(This essay was published in Hong Kong Economic Journal on 11 September 2013)

 

The period 1981 to 2010 was a time when growth in the world economy accelerated and poverty fell dramatically. According to the World Bank, 50% of people in the developing world were living on less than US$1.25 per day in 1981, but by 2010 this number had decreased to 21%, despite a 59% increase in the developing world’s population. This remarkable decline in global poverty is to a large measure the result of economic growth in the era of rapid globalization.

 

The idea that economic growth can help alleviate poverty is at the heart of the belief that growth is the best cure for poverty. But it can only work if governments of developing economies support economic opening and reforms that unleash market forces and embrace globalization.

 

A related observation of globalization is that it has also led to inequality and a widening of the gap between the rich and poor. Does this mean that the economic conditions facing the poor have worsened absolutely? It is of course always possible for some groups and sectors to have suffered in absolute terms despite economic growth and globalization, but this cannot be true of the poor as a whole for otherwise the World Bank findings would not show such a large drop in poverty over 30 years.

 

Growth Effects on Equality Uneven

 

Increasing inequality in developing countries is, however, consistent with the observation that while both the rich and the poor have gained, the rich have gained more. Measured inequality has risen even though the poor are better off than they were before. Why this can happen and what can be done about it is the focus of this essay. I shall look at the central role of human capital in this process and the challenge of capital market imperfections –– a term I will explain later.

 

Increasing inequality has adverse impacts on upward social mobility and can have serious political implications as hope falters and aspirations are frustrated. This is an important policy matter, but it should not blind us to the incredible progress made in world poverty alleviation. The fact that economic growth can lift poor people out of poverty is at the heart of the finding that freer economic markets improve some of the capital market imperfections that keep people poor, although this often requires willingness on the part of governments to adopt facilitating policies.

 

Nonetheless, the process of economic growth itself may sometimes lead to conditions that produce inequality. Increases in economic productivity are almost always unevenly distributed across industries and activities. Those sectors that experience slow or no productivity growth may decline and workers may become displaced; eventually both businesses and workers adjust and move into sectors where there is higher growth. This may take time and is costly, and some may suffer in the transition. Economic opening and globalization does not work well for these folks.

 

Some observers misinterpret this phenomenon to conclude that economic markets produce poverty, and they become critics of globalization. But they fail to recognize that markets also create wealth and income in sectors with a higher rate of productivity growth. These critics err by focusing on sectors of low productivity growth instead, so the picture they describe is therefore partial and incomplete.

 

Markets may produce both winners and losers, and growth occurs because the gains of the winners are larger than the losses of the losers. Growth also creates incentives for losers to seek better opportunities, and makes it possible for winners to compensate losers through transfers so that no one needs to suffer from growth. So growth can be a win-win game. Those in slow growth sectors can remedy their situation partly by seeking out better opportunities and partly through the provision of a social safety net, which can be funded either by government or private voluntary agencies. The safety net can be either an interim solution or a permanent one. Very often for political expediency, temporary solutions end up becoming permanent ones even after they have outlived their usefulness.

 

Rising inequality and declining poverty have given rise to two different interpretations of what today’s nations are facing. The positive interpretation sees declining poverty and interprets it as a beneficial effect of economic growth and globalization. The negative interpretation sees rising inequality and argues that life for the lower-income and even middle-income classes has become harder, with reduced upward social mobility, especially intergenerationally.

 

Both interpretations probably contain elements of truth: the glass can be accurately described as both half-empty and half-full. In most places the poor as a whole have been doing better, but often not as much as the rich have. The gap between them may have therefore widened in a relative sense. In the poorer developing world the widening of this gap is interpreted as the rise of the middle-class. In the rich developed world it is perceived to be the hollowing out of the middle-class.

 

The increase in Mainland tourists to Hong Kong and elsewhere is a manifestation of the rising middle-class in emerging China. For Hong Kong, a rich developed city, there is a growing fear that the middle-class is hollowing out. Hong Kong graduates bemoan that they cannot earn enough to afford a life of basic comfort that includes homeownership, quality health care, old age security, and access to university education for their children. This set of concerns is actually better described as a fear of poverty rather than poverty as such.

 

People in this group expect to be poor at some time during their lives – either sinking into poverty or, for some, struggling to make ends meet. One could describe this group as “near-poverty”.

 

Poverty in its various forms is becoming a growing political issue that is dividing the community. The government has indicated it wishes to do something about it, but do we really understand the underlying reasons that have contributed to the widening gap?

 

I shall try to outline in simple terms the basic economic logic of why a person becomes poor and then consider the most effective remedies society can administer to help him. Focusing on the micro individual decision level is very important for gaining a real understanding of poverty, inequality and upward social mobility issues and their interelatedness.

 

Diverse Capital Sources for Poverty Alleviation

 

Capital produces income. Poverty is the result of possessing too little capital. A person is poor if he starts off with very low levels of human and non-human capital and, even more importantly, is unable to accumulate significant amounts of such capital over time. His monthly income will therefore remain low for his entire lifetime. Human capital are assets embedded in a person like education, health, beauty, personality and the like. Non-human capital includes financial, physical, and property assets.

 

A third form of capital that is less discussed is social capital. A person who has parents, siblings and is married can often borrow and utilize the assets possessed by family members and can be regarded as able to acquire more capital than an isolated individual, and is therefore potentially wealthier. By the same token a person with close friends can also acquire more capital than one who doesn’t have them. That is why throughout human history family and kinship have played an important role in helping people to survive in the face of poverty and other harsh circumstances.

 

In some places the workplace is also a source of credit. Companies and organizations have credit unions to help employees. In a market economy, the process of capital accumulation is facilitated through well developed financial markets.

 

These different forms of social capital that an individual can have access to have been called the F-Connection by the late economist Yoram Ben-Porath: Families, Friends, and Firms. The ability to borrow from and utilize the assets of others is at the heart of the issue of capital market imperfections.

 

In modern day societies borrowing to invest in human capital is not a well-developed financial activitiy. One reason for this is that society frowns upon indentured servitude. It is therefore very difficult for a person to use himself as collateral to secure a loan from a financial institution. The financing of human capital investments often has to rely on family and kinship ties, i.e., traditional non-market institutions.

 

Demographic Changes and Inequality Income Indices

 

In traditional societies, possession of non-human capital was an important determinant of a person’s position in society. In modern societies, possession of human capital has taken on an increasingly important role. Moreover, possession of one form of capital can help beget other forms of capital. A poor person is essentially a person who has little of all forms of capital to start with and is unable to augment their capital very much.

 

Typically a person starts with accumulating human capital. In traditional societies a son learns to farm from his father. He then later inherits his plot of farmland, a form of non-human capital. In modern societies, children attend schools to learn market skills and rely on parents and the government to pay for tuition fees and support them through schooling. Some may subsequently inherit a business and other assets.

 

Since the level of human and non-human capital typically rises with a person’s age, it is not appropriate to directly compare the income of a younger person with an older person and conclude that the older person is richer than the younger person. There are two ways to make a proper comparison. One is to compare the lifetime income of two people. Another is to compare their monthly incomes at a comparable point in their lifecycle, say at age 40 or 50.

 

This point can be illustrated with an example. A university student may have no income while studying compared to a secondary school graduate who is working, but the university student is accumulating human capital that would allow him to earn a higher income in the future. For this reason, the Gini coefficient (a measure of income inequality) may change over time because of changes in the demographic structure of society even when the underlying distribution of lifetime incomes is unchanged.

 

In Hong Kong, part of the reason why the measured Gini coefficient of household income has been rising in recent decades has been due to the unusually rapid rate at which society is ageing. Table 1 provides the actual and estimated population figures over the period 1981-2041. The ratio of elderly to the working population was 0.115 in 1981, 0.138 in 1991, 0.170 in 2001, 0.193 in 2011; and is projected to increase to 0.287 in 2021, 0.449 in 2031 and 0.531 in 2041.

 

Table 1: Population Figures (millions)

 

Age groups 1981 1991 2001 2011 2021 2031 2041
Young:    0-19 1.85 1.62 1.55 1.25 1.15 1.19 1.09
Working: 20-64 2.99 3.63 4.42 4.88 5.06 4.81 4.82
Elderly:   65+ 0.34 0.5 0.75 0.94 1.45 2.16 2.56
All ages 5.18 5.75 6.72 7.07 7.66 8.16 8.47
Ratio of elderly to working population 0.115 0.138 0.17 0.193 0.287 0.449 0.531

Source: HKSAR Census and Statistics Department

 

 

Life expectancies have increased considerably over time as the population’s health has improved. In the past century life expectancies have risen by 50-100% in different societies. Longer life expectancies imply greater lifetime incomes through two effects. The direct effect is that a person can utilize his capital over a longer period of time to produce a higher lifetime income. The indirect effect is that a person will have an incentive to invest in more human capital, for example more schooling, which in turn produces higher income.

 

In summary, the question of whether income inequality has widened cannot be examined purely from looking at the distribution of household or individual incomes at a point in time, but must be deduced from the distribution of lifetime wealth or lifetime incomes. And the latter is greatly influenced by demographic factors.

 

Investment and Relief Measures

 

The above discussion demonstrates what should be the four central goals of society in alleviating poverty and its effects. First, learn the lesson that market driven economic growth and globalization are the primary policy tools for alleviating poverty. One has to open up the economy and embrace the market. Growth will lift a lot of poor people out of poverty as has been demonstrated by the Chinese economic miracle in the past 30 years.

 

Second, enhance broad based public investment in human capital, which will be beneficial for economic growth and reduce poverty.

 

Third, target subsidies for the poor when they are young, to help them augment their human capital at an early stage and thereby increase their lifetime incomes – this includes making investments in health and education.

 

Fourth, for the elderly poor who are retired, investing in their human capital is less relevant. The focus should be on subsidizing their expenditures and not enhancing incomes. This can be accomplished by providing income or capital supplements through public programs and private charity. The government’s means tested Old Age Allowance Scheme is a form of income supplement. My favourite proposal to privatize public housing would be a form of non-human capital supplement or wealth transfer.

 

Human capital investment is clearly a prominent tool for poverty alleviation. The amount of human capital one eventually acquires depends on two factors: “ability” and “opportunity”. Ability describes the efficiency of a person in transforming one dollar’s worth of investment in human capital into extra income. Some people are more efficient and can acquire $1.50 worth of human capital out of that one dollar investment. Others are less efficient and can only acquire 50 cents worth of human capital from the same investment. Ability differences mean that those with higher ability will invest in more human capital than those with lower ability.

 

Opportunity relates the cost of borrowing one dollar to making an investment. In today’s society, where slavery is illegal, one cannot indenture oneself as collateral against loans for human capital investment. The loans market for making human capital investment is necessarily very imperfect. If one has rich or loving parents, who are willing to make large sacrifices, then the cost of borrowing may be quite low even after factoring in future repayments often couched in terms of piety obligations.

 

In the movie American Dreams in China (中国合伙人), a short scene vividly depicts capital market imperfections in education loans and the role of family and kinship in improving some of these imperfections. The protagonist Meng Xiaojun is kneeling before his mother and elderly kinsman in the village, pleading for another opportunity to re-sit the university entrance examinations and avoid becoming a peasant. Some of the elderly kinsman speak in his favor and encourage his mother to accede to her son’s pleading. She finally consents, but as the elderly kinsman all rise to leave she quickly admonishes them all to contribute to the cost of her son’s education before they depart.

 

In most societies, religious groups, charities, and other voluntary associations all play a role in providing education loans and subsidized education for improving such capital market imperfections. But the role of government has become increasingly important. In most developed societies today education is heavily subsidized by government, which works to level out some of the differences in opportunity faced by a poor person.

 

The reason why opportunities in education are seldom fully equalized is due to the cost and technology of human capital investment. In the next essay I shall discuss this in more detail and consider how ability and opportunity interact to produce inequality. I shall also consider policy measures for dealing with the complexities of public support for human capital investment and the design of education policy.

 

Reference:

 

Yoram Ben-Porath, “The F-Connection: Families, Friends, and Firms and the Organization of Exchange,” Population and Development Review, Vol. 6, No. 1, March, 1980.

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