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What can monetary policy do about inequality?

By Benoît Cœuré:

Economic growth has sharply reduced the incidence of poverty in “developed” economies. In Europe, it is one of the great achievements of the Single Market and of Economic and Monetary Union (EMU) to have delivered growth and job creation over a prolonged period, contributing to this objective. The euro area has created about 14.4 million new jobs since 1999, compared with approximately 10.7 million in the United States. Nevertheless, the past five years have been a time of hardship, owing to the financial and economic crisis. The Great Recession of 2008-09 and the subsequent crisis in the euro area have dented growth in our economies, pushing millions of workers into unemployment or forced inactivity, and adversely affecting living standards for our entire population. Moreover, they have left a shadow of uncertainty over long-term growth prospects and run the risk of creating a lost generation.

I would like to bring to this discussion a central banker’s perspective on the theme of inequality. Inequality is a cause for concern for all European institutions, since social cohesion is one of the statutory objectives of the EU. For the ECB, the question naturally arises as to whether monetary policy can make a difference, and whether it is mandated to do so. Musgrave and Musgrave’s traditional description of the functions of economic policy [2] can help to explain the role of monetary policy in the economic constitution of EMU. The task of the ECB under the Treaty on the Functioning of the European Union is to ensure price stability in the medium term. It thus focuses on income and wealth stabilisation rather than on the allocation of economic resources, or on redistribution. In Tommaso Padoa-Schioppa’s concise words, monetary policy is focused on stability rather than on efficiency or equity. This should be the starting point of any discussion of the role of monetary policy in addressing inequalities.

Does this imply that inequalities are irrelevant for central bankers? Not at all, as first, monetary policy may have an impact on inequalities, and second, stability is conducive to equity. To the extent that it stabilises economic activity, monetary policy can help shield from poverty the lowest income classes of society, especially during recessions.

I will address these two issues in turn, starting from a few facts on the rise of inequality in recent years. I will maintain that preserving price stability over the medium term is the best contribution that monetary policy can make to economic stability. The ECB has achieved this goal throughout the crisis, thanks to its standard and non-standard monetary policy measures. Our recent decision to undertake Outright Monetary Transactions can also be seen in this context, to the extent that it helps to restore confidence in the integrity and irreversibility of the single currency.

Inequality/poverty is a cause for concern also in the euro area

It is well known that the relationship between inequality and growth is complex and not necessarily monotonic. [3] On average, inequality in developed economies has increased in recent years. The Gini coefficient, a standard measure of income inequality that ranges from 0 (when everybody has identical incomes) to 1 (when all income goes to only one person), stood at an average of 0.29 in OECD countries in the mid-1980s. By the end of the last decade, it had increased by almost 10% to 0.32. It rose in 17 of the 22 OECD countries for which long-term data series are available. Of the eight euro area countries for which we have data, inequality increased in five, changed little in two and declined in one. Thus, although incomes remain more unequally distributed in the United States, the data suggest that inequality is also on the rise in the euro area.

The increase in inequality since the 1980s largely reflects a faster increase in household incomes at the top of the income distribution. [4] More precisely, greater inequality in labour income, which represents about three-quarters of total income across the working age population, emerges as the most important driver of household income inequality. In particular, most of the microeconomic studies find a continuous and sharp increase in wage dispersion in Anglo-Saxon countries over the last 30 years.

Microeconomic evidence is, however, mixed across countries. In countries such as Sweden and Spain, inequality has followed a downward trend over the same period of time. In Germany and Italy, the changes in wage distribution are more erratic and do not show a clear upward or downward trend. [5]

Developments in labour participation, which also affects labour income, are more heterogeneous across countries. It is also difficult to find clear patterns in developments in capital income inequality, owing to measurement difficulties.

How wages evolve over the business cycle depends both on the reasons why growth moves up and down, and on the way the labour market is organised. [6] At first sight, a rigid labour market may appear to shield the poorest from economic shocks, as wages will not easily adjust downwards in a recession. However, the lack of reaction of wages is a clear symptom of an ill-functioning labour market, leading to a costly and prolonged adjustment in employment. Taking into account fluctuations in wages and unemployment, a typical finding in several countries is that inequality in earnings at the bottom of the distribution tends to rise during recessions. [7] Moreover, households that do not receive labour income face even higher hurdles when labour markets do not function well and protect insiders at the expense of outsiders. What this means is that the poor suffer most in relative terms in and after a recession. In fact, the pain they suffer does not fully disappear once the recession is over owing to the persistence of unemployment and the malfunctioning of labour markets.

With regard to developments since 2007, recent research finds marked differences across countries depending on whether they have also experienced large corrections in house prices. [8] Nevertheless, for most OECD countries for which data are available, there is thus far little evidence of changes in household income distribution in the two years following the start of the downturn, from 2007 to 2009. Once more data become available, however, larger changes can be expected over the coming years, especially in countries like Spain that suffered a severe slump in the housing market and massive job losses in the construction sector, mostly for temporary workers.

Taken together, these factors suggest that unemployment remains a crucial determinant of inequality and poverty. There is a need for a comprehensive strategy to support job creation and ensure that the unemployed are employable. In the global economy, the comparative advantages of European economies rest very much on human capital and skills. Active labour market policies and investment in higher education are the most powerful instruments at the disposal of governments to counter rising inequality and to foster employment. [9] This leads to a simple policy message. At a time when fiscal policies are being reorganised in European countries, reflecting the crucial need to restore the sustainability of public finances, it is essential that the composition of fiscal adjustment preserves governments’ ability to invest in skills and recreate comparative advantages in their economies, and that they are supported by mobilisation of EU instruments.

Can monetary policy affect inequality and poverty?

But let me now return to the contribution that the central bank itself can make to reducing inequality and poverty. Is there evidence that monetary policy affects inequality? I will discuss this question from two perspectives: first, the immediate distributive effects of monetary policy and inflation; and second, the benefits of macroeconomic stability for the more vulnerable.

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