The deliberate misreading of the Elephant Curve

(Source: here)

Take a close look at the chart above. The entire world's population is represented along the horizontal axis in income groups with the poorest on the left and the richest to the right. The vertical axis shows growth in real income per person. The undulating dark line running through the chart shows how all our incomes changed between 1980 to 2016. Everyone experienced positive income growth, but some had it better than others. The distinct shape of the line gives it its name: the Elephant Curve. With a bit of imagination, you can probably visualise an elephant's rounded haunches to the left, the big belly in the middle, and the elephant’s steeply rising trunk to the right.

The elephantine shape expresses the three main changes in the global income distribution over the period:

First, the poorest people in the world, who mainly live in developing countries more than doubled their incomes. Millions were lifted out of poverty. This is the hump on the left in the chart.

Second, the extremely wealthy did better than anyone else. This is the sharply rising line on the right in the chart. The top 1% alone multiplied its income many times over, capturing a whopping 27% of world income growth. The big increase in income inequality observed in rich countries over the last few decades is due to this increase.

Finally, lower-middle-income groups, most of whom live in Europe and the US, experienced lower income growth than the other two groups. This is the low-hanging belly of the elephant in the middle of the chart. While lower-middle-income groups did not suffer outright declines in income, their relative income growth was the slowest of the three groups. This has emerged as the single most important political issue in Europe and the United States over the past ten years. It is also the main subject of this article.

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The Elephant Curve assumed a central role in Western politics after the 2008/2009 Global Financial Crisis (GFC), which was a major turning point for the global economy. From this moment onwards, sixty years of progress for lower-middle-income people in rich economies went into reverse.

When the crisis struck, public anger quickly increased. Looking for someone to blame, politicians took one look at the Elephant Curve and drew the wrong conclusions. They adopted the view that the discontentment felt by lower-middle-income groups in rich countries must have been a direct consequence of the gains made by the poorest people, implying some kind of zero-sum game for global income growth.

Based on this rather simplistic interpretation, they launched a raft of policies that vilified immigrants and sowed suspicion about economic relations with poor countries, which is why politics in the West is now so dominated by anti-immigrant sentiment, anti-China policies, protectionism, and cuts to aid budgets amidst a general rise in economic nationalism.

However, higher income growth in poor countries did not render lower-middle-income groups worse off. That is simply not how economies work, neither in theory nor in practice. Western politicians chose to interpret the Elephant Curve the wrong way. In this article, I explain why.

I also explain the real reason why lower-middle-income groups under-performed other groups, highlighting the importance policies adopted during and after the GFC, which made the wealthy wealthier and hurt lower-middle-income groups. In other words, what happened at the top end of the income distribution in rich countries had far greater impact on lower-middle-income groups than anything that happened to the poor.

Unfortunately, Western policy-makers are still basing policy on the flawed interpretation of the Elephant Curve. The challenging political conditions in many Western democracies are therefore likely to get even more challenging in the years to come.  

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After World War 2, a broad consensus about the role of government emerged among Western democracies that governments should actively lean against natural tendencies for capitalist systems to increase inequality, ferment social conflict, and stimulate monopoly power. The consensus was born out of recognition that fascism in the 1930s had been fuelled by dire social conditions made worse by German reparations and serious macroeconomic policy mistakes committed before and during the Great Depression.

In a bid to prevent fascism from returning, Western democracies introduced welfare states with unemployment insurance, free education, and healthcare free or subsidised at the point of use. These services were paid for through general taxation using progressive tax structures that meant the rich paid more than the poor. Monopolies, which had been strong supporters of Hitler and Mussolini, were kept in check by robust application of anti-trust legislation.

The new policies were highly successful in both economic and political terms. Improvements in the absolute and relative incomes of lower-income groups helped to ease social tensions, so politics gradually de-polarised amidst the emergence of large middle classes. Economic growth also strengthened as businesses were able to tap into labour, whose productivity steadily improved due to better training, education, and healthcare.

The welfare state consensus lasted for more than sixty years. However, towards the end success began to breed complacency. The West's 'victory' over the communist economic system in the Soviet Union contributed greatly to a sense of invincibility; capitalism, it seemed, was not only superior to other systems, it was also dynamic, resilient, and sustainable. Many Western policy-makers genuinely believed the big policy questions had been answered. The old debate about state versus market had been settled decisively in favour of market economies with states operating along the lines I mentioned earlier. Business cycles, too, could be eliminated by outsourcing monetary policy to independent central banks and keeping public debt levels sustainable.

Unfortunately, the celebrations were abruptly cut short when Western governments discovered that they had been blind to risks emanating from the financial sector. By the turn of the century, the financial sector in many Western economies had become enormous on the back of lax regulation and the very long spell of economic advances. Serious bubbles appeared in one sector after another, first in telecoms, then in Dotcoms, and finally in housing. Regulators did nothing.

The US housing market crashed in 2008/09 with immediate and serious distributional consequences. For one, growth collapsed across the Western world, never to regain its pre-crisis dynamism, which disproportionately impacted lower-middle-income groups on account of their greater dependence on labour income compared to the rich, who also draw income from investments.

There were also sudden fiscal pressures to contend with, which culminated in the European Debt Crisis of 2009-2012. As spending was cut back, lower-middle-income groups were disproportionately affected, since many people in this income group rely to a very large extent on the state for provision of education, healthcare, and other public services.

Meanwhile, the party was just getting started at the other end of the income distribution. In the belief that higher profit margins would spark economic revival, governments cut taxes for businesses and wealthier segments of the population. The banking system was also recapitalised to enable banks to resume their critical role in mediating credit in the private sector. Central banks embarked on Quantitative Easing (QE), which brought down long-term interest rates, significantly reducing risks for banks.

The combination of corporate tax cuts, bank recapitalisation, and QE triggered massive rallies in both stock and bond markets. While the financial boom lifted all boats, again it disproportionately benefitted the rich, since financial assets make up a much larger share of the total assets of the rich than the poor.

In the US, the top 1% now have more than the entire middle class (Source: here) 

I am not saying that QE, banking recapitalisation, and fiscal incentives were the wrong policies at the time. Instead, the issue was that they also happned to materially worsen the income distribution within rich countries and no policies were put in place to offset this side effect. In the end, income inequality in rich countries was allowed to surge to the point where sixty years of progressive distributional policies were put into reverse, storing up serious problems for the future.  

The policy response to the GFC in rich countries also had deleterious international ramifications. Financial regulators were more concerned with stimulating recovery in Western economies than preventing future bubbles or how their policies might impact the rest of the world. They reinforced already powerful biases within the global financial system in favour of rich countries, such as preserving the risk-free status of bonds issued by rich governments, while raising the risk-ratings for nearly all other types of credit, including emerging market (EM) bonds even though EMs had not played any part in the bubble.

These regulatory changes were designed to encourage capital to flow out of poor countries and into rich countries to aid the recovery of the latter. Huge amounts of capital did indeed flow from EM to rich countries, where it further inflated stock prices and thus worsened income distributions further. Meanwhile, the outflows from capital-constrained EMs pulled the rug from under the world's last remaining growth engines. As EM slowed and their currencies weakened, exports from rich countries stagnated, which hit manufacturing workers in rich countries especially hard.

The GFC policy response therefore had severe and far-reaching distributional consequences, which, nsurprisingly, did not go unnoticed by voters. Lower-middle-income groups felt betrayed at seeing their share of global income growth decline. They also resented the bail-out of banks, whom they (rightly) saw as major culprits in the crisis. The insane increases in the wealth of the richest only rubbed more salt into the wounds. When voters demanded action only populists came forward with bold if questionable policy proposals as mainstream politicians were being jettisoned in election after election having been in charge of this entire mess.

Which brings us to 2016. In one of the most shocking political events in modern history, the British people broke away from the European Union (Brexit) after consuming copious amounts of far-right snake oil. Later the same year, Donald Trump was elected president of the United States to usher in the fastest descent into isolationism and protectionism since the 1930s.

In this new reality, politics was suddenly all about being seen to stand up marginalised lower-middle-income groups in Western economies. Brexiters, Trump, and other far-right politicians invoked the Elephant Curve. They argued that lower-middle-income groups in rich countries were worse off as a direct result of gains made at their expense by poor people, particularly immigrant labourers working in rich countries, but also those working in large EM economies with strong manufacturing credentials, such as Mexico, India, and China.

Soon, the scapegoating of foreigners was the only game in town. No one saw any political mileage in blaming the plight of lower-middle-income groups on the policy-makers who had designed the GFC policy response, because most of them had already been kicked out of politics.

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It only takes a brief glance at some basic statistics to see that the far-right's interpretation of the Elephant Curve does not stand up to scrutiny. Even after doubling their incomes between 1980 and 2016, the world's poorest 50% still only accounted for 8.5% of global income, which compares to a 40% share for lower-middle-income groups, who make up 40% of the world’s population. Lower-middle-income groups control 22% of global wealth, which is more than ten times more than the poorest 50%, who control only a measly 2% of global wealth. In other words, even if the gains made by the poor are entirely at the expense of lower-middle-income groups they can never be large enough to make a serious dent in the incomes of lower-middle-income groups.

The other major problem with the far-right interpretation of the Elephant Curve is that economies simply do not behave like zero-sum games. New York does not get poorer, when, say, Los Angeles gets richer. Growth in Germany does not cause contraction in Britain. In real economies, if one part of the world gets richer then typically other parts get richer too, since countries are linked by trade, investment, and the dissemination of technical progress all of which increase with growth.

The true reason for the underperformance of lower-middle-income groups was much closer to home. As the Elephant Curve shows, the top end of the income distribution made absolutely massive gains over the 1980-2016 period. As I explained earlier, these gains can largely be attributed to deliberate policy choices made before, during, and after the GFC, including overly lax regulations of financial markets and not placing enough emphasis countering the rise in inequality.

This was no accidental oversight. Western politicians chose to blame the performance of lower-middle-income groups on the poor despite overwhelming evidence to the contrary. They deliberately chose to scapegoat powerless poor people in far-flung in order to divert blame away from their own errors and to avoid politically challenging confrontations powerful lobby groups for the rich and businesses at home.

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Ten years have now passed since Britain and the United States descended into blatant populism, but the curse of the Elephant Curve is still with us. Policy-makers in Western governments continue to draw inspiration from their deliberate mis-reading of the Elephant Curve, manifested most clearly in ever-more draconian anti-immigration policies and, by now, collapsing international cooperation.

This is both sad and worrisome. The current policies do nothing to improve things; rather they worsen the distributional problems. For example, reducing immigration in rich countries with declining birth rates and ageing populations weakens growth and undermines public services. Protectionism, including the widespread use of tariffs, eliminates gains from international trade and prevents the spread of knowledge. Confrontational geopolitics reduces the willingness of businesses to make investments.

Trump's flagship legislation, the Big Beautiful Bill, was particularly damaging as far as income inequality in the United States is concerned. The bill was basically a massive give-away to billionaires, whose power has never been greater. In fact, the uber-rich in the US are now so wealthy that they have become genuine power brokers in the political sphere, witness Elon Musk's role in the Trump administration and Jeff Bezos's recent purchase of the Washington Post. A government, which grants billionaires direct access to the levers of power, will never confront the monopolies upon whose profits the billionaires depend. Monopolies therefore look set to continue to tighten their grip on the US economy, destroying economic dynamism and deepening already searing social divisions.

Most worrying of all, fascism is back. The world is literally replaying the script of the 1930s. By ignoring the needs of lower-middle-income groups and by fobbing them off with fairy-tales about evil Joe Foreigner Western politicians are pushing Western societies towards a more and more extreme politics. To pull back from this brink, policy must once again be based on economic reality rather political convenience. An honest interpretation of the Elephant Curve offers the economic reality, but solving the problems will be far from convenient. Will anyone have the vision and courage to take them on?

The End