Future of Capitalism: Resolution of inequality is imperative

Faculty Fellow, RIETI

Around 250 years after modern capitalism emerged in the United Kingdom, the so-called "advanced countries" experienced an economic growth that had been never observed before in human history. On the one hand, this economic growth created global warming and other problems through the consumption of vast amounts of resources and energy. On the other hand, it significantly extended the average life expectancy at the same time as raising per capita income.

In Japan, where the development of a capitalist economy started later than in the Western world, the average life expectancy was 43 years old for men and 44 years old for women from 1891 to 1898. In 2017, the average life expectancy was 81 years old for men and 87 years old for women (Life Table, Ministry of Health, Labour and Welfare). There is no doubt that this is an achievement of capitalism.

Even so, the path of development of capitalism has not been smooth. Across all countries and periods, inequality in income distribution has been a major problem. In the United Kingdom, the increased rich-poor gap became such a serious problem that it rocked the society as early as in the first half of the 19th century. It was in 1848 that The Communist Manifesto by Karl Marx and Friedrich Engels was first published in London.

Regarding the relationship between economic growth and inequality in the modern era, the inverted U-curve theory, advocated by Simon Kuznets, a Nobel Laureate economist, is well known. The inverted U-curve refers to a line plotted in a graph with the horizontal axis representing per capita income and the vertical axis representing the degree of inequality. When per capita income rises in line with economic development, inequality grows at first. However, the degree of inequality peaks at a certain point, and thereafter, inequality narrows in line with an income rise, according to this theory.

However, since around the end of the 20th century, economic inequality has continued to grow in advanced countries, which represent the wealthiest segment of the world. The relationship between growth and inequality is not as simple as is suggested by Kuznets' theory. Below, let's take a look at Japan's experience in the past 120 years or so.

♦  ♦  ♦

The Figure below shows the trends in the economic growth rate (five-year moving average: average for the period comprised of the current year and the two years each preceding and following it) and the Gini coefficient between 1895 and 2014. The Gini coefficient is an indicator of income equality: the value "1" represents complete inequality and the value "0" represents complete equality. On the situation in the prewar era, empirical studies have been conducted by many economists, including Hitotsubashi University Professor Emeritus Ryoshin Minami.

Figure: Trends in the Economic Growth Rate and the Gini Coefficient
Figure: Trends in the Economic Growth Rate and the Gini Coefficient
Source: Economic growth rate: The figures for the prewar era were cited from Kokumin Shotoku (Choki Keizai Tokei 1) (National Income (Long-Term Economic Statistics 1)) by Kazushi Okawa and others, and the figures for the postwar era were cited from data of the System of National Account. Both datasets are on a five-year average basis; Gini coefficient: The figures for 1895 and 1974 were cited from Nippon ni Okeru Shotoku Bunpu no Chokiteki Henka (Long-Term Change in Income Distribution in Japan) by Ryoshin Minami, and the figures for 1981 and 2014 were cited from the Survey on the Redistribution of Income by the Ministry of Health, Labour and Welfare.

In the prewar era, Japan was a society with very wide income disparity. As was pointed out by Kuznets with respect to the initial stage of the development of capitalism, the Gini coefficient rose from 0.43 in 1895 to 0.57 in 1937. Even in present day Latin America, where the Gini coefficient is said to be the highest in the world, the figure is 0.48 in Costa Rica and 0.45 in Chile, for example (2015, statistics prepared by the Organisation for Economic Co-operation and Development). The inequality in Japan in the prewar era was greater than in Latin America at present.

However, Japanese society rapidly moved toward equality after the war ended in 1945. The Gini coefficient declined to 0.35 in the 1950s-1960s in line with the country's high economic growth. In the 1970s, equality reached such a level that "ichioku so churyu," which means "100 million population all in the middle class," became a buzzword. However, when the economic growth rate declined in the 1980s, the Gini coefficient rose, and, in the 21st century, inequality has become a major topic of debate.

♦  ♦  ♦

Hereafter, we will consider two questions: how is income distribution related to the growth rate and what causes inequality to expand or narrow.

As saving is an activity practiced mainly by wealthy people, income inequality increases the savings rate in the whole economy, thereby generating economic growth through accumulation of capital. This reasoning, which was prevalent in the 19th century, was rejected flatly by The Economic Consequences of the Peace (1919), written by John Maynard Keynes in his early days as an economist. Keynes argued that resolving income inequality is essential if consumption, which is a pillar of effective demand, is to be stimulated.

Looking at the past 120 years of the history of the Japanese economy, it is clear that effective demand has played an important role in the relationship between growth and distribution. In the prewar era, as inequality was wide, Japan's economic growth was driven by exports. In that situation, low wages were regarded as a source of the Japanese economy's competitiveness.

On the other hand, in the period of high economic growth after the war, when Japanese society became more equal, the strong growth was driven mainly by consumption (the contribution rate of consumption was 60%). During that period, the contribution rate of exports was lower than 10%. The contribution rate of net exports, or exports minus imports, was almost zero. In principle, Japan's high growth was generated by domestic demand, particularly robust consumption. The robust consumption was supported partly by the narrowing of inequality. However, as inequality has widened since the collapse of the economic bubble, Japan's economic growth has once again become increasingly dependent on exports as its main driver.

Next, what kind of mechanism causes inequality to expand or narrow? The study of economics focuses on technological change as a factor. For example, it is said that labor income distribution became unequal because, while demand for skilled labor has grown due to technological advances in recent years, demand for unskilled labor has declined. It is also said that income for the middle class, including white collar workers, has fallen because of information and communications technology (ICT).

According to the mainstream theory of economics, prices for production factors (e.g., various types of labor, capital, and land) are generally determined by the degree of contribution to production by each production factor, namely by marginal production. As technological change alters marginal production, income distribution changes as a result. A change in income distribution is inevitable or rational as long as it is caused by technological change. That is what is implied by the argument that technological change is the decisive factor.

However, the narrowing or widening of inequality cannot be explained by technological change alone. For example, while technological change is a phenomenon common to most advanced countries, the degree of inequality varies widely from country to country. As is well known, although income concentration in the top 0.1% of income earners is remarkable in the United States, the story is different in continental Europe (excluding the United Kingdom) and Japan. Among European countries, Switzerland has not experienced a widening of inequality.

Even from Japan's experience in the past 120 years, it is impossible to fully explain changes in the Gini coefficient shown in the Figure with technological change.

In Japan, inequality narrowed rapidly in the postwar era because of such factors as the dismantling of zaibatsu conglomerates, farmland reform, wholesale freeze on deposit accounts, and hyperinflation. All of these factors represent institutional reforms promoted by the government or their consequences, rather than reflecting technological change. They narrowed inequality by causing the decline of the wealthy class that prospered in the prewar era. What is interesting is that the narrowing of inequality was not a circumstance unique to Japan, which was on the losing side of the war, but also in the United States and other countries. As Keynes pointed out a century ago, consumption by expanded middle classes supported growth in all advanced countries in the 1950s and 1960s.

♦  ♦  ♦

Capitalism has continued to function until now, through the 20th century, because governments have modified income distribution. In the past, there was a period when pursuing equality became a fashionable idea even in the United States. Adolf Berle, who advocated "separation of ownership and control," aptly observed in the 1950s that while capital and capitalism continued to exist, capitalists were disappearing.

Meanwhile, U.S. economist Paul Samuelson gave the name "mixed economy" to a capitalist system which is based on a decentralized market but also complemented by various redistribution policy measures taken by governments.

In the 21st century, capitalism is confronted with a new problem not experienced in the past: a widening of inequality due to the aging of society. As is clear from the rise in the Gini coefficient regarding initial income in the Figure, inequality has widened due to the aging of society in Japan as well. As shown by the trend in the Gini coefficient after income redistribution, social security systems, including pension and healthcare insurance systems, are curbing the widening of inequality. That is why it is essential to reform the social security systems in order to enhance their sustainability.

>> Original text in Japanese

* Translated by RIETI.

August 8, 2018 Nihon Keizai Shimbun

September 14, 2018

Article(s) by this author