Is inequality the root cause of global crisis? The World Bank's lead research economist thinks so

August 22, 2011 8 By admin

Back from my week off (Edinburgh Festival – fab) with a load of holiday reading to review. Here’s the first installment – an eccentric new book by Branko Milanovic, inequality guru and lead economist at the World Bank’s research division. The Haves and the Have Nots: A Colin FirthBrief and Idiosyncratic History of Global Inequality is aimed at people who love playing around with data.

In fact, it makes a perfect toilet book for geeks, an intriguing scattergun collection of ‘vignettes’ covering everything from wealth inequality in Pride and Prejudice (yep, that Pride and Prejudice – the Jane Austen/Colin Firth, puffy shirt one – see left) to a comparison between ancient Romans and today’s super rich (turns out that Carnegie, Rockefeller and Bill Gates are/were a lot richer than fabulously rich Roman Marcus Crassus).

Anyway, the book is so gloriously random and weird, that I am not going to try and review it. Instead, here’s an excerpt that caught my eye – a ‘vignette’ that argues that income inequality caused the global financial crisis.

Here’s how the reasoning goes:

‘In the US, the top 1% of the population doubled its share in national income from around 8% int he mid-1970s to almost 16% in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1% share reached its previous high-water mark. American inequality over the past hundred years thus basically charted a gigantic U, going down from its 1929 peak all the way to the late 1970s, and then rising again for 30 years.

What did the increase mean? Such enormous wealth could not be used for consumption only. There is a limit to the number of Dom milanovic picPerignons and Armani suits one can drink or wear.. So a huge pool of available financial capital – the product of increased inequality – went in search of profitable opportunities in which to invest.’

So the rich hand over their vast piles of spare cash to the financial sector and tell them to invest it well.

‘Overwhelmed with such an amount of funds, the financial sector became more and more reckless, throwing money at anyone who would take it.’

‘The second part of the equation explains who borrowed that money. There again we go back to the rising inequality. The increased wealth at the top was combined with an absence of real economic growth in the middle. The real median wage in the US has been stagnant for 25 years, despite an almost doubling in GDP per capita. Middle-class income stagnation became a recurrent theme in American political life, and an insoluble political problem for both Democrats and Republicans.’

Since they could not increase their wages, they helped them accumulate household debt.

‘Thus was born the great American consumption binge that saw the household debt increase from 48% of GDP in the early 1980s to 100% of GDP before the crisis’ Result? ‘The interests of several large groups of people became closely aligned. High-net-worth individuals and the financial sector were keen to find new lending opportunities. Politicians were eager to ‘solve’ the irritable problem of middle-class income stagnation. The middle class and those poorer than them were happy to see their tight budget constraints removed as if by a magic wand, consume all the fine things purchased by the rich, and partake in the longest US economic expansion since World War II.’

Milanovic book coverConclusion: ‘The root cause of the crisis is not to be found in hedge funds and bankers who simply behaved with the greed to which they are accustomed (and for which economists used to praise them). The real cause of the crisis lies in huge inequalities in income distribution that generated much larger investable funds than could be profitably employed….. in a democratic system, an excessively unequal model of development cannot exist with political stability.’

The IMF has also previously linked inequality and financial crisis, but not as comprehensively as this. Wonder if it’s true?