The “Occupy Wall Street” Inspired Resurrection Of A Paper On Inequality And Financial Crisis17 October, 2011, 20:17. Posted by Zarathustra
Tags: Economy, Financial Crisis, Inequality, Leverage, United States
Early this year I flagged a piece of research by Michael Kumhof and Romain Rancière on inequality, leverage and crises. The recent Occupy Wall Street thing, for some reason, reminds me of this research. Maybe I am not totally justified as the objective of this #OWS thing is not quite so clear to me, but I would like to resurrect some of the ideas from this piece of research.
I believe most can accept that income inequality has widening, not only in the US, but everywhere. From the perspective of social cohesion, that is not a particularly good thing, as we can see pretty clearly now. But the research by Michael Kumhof and Romain Rancière actually shows that inequality is actually associated with occurrence of financial crisis. In their detailed research paper, the abstract reads (emphasis mine):
The paper studies how high leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of the rich, a large increase in leverage for the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where these features arise endogenously as a result of a shift in bargaining powers over incomes. A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But restoration of the lower income group’s bargaining power is more effective.
The reason why increasing income inequality is associated with financial crisis is that as income of households from the lower and middle classes did not increase quite as much as the top end, these household would have to increase borrowing to maintain living standard (or to keep up with the increase of living standard of the wealthier classes). As the wealthier people have wealth to be invested, and the lower classes would have demand for credit, that increases the need for financial intermediation, increasing the size of financial sector, and made the financial system more vulnerable. So that contributes to the explanation of financial crisis. As they pointed out in the abridged version:
In our closed economy set-up, the increase in leverage of the bottom 95% is made possible by the re-lending of the increased disposable incomes of the top 5% to the bottom 95%, resulting 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 increases. The rise of poor and middle income household debt leverage generates financial fragility and a higher probability of financial crises. With workers’ bargaining power, and therefore their ability to service and repay loans, only recovering very gradually, the increase in loans and therefore in crisis risk is extremely persistent.
But the more depressing part is what happens afterwards. In their research, the deleveraging of households is a difficult process. As wage drops considerably in their model as the economy collapses, as it apparently did in 2008, and among other things, leverage ratio does not drop. As the paper says that in their base-case scenario:
The crisis however barely improves workers’ situation. While their loans drop by 10% due to default, their wage also drops signiﬁcantly due to the collapse of the real economy, and furthermore the real interest rate on the remaining debt shoots up to raise debt servicing costs to 9% of income. As a result their leverage ratio barely moves, and for the present calibration it in fact increases further later on so that by year 50 it is above its pre-crisis level, with a very slow reduction thereafter.
Surely, the reality did not match the base-case simulation entirely, but the result is that the bottom group of people borrowed as the income inequality widened, and then they suffered from the consequence of financial crisis badly, both as their wage decreases and leverage remains. Also, the share of income for the top 5% of people actually increases after the crisis.