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January 20, 2011

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January 20, 2011

Want to avoid financial crises? Then reduce inequality, says the IMF

January 20, 2011
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What are they putting in the water at the IMF these days? Following its recent advocacy of not one, but two new global taxes, a new IMF working paper by Michael Kumhof and Romain Ranciere links inequality with financial crises.

“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. 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. 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.”

Conclusion (after lots of suitably impressive equations)? “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.”

Dynamite. [h/t Matthew Lockwood]

8 comments

  1. An interesting counterpoint to those of the Austrian school (most recently Lleyellen Rockwell) who argue that central banks are the cause of, not the remedy for, financial crises. Keynes aside, maybe one answer lies in cash transfers (instead of or complementary to loans), whether targeted, universal or conditional. The logic of the latter option is actually rather neo-liberal: parents have an opportunity cost when they send their children to school instead of putting them to work, so they are on the supply side of the equation and deserve remuneration for their sacrifices. See Oportunidades in Mexico and Bolsa Família in Brazil.

  2. Wow – I wish I understood all that! did everyone else?

    I failed to see how the financial crisis are caused by inequality To me, the post says that the crises were caused by unsustainable debts of lower and middle income people. Reducing access to such debt seemed to be the solution rather than reducing inequality.

    I don’t see how “restoration of poor and middle income households’ bargaining power” would lead on it’s own to a reduction in debt for these people. It’s not my experience that if people get a higher income they don’t want to spend yet more.

    Could the rise in inequality be caused by the richest in society benefiting from the servicing of the debts of the rest, rather than causing it?

    Maybe I need to look at those equations, that should keep me quiet…. Thanks for the post.

  3. that’s really excellent.

    does the debt-to-income fragility analysis apply for the Great Depression? Or just the Awesome Recession?

    Would be a more robust theory if the former. Although I think the explosion in consumer credit and easy housing debt is post Depression. but maybe I’m not seeing something.

  4. The bargaining power of the poor and middle-income category.
    Is this not in the first place the strength of the Labour Unions? Those that are perceived as a dam for the tide that would “rise all boats” eventually?

    By the way, is there still anybody supporting the institution building of labour unions out there? Is it more convenient to support NGOs instead? All these pesky organisations with internal democracy, doing what the members ask for, are just not as dependable as the NGOs we create.

  5. It seems this just verifies, perhaps once again, that failing to address the disparity between the wealthier &poorer of the global population is to the detriment of all of us.
    The real question is about method to address.
    Structurally, taxation should be set to realize provision of the whole population with the infrastructures that mediate their path to their best potential i.e. Transport, communications, health, education.
    Ultimately, however, because some will always manage to realize greater wealth accumulation, there is a cultural imperative towards a philanthropic attitude, service to humanity, and complex collective problem solving as the traits of a mature citizen.

  6. David Harvey in a fascinating RSA Animate lecture on the financial crisis draws attention to the fact that this great recession differs from previous ones in that the comprehensive defeat of labour in the eighties in the US and UK mean that despite many years of growth this has not been accompanied by a rise in real wages as bargaining power has been lost http://www.youtube.com/watch?v=qOP2V_np2c0
    this has led to many on the right agreeing with the left that the power of capital and not labour is the problem here and we need more unions.

    in contrast to the great analysis by the IMF the economist this week contains an embarassing eulogy to inequality, concluding tht the new elite of super rich and growing inequality are in fact a largely benign and in fact positive fact in the world economy, and that unlike the middle ages the super rich of today are largely there because they are very clever and work so hard. well that’s ok then.

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