TWN Info Service on Finance and Development (Oct12/02)
11 October 2012
Third World Network

UNCTAD Trade and Development Report on inclusive and balanced growth highlights growing global inequality with red alarm

The United Nations Conference on Trade and Development (UNCTAD), based in Geneva, publishes an annual Trade and Development Report (TDR) that covers global economic and trade policy with an emphasis on economic and social development. This year’s Trade and Development Report is titled, “Policies for Inclusive and Balanced Growth” and highlights through thorough research and analysis the trend of increasing global and national inequality.

The TDR begins with an introduction on the current state of the world economy, which is slated to continue suffering from the fallout of the financial crisis that began in late 2007 and the meltdown in September 2008. In the US, a sluggish recovery and looming unemployment persist. Europe is on the brink of a deep recession. Both regions, the report points out, attempt to overcome their crisis by fiscal austerity, combined with calls to further “flexibilize”their labour markets. This means means wage restraint andin some cases massive wage reductions, which are more likely to further weaken growth and increase unemployment instead of stimulating investment and job creation.

At the same time, as has been demonstrated with similar structural reform policies in the developing world over the past 30 years, they will also serve to reinforce the trend towards greater inequality, which has become a visibly damaging feature of finance-driven globalization.

The immediate problem for developed countries is their inability to return to a normal growth pattern, but there is also an equally serious problem of contagion. Amidst their fragile recovery, an unreformed (and unrepentant) financial sector and macroeconomic policies that are timid at best, and counterproductive at worst, the developing countries will find it difficult to sustain their own growth dynamic, let alone that of the global economy.

The TDR argues that a fundamental policy reorientation is urgently needed, recognizing that healthy and inclusive growth will require a stable expansion of consumption and investment in productive capacity based on favourable income expectations of the working population and positive demand expectations of entrepreneurs. This requires a rethinking of the principles underlying the design of national economic policy and supportive international institutional arrangements.

In particular, while globalization and technological change, and their interplay, have created both winners and losers, their apparent adverse impacts on overall income distribution in many countries must be understood in the context of the macroeconomic, financial and labour market policies adopted. Those policies have caused unemployment to rise and remain high, and wages to lag behind productivity growth, and they have channelled rentier incomes towards the top 1% of the income ladder.

Neither globalization nor technological improvements inevitably require the kind of dramatic shift in the distribution of income that favours the very rich and deprives the poor and the middle-class of the means to improve their living standards. On the contrary, with more appropriate national and international policies that take into account the crucial importance of aggregate demand for capital formation, structural change and growth dynamics, job creation can be accelerated, inequality reduced and the requisite degree of economic and social stability guaranteed.

Reinvigorating global financial governance

The TDR contends that the Group of 20 (G20) body, established in 2008 to enhance global macroeconomic and financial coordination, has “lost momentum,” and has “lacked a clear idea of how to pierce through the thick fog of uncertainty enveloping the global economy and to ‘lift all boats’ on to a more sustainable growth path.”

It has made no progress towards reforming the international monetary system, even though exchange rate misalignments driven by currency speculation persist. International financial reform is another unresolved issue. While the crisis prompted the consideration of an agenda for placing the international financial system on a safer footing, policymakers’ attention to it remains fragmentary and hesitant. In fact, it now seems that the moment of opportunity has passed – the
advice to never let “a serious crisis go to waste” has gone unheeded.

Instead, the massive bailouts of banks and firms has led to even greater concentration in the financial sector, which has largely regained its political clout. Short-term rewards rather than long-term productivity remain the guiding principle for collective behaviour in the financial industry, even today. There is a very real threat that financial institutions and shadow banking activities may again succeed in dodging the regulators, as vividly demonstrated by recent banking scandals.

Austerity and bailouts

The crisis in Europe is being widely referred to as a “sovereign debt crisis,” marked by a deep deterioration of public finances and soaring interest rates across distressed economies. However, the situation with public finances is less dramatic in most countries in the euro zone than in other developed economies such as Japan, the United Kingdom and the United States, which have seen their bond yields fall to historical lows.

Overall, in developed countries the worsening of public finances is primarily due to the bailouts of financial institutions after the shock of late 2008, as well as the workings of automatic stabilisers. Since 2010, calls for an “exist strategy” from fiscal stimulus and moving quickly into “fiscal consolidation” plans have become the norm. Consequently, fiscal austerity has become the “golden rule” throughout the euro zone, consisting of draconian fiscal retrenchment in the Southern European member states. Austerity is not only proving to be counterproductive, it may, the TDR emphasises, be “lethal for the euro and dire for the rest of the world as well.”

Rising fiscal deficits in Europe are but symptoms – not the root cause – of the euro-zone crisis. Underpinning the huge divergence of long-term interest rates in the Economic and Monetary Union (EMU) are the wide wage and price differentials and the related build-up of large regional trade imbalances among the members. These imbalances started to build up at the very juncture when the most important instrument to deal with such imbalances – namely changes in the exchange rate – was no longer available. With fiscal policy ideologically blocked in many key countries and the existing monetary policy toolkit clearly inadequate, unconventional policy instruments are now needed.

Inequality in developed countries - structural changes and corporate strategies

Fiscal austerity, combined with wage restraint and further flexibilization of labour markets, not only causes an economy to contract, but also creates greater inequality in the distribution of income. The ensuing threat to social cohesion is already visible in several countries. However, rising inequality is by no means a recent phenomenon; it has been a ubiquitous feature of the world economy over the past 30 years, even if in some developing countries this trend appears to have come to a halt since the beginning of the new millennium.

The TDR report provides some perspective on the trajectory of developed country inequality since the 1970s and 1980s. It states that in developed countries, a period of “deindustrialization” began in the 1970s and 1980s, followed by structural change in recent decades shaped by the aggressive growth of the financial sector, advances in Information and Communication Technologies and increased competition from developing countries. Labour markets in some developed countries experienced declines in the demand for moderately skilled workers relative to both high- and low-skilled workers. As production offshoring came to mark corporate production models, the rise of imports from developing countries accelerated from the mid-1990s onward.

Corporate strategy, related to trade liberalisation and the pursuit of developing countries to attract foreign direct investment (FDI), reflected a fast-growing emphasis on the maximization of shareholder value. This incentivised managers to focus on short-term profitability and a higher stock market valuation of their companies, which altered the way companies respond to competitive pressures under conditions of high unemployment. Instead of adopting a long-term perspective and trying to further upgrade production technology and product composition through productivity-enhancing investment and innovation, companies began to increasingly rely on offshoring production activities to low-wage locations in developing and transition economies, and on seeking to reduce domestic unit labour costs through wage compression. This compression of labour costs is aided by the weaker bargaining position of developing country workers faced with the persistent threat of becoming unemployed, yielding a strengthening of profit-earners power vis-à-vis that of wage earners.

Inequality in developing countries - structural and macroeconomic factors

The TDR’s analysis explains how in a number of developing countries, especially in Latin America but also in some transition economies, the trend towards greater inequality in the 1980s and 1990s occurred in a context of “premature” deindustrialization.

Labour moved from formal sector manufacturing activities to informal sectors and primary commodities with lower wages, benefits and security. Declining industrial employment, combined with large falls in real wages, in the order of 20–30 per cent in some Latin American countries, led to increasing income gaps in conjunction with stagnating or declining average per capita incomes.

The TDR examines several explanations for this “premature” deindustrialisation, including that nascent industrial sectors were unable to sustain “dynamic processes of structural change” upon opening up to global competition. Some developing countries that were at the initial stages of industrialisation did not, or no longer, possessed abundant cheap labour and thus could not benefit from outsourcing by developed country firms. Imports of manufactured goods at cheaper prices than domestic-made goods disabled economic survivability of some firms as well.

However, the TDR report contends that the main cause of deindustrialization in a number of developing countries in the 1980s and 1990s lies in the macroeconomic and financial policies they employed in the aftermath of the debt crises of the early 1980s. In the context of structural adjustment programmes implemented with the support of the international financial institutions, they undertook financial liberalization in parallel with trade liberalization, accompanied by high domestic interest rates to curb high inflation rates and/or to attract foreign capital.

Frequently, this led to currency overvaluation, a loss of competitiveness of domestic producers and a fall in industrial production and fixed investment even when domestic producers tried to respond to the pressure on prices by wage compression or lay-offs. In other countries, such as India and many African countries, the manufacturing sector has not grown fast enough to generate sufficient employment and a much larger proportion of the labour force has been absorbed in informal and less remunerative employment, while agricultural price liberalization has led to lower incomes for farmers, particularly in Africa.

To the extent that liberalization has brought benefits, these have accrued mainly to traders rather than farmers. Moreover, where industrialization has largely relied on integration into international production networks, as in a number of countries in Southeast Asia and parts of Africa, production activities and job creation have been mainly in labour-intensive activities without igniting or sustaining a dynamic process of industrial deepening and value-add creation. As a result, traditional patterns of specialization in primary commodities and natural-resourceintensive manufactures have been preserved, if not reinforced.

The turning point: financial liberalization and “market-friendly” policy reforms

A key message of the TDR is that to comprehend the causes of growing inequality, it should be borne in mind that the trend towards greater inequality has coincided with a broad reorientation of economic policy since the 1980s.

In many countries trade liberalization was accompanied by deregulation of the domestic financial system and capital-account liberalization, giving rise to a rapid expansion of international capital flows. International finance gained a life of its own, increasingly moving away from financing for real investment or for the international flow of goods to trading in financial assets.

Such trading often became a much more lucrative business than creating wealth through new physical investments. More generally, the previous more interventionist approach of public policy, which strongly focused on reducing high unemployment and income inequality, was abandoned. This shift was based on the belief that the earlier approach could not solve the problem of stagflation that had emerged in many developed countries in the second half of the 1970s. It was therefore replaced by a more “market-friendly” approach, which emphasized the removal of presumed market distortions and was grounded in the strong belief in a superior static efficiency of markets.

This general reorientation has been centered on a monetary policy that gives almost exclusive priority to fighting inflation, while the introduction of greater flexibility in wage formation and in “hiring and firing” conditions is intended to reduce unemployment. The idea behind this approach, based on static neoclassical economic reasoning, is that flexible wages and greater inequality of income distribution will enhance investment by boosting net profits and/or aggregate savings.

In the context of expanding financial activities, greater inequality often led to higher indebtedness, as low- and middle-income groups were unable to increase or maintain their consumption without resorting to credit. This in turn tended to exacerbate inequality by increasing the revenues of owners of financial assets.

When excessive sovereign debts eventually led to financial crises, inequality frequently rose because the costs of the crises generally had a disproportionate impact on the poorest. While this shift in policy orientation occurred in most developed countries from the late 1970s onwards, the new thinking also began to shape policies in developing countries in the subsequent decades. In particular, a large number of countries were forced to comply with the conditionalities attached to assistance from the international financial institutions or followed their policy advice in line with the “Washington Consensus” for other political reasons.

Deregulation of labour markets and tax reforms

With regard to labour markets, this new policy orientation meant deregulation and the introduction of greater flexibility. The unwillingness of workers to accept lower wages was considered the main reason for unemployment. In an environment of high and persistent unemployment, the influence of trade unions was weakened in countries where they had previously been influential, and in countries where they were initially weak, they could not be strengthened. As a result, the power in wage negotiations shifted towards employers, and wage increases were kept low in comparison with overall productivity gains, leading to a widespread increase in the shares of profits in total income.

The new spike of unemployment in the context of the financial crisis in 2008–2009, rather than motivating a rethinking of this approach, has, curiously, led to a reiteration of the presumed superiority of flexible labour markets in most developed countries. Only a few governments, notably in Latin America, have not followed such an orientation. Instead, they have focused on policies that improve the economic situation of the poor and the bargaining power of workers without hampering growth and global economic integration.

In terms of fiscal policy, the reorientation of economic policy since the early 1980s towards the principle of minimizing state intervention and strengthening market forces entailed the elimination of “market distortions” resulting from taxation. According to this view, the distribution of the tax burden and the allocation of public expenditure should primarily be determined by efficiency criteria and not by distributive considerations.

Lower taxation of corporate profits and lower marginal income tax rates at the top of the income scale were expected to increase companies’ own financial resources for investment. Another argument in support of lower taxation of high-income groups and profits was that the resulting shift in income distribution would increase aggregate savings, since these income groups have a higher-than-average propensity to save. Supposedly, this in turn would also cause investment to rise.

Reduced fiscal space in developing countries

Fiscal reforms in developing countries in the 1980s, together with the loss of tariff revenues resulting from trade liberalization, played a key role in the consistent reduction of public revenue, or prevented it from rising to an extent that would have enlarged the scope for governments to enhance the development process and to act to improve income distribution.

This problem was aggravated by the stagnation of per capita flows of official development assistance (ODA) in the 1980s and their dramatic fall in absolute terms in the 1990s. As a result, in many countries the provision of public services was reduced or user fees for public services were introduced, often with regressive effects or leading to the exclusion of low-income groups from access to such services, especially in Africa and Latin America.

In subsequent years, although the share of ODA flows into developing countries increased, they were chanelled into social sectors almost exclusively. This implied a decline in the share allocated to growth-enhancing investment in economic infrastructure and productive capacities. As a result, the effects on structural change and the creation of new employment and wage opportunities were limited.

The failure of labour market and fiscal reforms

Insufficient growth of average real wages, coupled with inappropriate tax reforms, constitute the root causes of rising inequality in most countries, but they have not led to the promised outcomes of faster growth and lower unemployment.

This is because any policy approach that dismisses the important contribution of income distribution to demand growth and employment creation is destined to fail. A shift in income distribution to high income groups with a higher savings rate implies falling demand for the goods produced by companies. When productivity grows without a commensurate increase in wages, demand will eventually fall short of the production potential, thereby reducing capacity utilization and profits. This in turn will typically lead to cuts, not to an increase, of investments.

A reorientation of wage and labour market policies is essential

The TDR’s most pervasive argument is that influencing the pattern of income distribution in a way that society as a whole shares in the overall progress of the economy has to be a leading policy objective.

That is why, in addition to employment- and growth-supporting monetary and fiscal policies, an appropriate incomes policy can play an important role in achieving a socially acceptable degree of income inequality while generating employment-creating demand growth. A central feature of any incomes policy should be to ensure that average real wages rise at the same rate as average productivity. Nominal wage adjustment should also take account of an inflation target.

When, as a rule, wage growth is aligned with productivity growth, plus an inflation target, the wage share in GDP remains constant and the economy as a whole creates a sufficient amount of demand to fully employ its productive capacities. This way an economy can avoid the danger of rising and persistent unemployment or the need to repeatedly adopt a “beggar-thy-neighbour” policy stance in order to create demand for its supply surplus.

In applying this rule, wage adjustment should be forward-looking. This means that it should be undertaken in accordance with the productivity trend and with the inflation target set by the government or the central bank for the next period, rather than according to actual rates of productivity growth and inflation in the preceding period (i.e. backward-looking).

Income supporting measures in developing countries

These latter instruments are of particular relevance in developing countries, which generally may need to achieve a more drastic reduction of income inequalities than developed countries. There is considerable potential for enhancing productivity growth in these countries by increasing the division of labour and exploiting opportunities to draw on advanced technologies. This means that there is also considerable scope for these countries to reduce inequality by distributing productivity gains more equally, thereby also fostering demand growth.

No doubt, in developing countries, which are still highly dependent on the production and export of primary commodities, the link between growth and employment creation is less direct than in developed countries. Their growth performance is often strongly influenced by movements in internationally determined prices of primary commodities.

Moreover, in many developing countries the dominating sector is informal and is characterised by small-scale self-employment. Formal employment in the manufacturing sector accounts for a relatively small share of total remunerative occupations, and labour unions and collective bargaining typically play a much smaller role than in most developed countries. It is therefore important to complement an incomes policy for the formal sector with measures to increase the incomes and purchasing power of the informally employed and selfemployed.

Influencing income distribution through taxation

In addition to labour market and wage policies, taxation of income and accumulated wealth on the revenue side, and social transfers and the free and universal provision of public services on the expenditure side, play a central role in influencing distributional outcomes.

Progressive taxation can lower inequality among disposable incomes more than among gross incomes. The net demand effect of an increase in taxation and higher government spending is stronger when the distribution of the additional tax burden is more progressive, since part of the additional tax payments is at the expense of the savings of the taxpayers in the higher income groups, where the propensity to save is higher than in the lower income groups.

Indeed, the scope for using taxation and government spending for purposes of reducing inequality without compromising economic growth is likely to be much larger than is commonly assumed.

Taxing high incomes, in particular in the top income groups, through greater progressivity of the tax scale does not remove the absolute advantage of the high income earners nor the incentive for others to move up the income ladder.

Taxing rentier incomes and incomes from capital gains at a higher rate than profit incomes from entrepreneurial activity – rather than at a lower rate as practiced so far in many countries – appears to be an increasingly justifiable option given the excessive expansion of largely unproductive financial activities.

Public expenditures are key to reducing inequality

Well targeted social transfers and the public provision of social services can reduce inequality of disposable income. For example, higher spending on education may contribute to more equitable income distribution, especially in the poorer countries, but only if job opportunities are provided to those who have received such education. Employment creation also depends on overall economic dynamics such as the expansion of the formal manufacturing and services sectors.

Public employment schemes, such as those launched in a number of developing countries in recent years, may have a positive effect on income distribution by reducing unemployment, establishing a wage floor, and generating demand for locally produced goods and services. These can be implemented even in low-income countries with low administrative capacity, and can be combined with projects to improve infrastructure and the provision of public services.

If well conceived, they may also help to attract workers into the formal sector, and the proceeds from higher tax revenues coming from an enlarged formal sector may also be used for different forms of concessional lending and technical support to small producers in both urban industrial and rural economic sectors. Apart from supporting productivity and income growth, the provision of such concessionary financing can also serve as a vehicle to attract small-scale entrepreneurs and workers into the formal sector.

The TDR outlines that when wage share falls and inequality of personal income incrases, the following types of government policy, for example, can try to restore the wage share and reduce inequality:

  1. Collective bargaining between employers’ and workers’ associations;
  2. Wage adjustments;
  3. Creating additional public employment opportunities;
  4. Establishing legal minimum wages;
  5. Progressive taxation, and channelling its proceeds to social transfers; and,
  6. Public spending on essential goods and services in order to make them more affordable and accessible.

The international dimension

In a world of increasingly interdependent, open economies, a country’s macroeconomic performance is increasingly influenced by the policies and circumstances in other countries. Sharp fluctuations in the international prices of goods and currency misalignments can lead to distortions in international competition between producers in different countries.

The TDR recommends that macroeconomic shocks arising from such mispricing in currency markets cannot be tackled at the firm level, and should not be tackled by wage cuts in countries whose producers are losing international competitiveness. In order to protect global economic health and prevent beggar-thy-neighbour behaviour in international trade, mispricing in currency markets should be addressed by currency revaluation or devaluation, and nominal exchange rate movements should reflect changes in inflation rate differentials or in the growth of unit labour costs.

Another important aspect of the international framework is the way in which countries deal with the relocation of fixed capital. Greater coordination among developing countries may be necessary to avoid wage and tax competition among them. Such coordination should aim at obliging foreign firms to conform to two principles: to fully accept national taxation schemes; and to adjust real wages to an increase in national productivity plus the national inflation target.

Both these principles would set a standard for domestic firms. The latter would not deprive the foreign investors of their – often huge − extra profits arising from the combination of advanced technologies with low wages in the host country, because their labour costs would not rise in line with their own productivity but in line with the average productivity increase in the host economy as a whole.