Why does economic inequality rise in democracies?

Economic inequality is rising, and the United Nations reports that economic inequality impacts 70 percent of the world, even when we include democracies such as the US, UK, France, and Germany.

Why does democracy not reduce economic inequality? According to democratic theories, giving everyone the vote and allowing them to participate in democracy through protest should make policy-makers responsive to the public and reduce harm to them. Yet, this does not happen. Inequality rises in democracies.

Inequality may be the undoing of democracy.

This post explains why democracy has not reduced economic inequality. I rely on the innovative arguments of Dena Freeman in her seminal work, “De-Democratisation and Rising Inequality: The Underlying Cause of a Worrying Trend.”

Rising Inequality in Democracy: Elite Distribution and Voting Suffrage

Why has economic inequality increased alongside the rise in democratization? This is an old problem. Elites in the 19th century feared that the “universal suffrage” part of democracy would lead to the redistribution of wealth.

How would this redistribution happen? The democracy-reduces-inequality argument is the following:

In theory, the disadvantaged have greater voice in democracy, and therefore have greater impact on government response. This is an electoral politics argument about an agreement between the elite and the masses, otherwise known as “the class compromise of the post-war period.” It’s an exchange: The elite agree to redistribute economic resources through social welfare spending to the disadvantaged because the elite need the votes of the disadvantaged. The sheer size of the voting citizenry ensures that political parties operating within democracies must listen to a large and heterogeneous population. Thus, spending should be more universal than merely targeted to particular groups.

This is based, in part, on the median voter theory. This theory says that people are rational actors seeking to maximize benefits: parties want to win elections and thus end up proposing economic redistribution policies that benefit the median voter.

Democracies allow substantial bargaining power of labor — unions— that they can use to extract wages and other resources that reduce economic inequality.

Economic Redistribution Stopped Reducing Economic Inequality in the 1970s

Inequality did fall during the initial period of universal suffrage. But things changed dramatically during the 20th Century. As Piketty’s U-shaped graphs of economic inequality show, inequality declined, and then, in the 1970s, it rose.

Why the U turn? Unionization had helped to reduce economic inequality in the US, until the 1970s, when there was a great shift and a strong downturn in unionization. Some argue that the early 20th Century reduction in inequality was due to unusual circumstances. Once those circumstances ended, inequality resumed its normal upward path.

What were those circumstances? After the 1970s, there were major technological and economic changes:

Technological advances, especially computerization that lead to a dramatic increase for skilled workers and decreased wages for the “unskilled.”
Skyrocketing income and wealth compensation for CEOs and senior management.
Global finance: It has become easy to move money around the globe, and to hide it.

Freeman’s Thesis: Vox Populi Lost Control over the Economy

Dena Freeman offers a different argument. She argues that the vox populi, the people in democracy, have lost control over the economic process. “Decisions regarding the organisation and functioning of economic matters,” Freeman writes, “have become less subject to democratic influence.”

In essence, democracy itself has changed, and not for the better.

Within the democratic process, people ceded control over the economy to private interests and the market, and thus lost political control over how the economy functions. This loss of control limits the policies that elected representatives can create and get through the legislative system.

The result, Freeman argues, is that “economic policies have increasingly been made in the interests of capital and the class compromise of the post-war period has been undermined.”

Neoliberalism and Democracy

Freeman blames neoliberalism. The economic crises of the 1970s introduced a change in economic ideology toward what would be called, “neoliberalism.” In neoliberalism, the economy is self-regulating, and thus the state should leave it alone. According to Freeman, Hayek’s “ideas about constitutional limits to democracy were effectively ways to ensure that the economic sphere would be carefully insulated from the demos and thus that democracy’s redistributive threat would be neutralized.” The economy should be lightly managed by experts and technocrats whose prime directive is to let the market dictate its own future.

Neoliberalism demands free markets that spread across the world. The free movement of capital around the world accelerated after the 1970s. The rich got richer and hid their wealth in tax havens.

Monetary Policy, Trade Agreements, and Democracy

Independent central banks that set monetary policy are out of the control of vox populi. “Monetary policy is instead increasingly governed by the financial markets and the interests of financial capital,” writes Freeman. Policy is a tug of war between the interests of capital and the interests of labor, and capital is winning.

International trade agreements can create enduring and hard-to-revoke rights of capital in terms of strengthening property rights; these rights are designed to outlast the government that signed on to them, to endure as democratic elections produce new governments. Trade agreements can impose harsh penalties on governments that try to reverse the policy.

International Financial Institutions and Democracy

International Financial Institutions (IFIs) – G7 and G20, World Economic Forum, etc. – are global organizations that are not representative of all of the countries that they impact. Membership is based on invitation only, and the wealthy elite are the ones who control the invitations. These institutions define the space in which policies are discussed and decisions are made.

This restricts the policy options available to individual nations for a few reasons: The elite nations:

are deeply committed to neoliberalism and the global trade agreements that restrict national policies that could deal with within-nation income inequality;
promote international competition for international corporations to locate their businesses there (e.g. low corporate tax rates);
favor policies that promote economic growth instead of social welfare.

“In the post-1970s” Freeman writes, “firms and their interest associations have lobbied governments for rollbacks and efficiency-oriented reforms in national systems of social protection. They have argued that social programmes negatively affect profits, investment, and job creation and they have also used the threat of relocation to more favourable environments in order to put pressure on domestic policymakers.”

Rich countries have tools to resist these changes. Poor countries do not. As a result, the developing poor countries reduce public spending and take loans from the IMF and others to pay for what public spending they do.

The consequence is a spiral of debt and loans and more debt that reduces what little political leverage these countries have to change the policies of global finance. In addition, this debt is increasingly financialized, “packaged and repackaged in different forms of securities and traded on the bond market.” Thus, poor developing countries have a difficult time renegotiating and managing their debt with the rich countries.

In the mid-1970s, rich democracies decided to limit vox populi on their democratic control over the economic system and the distribution of economic resources, especially over social welfare.

“Two new approaches were developed at this time – New Public Management Theory (NPM) and Governance theory. Both promoted their changes in the name of costcutting and efficiency. NPM can be seen as an extension of neoliberal theory as applied to the public sector. It calls for governments to embrace private sector management strategies.”

While the de-centralization of decision making within governments over economic matters can be seen as, on paper, more democratic, it ignores the basic problem of political inequality:

“While some have argued that this new form of policy-making is in fact more democratic than top-down government – because a wider range of stakeholders are involved, including also NGOs, consumer groups and other elements of civil society – it must be remembered that the resources available to large companies, TNCs and business associations to engage in these processes is far, far greater than that available to civil society groups, many of which are poorly funded and under-resourced. As one commentator noted, it is like lining up rowing boats against battle ships. Rather the shift to decision-making in multi-stakeholder policy networks has led to an increased representation of the private sector, and thus of capital, in the policy making process.”

Summary and Conclusion

Democracy was supposed to reduce economic inequality through economic redistribution to the masses. As the masses allow the elite to become representatives, the representatives were supposed to allow political control over the economic policies that make sure redistribution works.

This worked, until the 1970s. After then, there were large scale changes to the economy. There was a technological change that rewarded a small group of workers. Growing automation will only accelerate this trend. CEO compensation went through the roof. And the rules of global finance, accelerated through neoliberalism, made it easier to move money around the world, incentivizing the wealthy to hide their wealth (Panama Papers) and create tax havens (Pandora Papers).

Freeman argues that the people mentioned in “We the people” — vox populi — have lost political control over the economy. Democracy outsourced knowledge on financialization to the market and to political appointees who believe in the power of markets.

The result is the inequality grows, and democracy does little to stop it.

Further Reading

Acemoglu, Daron and James Robinson. 2008. Persistence of Power, Elites and Institutions. American Economic Review, 98: 267-291.

Boix, Carles. 2003. Democracy and Redistribution. Cambridge: Cambridge University Press.

Brady, David, Beckfield, Jason & Wei Zhao. 2007. The Consequences of Economic Globalization for Affluent Democracies. Annual Review of Sociology, 33: 313-334.

Freeman, John, and Dennis Quinn. 2012. The Economic Origins of Democracy Reconsidered. American Political Science Review, 106: 58–80

Gradstein, Mark and Milanovic Branko. 2004. Does Liberte = Egalite? A Survey of the Empirical Links between Democracy and Inequality with some evidence on the Transition Economies. Journal of Economic Surveys, 18,4: 515-537

Piketty, Thomas. 2014. Capital in the Twenty First Century. Cambridge: Harvard University Press. (trans: Arthur Goldhammer)

Timmons, Jeffrey. 2010. Does Democracy Reduce Economic Inequality? British Journal of Political Science, 40, 4: 741-757.