Wednesday, March 16, 2011

Inequality and the Global Crisis

This is a Guest Post contributed by Branko Milanovic, a Lead economist in the World Bank's research department. Branko - at present a Visiting Fellow of All Souls College, Oxford - spent over a quarter century working on poverty and inequality and made original, pioneering contributions to this subject, including: Worlds Apart. Measuring International and Global Inequality, 2005, Princeton/Oxford; The Haves and the Have-Nots: A Short and Idiosyncratic History of Global Inequality, 2011, Basic Books (DMN)

The current financial crisis is generally blamed on feckless bankers, financial deregulation, crony capitalism and the like. While all of these elements may be true, this purely financial explanation of the crisis overlooks its fundamental reasons. They lie in the real sector, and more exactly in the distribution of income across individuals and social classes. Deregulation, by helping irresponsible behavior, just exacerbated the crisis; it did not create it.

To go to the origins of the crisis, one needs to go to rising income inequality within practically all countries in the world, and the United States in particular, over the last thirty years. In the United States, the top 1 percent of the population doubled its share in national income from around 8 percent in the mid-1970s to almost 16 percent in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1 percent share reached its previous high watermark American income inequality over the last 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 thirty 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 Pérignons and Armani suits one can drink or wear. And, of course, it was not reasonable either to “invest” solely in conspicuous consumption when wealth could be further increased by judicious investment. So, a huge pool of available financial capital—the product of increased income inequality—went in search of profitable opportunities into which to invest.

But the richest people and the hundreds of thousands somewhat less rich, could not invest the money themselves. They needed intermediaries, the financial sector. Overwhelmed with such an amount of funds, and short of good opportunities to invest the capital as well as enticed by large fees attending each transaction, the financial sector became more and more reckless, basically throwing money at anyone who would take it. While one cannot prove that investible resources eventually exceeded the number of safe and profitable investment opportunities (since nobody knows a priori how many and where there are good investment opportunities), this is strongly suggested by the increasing riskiness of investments that the financiers had to undertake.

But this is only one part of the equation: how and why large amounts of investable money went in a search of a return on that money. 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. Real median wage in the United States has been stagnant for twenty five years, despite an almost doubling of GDP per capita. About one-half of all real income gains between 1976 and 2006 accrued to the richest 5 percent of households. The new “gilded age” was understandably not very popular among the middle classes that saw their purchasing power not budge for years. Middle class income stagnation became a recurrent theme in the American political life, and an insoluble political problem for both Democrats and Republicans. Politicians obviously had an interest to make their constituents happy for otherwise they may not vote for them. Yet they could not just raise their wages. A way to make it seem that the middle class was earning more than it did was to increase its purchasing power through broader and more accessible credit. People began to live by accumulating ever rising debts on their credit cards, taking on more car debts or higher mortgages. President George W. Bush famously promised that every American family, implicitly regardless of its income, will be able to own a home. Thus was born the great American consumption binge which saw the household debt increase from 48 percent of GDP in the early 1980s to 100 percent of GDP before the crisis.

The interests of several large groups of people became closely aligned. High net-worth individuals and the financial sector were, as we have seen, 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 constraint removed as if by magic wand, consume all the fine things purchased by the rich, and partake in the longest US post World War II economic expansion. Suddenly, the middle class too felt like the winners.

This is what more than two centuries ago, the great French philosopher Montesquieu mocked when he described the mechanism used by the creators of paper money in France (an experiment that eventually crumbled with a thud): ‘People of Baetica”, wrote Montesquieu, “do you want to be rich? Imagine that I am very much so, and that you are very rich also; every morning tell yourself that your fortune has doubled during the night; and if you have creditors, go pay them with what you have imagined, and tell them to imagine it in their turn”.

The credit-fueled system was further helped by the ability of the US to run large current account deficits; that is, to have several percentage points of its consumption financed by foreigners. The consumption binge also took the edge off class conflict and maintained the American dream of a rising tide that lifts all the boats. But it was not sustainable. Once the middle class began defaulting on its debts, it collapsed.

We should not focus on the superficial aspects of the crisis, on the arcane of how “derivatives” work. If “derivatives” they were, they were the “derivatives” of the model of growth pursued over the last quarter a century. 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 which generated much larger investable funds than could be profitably employed. The political problem of insufficient economic growth of the middle class was then “solved” by opening the floodgates of the cheap credit. And the opening of the credit floodgates, to placate the middle class, was needed because in a democratic system, an excessively unequal model of development cannot coexist with political stability.

Could it have worked out differently? Yes, without thirty years of rising inequality, and with the same overall national income, income of the middle class would have been greater. People with middling incomes have many more priority needs to satisfy before they become preoccupied with the best investment opportunities for their excess money. Thus, the structure of consumption would have been different: probably more money would have been spent on home-cooked meals than on restaurants, on near-home vacations than on exotic destinations, on kids’ clothes than on designer apparel. More equitable development would have removed the need for the politicians to look around in order to find palliatives with which to assuage the anger of the middle-class constituents. In other words, there would have been more equitable and stable development which would have spared the United States, and increasingly the world, an unnecessary crisis.


Maurice said...

Brilliant, thanks.

However, why should a surge in savings by the rich lead them to expect and obtain higher though riskier rates of return?

Martha said...

"The credit-fueled system was further helped by the ability of the US to run large current account deficits". So, to what extent was the crisis linked to "global imbalances" i.e. China's current account surplus and the undervaluation of the renmimbi?

Branko said...


This is a very good question. What I meant is that the amount of investible funds was too high in relation to the number of investment opportunities yielding x. But rather than accepting x-something, people wanted to keep on hoping to get x even if it was riskier. (I know that the expected value of that is still x-something, but people might have systematically underappreciated the riskiness of these new assets.)

Branko said...

A very good point to which I have to plead partial ignorance. Since the crisis originated in the US and it is clearly US political economy that I had in mind in my short piece, I do think that the borrowing frenzy at the personal level was both helped (and perhaps it caused) the borrowing frenzy at the national level. This is where the imbalance story comes in. But in that rendition of the story, as you can see, the "blame" is squarely on those who borrowed and spent excessively rather than on those who ran current account surpluses. I must say that I never understood how a person who sold something to somebody can be accused of being responsible for that other person's profligacy. The US harping on China's surplus would have much amused Adam Smith, I think.

Unknown said...

Hi, Branko.
Akerlof and Shiller in their book (Animal Spirits) show how the pressure on the Clinton administration in the end-nineties lead to easing mortgage collaterals by Mac and Mae so that cheap credits could reach the poor (not only the middle classes). This contributed to the subsequent bubble on the one hand and greatly increased the spread of failures when the downturn came. What do you think about this?

Ludwig Buechner said...

this one is easy: Don't mix inequality with imbalance.
Importing things from China was a neccessary prerequisite to keeping the prices lower in order to keep the wages lower. Think of it as if it was a 25 year long deflation cycle (spiral?). Without this, the trick described in Your great post above wouldn't have worked out so perfectly.
A cycle can go round for a long time, a spiral could eventually reach a bottom.

Magpie said...

Dear Mr. Milanovic,

I found your post highly valuable.

You make a compelling case for the idea that inequality was among the leading causes to the global financial fiasco y the consequent great recession.

Your scenario, like that of Darren Acemoglu (see for instance stresses the role of income inequality as generator of risky investment, which I find fundamental.

In this sense, you extend Acemoglu's scenario by making explicit the use of the resources applied in risky investments.

Although I do have some minor quibbles with some parts of your narrative (particularly in this extension), the question I would like to ask is this:

Can you provide empirical basis for this scenario?

Thank for your attention.

Jacob Richter said...

"It follows therefore that *in proportion* as capital accumulates, the situation of the worker, be his payment high *or low*, must grow worse." (Marx)

Branko said...

Thank you for very valuable comments.

In response to Toth and Magpie I would like to give some background to my note. The piece was originally written and published in March 2009, that is a long time before Acemoglu and Rajan started arguing something similar. I was not (and am not now) particularly interested in this crisis. However, since I have been for “ages” working on inequality, and was somewhat interested in US inequality, it seemed to be quite evident that something like a mechanism explained in my post operated. So I wrote it and never looked back—until recently when similar opinions gained in prominence and I was somewhat miffed that these people seemed to believe that they were the first to have thought of it. (Take Acemoglu, who in a different context, at a conference when he was a commentator on one of my papers, went to great length to argue, quite forcefully, that for him economic inequality is immaterial; it is political inequality alone that matters. Now we hear from him that somehow economic inequality did seem to matter in this case. )

This indirectly answers Toth’s and Magpie’s question as to my ability to corroborate the story with clear policy instances from Clinton or Bush administrations. The truth is: I have not systematically looked at it. At another recent conference Alan Blinder asked me precisely that question. I said the same thing. But Jamie Galbraith jumped in with a list of specific policy decisions as well as personnel appointments made by the Clinton and Bush administrations precisely to make risky borrowing easier, thus satisfying both constituencies: the middle class and the poor, as well as the financial sector and the rich. So, I do hope somebody undertakes (or somebody might already have) to do the documentation more systematically.

I found Ludwig’s point very interesting. I have not thought of that. But on that, quite plausible interpretation, China plays the role of the Anti-corn league. Let me explain. Removal of corn tariffs in England enables a reduction in what is called the Ricardian real wage. The real wage as we currently use the term (nominal wage/price index) remained the same, but since the wage goods become cheaper, nominal wage could go down and thus the share of wages in net product could be reduced. The repeal of corn laws had the same impact as cheap Chinese imports do today: to allow for a stagnant or even slightly increasing real wage in conditions of massive increases in net product—making thus sure that non-wage part of net income increases both in proportion and in real terms. Under such interpretation Chinese “communists” and American capitalists are indeed complementary so long as China produces sufficiently cheap goods. Once wages in China rise, that might cease. This point implies, it seems to me, a very different take on the US-China deficit/surplus by arguing that it is indeed in the interest of US capitalists that the renminbi remain undervalued (if indeed it is).