A remarkable IMF Working Paper has come to my attention which should be Front Page News all across America (hat tip, Kevin Drum). Published in November, 2010, the paper is entitled Inequality, Leverage And Crises, and was written by two IMF economists Michael Kumhof and Romain Rancière. I first broached this subject explicitly in a recent post Part Of The Truth Is Better Than None At All. Rather than sum up the IMF paper, I will quote extensively from the introduction and conclusion of the paper, adding emphasis and making comments where appropriate.
I want you to read the easy parts of this study so you will understand how income inequality, debt and the financial meltdown are all linked together. In my view, if you understand these issues, you will also broadly understand what happened to our economy over the last 30 years, what happened to working people in the United States, and why the Empire is in decline. I've included some graphs from the paper in the text below.
The United States experienced two major economic crises over the past century—the Great Depression starting in 1929 and the Great Recession starting in 2007. Both were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis.
In this paper, we first document these facts, and then present a dynamic stochastic general equilibrium model in which a crisis driven by income inequality can arise endogenously. The crisis is the ultimate result, after a period of decades, of a shock to the relative bargaining powers over income of two groups of households, investors who account for 5% of the population, and whose bargaining power increases, and workers who account for 95% of the population.
The model is kept as simple as possible in order to allow for a clear understanding of the mechanisms at work. The key mechanism is that investors use part of their increased income to purchase additional financial assets backed by loans to workers.
By doing so, they allow workers to limit their drop in consumption following their loss of income, but the large and highly persistent rise of workers’ debt-to-income ratios generates financial fragility which eventually can lead to a financial crisis.
Prior to the crisis, increased saving at the top and increased borrowing at the bottom results in consumption inequality increasing significantly less than income inequality. Saving and borrowing patterns of both groups create an increased need for financial services and intermediation. As a consequence the size of the financial sector, as measured by the ratio of banks’ liabilities to GDP, increases. [graph below]
The crisis is characterized by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. financial crisis. Because crises are costly, redistribution policies that prevent excessive household indebtedness and reduce crisis-risk ex-ante can be more desirable from a macroeconomic stabilization point of view than ex-post policies such as bailouts or debt restructurings.
I hope things are clear so far, but I want you to pay particular attention to what the authors just said. Crises are costly, as we have found out to our regret, but redistribution policies that prevent excessive household indebtedness and reduce post-crisis risks can be more desirable than bailouts or debt restructurings. And what was the political response to the financial meltdown? Bank bailouts and debt restructuring programs initiated by the Obama administration.
The bailouts succeeded spectacularly—the too-big-to-fail banks are doing just fine—while the mortgage modification programs failed miserably. Thus we have basically returned to where we were before the crisis, with an even bigger, politically powerful financial sector and a mountain of household debt.
To our knowledge, our framework is the first to provide an internally consistent mechanism linking the empirically observed rise in income inequality between high income households and poor to middle income households, the increase in household debt-to-income ratios among the latter group, and the risk of a financial crisis.
It is simply astonishing that economists had not done a formal study of the common sense contained in this paper. Still, there has been some related discussion.
While not formally modeled there, the link between income inequality, household indebtedness and crises has been recently discussed in opinion editorials by Paul Krugman, and in books by Rajan (2010) and Reich (2010). Both authors suggest that increases in borrowing have been a way for the poor and the middle-class to maintain or increase their level of consumption at times when their real earnings were stalling. But these authors do not make a formally consistent case for that argument. Our model allows us to do so.
There are of course other candidate explanations for the origins of the 2007 crisis, and many have stressed the roles of excessive financial liberalization and of asset price bubbles. Typically these factors are found to have been important in the final years preceding the crisis, when debt-to-income ratios increased more steeply than before. But it can also be argued, as done in Rajan (2010), that much of this was simply a manifestation of an underlying and longer-term dynamics driven by income inequality.
Rajan’s argument is that growing income inequality created political pressure, not to reverse that inequality, but instead to encourage easy credit to keep demand and job creation robust despite stagnating incomes.
Rajan, R. (2010), Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton: Princeton University Press.
Reich, R. (2010), Aftershock: The Next Economy and America’s Future, New York: Random
House.
There it is—the Housing Bubble and its collapse depended on underlying and longer-term dynamics driven by income inequalty. This is precisely the position I have staked out on this blog. It is a key to the Empire's decline. I discussed Rajan's work in my Part Of The Truth post, which is linked in above. And now the paper's conclusion—
This paper has presented ... facts and a theoretical framework that explore the nexus between increases in the income advantage enjoyed by high income households, higher debt leverage among poor and middle income households, and vulnerability to financial crises. This nexus was prominent prior to both the Great Depression and the recent crisis.
In our model it arises as a result of increases in the bargaining power of high income households. The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while.
But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.
More importantly, unless loan defaults in a crisis are extremely large by historical standards, and unless the accompanying real contraction is very small, the effect on leverage and therefore on the probability of a further crisis is quite limited. By contrast, restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis.
As we've seen after the crisis, the "bargaining power" of poor and middle-income households has decreased even further, while the influence of high-income households has surged once again. This is exactly the opposite of what we might have hoped for. Thus the prospects for another crisis, or for a very long continuation of stagnation in the "lesser" of our two economies accompanied by very high underemployment, have been enhanced by the political response to the crisis. But as you all should know by now, our politics is corrupt through and through, with few of our leaders willing to represent the interests of poor and middle-income Americans.
Those of you who have come to know me can be sure that I will refer to this IMF working paper in the future. That's enough to chew on for today.
Dave,
It's an interesting paper. It's funny how seemingly obvious phenomenon don't get researched. You say that the banks are doing well, is that not just on the surface so that execs can get their bonuses? One component of the economy that I haven't been able to wrap my mind around is the derivatives market. It's seems like an out of control betting ring with no limits. I don't have a firm grasp of its economic purpose, but as an outsider, the shear size of the market seems to indicate that it's out of control. Any insights on where it's heading?
http://seekingalpha.com/article/251375-derivatives-the-real-reason-bernanke-funnels-trillions-into-wall-street-banks
Remi
Posted by: Remi | 02/21/2011 at 11:16 AM