that’s a little bleak about the classical view of country growth is that once you reach what’s called a steady-state equilibrium, that’s just a point at which countries are basically stuck, the idea is that if you’re rich enough as you invest more in capital, you don’t actually get that much more output. In fact, you reach this point where the rate at which your factories and your tractors are depreciating is the same amount that you reinvest in them, and your output isn’t increasing at all. According to the classical model, once you’re a developed country, you just stop growing. 

Luigi: You’re right, but this is in the classical model that ignores the importance of idea innovation. In fact, this year’s Nobel Prize winner, Paul Romer, got his prize precisely because he emphasized the importance that the spillover of ideas has increased the productivity of everybody. 

This bleak view that we converge to a steady state, and we don’t grow from a steady state, is too negative a view and too old-fashioned a view. I think that innovation is important in increasing the famous Solow’s residual and in guaranteeing an increasing standard of living to everybody. 

But this is the interesting part. China improved its productivity, not just importing capital or accumulating capital, but also importing technology and new ideas from the West. Globalization actually allowed China to do that and to do that very successfully. 

Kate: Yeah, so you had mentioned this point earlier about how we allow other countries to experience the same sort of growth. I think it’s relevant to mention that if you look at the reduction in extreme poverty in some of the worst parts of the world, so, sub-Saharan Africa, and you look at the number of people living on less than $1.25 per day, that’s barely changed between 1990 and 2013. 

Why is it that a country like China was increasing rapidly, whereas countries like those in sub-Saharan Africa didn’t benefit at all? The answer is mostly that it has to do with institutions. That you’ve got to give people property rights. You’ve got to create courts, and you’ve got to educate them at the elementary level and things like that. You have to have those basic institutions in order to really reap the benefits of technological improvements.

Luigi: This is where Africa starts at a major disadvantage, because it’s still affected by major fights and wars that are mostly a leftover of colonialists that divided Africa into countries that have very little to do with their ethnic origin, but more to do with which European power was grabbing what part of Africa. 

War is the biggest enemy of development. The second biggest enemy is the lack of property rights. Africa is behind in creating these property rights, partly because, during wars, it’s difficult to maintain them. 

But second, because you need a certain level of diffused education to do that. A friend of mine told me that when Tanzania became independent in 1961, there were 12 or 13 people with a college degree, 12 or 13 people in a country of 60 million people. 

I think that the amount of human capital to start with was low, and, as a result, the ability to create courts and reliable systems is behind. But I think that, at least in parts of Africa, this is changing today.

Kate: Absolutely, I used to copy my math homework off of my Tanzanian roommate. She was brilliant. Thanks, Gloria.

Luigi: That’s not what I meant with the human capital, because, unfortunately, probably, your roommate will stay in the United States and will not help Tanzania develop, wouldn’t change—

Kate: Yeah, she actually lives in D.C., so, yup.

Luigi: Which is actually … a very important point that we’re raising is the level of brain drain that the United States is doing with respect to the rest of the world, and I am a case in point, is a problem for the rest of the world, because it is depriving the rest of the world of a lot of resources and making it more difficult for those countries to develop.

But now, Uganda, Rwanda, and Burundi are actually developing fast with a much better ruling class, much more educated ruling class, and I think the hopes of a turnaround of Africa are pretty significant.

Kate: I think another thing that’s good news for Africa is that Trump is making it harder and harder for people with high levels of human capital from other countries to stay in the United States. That’s good news for other countries, not great news for the US.

Luigi: In our podcast, we discuss so often what does not work in capitalism, but I think that in this episode, we can celebrate what does work. The success of China is a success of globalization and capitalism. 

Remember that historically Western nations colonized other places, and this increased the poverty of those countries. Lenin famously said that colonialism was a way to exploit the monopoly power of Western nations over the rest of the world. 

The globalization starting in the 1980s is the other way around. It is, in fact, the Western nations transferring technology to mostly China, but also India and some other countries were able to catch up, and this brought an enormous increase in the standard of living in a large part of the world. I think that we can celebrate a big success for capitalism in this episode.

Kate: Usually, I’m the one who’s positive about capitalism. I’m always the one who says, “What’s working in capitalism today.” But this time, I might feel a little bit more negative. 

The huge success of China in the past couple of decades has led to an increase in the standard of living in China. But on the other side of it, there has been a lot of pain felt by Western democracies and, in particular, the United States. Many think that that was the flip side of the globalization that helped China out. This may have been what generated populist movements across Western democracies. 

Luigi: I think you are absolutely right on the last point. But we have to remind ourselves that the failure of capitalism in this case is to be too egalitarian, because capitalism made it easier for the Chinese to catch up to the American standard of living and brought the standard of living of some Americans, at least, down in the process. 

This is not something that capitalism is generally accused of. It’s accused of favoring inequalities, and, at least at the international level, it didn’t.

But you are right that it did create some losers. Globalization, in particular, created some losers in the United States. The big problem is that we vote on a national level, not on a global level, and so this legitimate concern was not addressed in any way politically, and that brought, too, a lot of disenfranchisement of a large part of the American population. I think that this is something that we need to analyze more.

Kate: On our next episode, we’re going to talk about how wealth inequality has changed over the past couple of decades within the United States, what the potential negative repercussions of that are, and we’re going to try to do it without sounding too much like nationalists or protectionists. I’m a little worried about that.