Inequality in the World Economy -
by the Numbers

An interview with Branko Milanovic

Multinational Monitor magazine, July / August 2003

[BRANKO MILANOVIC is lead economist in the World Bank research group and visiting professor at the School for Advanced International Studies at Johns Hopkins University. He has conducted cutting-edge research on the scale of inequality in the world economy. His work can be accessed on the web at:
www.worldbank.org/research/inequality
http://econ.worldbank.org/ resource.php?type=5
http://ssrn.com/author= 149002]

Multinational Monitor: Globally, is economic inequality rising, staying the same or diminishing?

Branko Milanovic: To answer requires distinguishing between three different concepts.

Concept one: If we treat every country as a unit, the differences between mean incomes of the countries are unambiguously rising over the last 20 years, and even over the last 50 years. In other words, countries are diverging.

Concept two: If, as before, we treat each country as a unit but give a weight to each country equal to its population, then inequality has been declining over the last 20 years.

That concept two is a useful one, but it is not really the one we want to study, because it is only an approximation to concept number three: the inequality of all individuals in the world. This measure of inequality takes each individual as equally important, gives to each the same weight, and adjusts for differences in price levels between the countries. It is the most difficult concept to calculate, not the least because we didn't have, or had only very fragmentary, data on national income distributions for many countries until very recently. These national distributions are necessary if we want to derive a world distribution of income across individuals.

Now, regarding concept three, we can say that inequality is extremely high. Everybody agrees on that. It is more difficult to say whether it is rising. I think that the preponderance of evidence is that it is slightly increasing or that it displays no clear trend over the last 20 years.

MM: When you are measuring inequality, are you looking at income or wealth?

Milanovic: In each case, we are looking at income, or more exactly income and/or expenditures. In other words, we are always looking at people's current welfare. We do not have measures of assets or wealth simply because there are no surveys of wealth in most of the world.

MM: Do you have any intuition of what you would find if the data existed on assets and wealth?

Milanovic: It is very difficult to say that, but within nations inequality of wealth is always higher than inequality of income. Income is the result of work and investment done over a year and income differences are the product of people's current jobs, investment luck, life cycle effects and so forth. Inequalities of wealth, that is inequalities in actual ownership of real and financial assets, are much greater because they are essentially due to several generations accumulating assets, or to the accumulation of assets over one's entire life. Thus annual differences in income are basically cumulated to produce much larger wealth differences.

MM: To return to the three different approaches to assessing global inequality, what makes for such different results? What role does China play?

Milanovic: What makes for such different results is that the units of observation are different. In concepts one and two, we're basically looking at each country as a unit and then assuming that there is no inequality within a country. So each Chinese has the mean income of China, each

American has the mean income of the United States. We ignore inequalities within nations; that is, we present a much simplified picture of actual inequality.

The difference in results between concepts one and two for the most recent period is precisely due to the role of China. China, and to a lesser extent India, have grown very fast during the last 20 years. Since they started as very poor countries, and indeed very populous countries, they have reduced the distance between their own GDP per capita and the world's average or median income. This, when we use population weights, has contributed to reducing inequality as expressed by concept two.

Most people stop at that point. They say that since China was very poor, and since it is a large country that has grown fast, it must have reduced inequality. So far so good. But then we have to go one step further and ask, What has happened to inequality within China? As a matter of fact, inequality in both China and India has increased significantly.

When we add that component, and take also into account increasing national inequality in countries as diverse as the UK, the United States, Russia, Indonesia, Nigeria, etc., then we find that overall inequality between people in the world is constant or slightly increasing.

MM: So both China and India are large countries in the developing world that are growing significantly although in different amounts, but where internal inequality is rising?

Milanovic: That's true. Inequality is rising in both of these countries.

When we think about world inequality, there are basically two steps. Step one, are mean incomes in China and India rising? We say yes and it is good news both for reducing world poverty and world inequality. In step two, we ask, is inequality within China and India increasing? The answer is, yes, it is going up. Inequalities between different provinces or states are rising, and inequalities between urban and rural areas have increased, and of course inequality between individuals has gone up. Because these are inequalities between large numbers of people, they contribute significantly to world inequality.

So these two aspects always have to be kept in mind: what is happening to the mean income of China and India, and what is happening to the distribution within these two nations. Of course, for the sake of simplicity I am speaking of these two countries alone because they, together with the United States and Western Europe, are key in influencing the evolution of world inequality. But formally speaking the same analysis applies to every country.

MM: Is there any rule that suggests that growing economies should be characterized by rising levels of inequality?

Milanovic: There is a famous argument by Simon Kuznets that says if you are very poor and then start growing, then by necessity there will be a structural change such that people would move from low productivity areas like agriculture that are characterized by low inequality to high productivity and high inequality areas like manufacturing or services. There is a view that development will therefore be associated with increasing inequality.

There are also more recent views that hold the reverse. This perspective holds that high inequality is an obstacle to growth, because you may have an entrenched elite which does not care about the country and this fosters political instability; also because people are not able to work in the areas where their contribution, given their talents, would be greatest. For instance, if you have lots of poor people who cannot get a proper education, and despite their inherent abilities, end up selling trinkets on the streets, that is clearly not going to be very good for growth.

We have different theories, but none of the theories works perfectly. While some theories might work okay when we compare countries' inequalities at a point in time, they may not work when we analyze the evolution of a single country over time. In the West, we have seen major declines in inequality during the last century, and at the same time these countries have grown tremendously.

In sum, there is really no clear cut relationship between level of income and growth on the one hand, and inequality on the other. The relationship seems to depend on many other things like institutions, spread of education, democracy, social history of the country and the like.

MM: To look at regions, say Latin America, what is the level of relative inequality there and how do you see that impacting on overall growth and economic dynamism?

Milanovic: Latin America has always been characterized by very high inequality, and with Africa, it is the most unequal continent in the world. So it has contributed always significantly to world inequality.

On top of that, we have had in Latin America a so-called lost decade (the 1980s). The mean income of many Latin American countries is today the same as 20 years ago. Two decades ago, the Latin American region, along with Eastern Europe, was the middle class of the world. With incomes stagnant in Latin America and sharply down in Eastern Europe, that "world middle class" has collapsed. So what has happened over the last 20 years in Latin America has exacerbated global inequality.

MM: What is the profile of inequality in Africa? Milanovic: We know the least about Africa, because data for Africa did not become available until the mid-eighties. This is one of the reasons why one cannot calculate with any level of precision world inequality among individuals before, say, 1985.

But we do know that Africa has traditionally been characterized by very high levels of inequality, similar to those in Latin America. To give you sort of a feeling how large they are, inequality levels are close to double of those in the United States. There is no clear evidence whether inequality within African countries has gone up or down over the last 10 years.

Actually, at such high levels of inequality as in Africa, it is difficult to have further increases. You cannot have a situation where one person has the entire income of the country. People would simply die or rebel at zero income.

MM: In general, growth rates in Africa have been negative over the last 20 years, but even so, they've managed to maintain the levels of inequality.

Milanovic: Exactly. Inequality within Africa has remained, it seems, unchanged. And because the overall growth rate of the continent has been negative, Africa has further declined behind the rest of the world. So there was a significant deterioration in the position of Africa as a whole, and in particular of the poor people in Africa. When you compare 1988 with 1998, the poor people in Africa, already among the poorest in the world, have lost a tremendous percentage of their incomes. Combining that fact with increasing population, Africa might in the not-too-distant future contain the largest pool of poor people in the world.

MM: Recent experience in Eastern Europe is particularly interesting because countries there started with a population that had relatively high levels of equality prior to the collapse of the Soviet bloc and communism.

Milanovic: Eastern Europe has had a similar evolution to that of Latin America in the sense that it was, prior to 1980, the world's middle class. It had a mean income maybe a third less than the developed world. Then both these regions - Latin America and Eastern Europe including the former Soviet Union-declined in real terms. The declines in most of Eastern Europe have been more severe than in Latin America. Countries there have had negative growth rates rather than being around zero, as in Latin America.

On top of that, in almost all countries of Eastern Europe, income inequality has shot up quite significantly.

However, the picture in Eastern Europe is a little bit more diversified than in other regions. Central European countries have now regained income levels of 10 years ago and maybe have even advanced, and there was not much of an increase of inequality in countries like the Czech Republic or Slovenia. On the other hand, we have had tremendous declines of income in most of the former Soviet Union, for example in Russia, Ukraine, Moldova and Armenia, and also tremendous increases in inequality in these countries. So for the poor and a lot of middle class in these countries, the transition from Communism has been a "double whammy."

MM: So the group of countries that have managed to rebound and either stay where they were or grow are relatively more equal versus the countries that have had negative growth rates and higher levels of inequality. What accounts for those two factors going together?

Milanovic: There is clearly a relationship such that the countries that have recovered much faster and are in a much better shape today have had much smaller increases in inequality following the fall of Communism. You may not want to say that the relationship is mono-causal, that is, that smaller increases in inequality enabled these countries to grow faster, but it is, I think, one of the contributing factors.

For example, countries of Central Europe have continued with large spending on social programs for the unemployed, for children, for families, pensioners and so forth. They have also been able to preserve institutions and to observe the rules much better than the countries with larger increases in inequality.

It is almost impossible not to see that the way privatization was conducted in Russia led both to the collapse of institutions, and contributed to increased inequality. Russian-type privatization (and, of course, Russia is not the only such country) meant that some people have been able to acquire assets for practically free. They then had to manipulate public institutions so that nothing they acquired de facto illegally would be taken away from them. So these three things went hand in hand: the type of privatization, the collapse of institutions, and the increase in inequality.

MM: There has been quite a considerable debate in recent years about whether processes of economic globalization are contributing to or diminishing inequality. What is your perspective on that?

Milanovic: First, I would say that it is very difficult to come to any strong and sound judgment on that, because the data are quite imperfect and we have a long way to go before we get good and accurate data about distribution of income across individuals in the world. But even if we had perfect data, it would still be difficult to establish the causal link because it is likely that globalization or openness has very different effects on inequality from country to country depending on the countries' endowments, institutions, level of income, position in the world economic system and so forth.

My view, based on my own work as well as that of a number of people, including Robert Barro and Martin Ravallion, is that in very poor countries increased openness to foreign investment and trade might exacerbate inequalities. Large segments of people in those countries are totally unskilled, at least in terms of the demands of the modern economy, and cannot take advantage of international trade. Only the relatively few medium- and high-skilled people in those countries can get ahead.

There is some evidence that it is only at some middling levels of income around the three C's- Chile, Colombia and the Czech Republic - where one might find a reversal in the sense that the poor benefit more from openness than the rich. Note however that even when we say that they benefit more, we mean that they benefit more in terms of their initial (pre-trade) income. But since that income may be, and often is, much lower than income of middle and upper strata, absolute income gains from openness would still be skewed towards the rich.

In conclusion, I would think that the overall picture is fairly nuanced and that it is difficult to say that globalization simply increases inequality or decreases it.

MM: Is it the case that trading among countries that are closer in economic levels confers broader benefits than trading among countries that are economically disparate?

Milanovic: There may be some evidence that trading between countries that are on a fairly similar level of development leads to a convergence in their incomes, so that the poorer countries catch up with richer countries. The European Union is the best example of that convergence. Ireland, Spain, Portugal and Greece now are more similar in incomes to, and in some cases have even higher incomes than, the old developed countries, like the United Kingdom or France.

But there are two elements here. One element is that you might have benefits from trade even for dissimilar countries (as the theory of comparative advantage suggests). Opening oneself to trade might be good for the mean income of both countries. Yet even there the gains from trade may be unequal between the two countries. The second question is how the increase in mean income is distributed between people in the country. There, under some conditions, as I mentioned before, trade might exacerbate inequality.

MM: Are there other elements of economic globalization or processes of international trade or international investment flows that contribute significantly to equality or inequality,

Milanovic: The thing that is frequently overlooked is the significant increase in world interest rates in the early 1980s, which not only led to the debt crisis in Latin America and later Eastern Europe, but also contributed to increasing inequality within countries, and ultimately to world inequality. Within a year, real interest rates went up from practically zero to 5 percent or 6 percent. We know that the distribution of assets in each country is very skewed, and the rate of interest is the return on the assets. So within each country the rich gained from higher interest rates.

On the world level too, rich countries which are by definition capital-rich gained from it. It is of course the rich people in rich countries who gained the most.

Elements which level inequality have to do mostly with domestic policies-investment in education, in health and infrastructure, and social transfers as well as progressive taxation. It is more difficult to think of international factors that have the same effect, although trade and openness might be equalizing in countries with some reasonably high level of income, higher than the turning point of our three-C countries.

MM: Is it fair to say that the global financial system has evolved so that it makes sense to talk about global interest rates and that that was less so in a previous period?

Milanovic: We have clearly moved toward a more integrated international capital market, as compared to, say, the 1960s. And it is not only shown by the financial flows, which of course have increased tremendously, but is also shown empirically by the correlation between real interest rates between countries. Interest rates in one country are today much more related to interest rates in other countries than was the case 20 or 30 years ago when financial and capital markers were much more segmented and isolated.

MM: What have you found in looking at the period of deglobalization between the end of WWI and the start of WWII?

Milanovic: That period has received almost no attention from economists. It is very much a political period, so political scientists have studied it a lot, and economists much less with, of course, the notable exception of the Great Depression. But although the Depression was the signal event of the period, it is not the only thing which happened between 1918 and 1939.

I was motivated to study this period for the following reason. The mainstream position, in a simplified way, is to say that integration is good because it leads to convergence in incomes.

But if you look at the first period of globalization, from 1870-1913, at the world level you find a huge divergence of incomes. The poor countries at that time did not catch up at all, they actually fell behind in absolute terms while the already richer countries-the United Kingdom, France, the rest of Western Europe, the United States- became richer. Now most economists either ignore this fact or say that this is because poor countries did not really integrate. So presumably the theory is still correct but applies only to the countries that do integrate and/or are at a similar level of income.

Well, when you look at such countries, Western Europe and North America, in the period between the two wars, which was clearly a period of de-globalization, you would expect that their incomes should diverge. If the set of rich countries converges during the period of globalization, then they should diverge during the period of de-globalization. But you don't find that. You find continued convergence of incomes.

If integration equals convergence among the club of the rich, why is it then that the disintegration between the two wars is associated with convergence of incomes as well?

This leads me to believe that transfer of knowledge and information, among countries at a similar level of income, is very important in furthering convergence. In other words, it is not trade alone.

MM: Does all this matter? Why should anyone care about levels of inequality?

Milanovic: I think we should care about levels of inequality because as processes of globalization become stronger there is a much greater awareness of differences in income between different people and nations, and this influences people's attitudes and behavior.

This process is very similar to what happened in nation states in the eighteenth and nineteenth centuries. Nobody cared about inequality when people lived in small hamlets which were totally isolated from each other.

Once you start communicating, though, you realize that some other people are richer, often much richer than you. They may not work harder than you or be smarter than you, but they may have an income which is 10 times as high. That creates lots of anger and negative feelings. Some people call it envy and treat it as somehow unacceptable. But even if this were the case, you cannot just rule envy out and forbid it to influence people's behavior. But treating it as envy is fundamentally wrong. One man's envy is another man's

justice: a rich man considers each comparison of incomes to be a product of envy; a poor man might on the contrary see the same difference in incomes as unjust.

Large income inequality between countries also leads to migration, because people from poor countries realize they can migrate to rich countries and increase their income significantly. Tensions arise because rich countries don't want to have too many people overwhelm their social safety systems and in some cases might also have problems culturally and socially integrating the migrants.

Finally, there is the purely ethical consideration, which says we should care about each individual in the world approximately the same, that we should not be totally indifferent to the fate of people who are very poor.

MM: You mentioned investment in education, health care and infrastructure as primary tools to remedy inequality. Are there other key elements, including for international policy?

Milanovic: My feeling, and it is not based on empirical work, is that most of the tools to remedy inequality are domestic in origin. We see that from the differences in inequality levels within the countries of the European Union, from an egalitarian Nordic group to much more unequal France or Great Britain. While international economic policies are practically indistinguishable, domestic policies vary quite a lot, from those of say Margaret Thatcher's UK to socialist-led Sweden or to corporatist Austria.

There is however an important role for international organizations, because the argument can reasonably be made that the current system as embodied in the World Trade Organization and international institutions is basicalIy skewed against poorer countries. For instance, protection of intellectual property rights has now become much stronger and makes the transfer of technology to poorer countries much more expensive than was the case 20 or 30 years ago, or at the time when today's rich countries were poorer and often copied technology freely from other. While today's rich countries .. able to imitate, and learn from each other when they were developing in the nineteenth century, today's poor countries are inhibited from doing so because they need to pay huge sums to get patent rights and access new technology.

Of course another example which everyone quotes these days is agricultural and textile subsidies in the rich world, which negates the comparative advantage of poor countries.

So there is a scope also for policies which would help inequality and poverty at the world level.

MM: What would you prescribe as an appropriate role for income transfer policies-whether domestically, regionally or internationally-to remedy inequality?

Milanovic: This is a very difficult question. People have generally agreed that the state does have a significant redistributive role at the national level, though there are ongoing debates about how generous that welfare function should be.

It is much more difficult to argue that there should be the same policy at the world level. People in country x, which is rich, are certainly much less interested in the fate of people in country y, which is very poor, than they are in what happens in their own country. This is quite understandable both because people feel more concerned about those who are closer to them and because their own welfare, in terms of say political stability, may be more strongly influenced by what happens to the poor who live nearby than what happens to people who are faraway.

But I think that we have nevertheless made some progress in the area of world redistribution. If you look 30 or 40 years ago, there was no official development assistance. It didn't exist at all. Now for the first time rich world countries are willing to transfer money to the poorer countries.

There is of course the issue whether the money is sufficient. I think that most people would agree that it is not. It falls far short of rather modest and formally accepted UN targets. A second problem is whether the money is well used, and there is general consensus that it is not.

So greater accountability or transparency in the use of this money is important. The big question is how that greater transparency can be insured. I think that this is the next big issue in international aid with which we shall have to deal. Only when we can show that money is reasonably well used will there be greater willingness from the people in the rich countries to transfer some more money.

MM: You have also floated the idea that aid money perhaps should be conditioned on or related to levels of inequality in recipient countries.

Milanovic: This is based on a simple idea: if you have a very unequal distribution in a poor country, then there is a certain percentage of people who are better off than, let's say, poor people in the United States. Then the question could legitimately be raised in the rich country, Why should we transfer money to a poor country if that money might end up in the pockets of somebody who is richer than the taxpayer who originally paid for it?

It is desirable to give assurance to the taxpayer in the rich world, first that the money is not going to be badly used, and secondly that it will be a "progressive transfer," that is that it will be a transfer which will help someone who is poorer than he or she. If you have countries with very high levels of inequality of income, as in Latin America, then you really can doubt that this kind of progressive transfer will occur.

MM: How would you operationalize the idea of tying aid to inequality levels?

Milanovic: It would be reasonably easy to operationalize. We could, say in World Bank lending, adjust levels of aid to countries taking into account their domestic levels of inequality, penalizing highly unequal countries and helping those that are very equal. For example, the GDP per capita level-which is used as the eligibility criterion for soft loans-could be adjusted by the ratio between mean and median income in the country. If income distribution is very unequal, the mean-to-median ratio will be high. Thus, the inequality-corrected GDP per capita will be raised in high inequality countries and they could lose eligibility for interest-free loans.

Consider Bangladesh and Nigeria. These two countries have approximately the same level of income, but inequality is much greater in the latter. The mean-to-median ratio is 1.7 in Nigeria and 1.2 in Bangladesh. The introduction of inequality-adjusted income will therefore penalize Nigeria and could possibly disqualify it from receiving soft loans as long as inequality remains so high. This is similar to what is already being done through attempts to aid more countries with good governance and lower corruption. As already mentioned, this proposal is based on the simple idea that transfers at the international level should follow the same rules as transfers at the national level: they should flow from a richer to a poorer person, and hence be inequality reducing.

Overall, I think there is a movement toward some redistributive scheme at the world level. People like John Rawls basically saw a very limited role for international redistribution, but I think that that view is becoming superseded by a growing awareness of global inequality and poverty. This in turn will lead to greater willingness to help in the rich world provided one can reasonably insure that transfers are helping the poor. However, redistribution at the world level cannot be a substitute for normal economics. Greater opportunity to benefit from international trade and technology is key for poor countries' development. This will not happen until the current rules of the game, often determined by the rich world alone, are changed.

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