We need to understand the links between rising income inequality and frequent economic crises
The frequency of global financial and economic crises has increased over the past decade-and-a-half, and they appear to have become a systemic feature of the international economy. The risk of economic growth and human development achievements being undermined by such volatile international developments is fostering an overall rethink about the inner nature of crises, the growing vulnerability of developing countries and their capacity to be resilient in the face of these shocks.
As the 2015 Millennium Development Goals deadline approaches, the debate around a new framework for understanding macroeconomic vulnerability and resilience is gaining momentum among a wide array of stakeholders, ranging from academia, civil society and grassroots movements, to international organisations, development policymakers and the media. A new research piece by the United Nations Development Programme contributes to the public debate by arguing that at present there is no uniform approach to understanding macroeconomic vulnerability or resilience in the context of financial and economic crises in developing countries.
TWO APPROACHES MAJOR FACTOR A RELOOK
Broadly, two distinct approaches can be identified: the first addresses macroeconomic vulnerability principally in relation to financial crises — currency, debt or banking crises. Currency crises, for instance, are seen as being driven mainly by macroeconomic imbalances in the financial sector of developing economies and by fragile domestic financial systems. Hence, policy recommendations to build resilience to such shocks are focused on containing credit growth and the money supply, ensuring flexible exchange rates and guarding against expansionary fiscal policies. However, the empirical and theoretical assumptions underlying many of the studies and articles that support this approach have been long questioned — in particular, the assumption that markets are self-regulating and inherently efficient.
A second approach frames macroeconomic vulnerability in the context of both economic and financial crises. The focus here is on identifying the structural determinants and transmission channels through which an economy is exposed to crises, reflecting the rapid integration of developing countries in international trade and finance. This broader perspective argues that the growing dependence of many developing countries on exports — specifically primary commodity exports, their increased dependence on foreign investment for economic growth, coupled with limited fiscal and institutional capacity — renders them vulnerable to economic and financial shocks. Yet, there is no clear agreement on which structural determinants and transmission channels are the primary drivers of macroeconomic vulnerability. Some argue that the size and location of an economy are critical determining factors, whereas others focus on trade dependency or dependency on international private capital flows as the primary conditions that expose an economy to shocks.
A major determinant of macroeconomic vulnerability that is either totally neglected or barely mentioned by these studies is that of rising income inequality. The staggering escalation in inequality contributes to global and domestic economic and financial instability by fostering a political environment that lends itself to risky investment behaviour and the emergence of asset bubbles. The critical importance of inequality as a driver of crisis is clear when one is confronted with the fact that the average income of the world’s richest five per cent is 165 times higher than the poorest five per cent. In a world where the richest five per cent earn in 48 hours as much as the poorest in one year, understanding the linkages between rising income inequality and the greater frequency and severity of the financial and economic crises is central to proposing policies that build systemic resilience and enable a less volatile growth process. In traditional thinking, there is no disagreement on the need for policies that help economies cope with or counteract the impacts of shocks. Indeed, this is how resilience is defined in the economics literature. Nevertheless, coping with a shock only when it happens presents decision makers with a limited set of policy options to build resilience. This narrows the choices for concerted action to tackle rising inequality and to address the longer term policies needed to build systemic resilience.
The recent — and lasting, economic and financial — crisis, along with renewed calls for a rethink on traditional approaches to economic growth and development, offers us the opportunity to embark on a more comprehensive framework for the assessments of macroeconomic vulnerability in developing countries. Such a framework should allow for a comprehensive mapping of all the structural conditions and transmission channels that drive the vulnerability of developing economies, and that expose them to the virulent impacts of crises. Calls for a rethink of existing approaches should ultimately help us deliver policies for resilience that build coping capacities to withstand and counteract a shock and reduce exposure to shocks, while advocating for global coordination mechanisms to minimise the frequency of global crises themselves.
(The writer is Anuradha Seth is the Senior Policy Adviseo√r on Macroeconomic Policy and Poverty Reduction with the Poverty Practice of the UNDP’s Bureau for Development Policy in New York.)