The IMF is holding up Australia as an example to the rest of the world. What example would that be? How to end up with a $40 billion budget deficit following a once in a century mining boom? Surprisingly, no. Instead, Australia is bucking the trend of rising worldwide income inequality.
According to the IMF, we’ve managed to do this by preserving our middle class. That’s helped us avoid many of the pitfalls associated with income inequality. Here’s their take on it:
‘Pre-tax incomes of middle-class households in the US, UK and Japan have ‘ experienced declining or stagnant growth rates in recent years. Australia, Canada and Sweden are important exceptions.’
The middle class is so important for one key reason. It’s seen as the glue that holds equality in place. A shrinking middle class may indicate a growing split between the haves and have nots.
A more equitable Australian society, relative to the rest of the world, is commendable. Most developed economies have struggled to maintain a balance between growth and equality.
Globally, the gap between the richest and poorest segments of society has only widened. Today it stands at the highest level its been in decades. That makes Australia’s effort look good by comparison. But before we hang our hat on this achievement, it bears looking at it from a different angle.
Measuring against other nations might make us feel better about ourselves at face value. But there’s another, more important, question we need to ask. One that puts the IMF findings in context.
We need to ask how our current income equality compares with trends in recent decades? In order to do this, I’ll need to introduce you to the Gini coefficient.
The Gini coefficient is simply the most commonly used method that measures inequality. Its range measures from zero (perfect equality) to one (extreme inequality). So how does Australia’s current Gini coefficient stack up against previous decades?
Economists David Johnson and Roger Wilkins found that the coefficient increased from 0.27 in 1982 to 0.30 by 1998. That may not sound like much, but remember that it only goes up to one. What’s more, between 1998 and 2008, inequality again increased to 0.34.
I’ll give you a quick example of what this looks like today. In 2012, the wealthiest 20% of households were worth an average of $2.2 million. Their disposable incomes were 68 times higher than the bottom 20%.
There have been occasional improvements in the coefficient. In 2011 it dropped slightly to 0.32. But the point here is that the overall trend suggests greater inequality. Within the economy, income distribution has become far more concentrated in recent decades. In turn, this has tipped inequality to its highest levels in our nation’s history.
Why has all this come about? For one, more money is being concentrated in the hands of fewer people. Of more concern is the arguments used to justify this development. What am I getting at here? I’m referring to the concept of trickle-down economics. Let me explain.
Why trickle-down economics is a nice theory that fails to work in practice
Rising income inequality is bringing some economic ‘truths’ under greater scrutiny. The IMF has some interesting findings relating to it in its latest report. So what is trickle-down economics anyway?
Basically, it states that economies grow on the back of spending by the rich. In theory, it seems to make sense.
As the wealthiest segment of society accumulates more assets, they begin to spend more. That spending then ‘trickles-down’ to the rest of society. Supposedly, the economy benefits from this increased activity in the economy. That’s the prevailing theory anyway. And it’s often used to excuse the concentration of wealth.
It does work to some extent, but its overall effect is exaggerated. Take the IMF’s word for it.
Their new models show that the opposite effect might be taking place instead. As the concentration of wealth at the top gathers pace, economic growth slows down.
Globally, GDP growth was 0.08% lower when the top 20% of the richest households increase their share of the total income by 1%. At the same time, economic growth increased when income was more evenly distributed. Economies grew by 0.38% when the bottom 20% received a 1% rise in their share of total income. The same is true of the middle class, too.
That may be an uneasy truth to swallow for some economists. Especially since trickle-down economics has enjoyed its fair share of popularity in recent decades. But it’s always been unclear as to how a smaller segment of society can benefit the other 80%.
For one, the middle and poorer class have less disposable income to buy goods. It’s logical that more people have less money to spend as wealth concentrates in fewer hands. And as this money concentrates at the top end of society, the rest of the economy becomes heavily dependent on their spending.
Let’s assume this income was distributed more evenly. People would likely feel more confident about their own spending habits. They’d certainly have more disposable income if their share of income grew. And they’d be less reliant on spending habits of the rich trickling-down to them slowly over time.
The other reason why it fails in practice is that spending, across all segments of society, is narrow. The spending habits of the top 20% will never be as diverse as those of the other 80%. Sure, yacht manufacturers may experience a windfall in business. But spending habits will remain relatively narrow nonetheless.
I already know what you’re thinking. Isn’t that the whole point of trickle-down economics?
After all, the yacht builders would spend their hard earned money on other goods and services. In turn their spending would benefit other businesses, which would spend on other diverse goods and services — and so on. Taken as a whole, spending would diversify as that money reached all levels of the economy. Right?
Again, that’s all very well in theory. But the truth is that the concentration of wealth warps the benefits of trickle-down economics. If you’re amassing untold wealth, you cannot possibly spend enough to benefit the rest of society.
Let’s take the example of a household measuring their wealth in the millions. It seems unlikely that they’d spend quickly enough to benefit society as a whole. Many rich households stash their wealth in assets like gold or stocks. That’s their given right of course. Everyone is entitled to safeguard their wealth.
I’ve never had millions — let alone billions — in the bank. If I did, I would spend some of it, and would house the rest in safe assets. After all, the reason why people flock to assets is for the very reason that they can’t spend that other money to benefit others.
But that does very little for the wellbeing of the broader economy. And it’s the only logical way for trickle-down economics to work as intended.
Here’s the simple truth of the matter. Income equality is important for spending because it determines how much people have to spend. But once income rises beyond a certain level, the ability to spend all that money drops. And, as that money concentrates in ever fewer hands, those at the bottom have even less to spend. That only serves to further increase the inequality in the economy.
So what does all this mean? We can draw two conclusions.
The first is that income inequality in Australia is worse today than it has been in the past. Measured against other economies, we might be doing fine. But I believe it’s better to measure our progress against ourselves. Only that gives us a clearer picture of where we are, where we’ve been, and where we might be going.
The second is that it will be difficult to maintain current levels of income equality.
Firstly, wages must remain high. That’ll be difficult to achieve with recent data indicating stagnating wage growth.
We also need to keep the unemployment rate low. And keep housing affordable for everyone. Neither of those two things are looking likely. The unemployment rate is a stubbornly high 6.1%. And the housing market, in Sydney and Melbourne, is becoming increasingly unaffordable for many.
If we can’t achieve these things, then income inequality will only rise in the future. And it will make our present economic situation much harder to improve as a result.
Contributor, The Daily Reckoning
PS: Rising income inequality is a sign of the ills afflicting the Aussie economy. The Daily Reckoning’s Greg Canavan believes we’re headed for disaster in the future. He believes that RBA and government policymaking is leading us towards certain decline. As one of Australia’s leading investment analysts, Greg is convinced that Australia faces a recession in 2015.
In a free report, ‘Australian Recession 2015: Unavoidable’, Greg reveals why our economy finds itself in the hole it’s in. He’ll show you why our economic conditions have spiralled out of control — and why that means a recession is almost inevitable.
But he also wants to show you a way to protect your wealth. Greg believes there are steps you can take right now to protect yourself from the fallout of the imminent recession. To find out how to download his free report right now, click here.