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 is what 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 captures 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. This is the main reason why politics in Western economies 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 has not rendered lower-middle-income groups worse off. That is simply not how economies work, neither in theory nor in practice. In this article I will explain why and how Western politicians chose to interpret the Elephant Curve the wrong way. I will also cast light on the real reason why lower-middle-income groups under-performed other groups, highlighting the role of policy during and after the GFC, which made the wealthy much wealthier, while neglecting the erosion of living conditions for lower-middle-income groups. In other words, what happened at the top end of the income distribution was far more relevat to the fate of lower-middle-income groups that what happened at the bottom end.

Unfortunately, Western policies continue to be based on the flawed interpretation of the Elephant Curve. This means that the already challenging political conditions that prevail in many Western democracies could get even more intimidating in the years to come.  

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A broad consensus about the role of government emerged among Western democracies after World War 2, which said 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 the fascism of the 1930s was fuelled by dire social conditions made worse by German reparations and serious macroeconomic policy mistakes committed before and during the Great Depression.

In a bit to prevent fascism from returning, Western democracies introduced welfare states, which provided unemployment benefits for those without work, free or subsidised education, and healthcare free at the point of use. These services were paid for by taxes collected through 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 eased social tensions, which meant that politics gradually de-polarised amidst the emergence of large middle classes. Economic growth was also strong, because businesses were able to tap into labour, whose productivity was now steadily improving due to better training, education, and healthcare.

The welfare state consensus lasted for more than sixty years, but towards the end of this period the 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 began to believe that all the big policy questions had been answered. The old debate about state versus market had clearly been settled decisively in favour of market economies with states operating along the lines I mentioned earlier. Business cycles, it was believed, could be eliminated by outsourcing monetary policy to independent central banks and by running fiscal policy such that debt stocks did not become unsustainable.

Unfortunately, the celebrations were cut short when it suddenly became clear that Western governments had been blind to the risks emanating from the financial sector. By the turn of the century, the financial sector in many Western economies had grown very large on the back of the long spell of broad economic advances. Serious bubbles appeared in one sector after another, first in telecoms, then in Dotcom, and finally in housing. Regulators were blind to the risks, or, perhaps, just in denial.

Regardless, when the housing market crashed in 2008/09 there were immediate and serious distributional consequences. Growth collapsed across the Western world never to regain its pre-crisis dynamism, which disproportionately impacted lower-middle-income groups, who depend more on labour income than the rich, who derive much of their income from investments.

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

By contrast, the party was just beginning 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 eased financial conditions, which triggered a massive rally in both stock and bond markets. The rally disproportionately favoured the rich, because financial assets generally make up a much bigger share of the total assets of the rich thanof lower income groups.

That is not to say that QE, banking recapitalisation, and fiscal incentives were the wrong policies at the time. Rather, the issue was that these policies materially worsened the income distribution within rich countries and no policies were put in place to offset this side effect. Income inequality in rich countries therefore skyrocketed to the point where it reversed sixty years of progressive distributional policies.  

In addition, the policies adopted in rich countries had international ramifications, which further exacerbated the adverse domestic distributional consequences. Financial regulators were far more concerned with stimulating the recovery of Western economies than preventing future bubbles or how their policies might impact the rest of the world. They reinforced already powerful biases in favour of rich countries within the global financial system, such as preserving the risk-free status of bonds issued by rich countries, but raising risk-ratings for other types of credit, including emerging market (EM) bonds even though EM had not played any part in the bubble.

The biases in financial regulations were entirely deliberate; they were designed to encourage capital to flow out of poor countries and into rich countries to aid in the recovery of the latter. The money did indeed leave EM and flowed into rich countries, where it further inflated stock markets and further worsened the income distribution. Meanwhile, the outflows from capital-constrained EMs pulled the rug from under the world's last remaining growth engine. As EM slowed and their currencies weakened, exports from rich countries to EMs stagnated, which hit manufacturing workers in rich countries especially hard.

In summary, the policy response to the GFC in rich countries had severe and far-reaching distributional consequences. Unsurprisingly, this did not go unnoticed. Lower-middle-income groups felt betrayed seeing their share of global income growth decline. They also resented the decision to bail out the banks, which 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. Voters demanded action, but only populists seemed able to come forward with bold if questionable policy proposals. Mainstream politicians, meanwhile, were jettisoned in favour of far-right populists in election after election.

Which brings us to 2016. In one of the most shocking political events in modern history, the British people decided to break away from the European Union after having been sold copious amounts of far-right snake oil. Later the same year, Donald Trump was elected president of the United States, which ushered in the fastest descent into isolationism and protectionism since the 1930s.

Politics was suddenly all about standing up for marginalised lower-middle-income groups in Western economies. Brexiters, Trump, and other far-right politicians did this by invoking the Elephant Curve. They argued that lower-middle-income groups in rich countries had become worse off as a direct result of gains made at their expense by poor people, particularly those immigrating to rich countries, but also working in large EM economies with strong manufacturing credentials, such as Mexico, India, and China. Scapegoating of foreigners became the new game in town. No one saw any mileage in blaming the plight of lower-middle-income groups on the true culprits, the policy-makers who designed the policy response to the GFC.

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It takes only a glance at some basic statistics to see that the far-right's interpretation of the Elephant Curve does not stand up to scrutiny. For example, even after doubling their incomes between 1980 and 2016 the world's poorest 50% still only accounted for 8.5% of global income. This compares to the 40% share for lower-middle-income groups, who make up 40% of the world’s population. Besides, lower-middle-income groups control 22% of global wealth, which is more than ten times more than the poorest 50%, who only own a measly 2% of global wealth. Even if the gains made by the poor had been at the expense of lower-middle-income groups they would never have been big enough to make a major dent in the income share of lower-middle-income groups.

The other major problem with the far-right interpretation of the Elephant Curve is that economies do not behave like zero-sum games. Think about it. 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 very clearly, the top end of the income distribution made absolutely massive gains in income growth over the 1980-2016 period. As I explained earlier, many of these gains were due to deliberate policy choices, such as being overly lax on financial regulation and not putting in place an adequate policy responses to the GFC; policies not only made the rich richer; they also undermined lower-middle-income groups.

I do not for one second believe that this was an accidental policy oversight. Western politicians chose to blame the performance of lower-middle-income groups on the poor despite overwhelming evidence to the contrary. They did so to divert blame away from themselves and because it was politically expedient to do so. It was much easier to blame powerless people in far-flung places than to assume the blame themselves and jeopardise relations with powerful lobby groups for the rich and businesses at home, especially in the politically charged and difficult economic aftermath of the GFC.

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Ten years have now passed since populists ascended to power in Britain and the United States, but the curse of the Elephant Curve is still with us. Perhaps we should not be surprised. A Basotho proverb says, "An elephant does not die from one broken rib". Elephants are tough. They stick around.

Government policies in Western democracies continue to draw inspiration from the deliberate mis-reading of the Elephant Curve, manifested most clearly in ever-more draconian anti-immigration policies and the collapsing international cooperation. This is both sad and worrisome, because these policies worsen the distributional problems, for example by undermining public services and hurting growth in countries where birth rates are declininh and populations are ageing. 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, significantly increased income inequality in the US. It was a massive give-away to billionaires, whose power has never been greater. The rich in the US are now so rich that they have become actual power brokers (witness Elon Musk's role in the Trump administration and Jeff Bezos's recent purchase of the Washington Post). In an environment where billionaires have direct political control there is no chance whatsoever that governments will confront the monopolies upon whose profits the billionaires depend. Monopolies therefore have free reign to continue to kill economic dynamism and deepen already searing divisions between 'haves' and 'have nots'.

Most worrying of all, fascism is back. The world is literally replaying the 1930s. The neglect of vulnerable groups, especially groups as large as the lower-middle-income segment of Western populations, is once again pushing Western societies down a path towards dangerous political extremism.

To pull back from the brink, policy has to be based on economic realities rather political convenience. The Elephant Curve is pure economic reality, but the problems it exposes are far from convenient, so will anyone have the courage to take them on?

The End