At the last World Economic Roundtable, Michael Kumhof, Deputy Division Chief of the Modeling Division of the International Monetary Fund, and Raymond Torres, Director of the International Institute for Labour Studies of the International Labour Organization, came to discuss the relationship between inequality and financial crises.
Kumhof's presentation, based on a recent IMF white paper titled Inequality, Leverage and Crises, explored the impact of income inequality on leverage among U.S. households. It is commonly understood that during the past three decades income inequality rose while household leverage also increased. What is less well known is that leverage (in this case the debt-to-income ratio) for the top 5% of the income distribution remained flat over the past three decades while leverage among the bottom 95% of earners increased steadily. There has been some recognition that middle and lower income households supplanted a rising standards of living with increased levels of debt during the past few decades, but I have yet to see anyone lay the argument out this clearly:
To see the full PowerPoint presentation, click here.
According to Kumhof, rising inequality creates a demand for credit to sustain the standards of living of the lower and middle classes. Inequality also creates a supply of credit because the extra income of top earners needs to be invested. Based on the empirical finding above, the paper models the impact of decreased worker bargaining rights on inequality, assesses the impact on the top income "investors" and the lower and middle income "workers," and shows the increase in financial stability instability. According to the model, the decrease in worker bargaining rights increases top income consumption and massively increases lending from investors back to workers. Conversely, the lower income group decreases consumption and increases borrowing. The model shows that less worker bargaining rights leads to more leverage in the lower income groups and a greater risk of financial crisis.
The obvious question was to ask what the relationship is between foreign borrowing (a current account deficit) and inequality. In other words, if a country borrows more from abroad is there a tendency toward higher income inequality? In Kumhof's last slide he showed the change in income share of the top 5% and the change in the current account balance. Those countries with large current account deficits like the United Kingdom, United States, and the countries in peripheral Europe experienced the largest increase in inequality. It's important to note that while deficit economies experienced the greatest increase in inequality, most surplus countries in this sample also saw growing inequality.
Raymond Torres's presentation helped to explain the broad-based rise in inequality. He highlighted the decline in the wage share of national income and the increase in the capital share that has taken place across the globe. He attributes this to financial globalization, weak labor market institutions, less progressive taxation, and global economic uncertainty and lack of employment. He also noted that the increase in the capital share of national income does not have the benefits to investment that many argue. Torres's chart (slide 6) shows investment stagnates while the capital share of income increases. Torres, like Kumhof, added that government transfers can reduce inequality but that to reach levels of income distribution in the 1980s the U.S. government would have to increase expenditure by an astronomical 8.5% of GDP. If anything, elevated government debts are likely to reduce government expenditure and lead to higher inequality. Fiscal contraction in the United States could be somewhere in the range of 1-2.5% of GDP during the next two years.
The remaining question is what will happen to inequality in the wake of the Great Recession and what are the implications for the stability of the financial system going forward. Here the data are mixed. On one hand, the debt-to-income ratio fell from 130% in July 2007 to 114% in July 2011, a sign that household deleveraging is taking place. On the other hand, income inequality appears to be rising with downward pressure on wages and high levels of underemployment and unemployment. Still stuck in the deleveraging cycle of the Great Recession, lower and middle-income households will continue to delever for some time, even as their incomes stagnate or fall. But, inequality alone could cause future financial instability if the assets that once financed excess borrowing by households found another asset market to crowd into. When that happens, it will likely be the first warning sign of our next financial crisis.