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Cronyism Causes the Worst Kind of Inequality

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Economic inequality has skyrocketed in the U.S. during the past few decades. That has prompted many calls for government policies to reverse that trend. Defenders of the status quo argue that rising inequality is a necessary byproduct of economic growth -- if we don’t allow people the chance to become extremely rich, the thinking goes, they will stop working, investing, saving and starting businesses. A receding tide will then cause all boats to sink. 

Critics of the status quo have responded with the claim that inequality doesn’t help growth, but instead hurts it. This view was given ammunition by a number of recent studies, which have found a negative relationship between how much income inequality a country has and how fast it grows. One example is an International Monetary Fund study from 2015:

[W]e find an inverse relationship between the income share accruing to the rich (top 20 percent) and economic growth. If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth.

A similar 2014 study from the Organization for Economic Cooperation and Development concluded the same thing. Interestingly, the negative correlation between inequality and growth is found even when controlling for a country’s income level. This isn't simply a case of wealthier countries growing more slowly and also being more unequal.

Income Inequality

So the evidence is pretty clear: Higher inequality has been associated with lower growth. But as with all correlations, we should be very careful about interpreting this as causation. It might be that countries whose growth slows for any reason tend to experience an increase in inequality, as politically powerful groups stop focusing on expanding the pie and start trying to appropriate more of the pie for themselves. 

The IMF and OECD list some channels by which inequality might actually be causing lower growth. The most important one has to do with investment. When poor people have more money, they can afford to invest more in human capital (education and skills) and nutrition. Because these investments have diminishing marginal returns -- the first year of schooling matters a lot more than the 20th -- every dollar invested by the poor raises national productivity by more than if it gets invested by the rich. In other words, the more resources shoring up a nation’s weak links, the better off that nation will be. 

That’s a plausible hypothesis. But there might also be other factors contributing to the correlation between inequality and growth. It could be that there is something out there that causes both high inequality and low growth at the same time. 

The obvious candidate for this dark force is crony capitalism. When a country succumbs to cronyism, friends of the rulers are able to appropriate large amounts of wealth for themselves -- for example, by being awarded government-protected monopolies over certain markets, as in Russia after the fall of communism. That will obviously lead to inequality of income and wealth. It will also make the economy inefficient, since money is flowing to unproductive cronies. Cronyism may also reduce growth by allowing the wealthy to exert greater influence on political policy, creating inefficient subsidies for themselves and unfair penalties for their rivals. 

Economists Sutirtha Bagchi of the University of Michigan and Jan Svejnar of Columbia recently set out to test the cronyism hypothesis. They focused not on income inequality, but on wealth inequality -- a different, though probably related, measure. Concentrating on billionaires -- the upper strata of the wealth distribution -- they evaluated the political connections of each billionaire. They used the proportion of politically connected billionaires in a country as their measure of cronyism. 

What they discovered was very interesting. The relationship between wealth inequality and growth was negative, as the IMF and others had found for income inequality. But only one kind of inequality was associated with low growth -- the kind that came from cronyism. From the abstract of the paper:

[W]hen we control for the fact that some billionaires acquired wealth through political connections, the effect of politically connected wealth inequality is negative, while politically unconnected wealth inequality, income inequality, and initial poverty have no significant effect.

In other words, when billionaires make their money through means other than political connections, the resulting inequality isn’t bad for growth. 

That’s a heartening message for defenders of the rich-country status quo. If cronyism is the real danger, it means that a lot of the inequality we’ve seen in recent decades is benign. Eliminate corrupt connections between politicians and businesspeople, and you’ll be safe. 

But Bagchi and Svejnar’s finding cuts two ways. It also means that plain old inequality isn't beneficial for growth, as its defenders have claimed. That removes one of the big objections government policy makers face in talking steps to reduce inequality -- and that doing so is unlikely to hurt economic growth.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net