Comments on Inequality, Leverage, and Crises

Clifford Clark’s post at ataxingmatter* is worth a more complete look. This also brings to mind Steve Keen’s work on private debt and the economy on his blog Debt Watch as well as Lane Kenworthy’s exploration of poverty and severe poverty at Consider the Evidence, and Angry Bear Robert Waldmann’s recent posts here and here.

Comments on Inequality, Leverage, and Crises–Kumhof & Ranciere Nov 2010 IMF working paper

[guest post by Clifford D. Clark]

Michael Kumhof’s and Romain Ranciere’s November 2010 paper relates income inequality to national economic crises, particularly those experienced as the Great Depression and the Great Recession. They conclude that increases in income inequality –comparing the top 5% of households to the bottom 95%–in the years leading up to the two crises exerted a determining influence on the economy.

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First, income inequality grew in similar ways in the years before the depression and the recent deep recession. …. The authors find a link between the two phenomena: income inequality increased at a greater rate than consumption expenditures in the years before the two crises. The public was spending at rates greater than increases in their income.

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Second, in the years before the recent downturn the growth in household debt was due almost entirely to the bottom 95%. Real hourly wages of the top 10% of households increased by an accumulated 70% between 1967 and 2003, while the median households decreased by 5% and wages at the bottom 10% decreased by about 25%. … That represents a clear switch: whereas in 1983 the top wealth group was more indebted than the bottom 95%, by 2007 the reverse was true. By then the bottom 95% had debts equal to 140 % of income, nearly twice that of the top 5%. They conclude that almost all of the change in the debt to income ratio in aggregate was due to the bottom 95%.

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Third, an increase in debt requires and increased need for financial intermediation: accordingly, the size of the financial sector between 1980 and 2007 increased considerably. Measured by the ratio of private credit of deposit banks and other financial institutions to GDP, that quantity increased from 90% in 1981 to 210% in 2007…

Their conclusion is succinctly stated.

“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.” Id. at 22.

* correction of source