Economic inequality: Putting the S into ESG

Economic inequality is the financial equivalent of high blood pressure: it affects the whole body and suggests problems elsewhere.

Economic inequality is understood as the gap between the rich and poor in terms of both income and wealth.

Economic inequality can be understood as both a macro and a micro issue. It is apparent on a systemic level, between countries, within countries and between different levels of society, affecting households and individuals. It also relates to issues around diversity and opportunity such as gender, disability, age, ethnicity and education.

As US economist James Galbraith surmised, it is the financial equivalent of high blood pressure: it affects the whole body and its prevalence is bad for the health, suggesting problems elsewhere.

As a term, it has been widespread for many years and there have been many policy attempts to redress the balance. The issue has, however, remained lower down on many governments’ policy agendas and beyond the interests of all but the most sociallyconscious investors. Now there are signs that the situation is changing.

A plethora of reporting suggests that, despite a growth in the world’s middle class, in-country economic inequality is increasing in both developed and developing nations.

It has recently entered mainstream political discourse and is increasingly the subject of scrutiny. Two major political events of 2016 – Brexit and the results of the US presidential election – have been described as manifestations of the risks associated with it.

Whether or not this accurately reflects the issue is a cause for debate, but what these and other events have done is to push the issue not just onto the political agenda, but forced it up the list of priorities around the world. Alongside this, the UN’s Sustainable Development Goals (SDGs) have given the issue greater focus. The UN has explicitly called on private investors to engage with the SDGs, particularly SDG 10, reduced inequalities.

Brexit and the results of the US presidential election have been described as manifestations of the risks associated with economic inequality.

At this stage, many of the suggestions being made about the long-term consequences of the issue are just that – suggestions. However, there is the sense that inequality might have negative consequences on long-term investment performance. Similarly, it might negatively affect financial systems, while its emergence as a topic of growing concern might change the risks and opportunities that investors face. As a new PRI report, Why and how might investors respond to economic inequality argues, in terms of responsible investment, inequality is emerging as a central issue of the ‘S’ in ESG factors, just as climate risk is to the ‘E’.

Inequality and investment portfolios: What’s the effect?

As a discipline, responsible investment suggests that investors can enhance their investment decisions through the integration of ESG information. A central tenet of responsible investment is that, in the longer term, the interests of both investors and society will converge. This underlines why economic inequality is such a key issue.

Current research is showing that, contrary to past conventional wisdom, there isn’t a trade-off between growth and equality. In fact, increasing evidence suggests quite the opposite, arguing that in instances where there is excessive economic inequality, policies that strive to change this can improve economic performance.

However, judging how much inequality is ‘excessive’ is difficult, and typically linked to specific economic, political and cultural circumstances.

How inequality may affect growth

Reduced consumer demand

The wealthy tend to save more, so wage stagnation and the resulting inequality may reduce the spending power of everyone else in society.

Increased economic instability

As those without economic resources increase their debt for consumption, inequality may produce economic bubbles.

Rent-seeking and political power

The concentration of wealth may lead to increased political power and influence, capturing economic rents at the expense of productive activity.

Exacerbating social instability

There is the risk that social tensions, and with this political and social instability, will rise as the gap between the ‘haves’ and the ‘have nots’ grows.

Much of the recent research into economic inequality focuses on the policy options designed to allow the public sector to mitigate the problem. This excludes the investor, but it is an area in which their role could be key. Investor involvement has the potential to deepen participation in multi-sector efforts to understand, mitigate and redress the potential harm resulting from excessive economic inequality.

Investor involvement could be key to mitigating the harm of economic inequality.

Still, why should the issue really matter to investors? Research suggests that excessive economic inequality can cause or be a sign of low growth and financial instability. It is argued that the financial sector may play a part in generating harmful inequality, something that then harms the beneficiaries of investment they represent or serve. On the flip side, investment channels may help to mitigate economic inequality.

Considering the role of the financial sector in greater detail, recent research has drawn direct links between ‘financialisation’ and the rise in economic inequality.

Financialisation is understood as being the relative rise in the role of finance in economic affairs, the proliferation of financial products and instruments, and the extension of financial practices into new areas.

There are a number of ways in which this may affect economic inequality. For example, short-termism and its negative impact on equality. Following the financial crisis, attention has increased over the fees paid for financial services as compensation schemes, which are linked to shortterm risk taking and speculative investing to the detriment of longterm productive activity. Other practices, such as cash allocation (e.g. share buybacks), may extract value from companies in the short term at the expense of other investments and wage increases.

Clearly, the time is ripe for investors to act. Areas that require attention include how investors tackle the systemic structure of finance and their role in shaping a financial system that better serves social objectives. Risk management tools may be used to inform investment decisions and determine shareholder engagement. Investors might also want to consider a wider range of issues that may pose reputational and/or political risk in light of increasing concerns over inequality to bring economic blood pressure in check.

Economically-targeted investment sees investors provide products that target specific, underserved areas or communities.

Microfinance has been specifically linked to the idea of financial inclusion, increasing access to financial services and opportunities for economic development for poor communities.

Bottom of the Pyramid strategies, with their focus on delivering goods and services to the poor, are often suggested as a means of mitigating poverty and so reduce inequality.

‘Blended finance’ has the potential to explicitly target social objectives such as inequality. The blend comes from the mix of investors, typically institutions, banks and governments attracted by the social objectives of the scheme, while investment opportunities provide a chance for private capital to participate.