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Capitalism Will Shrink Inequality. In fact It's Already Happening

Noah Smith
March 23, 2017
Bloomberg View

Does capitalist economic growth lead to greater inequality, or less? The mid-20th-century economist Simon Kuznets believed that at first, industrialization would lead to greater inequality as a few pioneering entrepreneurs and workers moved to the cities where the growth was happening. But as rural areas emptied out and the economy matured, he said, inequality would fall. This prediction contradicted Marxist ideas, which envisioned a capitalist class steadily immiserating the workers of the world. The solution to the problems of capitalist growth, Kuznets asserted, was more capitalist growth.

Recently, many developing countries have been moving along the path of economic enrichment once trodden by the developed world. China’s industrialization, which followed free-market reforms in the 1980s, has been spectacular, and India’s only moderately less so. Latin America’s ascent has been more stately, but its citizens, too, have entered the ranks of the global middle class.

As many skeptics of capitalism feared, this economic development has been accompanied by deep inequality. In Latin America, the problem is chronic and notorious -- "Latin American levels of inequality" is a cliche in policy discussions. Accounts of China's widening inequality are commonplace. Some economists, notably Thomas Piketty, claim that inequality naturally increases unless war or disaster intervenes to stop it.

If capitalism’s detractors are right, these trends will continue as long as growth based on free markets persists. But if Kuznets was right, then there will be a turning point when growth begins to drive inequality downward. Fortunately for everyone involved, recent evidence is coming down on the side of Kuznets.

In Latin America, inequality has been falling for over a decade. A recent study by economists Nora Lustig, Luis Felipe López-Calva and Eduardo Ortiz-Juarez found that almost all Latin American countries became more economically equal from 2002-2012. That's measured by the Gini coefficient, a number between 0 and 1 that quantifies the concentration of a nation’s income. The higher the number, the more income is flowing into the hands of a few.

These numbers include government transfers, so it’s important to ask how much of the region’s narrowing inequality results from socialism. Venezuela and Bolivia implemented aggressive socialist policies to the detriment of their economies overall and saw some of the biggest reductions in inequality.

Lustig and her colleagues found that government transfers and pensions accounted for between 21 and 26 percent of the decline in inequality. That’s important, but it’s far from the whole story. The biggest share of the improvement, by far, was caused by reductions in wage inequality. Lustig's group connected this to increasing levels of education -- in the 1990s, a lot more Latin Americans started going to school. Economic growth has been another reason for increasing wages.

This last story is consistent with Kuznets’ hypothesis. But even the reductions in inequality that come from better education and more government redistribution depend on economic growth to fund these progressive policies. So this is another way that growth can eventually bring inequality down. 

As for China, there are signs that inequality there has peaked as well. A recent study by economists Ravi Kanbur, Yue Wang and Xiaobo Zhang combed through China’s notoriously murky data and found that the Gini coefficient declined to 0.495 in 2014 from 0.533 in 2010.  That's a high level of inequality by international standards, but a trend in the right direction.

Kanbur, Wang and Zhang also found that Chinese consumption has been getting less unequal since 2003. And inequality from wage income has been going down since the mid-1990s. Though a fraction of the drop is due to government redistribution -- mostly from the wealthy coasts to the poorer interior -- the bulk is being driven by industrialization and urbanization. As more workers move from villages to cities, wages rise in the rural areas since labor becomes scarce. This is exactly the process that Kuznets had in mind when he predicted that growth would eventually combat inequality.

So although it’s too early to be certain, it looks like Kuznets’ broad hypothesis is correct. Capitalist growth eventually pushes countries toward lower inequality. It helps, of course, to have socialist redistribution in the mix. As long as socialist policies don’t crash the economy, as in Venezuela, they are an important way to make the process of industrialization less painful.

But the overall lesson is not to fear capitalist industrialization and growth. Inequality may go up for a while as a country starts to climb out of poverty, but that trend won’t last forever.