The Main Causes of Increase in Income Inequality - Essay Example

?“Economic Globalisation is the main reason for an increased income inequality in the world economy as well as high rates of unemployment in industrial countries during the last two decades.” Table of Contents Introduction 3 Economic Globalization 3 Income Inequality and Unemployment 4 The Causes 6 Foreign Direct Investment and International Economics 8 Foreign Direct Investment and Income Inequality 10 Conclusion 14 References 16 Introduction This essay entails the discussion and assessment of main causes of increase in income inequality within and between the countries since 1980 in the light of foreign direct investment (FDI) and trade liberalization and globalization. The income inequality has been analyzed in various developing and developed countries to find out if there has really been the dispersion in wages in the two decades following 1980. There have been international trade theories describing the importance of efficient allocation of resources through trade. Such theories have been explored and looked for insights if the international trade liberalization and economic globalization truly allocates the resources efficiently amongst the countries. Economic Globalization Globalization is broadly defined as the integration of technological, cultural, political, social and economical aspects between the nations throughout the world (Hamilton, 2008, p.10). The term is also used synonymously with economic globalization that involves investments and trades between two countries. This, however, has impact on every aspect of the society. The proponents of globalization view the globalization as means of economic development and improved standard of living. Trade assists in the creation of a nation’s wealth and healthy political relations with other nations. It also promotes competition and free trade between the corporations which in turn provide cheaper and diverse range of goods and services to consumers around the world. These benefits can be measured in a number of ways such as comparison of relative output and external trade between countries, price convergence for homogeneous or identical goods and services in different economies, comparison of national direct investment with the foreign direct investment and the size of total foreign assets and liabilities. However, globalization has also been subject to criticism for the mere fact that while the market integration for capital, goods and services has occurred, the labour markets around the world are barely integrated. It is observed that all the factors of production technology, plants, and capital except land can be shifted between the countries but it is the labour that globalizes at a very slow pace (Reich, 1991 cited in Dehesa, 2006, p.7). Labour mobility between the developing and developed countries has slowed down over the years and this has led to diverged per capita income across countries. This shows that migration surely does not contribute towards the income equality. Anti-globalization sentiments stress the perils of globalization in the form of contributions towards poverty in already poor nations and environmental degradation. Another argument against globalized economy has stemmed from biased development of North (developed countries of Northern hemisphere) as compared to the South (developing and under-developed countries in Southern hemisphere). Through the establishment of GATT and WTO, the removal of economic disparity through trade flow between these two hemispheres has been unsuccessfully tried. However, there are many factors as to why such objective could not be accomplished. One of them could possibly be the anti-globalization sentiment of rich countries in North while the perception of globalization as positive force in the South countries (Bhagwati, 2007, p.8). Income Inequality and Unemployment Income inequality refers to the unequal income distribution across the population, genders and races. There are many factors that cause income inequality such as work experience, productivity, gender, race, inheritance etc. Firebaugh (2006) analyzes the world income growth and population growth over the last two centuries and finds that the western industrializations occurred in America, Europe and Britain have contributed more towards increase in global inequality more than the recent Asian industrialization. In fact, the income inequality under Asian industrialization is no longer accelerating. Figure 1: Region-wise Per Capita Income 1820-1950 & 1950-1990 Source: (Maddison, 1995 cited in Firebaugh, 2006, p.10) Figure 1 shows the absolute per capita income in various regions and income growth in two different time periods. The income growth was high in American and European regions during 1820-1950 (western industrialization) but the Asian and African regions’ growth rates are higher during 1950-1990 period (Asian industrialization). This confirms the possibility of shrinkage in income inequality during recent times that widened during the western industrialization as low income group regions have grown faster than the high-income group regions. The economists have paid more attention on studying the income inequality rather than the issue of poverty across nations because the study of poverty only would ignore the fact that the poverty problem is more a distribution problem rather than a production problem and this shift has resulted from the industrial revolutions in earlier two centuries. However, globalization has brought in another era of income distribution trend across economies. The Causes Economic growth of a country is indicated by the increase in national per capita income. However, this does not imply improvement in living standards because the rise may be due to rise in wealth of rich whereas the standard of living of poor is the same. Such an uneven income distribution is known as income inequality. Since 1990s, emphasis on macroeconomic stability, privatization, liberalizations of domestic markets, international trade and financial flows without barriers and market oriented solutions to the large externalities persistent in public goods and services has been at the heart of the policy-making in both developed and developing economies. The economist proponents of trade and economic liberalization have argued that such measures increase competition and efficiency, reduce rent-seeking and boost convergence of living standards and incomes of developing and poorer countries with those of advanced countries. They also claim that such policies have had positive or neutral distributive impact i.e. the income inequality has been relatively stable within the countries and varied between the countries (Li, Squire and Zou, 1998, p.26). However, the criticism of neo-liberal policies comes in the form of blame on the global institutions such as IMF and World Bank for their contribution towards increase in income inequality in developing countries. Pieper and Taylor (1998) term this as ‘The Washington Consensus’, a phenomenon of amalgamation of IMF’s macroeconomic stabilization policies, supply side policies in Washington during 1980s and market de-regulation policies of World bank. In general, the causes of income inequality comprise of changes in labour’s income share, labour mobility, technological changes, international differences in distribution of income, consumption inequality and geographical inequality (The National Bureau of Economic Research, 2012). The argument that globalization and economic liberalization contributes towards widening of income gap between labour and capital is supported by the fact that subsequent increase in global competition has induced the domestic corporations to seek the low cost labour from other countries such as India, China and Brazil (Singer and Chen, 1998, pp.190-191). This has eventually resulted in lowering of domestic wages for unskilled workers. Realizing the global technological changes, many multinational firms try to reverse the declining profits by adopting new technologies in order to make high-skilled labour more productive while outsourcing the production to foreign countries. This only leaves management and executive jobs in home country. Escape from union agreements is another factor for outsourcing decision. With the ease of transnational capital mobility, the profits relative to income rise rapidly along with concentration in higher wage occupations and lower wage offshore industries. This widens the income inequality. Post-1984 economic liberalization and market-oriented reforms in Mexico increased the income inequality, which was contributed by expansion of service sector average income relative to the agricultural sector, decline in unionisation rates, and increased skill premium i.e. rise in wages of high-skilled labour. This trend was also reversed after 1998 when inequality fell slowly driven by decrease in high-skill requirement, union premium and stabilized unionisation rates (Angeles-Castro, 2007, p.21). This reverse in trend has been earlier explained by Simon Kuznets through inverted U hypothesis (Banya, 1995, p.2). Kuznets explained that output growth in early development stage contributes to increasing wage differential between unskilled and skilled labour where the trend is reversed at later stage when the wage differential drops. In case of Argentina, the IMF-backed stabilization package in early 1990s drove up the CPI (Consumer Price Index), which was dominated by service or non-traded goods, more than the nominal wages in the country. However, the nominal wage levels increased by more than the WPI (Wholesale Price Index) as dominated by traded goods. Argentina’s current account in Balance of Payments was heavily liberalized then. As a result, the real purchasing power of the workers declined as the real labour costs increased for the producers of traded goods (Pieper and Taylor, 1998, p.9). Foreign Direct Investment and International Economics Countries’ attitudes towards foreign investments have changed in the last two decades giving for the expectations of knowledge transfer, employment generation and tax revenues. Therefore, in order to attract FDI many countries’ governments have removed the entry barriers and adopted liberal policies by opening up new sectors for foreign investments and this has led to increase in intra-regional competition among economies to attract FDI. The incentives entail low taxation for foreign investors, preferential loans and grants to multinational firms, infrastructure and even monopoly rights. The trade liberalization through global bodies such as WTO, EU and NAFTA has made the FDI incentives important for the governments. There are many substantial arguments in favour of FDI as the developing countries try to increase domestic employment, growth rates, technological know-how, and various other benefits in the form of positive externalities. The increased competition in domestic markets due to competition from foreign firms is one the most important benefit, governments try to capture. Figure 2 provides the size of global FDI inflows from 1996 to 2006. The peaks in 2000 and 2006 are because of rise in cross border mergers and acquisitions. Figure 2: FDI Inflows 1996-2006 Source: (CEI-RD, n.d., p.19) With a view that free trade boosts efficient allocation of world resources, countries frequently negotiate trade agreements on regional and international levels. Statistical analyses of 122 developing countries that belong to international, regional and preferential trade agreements experienced greater FDI inflows during 1970 to 2000 with a control of their domestic policies and boost economic growth (Buthe and Milner, 2008, p.). Countries not only face options of FDI incentives and trade agreements but they also have to face the conflicting interests with the multinational corporations. MNCs often encounter different conflicting demands and preferences due to changes in social and cultural norms, social structure, economic structure, customer preferences and government regulations in a country. However, a major disadvantage of foreign investment is posed by the contradictory relationship of local government and multinational firms arising from the differences in their objectives, motivations and evaluation. MNCs seek to gain strategic advantages and unrestricted access to the country’s markets and resources. They aim to integrate their operations around the world to gain economies of scale and scope. On the other hand, host government seeks other benefits described above such as development of the economy by promoting domestic business environment. These potential conflicts stem from the economic issues as well as political, social and cultural issues. Therefore, in such situations the relationship between both the entities is considered a zero-sum game. The rising global power of multinational firms often poses threat to the national governments, as they perceive this to be a disruption in their economic policies through increasing import penetration. As multinational firms play major roles in international trade, their strategies can affect the trade policies. Unlike the assumptions set out in international trade theories, there are no perfectly competitive markets. The international trades done by large multinational corporations do not reflect market transactions and their goods’ prices do not reflect market competition. This is because setting the value of goods is a part of international strategy of the corporations in order to maximize foreign currency flows and minimize the taxes. Foreign Direct Investment and Income Inequality In an economically open country, some benefit from foreign direct investment while others lose. As per the Heckscher-Ohlin international trade theory, countries will export those goods that use factors of production that it has abundantly while import those goods that use scarce resources. This has been the logic behind many economists’ preference for free trade agreements such as NAFTA. The Stolper and Samuelson theorem, which is based on Heckscher-Ohlin theory, provides that the income of the owner of abundant factor will rise while those of owner of scarce factor will decline assuming that the amount of factors of production are fixed and there is perfect labour mobility (Magee, 1994, p.138). The implications of these theories are that the developed countries have relatively more capital and skilled labour than the developing countries. Therefore, developed countries exports would benefit their skilled labour and capital providers and imports would hurt their unskilled labour while developing countries would have the effect vice-versa. Hence, international trade increases income inequality. Proponents of free trade and open economy often favour foreign direct investment as it boosts development. The distributional effects of foreign direct investment in Latin America can be analyzed by looking at the labour income inequality. Most Latin American countries have had improvement in position of skilled workers since 1990s. The income inequality is determined by three factors demand for factors of production, distribution of these factors, and distribution of education. FDI does drive development and standard of living but it is induced by the skill specific technological changes and wage bargaining. This is likely to increase the income inequality. The impetus of FDI determines the effects of FDI on income inequality in a country. The FDI growth in Latin America from figure 3 is largely a result of liberalization of FDI post 1980, where the majority of foreign investments were in manufacturing and services sector and not in primary sector. Therefore it is quite likely that the foreign firms were seeking efficiency exploiting low costs of labour. Evidence from empirical studies done by te Velde (1998) indicates that FDI’s benefits have been more towards the skilled workforce than unskilled one and the control of wages inequality depends largely on the government’s initiatives and policies to promote supply of skilled labour. However, the real income inequality in some countries is also indicated because of reduction in spending power as a result of privatization in some sectors. Figure 3: FDI as Percentage of GDP in Latin America 1980-1999 Source: (UNCTAD cited in te Velde, 2003, p.18) In another empirical study of impact of FDI on the income distribution in Pakistan revealed that FDI has worsened the income distribution because foreign investment was more oriented towards capital intensive industrial sector and service sector (Shahbaz and Aamir, 2008, p.15). In East Asian countries Singapore, Korea, Philippines, Hong Kong and Thailand, results post 1980 show that wage inequality is low in some countries but has increased in Thailand and Philippines (figure 4). The education system of Thailand was not aligned with the demands of foreign investments (Te Velde and Morrissey, 2002, p.17). Figure 5 shows the proportion of skilled labour in East Asian countries where the percentage in Thailand has not increased as compared to other countries. Similar is the case with Philippines. Figure 4: Wages Inequality in East Asian Countries 1981-1999 Source: (Te Velde and Morrissey, 2002, p.3) Figure 5: Proportion of Skilled Labour in Total Employment Source: (Te Velde and Morrissey, 2002, p.4) Not only in developing countries, but the majority of labour problems in US, Japan, EU and other advanced industrial nations are attributed to degradation of incomes and employment of unskilled labour force. The income gap in US expanded due to development in education and technology for some groups while declined for others such as minority groups after 1980 (Card and Freeman, 1993, p.12). Other factors that have contributed to widening of income inequality are less regulated markets, less re-distribution of taxes and transfer policies (OECD, 2000, p.50). The effect of trade integration such as between North and South on the wage inequality depends upon the legislative setting of that country as empirical results of trade integration among the developed and developing countries showed that the imports with developing economies tend to curtail income inequality in those countries that have had strict employment protection rules. Conclusion This essay is an attempt to explain the impact of economic globalization and trade liberalization on the income inequalities in developing as well as developed countries. Despite the stated benefits of globalization, and evolution and acceptance of international trade theories, there has been consistent rise in income inequalities throughout the world. Economists against the globalization and economic liberalization have often blamed these two phenomena for the rising wages disparity and drop in real wages of labour. Even the disparity between the economic development of North and South nations have been blamed consistently on the liberalization barriers-free international trade. However, the explanation of the role of globalization in income inequality is subject to various exceptions such as the countries that attract foreign investments and get into trade agreements should be prepared to reap benefits of the transfer of technological know-how brought by foreign multinational corporations and promotion of skilled labour force through development in education system in home country. The countries in Latin America and East Asia suffered from liberalized policies because they did not prepare themselves for the sudden changes being brought by free trades and strategically placed business operations by foreign firms. Instead of relying solely on the foreign investors for the employment and income, which proves the developing countries’ short-termism, they should have focussed on reducing the income disparity boosting education system. However, this cannot be said true for the poorer nations such as in African continent, where the social and economical developmental activities are motivated by the international organizations such as IMF and UN. It is inevitable not to agree with that the concept of Washington Consensus as coined by Pieper and Taylor (1998), where the crippled and defunct policies of IMF and World Bank have been exposed. References Banya, B., 1995. Income Inequality in Developing Countries, Honors Projects, Paper 53. 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