a comprehensive review on capital structure theories

The Romanian Economic Journal

Year XVI no. 47 March 2013

149

Income inequality and income distribution have always represented a foremost topic with important economic, political and social implications. The large income disparities both at a national and global level present nowadays an even greater importance since after three decades of global capitalism, the anticipated and desired convergence of world economies fails to materialize. In recent decades, the large income gaps still remained: the poorest fifth of the world population possessed in 2009 only 1.4% of global incomes while the richest fifth owned 82.7% of global revenues. The present paper aims to illustrate the underlying causes of the persistent income inequality from the recent decades performing the analysis from the interventionist economic theory perspective developed by John Maynard Keynes.

Keywords: income, inequality, distribution, Keynesian, economic growth. JEL Classification: D31, E12, O15, O43. Introduction The income inequality problem and the distribution of income have been recurrent topics in the history of economics generating diverging

1Asăvoaei Alexandru, PhD Student at Alexandru Ioan Cuza University of Iasi, Romania, E-mail: [email protected].

A Comprehensive Review on Capital Structure Theories

Asăvoaei Alexandru 1



150

opinions and lively debates. Nowadays, after more than three decades of economic globalization, the concerns relating to income inequality are more relevant than ever if we take into account the magnitude of the negative effects that inequality has upon economic growth and on the entire development process as a whole. The need for a deeper understanding of the channels by which economic growth and income inequality interrelate has become clearer in the recent years partly as a consequence of the difficulties encountered by some countries once they started the economic liberalization recommended by the Washington Consensus and partly as recognition of the successes achieved by other countries in the same economic liberalization process. The keystone stands probably in finding the optimal proportion of income inequality for each country, without forgetting to take into account its own peculiarities. It is well known by now that opening the national economies by allowing the influx of private capitals and reducing the customs barrier facilitating the international trade will have a great impact on a country’s economic “take off”. But only the market liberalization by itself does not improve the societies’ development as a whole. For this reason, James Wolfensohn, the president of the World Bank during 1995-2005, proposed in 1999 a “comprehensive development framework” (Comprehensive Development Framework, 1999), thus criticizing the compartmentalized way of seeing the development process advocated until then, such as seeking for a single panacea like the “open market “ or “getting the prices right”. It was arising so the need for a wider and more pluralistic view on the development process. Within it the income inequality’s evolution, both nationally and globally, should be considered an important landmark in creating a comprehensive framework for economic development. On a theoretical level, the relationship between economic globalization, through its high potential to boost the national economic growth, and the evolution of income inequality constitutes a



151

controversial topic. On the one hand, the neoclassical growth theory argues that in an integrated global economy the levels of productivity and those of average incomes are converging as capital moves from developed countries, abundant in capital, which will record decreasing rates of marginal productivity to less developed countries where each unit of capital will record a higher marginal productivity because of the scarcity of capital. On the other hand, endogenous growth theories argue that the decreasing trends of the productivity rates assumed to occur in developed economies is canceled by the technological innovation specific to these countries, expecting rather a divergence of global incomes than a convergence of them. Moreover, the dependency theory and world system theory claim as well that income and productivity convergences are unlikely to occur due to the differential benefits associated to global integration and due to the uneven terms of exchange between the central economies with high levels of incomes and the periphery economies which record low levels of incomes. Also, the empirical findings regarding the evolution of global income inequality do not record any change in the last two and a half decades. In 2007, the richest fifth of the world population owned 82.7 percent of the world incomes while the poorest fifth just 1.4 percent of them (see Figure 1). The most suggestive representation of world income inequality is the Champagne-glass distribution where each horizontal band represents an equal fifth of the world’s population. Therefore, it was these theoretical controversies regarding the economic development process along with the divergent nature of the theories regarding the impact of income distribution on economic growth and the empirical evidences that are not recording any reduction of global income disparities that formed the basic arguments for the increased attention upon income inequality problems manifested in recent decades. But the problem is far from being new and it is hard to believe that it could be settled sometime in the



152

foreseeable future. It can be found in a concrete form in the writings of some famous mercantilist authors such as William Petty, Gregory King or Joseph Louis Lagrange, then even more debated in classical writing of Adam Smith and David Ricardo, John Stuart Mill or Karl Marx, and from then on in the neoclassical writings or Keynesian works.

Figure 1 Champagne-glass distribution of the global incomes in 2007

Source of data: Dalton, 2008, p. 392



153

Keynes’ perspective on income inequality Almost a hundred years ago, Keynes identified as one of the biggest economic problem of his time the inability of the free market economy to ensure an equitable distribution of the national income and since the issue of high income disparities still persists, finding solutions concerning it still has that high priority nowadays as well as on Keynes’ time. At the beginning of the twentieth century, the persistence of some large disparities of income levels was reflecting a different reality from the one envisioned by the “invisible hand” theory and neoclassical economics. It was this reality that led John Maynard Keynes to state in the end of his General Theory of Employment, Interest and Money that “for my own part, I believe that there is social and psychological justification for significant inequalities of incomes and wealth, but not for such large disparities as exist today” (Keynes, 2006, pp.342-343). Thus, along with the onset of the Great Depression from 1929-1933 and as the mainstream economics was proven weak in offering viable solutions for the new economic problems Keynes intervenes and offers a radical vision on the entire economics, bringing along a new vision and a new methodological apparatus. Ardent believer in the economic interventionism politics, favoring the involvements on the markets to a public benefit purpose on behalf of the government, Keynes does not renounce though on the “good old doctrine”, nor does he sympathize with the communist supporters, but instead achieves a brilliant synthesis that offers a unique interpretation of the classical economic theory pleading in favor of the state only as far as it helps the private initiative to manifest. In his attempt to understand the triggering mechanisms of crises and the ways of minimizing their negative effects Keynes is at the same time performing a pertinent analysis on the causes of poverty. His first writings on poverty and its link to inequality of incomes appear therefore in the early 1930s in an effort to combat the consequences



154

of the Great Depression by emphasizing the relationship between economic growth and employment levels thus providing a series of solutions for reducing the high unemployment rates. Keynes’s policies concerned the increasing of government expenditures during recession periods in order to reestablish the economic growth. However they should not be understood as an impulse for a wasteful state, but rather as a government intervention during crisis meant to restore the equilibrium of a national economy. Keynes believes, and for good reason, that it is precisely the major inequity of income distribution existing in a society, that is the main cause for the occurrence of the recession phase of the business cycles. He supports his view by formulating what is today known as psychological fundamental law, which states that “when aggregate real income is increased aggregate consumption is increased, but not by so much as income”. (Keynes, 1970, p. 64) Of course, Keynes was thinking especially of the consequences that either the increases or the decreases of aggregate demand will have on the essential economic parameters, such as the level of employment. By formulating this law, Keynes notes that the increase of the marginal propensity to hoard, which implicitly coincide with the decrease of the propensity for consumption or investment, is even more pronounced as the individual incomes are higher. Therefore, Keynes believes that it is precisely the richest people who live in a certain society that are those responsible for the occurrence of macroeconomic imbalances like those that caused the outburst of the Great Depression of 1929 – 1933, but which also started the current economic crisis. The Keynesian reasoning is simple: as the economy begins to falter, both enterprises and consumers – either out of fear of losing their jobs, or because they are already unemployed – will begin to reduce their costs that will further on cause a fall of demand below the levels of the existing supply, exacerbating the adverse economic and social consequences of the crisis. Given this, the only viable solution from



155

Keynes’s perspective is the government intervention through macroeconomic policies designed to restore the consumption at current production levels, equalizing savings with investments and achieving a full employment state when the economy is employing all of its available resources. The government spending theory developed by Keynes assumes state intervention on the market through various budgetary expenditures programs and tax incentives in order to create a sufficient number of jobs and to restore the aggregate demand at the same level with the existing market supply. But Keynes is aware of the fact that economic growth does not necessarily reduce poverty by itself. His opinions on inequality are found particularly in the last chapter of The General Theory of Employment, Interest and Money. Unlike the neoclassical beliefs, Keynes notes that income inequality leads to an economic growth slowdown rather than boosting it. People living in poverty spend all their incomes to purchase the basic goods for their living and any additional income will be spent on basic subsistence goods as well. But once a higher level of income is reached, individuals will generally tend to save more and consume less, so that “up to the point where full employment prevails, the growth of capital depends not at all on a low propensity to consume but is, on the contrary, held back by it; and only in conditions of full employment is a low propensity to consume conducive to the growth of capital” (Keynes, 2006, p. 342). Therefore, given that the normal state of an economy is to achieve the goal of full employment, it will be public spending that will have a stimulating effect on the economic growth and not the savings as in the neoclassical theory. Also, for Keynes the investments (determined by demand size) represent the active element in their relationship with savings (Popescu, 2004, p. 657) and not vice versa as in the classical and neoclassical doctrines. Keynes frequently stood in favor of a higher taxation plan for large incomes and inheritances, thus the solutions proposed by him



156

concerned state interventions aiming to increase the consumption propensity, either by fixing the interest rate or by other economic and monetary means such as the adoption of a direct taxation scheme for the redistribution of incomes. Willing to strengthen this very idea, Keynes militates for the “euthanasia of the renter” (Keynes, 1970, p. 378). He considers that this social class is parasitic, unproductive, and inclined towards the “blocking” of large amounts of cash, which otherwise could represent a catalyst to economic recovery. In order to achieve this goal of "cutting the ground from under renter’s feet" (Moldovanu, 1994, p 143), the British economist also recommended, especially in times of extreme economic crisis, a substantial reduction of interest rates, even to the point where they would be close to 0%. Although Keynes was fully aware of the inflationary pressures that would result from the adoption of such economic policies, he strongly believed that this was the only way to gradually eliminate the renter class, and thus the important amounts of money hoarded by them could be returned to the economic circuit. But even so, Keynes does not forget to emphasize at the end of his General Theory of Employment, Interest and Money that “apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialize economic life than there was before” (Keynes, 2006, p. 347). Hence, Keynes advocates state intervention in lessening the large income disparities for at least three reasons (Kirshner, 1999). First, from a pure positive economic perspective, Keynes argues that a heavily unequal distribution of income will lead to an aggregate level of demand under the existing level of productivity, thus slowing the economic growth and causing rates of employment below the full employment state. Then, from a normative perspective, the unregulated market forces will tend to realize an arbitrary and unfair distribution of income and wealth by rewarding the ones who are already rich than the poor. Finally, from a practical perspective, large



157

disparities of wealth can lead to social unrest and even riots, having strong negative consequences on the economic growth and social development unlike the Keynesian solutions which are “more favorable to peace than the old has been” (Keynes, 2006, p. 349). The present income inequality and the actuality of Keynesian solutions The issue of income inequality is nowadays at least as relevant, as it was in the Great Depression era. And more than that, taking into account the austerity policies adopted by the great majority of economically developed countries from Europe in recent years, many leading economists believe that the wealth disparities are likely to increase even more in the near future. For example, one of the latest laureates of the Nobel Prize for economics, namely the American professor Paul Krugman, in an article published on 31 May 2012 in the American newspaper “The New York Times”, expresses his concerns about the possibility that the American authorities might adopt a similar line of action for the U. S. economy. In the same article he also launches an interesting hypothesis, about the real motivations behind these political decisions. The American economist believes that the real purpose of those governments which had adopted the “austerity agenda”, was to dismantle many of the active social programs, existing in their countries. He also thinks that the existence of deficits was only an excuse used by the governments, in order to justify the necessity of implementing such economic policies. Therefore, Paul Krugman clearly states that the final objective of these decisions is that of “aiding the rich and punishing the poor” (Krugman, 2012). He motivates this statement by the fact that, especially in the United States, many politicians had proposed, along with the austerity measures, significant tax reductions for the wealthiest American citizens.



158

In spite of the fact that we cannot provide sufficient arguments in order to certify beyond any doubt professor Krugman’s hypothesis, we believe it would be a serious mistake to completely ignore it, especially since in the recent decades, both within the American society and at a global level, the wealth concentration has become more and more pronounced. Thus, in 2007, according to official statistics, 20% of the U.S. population held approximately 85% of the national wealth, while the 1% corresponding to richest Americans would own no less than 34,6% of it. Moreover, during the years that have passed since the beginning of the current economic crisis, this trend continued to amplify. Hence, in 2010 the percentage of wealth held by the richest fifth of the American population, reached the threshold of 89% (Dornhoff, 2013). Other statistics show that during the time interval since the early '80s until now, the net income of the richest 1% of U.S. citizens has grown by 281% while the revenue increase of the middle class citizens was much lower, of only about 25% (Sherman & Stone, 2010). The entire dynamics of income changes for every category of the U.S. population, from the last 30 years is shown in Figure 2.



159

Figure 2 Income gains at the top dwarf; those of low and middle income

households

Source of data: Sherman & Stone, 2010

All this data shows that the wealth concentration process has intensified in the same time interval, when U.S. financial sector regulations were successively abolished, enabling the emergence of those huge private corporations, which were at the same time, extremely strong in financial terms. We can also easily infer that the impressive financial strength of this oligopoly formed by giant financial institutions, is able to provide them with a major influence among American politicians, a situation which could provide a strong foothold for the disturbing hypothesis launched by Professor Krugman. It cannot be just a simple coincidence that, at least in the United States, there has been only one period in the entire economic history



160

that was characterized by a significantly larger discrepancy regarding the national wealth distribution, than the one existing nowadays, and those years are just the ones that precede the Great Depression of 1929 – 1933. Thus, in 1929, the richest 1% of the American citizens shared 44,2% of the total wealth of the nation (Dornhoff, 2013). Another similarity between these two time periods is that both are characterized by the absence of an efficient regulatory framework, regarding especially the financial sector of the economy, fact which appears to have facilitated the increment of wealth gap between the rich and the poor. The wealth distribution in the United States since before the Great Depression till the year 2010, cat be visualized in the following chart.

Figure 3 Share of wealth held by the Bottom 99% and Top 1% in the

United States, 1922-2010

Source of data: 1922-1989 data - Wolff (1996). 1992-2010 data - Wolff (2012).



161

Moreover, further analysis has revealed that, in the same period of time, the richest 24,000 American families earned an income three times higher than the poorest 6,000,000 families settled within the borders of the United States (Walsh, 2008). Of course, the United States is not the only country in the world which is suffering from this “disease”. In almost every country, the income gap between the rich and the poor has increased in the recent years. For example, in the UK, the share of the national income held by the richest ten percent of the population was significantly higher in 2009 than a decade before. Thus, in only ten years, the richest British citizens expanded their wealth from 28% to 31%.(source: The poverty site, 2010) More than that, in the same period of time, the poorest ten percent of the British citizens had experienced a fall in their real incomes, while other categories of people had their real income increased, to a greater or lesser extent. In France the situation is not different. From 1999 till 2009, the nominal income gains of the poorest ten percent of the French citizens were of 8.4%, while the richest ten percent earned, on average, 18.2% more. But this average does not reflect the existing discrepancy entirely, because the top 0.01% gained much more than the average. More specifically, between 2004 and 2008, the richest 0.01 of the French citizens obtained an annual increase of their wealth of 33%. (source: Inequality watch, 2012) For other European countries, the situation is even worse. According to statistics, in 2010 the relative median at-risk-of-poverty gap, was the widest in Lithuania – 32.6% and both in Spain and Romania – 30.6%.(source: Eurostat, 2012) The examples could continue but the conclusion would be the same: almost everywhere the wealth inequalities has increased. Under these circumstances, we consider that the call to the authorities lunched by Keynes against those “blind forces of the market”, which represents the private monopolies of his time is fully justified. Only by limiting their power and influence on the healthy free market



162

mechanisms, it would be possible to ensure both, a high level of employment and a more equitable distribution of national income between the members of the society. Conclusions In our opinion, the income inequality phenomenon and its implications should be brought again into the attention of economic debates, since in the last decades the statistical facts relating it are revealing some troubling realities. The global income inequality has increased steadily both at a national and international level. Therefore, the present paper aims to highlight that unlike the current mainstream perspective upon income inequality, the keynesian perspective is more economically and socially optimal. In the past decades, the inequality problem has been treated in neoclassical terms, being understood as having one causality direction, from growth to income distribution process. The arguments of the neoclassical theories are based on the inverted U curve hypothesis, advanced by Kuznets in 1955, according to which income inequality tends to increase in the early stages of the economic growth, because as it becomes sustainable, the inequality begins to decrease gradually. Therefore, the neoclassical economists do not perceive the widening in income as a serious problem. They assume that the income disparities will inevitably decrease as the society develops, without the need for governmental intervention. However, we believe that in the last decades reality has proved exactly the opposite, namely that income inequality is a real problem whose consequences are at least worrying. For this reason, we consider it is necessary to remind the recommendations made by John Maynard Keynes, concerning the opportunity of state intervention, in order to increase the population propensity to consume. The interest rate mechanism and the implementation of a progressive taxation scheme are in our opinion



163

the most efficient ways for obtaining a more equitable income distribution. Acknowledgements: "This work was supported by the European Social Fund in Romania, under the responsibility of the Managing Authority for the Sectorial Operational Programme for Human Resources Development 2007-2013 [grant POSDRU/CPP 107/DMI 1.5/S/78342]". References Conley, D. (2008), “You may ask yourself: An introduction to thinking like a sociologist”, NY: W. W. Norton. Dornhoff, G. W. (2013), “Wealth, Income, and Power”, Data base, http://www2.ucsc.edu/whorulesamerica/power/wealth.html, Accessed on January 2013. EUROSTAT (2012), Income distribution statistics, Data base, http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/Income_distribution_statistics, Accessed in April 2013. INEQUALITY WATCH (2012), The evolution of income inequality, in France, Data base, http://www.inequalitywatch.eu/spip.php?article93&lang=en, Accessed in April 2013. Keynes, J. M. (2006), “The General Theory of Employment, Interest and Money”, New Delhi: Atlantic. Keynes, J. M. (1970). “Teoria generală a folosirii mâinii de lucru, a dobanzii si a banilor”. Bucureşti: Editura Ştiinţifică. Kirshner, J. (1999), “Keynes, capital mobility and the crisis of embedded liberalism”, Review of International Political Economic, 6(3): 313-337. Krugman, P. (2012), “The Austerity Agenda”, Data base, http://www.nytimes.com/2012/06/01/opinion/krugman-the-austerity-agenda.html?_r=2&, Accessed on January 2013.



164

Moldovanu, D. (1994). “Doctrinele economice”. Chisinău: Universitas. Popescu, G. (2004), “Evoluţia gândirii economice”, ed. a III-a, Bucureşti & Cluj: Editura Academiei Române & Editura Cartimpex. The Poverty Site (2010), United Kingdom Income Inequalities, Data base, http://www.poverty.org.uk/09/index.shtml, Accessed in April 2013. Sherman, A. and Stone, C. (2010), “Income Gaps Between Very Rich and Everyone Else More than Triples in Last Three Decades, New Data Show”, Data base, http://www.cbpp.org/cms/?fa=view&id=3220, Accessed on January 2013. Smith, A. (1962), “Avuţia naţiunilor – cercetare asupra naturii şi cauzelor ei”, vol. I, Bucureşti: Editura Academiei Republicii Populare Române. Walsh, I. (2008), “Keynes and the Market: How the world’s greatest economist overturned conventional wisdom and made a fortune on the stock market”, NY: John Wiley & Sons. Wolff, E. N. (2012), “The Asset Price Meltdown and the Wealth of the Middle Class”, NY: New York University. Wolff, E. N. (1996), “Top Heavy”, NY: The New Press. Comprehensive Development Framework (1999), Data base, http://web.worldbank.org/WBSITE/EXTERNAL/PROJECTS/0,,contentMDK:20120725~menuPK:41393~pagePK:41367~piPK:51533~theSitePK:40941,00.html, Accessed on January 2013.

a comprehensive review on capital structure theories

Documents