Globalization, Inequality, & Parasitic Growth of the Finance Sector

“Inequality is the defining issue of our time.”

Barack Obama.

In the first part of the series, we explored how inequality-inspired undercurrents delivered the BREXIT and Trump victory bombshells. Inequality is capable of worse – civilizational collapse. History bears testimony.

From where does inequality spring up? How does it entrench itself? What role does globalization play in intensifying it? And why does the exorbitant expansion of the finance sector slow down the economy?

Economist Thomas Piketty nails the genesis of inequity in his 2014 work Capital in the Twenty-First Century – it begins when someone makes more than the average economic growth. Mind you, there is nothing wrong if that someone is smarter and works harder than average folks. Perfect equality is a myth. Neither is it desirable for it eliminates the urge to go out of the way as it did in countless former communist nations. What’s the point in toiling harder and smarter if that doesn’t get you ahead of the pack?

In Global Inequality: A New Approach for the Age of Globalization, economist Blanko Milanovic opines that while globalization has slashed inequality between nations (say, international inequality), it has aggravated inequity inside nations (say, national inequality), particularly the rich ones. The author provided valuable insights on the populist reaction against globalization in an interview to Gawker Media LLC. Please note, the book was published in April 2016, before the BREXIT shocker.

Gini Index
Figure 1. Gini Index as an Inequality Metric in the Developed World (Source: OECD)

Defined as the smooth flow of capital, knowledge, goods, services, and workers across international borders, globalization allowed manufacturers in rich countries to outsource industrial production to poor economies where labor came at dirt cheap rates. Importing goods so made from poor countries proved economical than crafting them at home.

Next, globalization allowed the influx of people from poor countries who were humbly willing to work at a fraction of the cost that local workers demanded proudly. Some would say, globalization opened the floodgates to hordes of invading migrants!

For the lower and middle classes in developed economies, therefore, globalization became largely synonymous with job losses and stagnant or falling incomes. Skills are mighty important for globalization rewards skilled labor more than the unskilled. This widens the gulf of inequity.

What deepens this rift is that wealth inequality is greater than income inequality. With greater income, you save more and invest more. Over time, you make progressively greater returns and your wealth swells. Precisely why the rich get richer and the poor get poorer. The elite of the elite – the topmost 1 percent – make 29 percent of the total global income, but possess an astounding 46 percent of global wealth! No surprises there.

Upward Trends in Income Inequality in the Developed World
Figure 2. Upward Trends in Income Inequality in the Developed World

Between 1998 and 2011, the real (inflation-adjusted) income of this super elite has skyrocketed by 40 percent. The global middle class – those between the 45th the 65th percentiles starting from the bottom – have seen their incomes double. The losers, as expected, are those from the 80th to the 95th percentile – the middle classes of the developed world.

As a result, national inequality has jumped inside rich countries. And because politics is mostly national and elections are fought largely on national issues, national inequality assumes immense importance. The ones caught on the receiving end of globalization decided to allow the volcano of their pent-up grievances to erupt through BREXIT and the Trump victory. In an interconnected world, the shockwaves became a global contagion making the earth tremble!

Another, oft-neglected face of the multifaceted coin of inequity is the parasitic growth of the finance sector. In their 2012 paper, Reassessing the Impact of Finance on Growth, Stephen Cecchetti and Enisse Kharroubi show that expansion of the finance sector helps boost the productivity of the economy only till the tipping point represented by:

  • employment of over 3.9 percent of the workforce;
  • lending private debt in excess of the GDP i.e. when private-debt-to-GDP crosses the 100 percent

When the finance sector employs more than 3.9 percent of the workforce and lends larger private debt than the GDP, it drags down the economy’s productivity. For example, Ireland’s financial sector galloped at 4.1 percent and that of Spain forged ahead at 1.4 percent between 2005 and 2009. Alas, output per worker dropped by 2.5 percent for Ireland and 1.4 percent for Spain in the same timeframe.

Now productivity is the lifeblood of economic growth. Genuine, long-term growth comes from productivity upsurges as also from greater labor force participation and demographic changes.

Cecchetti and Kharroubi outline the mechanism of this finance tumor in their 2015 paper Why Does Financial Sector Growth Crowd Out Real Economic Growth? Lured more by short-term speculative gains than by long-term wealth generation, the finance sector:

  • Lends more to low-productivity-high-collateral industries such as construction. Why? Because they create tangible assets (buildings) in rather short time spans that can be confiscated in case of default. Contrast this with a high-productivity-low-collateral project such as research and development (R&D). Let’s say, it is looking to build a device to cut the fuel consumption of cars, an inherently intangible process that may or may not succeed. If it fails, what will the financers seize?
  • Diverts talented manpower away from other sectors by offering astronomical pay packages. Manufacturing, R&D, computing, and aircraft sectors lose heavily in this race for intellectual cream.

A June 2015 OECD report How to Restore Healthy Financial Growth that Supports Long-Lasting, Inclusive Growth? as analyzed by The Guardian, brings out the stark contrast in remunerations:

  • Top finance professionals earn a mind-boggling 40 percent more than their counterparts in other sectors. Even at the lower end, this gap is at a startling 15 percent.
  • Among the 1 percent topmost earners, as many as 20 percents are finance professionals who make up only 4 percent of the workforce.

The point is, undue expansion of the finance sector not only creates and reinforces economic fault lines but also dampens economic growth, which can precipitate horrendous strife as we have noted in the first article of the series. Inequality in excess is not just bad, it is cancerous!

Policymakers must surely know of ways to better allow the fruits of globalization and growth. After all, isn’t there a shining example of Scandinavian countries – capitalist economies with meager inequity levels?

Indrajeetsinh Yadav @ Falcon Words is the author of this article. For more such beyond-the-obvious insights on malignant inequality-immorality, keep reading our blog.

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