A lesson in how not to help the poor

Larry Elliott, Guardian News Service, London

Everybody knows that the world isn't fair. What has never really been clear is just how unequal life is. Now, thanks to an economist at the World Bank, we do. The richest 50 million people, huddled in Europe and North America, have the same income as 2.7 billion poor people. The slice of the cake taken by one percent is the same size as that handed to more than half of the world's people.

Well might Branko Milanovic, the economist responsible for the study in the January 2002 Economic Journal, wonder whether this state of affairs is sustainable.

There is scant comfort to be drawn from the fact that the rich are becoming spectacularly richer rather than the poor becoming poorer in absolute terms, although this is true for a sizable minority, especially in sub-Saharan Africa. It is relative poverty that is the danger.

As Milanovic puts it, there must be serious doubt about how long such huge inequalities can last when the poor can see the rich flaunting their lifestyles on TV and in the movies.

The danger is that we assume that inequality on this scale is a natural phenomenon. Policy choices have been made to organize the world in the way that it is because that is deemed the way to maximize utility.

The intellectual basis for trickle down economics is that you might need to make societies more unequal (but only in the short- term) to foster the dynamism and flexibility that will eventually enrich us all. Germany's problem, according to this view, is that it has tried to be too equal, which is why a truckload of trickle down advice is heading its way right now.

Extreme caution is needed here. Shock treatment didn't work in Russia; it shortened male life expectancy by six years within a decade. Shock treatment didn't work in Argentina; the country is effectively bankrupt. Shock treatment works well in the theoretical models of free-market ideologues but nowhere else.

In 1984, New Zealand was the perfect field trial for extreme structural reform. It was small and geographically separate, it has a single-house parliament dominated by the executive and it was dosed up to the eyeballs with all the toxins that the reformers said were poisoning capitalism. Import controls, capital controls, strong trade unions, a redistributive welfare state, a large state sector; New Zealand was hooked on all the bad drugs.

Starting in 1984, the country's Labor government said that this all had to change. It started by deregulating interest rates, removing international capital restrictions, floating the currency and removing agricultural subsidies. It then scrapped regulations on business, abolished import quotas, enshrined price stability in law as the sole object of monetary policy, forced workers into individual contracts, announced that budget deficits would eventually be banned, cut income taxes and slashed welfare benefits. This was not a detox regime: It was cold turkey.

As a consequence, inequality in New Zealand grew more rapidly than in any other country. The government created an underclass where none had existed before. But it was hailed as the country that the rest of the west should emulate. The problem was Australia. It is relatively close to New Zealand and has strong cultural and economic similarities. Australia has by no means turned its back on economic reform in the past two decades, but it has been more selective and a lot more gradualist in its approach.

The latest edition of Political Economy (Volume 14 number 1) contains a fascinating comparison of the track records of the two Australasian nations by Paul Dalziel, a New Zealand academic. His first conclusion is that New Zealand's living standards have suffered badly when compared with those in Australia.

Up until 1987, the two countries had a similar growth pattern, but the upshot of New Zealand's spell as an economics laboratory mouse is that it has expanded much more slowly than its neighbor, with significant effects on personal incomes. Dalziel says that had output in New Zealand matched that in Australia, annual per capita incomes in New Zealand would have been almost NZ$5,000 (US$2,500) higher by 1998 than they actually were.

Higher unemployment has always seen by the free-market fundamentalists as a price worth paying for necessary structural reforms, so Dalziel's second conclusion -- that New Zealand's record on joblessness has worsened relative to Australia -- is hardly a surprise. At the end of the 1970s, New Zealand had an unemployment rate of 1.5 percent, only a quarter of that in Australia. The gap closed by the end of the 1980s, and although the jobless rate in New Zealand was lower than in Australia for much of the 1990s, by 1998 both countries had similar levels of unemployment -- eight percent.

More surprising, perhaps, is that New Zealand's record on labor productivity has been so rotten, despite the shake-out in the labor market and the attack on trade unions. The notion that slash and burn tactics allow managers to "clear out the dead wood" and force through changes to improve efficiency is hard to substantiate in the light of the fact that in the 1990s -- after the deregulation of the labour market -- New Zealand's productivity increased by 5.2 percentage points, while Australia's rose by 21.9 percentage points.

In terms of inequality, New Zealand was in a class of its own. The rich were the real beneficiaries of structural reform. What was different about New Zealand was that the poorest half of the population had less real purchasing power at the end of this period, and the poorest groups suffered the most.

This was not what the reformers in New Zealand had expected or desired. The aim had been to tackle "an unacceptable level of poverty". Dalziel concludes that the shock treatment of the 1980s and 1990s did not achieve that core objective, a view that is shared by New Zealand's current prime minister, Helen Clark. She has raised the top rate of income tax, increased pensions, reregulated the labour market and cut student fees.

In a brutal sense, the New Zealand experiment was worthwhile. It highlighted the ineffectiveness and risks of policies that deliberately foster inequality. New Zealand has shown the world how not to do it.