Debt, Inequality and Financial Crises

Paul Krugman is a figure of hate for the right in American politics. He is a liberal in the American sense of the word. But he is also an intelligent economic liberal, which means that he realises the benefits of markets and the necessity of government intervention.

In a recent blog post he counters views that he only talks about the Bush property bubble, while ignoring the Clinton stock bubble.

Except I did. Actually, back then the WSJ editorial page was flogging Dow 36,000 and telling readers that anyone who had doubts about the level of stock prices must hate capitalism.

Beyond that, there are some real differences between the Bush and Clinton bubbles.

One is that Bush presided over only four years of job growth, 2003-2007 — and those were all bubble-driven years. Clinton presided over eight years of job growth, with job growth at roughly equal rates in the first and second halves of that eight-year period, and the Internet bubble inflated only in the second half.

Another difference, which is really crucial, involves the debt implications. Here’s non financial debt, public plus private, as a percentage of GDP.

Have a look at those years of debt growth and which Presidencies they are associated with. 

One of the arguments that I find most interesting about the growth of debt, beyond the significance of financial liberalisation, is the clear association of increasing debt with income stagnation.

During a period of income stagnation households increase their level of debt to maintain their living standards or to keep up with new consumption norms (often based on the consumption patterns of those on upper income levels).

Another interesting argument is that higher inequality might, therefore, be an important factor in creating the conditions for financial crises.

Michael Kumhof and Romain Rancière in Finance and Development argue that

Long periods of unequal incomes spur borrowing from the rich, increasing the risk of major economic crises.

The United States experienced two major economic crises over the past 100 years—the Great Depression of 1929 and the Great Recession of 2007. Income inequality may have played a role in the origins of both. We say this because there are two remarkable similarities between the eras preceding these crises: a sharp increase in income inequality and a sharp increase in household debt–to-income ratios.

Kumhof and Rancière argue that there are two major policy options for governments to deal with high levels of household indebtedness.

There are two ways to reduce ratios of household debt to income.

The first is orderly debt reduction. What we have in mind here is a situation in which a crisis and large-scale defaults have become unavoidable, but policy is used to limit the collateral damage to the real economy, thereby leading to a smaller contraction in real economic activity. Because this implies a much smaller reduction in incomes for any given default on loans, it reduces debt-to-income ratios much more powerfully than a disorderly default. Still, a long-lasting trend toward higher debt-to-income ratios resumes immediately after the debt reduction, because workers continue to have a reduced share of the economy’s income.

The second possibility, illustrated in Chart 4, is a restoration of workers’ earnings—for example, by strengthening collective bargaining rights—which allows them to work their way out of debt over time. This is assumed to head off a crisis event. In this case, debt-to-income ratios drop immediately because of higher incomes rather than less debt. More important, the risk of leverage and ensuing crisis immediately starts to decrease.

Any success in reducing income inequality could therefore be very useful in reducing the likelihood of future crises. But prospective policies to achieve this are fraught with difficulties. For example, downward pressure on wages is driven by powerful international forces such as competition from China, and a switch from labor to capital income taxes might drive investment to other jurisdictions. But a switch from labor income taxes to taxes on economic rents, including on land, natural resources, and financial sector rents, is not subject to the same problem. As for strengthening the bargaining power of workers, the difficulties of doing so must be weighed against the potentially disastrous consequences of further deep financial and real crises if current trends continue.

Restoring equality by redistributing income from the rich to the poor would not only please the Robin Hoods of the world, but could also help save the global economy from another major crisis.

It certainly makes intuitive sense, irrespective of the economic modelling.  Mix easier access to credit with stagnating incomes and a culture of conspicuous consumption and you have a major factor in why the developed world is in crisis at the moment.

It also returns to my long-standing point that Australia's greatest generally unremarked vulnerability is our vulnerability to rising inequality. 

Inequality, not just poverty, does matter, and research like that above makes clear that it presents real dangers to economies as well as societies.