Friday, April 24, 2009

To Have And Have Not

The forthcoming International Review of Applied Economics (Vol. 23, n. 3, May 2009, Routledge) is a special issue on Mechanisms of Inequality, reporting on a research project undertaken at the Universities of Rome “La Sapienza”, Ancona and Urbino (Guest Editors Maurizio Franzini and Mario Pianta). The issue is still in proofs, but its contents were discussed two days ago at a Round Table at the Faculty of Economics of “La Sapienza”. The benefit of Round Tables, like that of Blogs, is that of helping – indeed forcing – one to formulate decisively one’s own convictions about the subject under consideration. This is what I propose to do here with regard to Income Inequality, while referring interested readers to that excellent special issue of the IRAE.

1. Market-determined income distribution. In a market economy personal income distribution is determined by 1) the distribution of the many productive factors and of financial claims; 2) the state and progress of technology; 3) the price of goods and services and therefore the derived prices for productive factors and financial claims, determined in their markets and therefore depending on the degree of competition in those markets ; 4) institutions and policies, in particular re-distribution policies.

2. Efficiency, equality, re-distribution. Under a number of highly restrictive conditions – that are frequently neglected and deserve a separate post of their own – market allocation will deliver economic efficiency [in a Paretian sense: no more output of anything can be produced without either less of some other output(s) and/or more of some other input(s); nobody can be made better off without having to make someone else worse off]. But nobody in his right mind has ever argued (or should ever have argued) that market-determined income distribution is necessarily desirable, and cannot be improved.

A democratically elected government can and does re-distribute a certain amount of income through taxation and budget transfers, usually in an égalitarian direction – though the recent global crisis, financial and real, has induced governments to make large transfers to cover the losses of unsecured creditors, shareholders and other unsuccessful investors, all largely belonging to richer income groups.

Governments are perfectly legitimate in their re-distributive measures, within the bounds of democratic consensus, even at the cost of resulting inefficiency in the allocation of resources, i.e. at the cost of a loss of output.

3. Efficiency and equality gains? There may be a range of possible re-distribution policies over which no such conflict arises between efficiency and equality. The market allocation may be inefficient to start with (some of the necessary conditions for efficiency not being satisfied); lower inequality may enhance cohesion and reduce losses from conflict; re-distribution from the rich to the poor may result in a higher level of activity. But re-distribution is bound to generate opportunistic behaviour (or “moral hazard”), which will reduce the net benefits of re-distribution even over the otherwise safe range. Sooner or later moral hazard will re-instate the conflict between efficiency and equality even if no other causes for such a conflict were present.

4. Countries and the world: income and wealth inequality. The most popular index of Inequality in the distribution of anything is the Gini coefficient, a measure of statistical dispersion taking the value zero for absolute equality between the members of the investigated population, and the value of one for a single member taking all. Inequality in the distribution of income in individual countries is relatively high and rising (see the UN-WIDER The current picture in the European Community is given in the Figure below (click on it to enlarge):

Other sources give different coefficients, usually slightly higher. Throughout the world, Gini coefficients of income inequality in different countries range from around 0.25 in Northern Europe and Japan, to over 0.50 in Latin America, to peaks of over 0.60 in some African countries, where however measurements are less reliable and more volatile (up to 73.9 in Namibia in 1993, the last reported value of its coefficient).

Income Inequality world-wide, treating the world as a single country, naturally is much higher, with a Gini Coefficient of 65% (See Milanovic. 2005) [1]

Cornia and Court (2001)[2] consider the positive and negative impact of income inequality within a country. Extreme egalitarianism tends to reduce incentives, encourage free riding behaviour, involves high costs and corruption in the distributive system. Extreme inequality erodes social cohesion, raises social tension and conflicts, causing uncertainty in property rights. Both reduce the capacity to growth. The authors suggest a desirable range of Gini coefficients between 0.25 (typical of North European countries) and 0.40, lower than the Ginis of Russia, China and the USA, not to speak of Latin America and Africa. All the EU-27 countries fall within this range (Turkey being the only European country above 0.40, at 0.436). Cornia and Court (2001) call this the efficient inequality range, though there is considerable arbitrariness in the determination of the upper and lower bounds of the range.

Time trends of Gini coefficients are complex to identify in different periods, countries, country groups: data differ for sources and methods and are not directly comparable over time. The IMF World Economic Outlook of October 2007 confirm that “Inequality has risen in all but the low-income country aggregates over the past two decades, although there are significant regional and country differences... While inequality has risen in developing Asia, emerging Europe, Latin America, the NIEs, and the advanced economies over the past two decades, it has declined in sub-Saharan Africa and the Commonwealth of Independent States (CIS)...Among the largest advanced economies, inequality appears to have declined only in France” (p. 140). The next figure ( also suggests that by and large, with a few exceptions especially in initially very unequal countries such as Mexico, in the last 20-30 years there has been a visible increase in income inequality as measured by Gini coefficients (click on the Figure to enlarge).

A first estimate of the world distribution of household wealth has been provided by Davies et al. (2008) [3]. They find that “… the distribution [of wealth] is highly concentrated—in fact much more concentrated than the world distribution of income, or the distribution of wealth within all but a few of the world’s countries. While the share of the top 10 per cent of wealth-holders within a country is typically about 50 per cent, and the median Gini value around 0.7, our figures for the year 2000 using official exchange rates suggest that for the world as a whole the share of the top 10 per cent was 85 per cent and the Gini equalled 0.892. By comparison, Milanovic (2005) estimates that the world income Gini was 0.795 in 1998… Roughly thirty percent of world wealth is found in each of North America, Europe, and the rich Asian-Pacific countries. These areas account for virtually all of the world’s top 1 per cent of wealth holders”[4]

5. Technology and Macroeconomics. Some explanations of income distribution are rooted in the nature of technology and of technical progress; another explanation is rooted on macroeconomic, allegedly Keynesian foundations. Both refer primarily to the income shares of wages and profits, but in general we can expect a lower share of wages to be associated with a more unequal distribution, given that capital is much more unequally distributed than labour (except that employment trends may offset this factor, as observed by my colleague Francesco Farina at the Rome Round Table). Both explanations seem to be very unsatisfactory.

In its extreme formulation, the impact of technology is formalised under the guise of a production function, whereby national income depends on the amount of aggregate capital and labour in existence. Under a few assumptions about the mathematical properties of that function, and factor prices corresponding to the marginal productivities of factors and exhausting the product, the relative income shares correspond to the elasticities of national income with respect to the two factors. “Income distribution – Joan Robinson used to say of this approach – depends on god and the engineers”.

There is no denying that technology has an influence on distribution; for instance it is plausible to conjecture that recently an increasing skill-intensive bias in technical progress may have raised the degree of inequality. But there are too many problems in attempting to isolate the impact of technology on distribution: the aggregation of capital, the divergence between capital measurements at historical cost, at current prices and at replacement cost; the varying degree of capacity utilisation; the separation of increasing returns to scale from technical progress; and many others. Such problems arise even in less aggregate formulations of this approach.

The impact of macroeconomic accounting, also in its extreme formulation, establishes a link between profit share and investment share in income, given the respective propensities to save of profit earners and wage earners. Suppose wage earners do not save; if they do, they get the same profit rate on their investments, and the respective saving propensities differ according to income category not class. In that case the share of profit will be equal to the share of investment divided by the saving propensity of profit earners (presumed to be constant and equal to the marginal propensity). The alleged Keynesian connection is in the driving force of investment. But relationships based on average propensities hold always necessarily ex-post, while average propensities are not necessarily behavioural parameters, constant and therefore equal to marginal propensities. The approach has little explanatory let alone predictive value. [5]

The highly unequal distribution of wealth, documented above, by itself generates unequal distribution of income, and thereby unequal distribution of savings out of income and investments that unequally raise total wealth, preserving and probably augmenting the inequality in the distribution of wealth. It is conceivable but unlikely that the distribution of new investments might be less unequal than the distribution of the wealth from which they originate, for this would involve the wealthy saving proportionally less than the less-wealthy-but-still-fairly-wealthy. The preservation of wealth inequality preserves income inequality which in turn preserves or enhances wealth inequality.

This applies not only to financial capital but also to human capital. One of the more disturbing results reported in the May 2009 issue of the IRAE is the high correlation between one’s income class and educational achievements and those of one’s parents, even in countries usually characterised as socially mobile like the US [6].

The persistent combination of 1) a high inequality of income and 2) a much higher inequality of wealth has a devastating corollary, namely the persistence of social classes. The gradual abolition of classes – which many predict or even regard as a fait accompli, would require workers to command increasing, though still below average, shares of capital. In that case, over time both income distribution and wealth distribution would become more equal, and the gap between wealth inequality and income inequality would narrow. This is the opposite of what we observe: classes are still with us and are here to stay.

7. Primitive accumulation. Some of the largest fortunes, like that of Bill Gates, are built from zero with the foundation and growth of a successful company. But among the rich there are also many beneficiaries of what Karl Marx called primitive or original accumulation (ursprungliche Akkumulation, Das Kapital, Vol. I, ch. 26), i.e. conquest, robbery and theft rather than thrift. Primitive accumulation, from which further accumulation originates from profit reinvestment, is not only an inheritance from the past, but a continuous occurrence in today’s economies. It takes the form of fiscal evasion, corruption, crime, international trade of arms and drugs, monopoly profits of all kinds, reciprocal salary and bonus fixing by the managerial class, the conquest of Iraqi oil, the procurement contracts of Halliburton, fraudulent Ponzi schemes like the large scale swindle by Bernie Magdoff, the looting of government resources by subjects undertaking risky ventures on the expectation of public rescue in case of failure, the appropriation of national wealth by the beneficiaries of privatisation in states divesting of social assets, like the UK and the post-socialist countries, particularly the appropriation of Russian natural resources by “oligarchs”. The adverse impact of post-socialist transition on income distribution, without any justification on efficiency grounds, through privatisation but mostly through price liberalisation (and globalisation, see below), is well documented in one of the essays in the IRAE May 2009 issue.[7]

The notion that wealth is simply the result of frugality has no more credibility today than it did in Marx’s time. If there are objections to the re-distribution of income and wealth on grounds of presumed efficiency a lot more needs to be done to prevent immoral and illegal enrichment and entitlement.

8. What is the impact of globalisation on income distribution? There are two contrasting views, both originating in IMF publications. The first is put forward in the World Economic Outlook, on Globalisation and Inequality, October 2007. “The analysis finds that increasing trade and financial globalization have had separately identifiable and opposite effects on income distribution. Trade liberalization and export growth… are found to be associated with lower income inequality, whereas increased financial openness is associated with higher inequality. However, their combined contribution to rising inequalityhas been much lower than that of technological change, especially in developing countries” (p.136). In sum, financial globalisation and FDI raise demand and therefore wages for skilled labour relatively to the unskilled.

The second view put forward in the World Economic Outlook, on Spillovers and Cycles in the Global Economy, April 2007, notes the rising globalisation of labour: in 1985-2005 global labour supply has increased by only about 60%, but the “effective” labour force – i.e. labour weighed by a country’s exports to GDP ratio – has increased by about 360%. Labour globalisation by means other than foreign trade, that is immigration and off-shoring, by comparison is almost negligible (respectively about 5% on average and at most 2% of the labour force). This stunning rise in labour competition has been accompanied by a significant fall in the wage share in GDP in advanced countries. Over the period 1980-2005 in which the labour share has fallen: “The decline in the labor share since 1980 has been much more pronounced in Europe and Japan (about 10 percentage points) than in Anglo-Saxon countries, including the United States (about 3–4 percentage points)…Within Europe, the strongest decline is observed in Austria, Ireland, and the Netherlands. Further, most of the decline in the labor share can be attributed to the fall in unskilled sectors, which was more pronounced in Europe and Japan than in the Anglo-Saxon countries. This decline reflects a combination of the reduction in the within-sector labor share and the shift of output from unskilled toward skilled sectors” (p. 166). In Europe, the United States, other Anglo-Saxon countries, Japan, the labour share has fallen from a range of 65%-73% in 1980 to a range of 58%-66% in 2005.

Clearly - as already noted above - there is no necessary one to one correspondence between growing inequality in personal distribution and falling wage shares, but over the long run it is reasonable to presume a connection between the two. In any case, globalisation has winners and losers – lowering tariffs in one sector damages domestic producers to the advantage of foreign exporters – and even if there were net advantages to be reaped the problem would remain of actually (over)-compensating the losers, for we know that potential over-compensation is not sufficient to establish an unambiguous gain from globalisation. Moreover, another essay from the IJAE May issue, by Serranito, establishes that “the positive effect of a decrease in tariffs on growth depends on the level of development; for the majority of the developing countries included in our sample a decrease in tariffs will have no effect on growth”. [8]

9. Other aspects of inequality. All the propositions listed above only scrape the surface of the issue of inequality. Gini coefficients are often ambiguous in ranking degrees of inequality (unless their respective Lorenz curves do not cross). Inequality within country groups (Europe, the world) is much greater than in individual countries. There are many alternative indicators, which may give different results; the choice among them is largely arbitrary. Countries differ not only by indicator but also by the selected dimension of inequality. Both persistence and turning points in inequality time patterns are difficult to explain. Besides household average income we should consider intra-household income distribution, in order to take into account the specific position of children, women and the aged. Access to medical care and education, and indications of life expectancy should be specifically considered, together with the inter-generational distribution of income and wealth. There are not only profits and wages but also rents, central to the classical tradition and largely neglected today. Beside distribution, i.e. relative poverty, there is the issue of absolute poverty – which we have chosen not to discuss at all in this post.

There is the question on what makes high degrees of inequality acceptable: whether ideological propaganda, or the willingness to risk destitution for a small chance of riches, or reliance on unconditional solidarity in case of failure. And what makes inequality intolerable, either to the masses, or to the ruling élite out of concern for sustainability (after all, the Bismark-style welfare state is not a revolutionary conquest but a concession induced by such a concern, as argued by my colleague Anna Simonazzi at the Rome Round Table).

One question that has began to be considered only recently is the relativity of both inequality and poverty with respect to relative prices. An apparently rising income inequality may be – partly, or totally, or more than – counterbalanced by a change in relative prices adverse to the richer income groups; the reverse may also happen, inequality falls counterbalanced by, say, the rise in the price of foodstuffs like those taking place in 2007 and 2008. Moreover, even for the same categories of goods, the rich do not necessarily pay the same price as the poor. The poor buy worse quality food, in smaller quantities and therefore more expensively, and receive lower quality public services – enough to induce the World Bank in 2008 to revise upwards the poverty line and recognise the existence of 400 million more poor than previously believed, a rise of 40% at a stroke.

10. What is the impact of the global crisis – financial and real – on income and wealth inequality? There can be no doubt that the crisis will raise the numbers of the poor, no matter how defined. The order of magnitude of stock exchange falls of one half or more in 2008 is bound to have reduced the inequality of wealth distribution both within countries and worldwide. It is possible – though we will not know for sure until some time after the end of the crisis – that the rich will also suffer a proportionately greater fall in income – though not as much in consumption – than the poor; except that many of the poor might suffer a total loss of income, thus tipping the balance towards greater income inequality. But even if a more equal wealth and income distribution resulted after the crisis, most people would regard the corresponding increase in poverty an intolerably high price to pay for more equality.

This does not mean that the converse is true, i.e. that an increasing inequality is necessarily an acceptable price for poverty reduction. It is not just a question of the actual trade-off on offer between inequality and poverty. Many, perhaps most of us, may simply not be prepared to entertain a trade-off between the two, and regard achieved levels of poverty and inequality as ceilings, beyond which there can be no sustainable welfare improvement.

[1] Branko Milanovic. Worlds Apart, Measuring International and Global Inequality, Princeton University Press, 2005.
[2] Andrea Cornia and Julius Court, Inequality, Growth and Poverty in the Era of Liberalization and Globalization, WIDER Policy Brief No. 4, Helsinki, 2001.
[3] James B. Davies,1 Susanna Sandström, Anthony Shorrocks, and Edward N. Wolff, The World Distribution of Household Wealth, UNU-WIDER Discussion Paper No. 2008/03, February 2008,
[4] Davies et al, 2008, who also discuss the appropriateness of using actual instead of PPP exchange rates. They add that “About 34 per cent of the world’s wealth was held in the US and Canada in the year 2000, 30 per cent was held in Europe, and 24 per cent was in the rich Asia-Pacific group of countries. Africa, Central and South America, China, India and other Asia-Pacific countries shared the remaining 12 per cent. The location of top wealth-holders is even more concentrated, with North America hosting 39 per cent of the top global 1 per cent of wealth-holders, and Europe and rich Asia-Pacific having 26 per cent and 32 per cent respectively. The high share of top wealth-holders in North America is particularly disproportionate, as this region contains just 6 per cent of the world population”.
[5] On both approaches see Geoff Harcourt, Some Cambridge Controversies in the Theory of Capital, CUP, Cambridge, 1972 (critical of the first approach, supportive of the second); Luigi L. Pasinetti, Keynes and the Cambridge Keynesians, CUP, Cambridge, 2008.
[6] Maurizio Franzini and Michele Raitano, Persistence of inequality in Europe: the role of family economic conditions, IRAE May 2009.
[7] David Barlow, Gianluca Grimaldi and Elena Meschi, Globalisation versus internal reforms as factors of inequality in transition economies, IRAE May 2009.
[8] Francisco Serranito, Trade, catching up and divergence, IRAE May 2009.

Tuesday, April 21, 2009

What makes the current crisis unique? Is it overextension of financial instruments?

This is a Guest Post contributed by Vladimir V. Popov,

The current crisis is often compared to the Great Depression of the 1930s
(see: Barry Eichengreen, Kevin H. O’Rourke. A Tale of Two Depressions. 6 April 2009 -

But there is still little evidence that it could reach the same magnitude. So far this current crisis is not unique – neither in terms of the collapse of stock indices (between October 1972 and July 1974 and between January 2000 and July 2002 S&P fell nearly 50% - pretty much like in October 2007- March 2009), nor in terms of the collapse of output (world GDP is projected to fall in 2009 by 1 to 2 % - for the first time in 60 years, but it is not dramatically different from 0.3 growth in 1982 and 0.9 growth in 1975 (see charts below).

There is also a theory that the rates of productivity growth are slowing down after the ICT revolution happened and the stream of innovations started to dry up. But, again, so far the evidence does not support the hypothesis – productivity growth rates since the late 1980s in the US were higher than in the 1970s-80s (chart below). And if Kondratieff long waves do exist, the lowest point of the long cycle should come some time in the 2020-30s, not now (the previous troughs were in the 1870s, 1930s, and 1970-80s).

The expansion of financial sector and derivatives that took place in recent decades is really unique and could be held responsible for the extra-ordinary character of today’s recession. The ratio of total debt – corporate, household, financial and government – to GDP today (since the mid 1980s) is as high as it was never before, except for the 1920s-30s (chart below). And the market in derivatives that virtually did not exist before the 1970s, expanded to astronomical size. As Mario puts it, the current crisis is unprecedented due to “the unregulated degeneration of financial institutions, banks and non-bank intermediaries, the result of twenty years of hyper-liberalism... According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and reached 1.14 quadrillion dollars… By comparison, the gross domestic product of all the countries in the world is only 60 trillion dollars”. Derivative financial instruments designed to hedge risk, became themselves the source of volatility.

Relative wages in the financial sector (after controlling for education, experience and other usual determinants) in recent years were equally unusually high – as high as they were only in the 1930s (chart below from: Thomas Philippon and Ariell Reshef. Wages and Human Capital in the U.S. Financial Industry: 1909-2006. December 2008. -

However, it could be argued that what was dangerous in the 1920s-30s and led to the Great Depression today is manageable due to the experience and sophistication in applying Keynesian policies of managing aggregate demand. This may be true and may be not, but the fact is that the response to the current crisis by means of monetary and fiscal policy today is really unprecedented. The following two charts borrowed from cited paper by Barry Eichengreen and Kevin H. O’Rourke show that the increases in both the money supply and the budget deficits during this recession were by far more pronounced than in the late 1920s and 1930s.

Money Supplies, 19 Countries, Now vs Then (Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators)

Government Budget Surpluses, Now vs Then
(Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009)

The US federal budget deficit is projected to increase to 12% of GDP in 2009 (from 3.2% in 2008) and stay at a level of 8% of GDP in 2010, so the total US public debt to GDP ratio in several years from now can exceed 100% of GDP from about 70% in 2008. In EU countries the increases in budget deficits are not that dramatic, but also substantial.

The danger with Keynesian policies, of course, that its effects accumulate, the economy gets addicted to stimuli, and the new and bigger doses are needed to get the desired result. This was exactly the problem with the stagflation of the 1970s. And it may well be this same problem is going to build up after enacting the stimuli designed to cope with the current recession.

To prevent this type of recession from happening in the future it would be needed to limit the expansion of the financial markets (derivatives – in the first place) through tighter government regulations. But this is exactly what is very unlikely to happen, as the recent G-20 meeting showed. The analogy would be the global warming. Until several islands in the Pacific would not go under water, it is virtually impossible to mobilize public support for the austerity measures, like the carbon tax.

Until there is a major crash, the new regulations for financial markets are not likely to be adopted. If so, in 10-20 years from now we are likely to find ourselves in a greater trouble, but with less room for managing the problem by means of Keynesian policies.

Vladimir Popov

Monday, April 20, 2009

Our Own Transition

There was a time when Ronald Reagan could claim that “Government is part of the problem, not part of the solution.” [1] Bill Clinton and Tony Blair endorsed and replicated Reagan’s contempt for government. Now the financial crisis that began in August 2007 in the USA and the UK, and exploded globally since September 2008, has spectacularly reversed this proposition.

Governments have become the sole, large-scale actors in the search for a solution to global crisis problems, through initiatives for new, stricter market regulations; large injections of liquidity by central banks (whose cherished independence of over twenty years has gone by the board or has been practically suspended); expansionary fiscal policies far beyond what until now was regarded as prudent, for instance by the EU now softened Growth and Stability Pact; through bail-outs of banks, insurance companies and other financial institutions, then even of productive enterprises making cars and other durables, also newly supported by previously unthinkable government subsidies. There have also been outright nationalisations, qualified as “temporary”.

No wonder many observers have talked of “The End of Capitalism”, with or without a question mark, or qualifications such as “American”, “financial”, “as we know it” or “knew it” [2].

Risk-bearing, i.e. appropriating profits and suffering losses, is a fundamental feature of private property and enterprise. When losses occur they eat up enterprise capital. When liabilities exceed the value of capital assets, the enterprise goes bankrupt; an established ranking of secured creditors (wage employees, mortgage lenders) satisfy their claims first, as far as they can, while unsecured creditors satisfy a fraction of their claims on the residual, if any, owner(s)/shareholders being last. Before that happens the enterprise may be liquidated; if it is still viable as a going concern (under Ch. 11 Bankruptcy in the US) it might continue to operate after being sold as such or relieved of the burden of net debt.

One way or another, the “exit” of insolvent, non-viable enterprises is the essence of the capitalist system, together with the associated market discipline, competition, evolutionary survival of the fittest – all good things that are presumed to be alien to state enterprises.

“Temporary nationalisation” of those banks that risk bankruptcy is meaningless, or positively misleading. “Temporary” here involves an indefinite period, without specification of the precise circumstances in which re-privatisation might occur, without the subsequent re-instatement of the initial position, for there will be different owners, who will have paid a different price, or a price bearing a different ratio to the underlying assets, from the nationalisation price. Presumably nationalisation will happen at an over-inflated price (otherwise there would have been no need for nationalisation), that involved a subsidy to shareholders and/or to depositors, plus often a separate additional subsidy in the form of free, retroactive insurance (which is an oxymoron, indeed the caricature of insurance) on deposits. Like death, nationalisation is irreversible; we can always be reborn, in another life or on the Day of Judgement, but that’s something else.

Nevertheless, the End of Capitalism has been grossly exaggerated. An overwhelming share of GDP is still produced in the private sector. There are still domestic and international markets for goods and services, and markets for labour and other productive factors. Their degree of competition may disappoint, but they are there, and mostly private subjects buy and sell inputs and outputs in those markets. We are certainly not under a socialist system of any description, nor is a new system in sight. The blogger[3] who asked whether “the USA should now be known as the USSA (United Socialist States of America), and the UK as SUK (Socialist United Kingdom)”, is out of order.

All the same, we are in a middle of a New Transition. Not from capitalism to socialism, as some observers hope or fear, but from financial hyper-liberalism to state financial capitalism; as Willem Buiter argues, “From financialisation of the economy to the socialisation of finance” (op.cit.). But there is a big problem: the widespread pretence that either this is not happening, (or if it is, it is a momentary reversible morphism of no consequence, almost an optical illusion); or that this is part of a new socialist revival, instead of the degeneration of the welfare state towards the protection of capitalists in place of workers and the poor. Both delusions are equally false and most dangerous.

[1] Godfrey Hodgson, The true legacy of Ronald Reagan, The Independent, 8 June 2004.

[2] References abound. Just to give a few examples: Phillip Blond, Outside View: The end of capitalism as we know it?, The Independent, 23 March 2008; Willem Buiter, The end of American capitalism (as we knew it), The Financial Times, 17 September 2008; Anthony Faiola, The End Of American Capitalism?, The Washington Post, 10 October, 2008; Saskia Sassen, Too big to save: the end of financial capitalism, Open Democracy, 1 April 2009.

[3] Mike Talbot, 18 September 2008,

Wednesday, April 15, 2009

Bucket and Spoon

Anyone telling you when and where the next earthquake is going to happen should be disbelieved and treated with contempt. The same applies to anyone telling you when and where recovery from the current global crisis is going to happen. Maybe the green shoots are already here, in Europe and/or the US. Maybe in China end-2009 and 2010. Maybe globally in 10 years time. We are sailing in uncharted waters and nobody can speak with any acceptable degree of confidence and credibility.

The current global financial crisis is unprecedented. It is not due to an exogenous shock (like the oil shock of 1974) but it is an endogenous, systemic crisis, due to the unregulated degeneration of financial institutions, banks and non-bank intermediaries, the result of twenty years of hyper-liberalism. In August 2007 USA sub-primes acted as trigger, but the process was amplified by their securitisation and repackaging in structured bonds, as part of a much larger bubble in the derivatives market. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and reached 1.14 quadrillion dollars. More precisely: $548 trillion in Exchange Traded Derivatives[1] plus $596 trillion in notional Over-The-Counter[2] derivatives. By comparison, the gross domestic product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk has turned into a multiplication of risk.

Ultimately the problem with derivatives is that they represent bets that are only marginally covered. If those bets had to be 100% covered – and therefore losses constrained by a ceiling – at the time a transaction takes place, the size of the derivatives markets would be only a fraction of its present size, and counterparty defaults would not occur. With uncovered bets, mostly laid down on credit, when the value of underlying assets falls the whole pyramid collapses. In 2006 there were no bank failures in the USA; these were 3 in 2007, 25 in 2008, 23 in the first quarter of 2009.

The crisis is synchronised throughout the world, thus offering no geographical or sectoral shelter.
It spreads fast moving from the financial sector to the real economy, from one country to the other thanks to the globalisation of trade and capital movements, and in turn tends to de-globalise the world economy.

It is a deep crisis: for the first time since 1945 world income is falling, on average by 2% in 2009, accordingly to the IMF. World exports (obviously by definition equal to world imports), after growing steadily from 7% of world income in 1970 to 27% in 2007 are now falling, and at a rate much faster than income: minus 9% in 2009 according to the IMF, minus 13% according to the WTO. This brings down the world exports/income ratio, which is the most common and reliable index of globalisation. Labour unemployment has been growing fast. According to OECD forecasts Europe unemployment will rise by 20 million in 2009.

Such an unprecedented occurrence appears to have brought about, first, a re-thinking of the need for supervision and regulation of financial markets, and more generally for corporate governance in financial institutions and also in production, nationally and globally; second, an attempt to achieve a co-ordinated effort by at least the major countries and international financial institutions, for monetary expansion, as well as additional large scale fiscal stimulation. But there are considerable obstacles and doubts about both the actual implementation of such policies and their likely success.

The United States are unwilling to negotiate financial regulations internationally. They have injected large scale liquidity in the rescue of financial institutions, a process rightly criticised by Joseph Stiglitz as collectivisation of losses – directly, under Paulson and Bush, indirectly via government guarantees, under Geithner and Obama – after past profits have been privatised and salted away by shareholders and overpaid managers. Millionaire bonuses for managers of failing companies have been taking some cuts, through tax and ceilings, which have been criticised as improper interferences with “the market for managerial talent” – as if the medieval corporative practice of managers’ salaries being decided by other managers with a vested interest in inflationary settlements had anything to do with a competitive market. But by and large managers have kept their ill-gotten gains.

The effectiveness of monetary expansion, in any case, is limited by the current low level of interest rates, and by the liquidity preference that the public exhibits at such low rates (as we should all know very well from the experience with Japan’s monetary policy).

Fiscal expansion – Keynes resurrected and rehabilitated – on a world scale makes infinitely more sense than unilateral fiscal expansion by a single country. But many governments are already heavily indebted and feel they do not have much of what the World Bank calls “fiscal space” for sustaining larger deficits. The US have contributed fairly generously, however Gordon Brown himself, after posing as world saviour by promoting coordinated fiscal stimulation, had to trim his own sails and failed to do in the UK what he preached abroad. And there is the great temptation for governments (e.g. Italy) to benefit as free riders without contributing to the common effort.

In general, the size of the combined world-wide monetary and fiscal stimulus is at best a couple of percentage points of the size of the derivatives markets. Emptying water from the sinking ship with a spoon is not enough.

[1] ETD, traded via specialized exchanges or other exchanges acting as an intermediary, taking an initial margin from both sides of the trade to act as a guarantee.
[2] Over The Counter, privately negotiated and traded directly between two parties, without going through an exchange or other intermediary.