Tuesday, May 15, 2012

Show Me the Mechanism!

The Economic History of 2008

We have been searching through the economic literature for articles that support our opinion regarding the causative role of income inequality in the crash of 2008, and we have been encouraged by finding views similar to ours in the writings of analysts like Robert Reich. A few days ago we came across a key paper just about the same time as the New York Times apparently discovered it. (The Times commented favorably on the paper in a leading article on May 4, under the heading Inequality, Debt and the Financial Crisis.)

What is curious is that the paper, Inequality, Leverage and Crises, an International Monetary Fund Working Paper, WP/10/268, by Michael Kumhof and Romain Ranciere, was published more than two years ago, in November 2010. In our view, Kumhof and Ranciere have provided the most convincing account of the crash of 2008 that we have read, but their work has not, as far as we are aware, received the publicity it deserves.

The Kumhof and Ranciere paper is not an easy read and for non-economists we would recommend a shorter version titled Leveraging Inequality by the same authors in the IMF publication Finance and Development, December 2010. http://www.imf.org/external/pubs/ft/fandd/2010/12/Kumhof.htm

The Mechanism

The chain of causation in the crash of 2008 (and that of 1929) – the "mechanism" by which increasing inequality leads to a financial crash -- will be familiar to readers of this blog, and is contained in our booklet, accessible from the blog's Home Page, How to Unblock the Economy by Reducing Inequality.

The Kumhof and Rancier version of the financial history of the 2008 crash goes something like this:

    1. Over several decades, the politics of wage setting and income determination favor a shift in the share of income to the top 5% of income earners and away from the bottom 95%, whose share falls from 78% in 1983 to 66% in 2007.

    2. The bottom 95%, trying to maintain a middle class standard of living, borrow money from the top 5%, and become increasingly indebted. The figures they cite are striking: the debt to income ratio of the bottom 95% rises from 60% in 1983 to 140% in 2007.

    3. The magnitude of the financial intermediation involved – bringing rich lenders and middle- and lower-income borrowers together – results in a doubling of the share of GDP going to the financial sector – from about 4% to about 8%.

    4. Because of the high level of indebtedness the whole economy becomes increasingly vulnerable to financial crises, although the exact nature, timing and playing out of the likely crisis is uncertain. In 2008 it manifested itself in the form of a subprime mortgage crisis that spread across the financial sector and was only stopped by the dramatic intervention of the U.S. Federal Reserve and Treasury.

Some Remarkable Features of this Analysis

The reason why the IMF Staff Working Paper seems to us such a convincing account of the financial crisis of 2008 is, for one thing, that it breaks ranks with the majority of economists who regard class as a taboo topic. The paper breaks this taboo by analyzing consumers or households in two classes, the top 5% and the bottom 95%. In one stroke the authors have opened up a whole different insight into the way the economy has been working. It allows them to recognize that high-income households have a low propensity to consume -- i.e., a high propensity to save -- while the rest of us tend to consume most or all of our income, or even go into debt so that we can consume more than we earn.

Likewise, the authors understand the role of the financial sector more clearly than most economists do. They knock it off its high pedestal as the "maker of perfect markets" and treat it as part of the hurly-burly of unstable macro-economic forces. Forget all the hogwash about "risk management," they see that when the chips are down the financial sector can contribute to instability rather than controlling it.

In this regard, the IMF staff analysis validates the remark of William McChesney Martin, the Federal Reserve chairman during the 1950s and 1960s, that "the job of the Fed is to take away the punch bowl just as the party gets going." His image of the financial sector as a bunch of potentially intoxicated party-goers turns out to be far more realistic that the view espoused by Alan Greenspan, the Fed chairman in the early 2000s, who continued to believe that his wards were sober financiers, even as the level of intoxication of revelers in the mortgage market was becoming increasingly dangerous to the whole economy.

The recent woes of JPMorgan Chase, one of the two most admired companies on Wall Street along with Goldman Sachs, show that sober judgment has not yet returned to Wall Street. A JPMorgan financial subsidiary designed to hedge risks morphed into a profit center that took exposed positions on bond prices. It has lost more than $2 billion since the beginning of April, is expected to lose another $2 billion in the next couple of months, and is apparently likely to have billions of dollars of exposed positions after that.

A Limitation of the IMF Staff Analysis

The Kumhof and Ranciere scenario should be read as a special case rather than a general one. They are trying to describe events that actually occurred -- the two great financial crashes experienced by the United States in the past 100 years. But history is not a matter of predetermined or inevitable events. in a counter-factual or "what-if" historical scenario, events could have taken a different turn in the years leading up to 2008, resulting not in a financial crisis but in a protracted period of economic stagnation. For example, the Federal Reserve could have slowed the growth of mortgage lending in the early 2000s by such measures as tightening monetary policy, enforcing mortgage standards, prohibiting liar loans, limiting the amount of financing to say 80% of the value of a dwelling, and so forth.

With measures such as these, unpopular though they would have been with almost everybody, liberal or conservative, at the time, the mortgage bubble might not have come about, and a financial crisis might have been averted, at least for the time being. But the price of reduced extension of credit would have been slower economic growth during the early 2000s, and possibly a recession. The economic outcome would probably have better than it actually was, but it would not have been great.

The Outlook Today:

Will Indebtedness and Inequality Lead to Another Financial Crisis?

If we expand the analysis of the consequences of extreme inequality, and we acknowledge that it does not necessarily lead to a crisis, it is quite possible that it can lead simply to sluggish consumer demand and resulting economic under-performance. This could be the road we are on today.

The problem is that the financial crisis has not resolved the issues of middle- and low-income indebtedness or the continuing extreme inequality in the distribution of income. The recent statistics suggest that the lion's share of the recovery of incomes since 2008 is going to the rich. The corporate sector (both Wall Street and Main Street) and wealthy individuals are sitting on literally trillions of dollars available for investment (if only there were demand for the products of that investment). ) Once again, as their incomes build up, they will put pressure on the financial sector to find investment outlets for their cash. Tempting outlets will suggest themselves. If the pressure gets too great, bubbles will form.

But wealthy investors and the financial sector are well aware that bubbles can burst, sooner or later. In the years leading up to 2008, it seems the memory of the dot-com bust of 2000 was in the process of being forgotten by investors and the Fed. Or put it this way: in bullish times such as those, investors are willing to believe rosy investment stories if they could semi-plausibly be true, and regulators are reluctant to intervene. The burden is on the skeptics to prove that the rosy scenarios are not true.

However, when the crisis of 2008 developed into such a shocking financial calamity, maybe the burden of proof shifted (except, apparently, at JPMorgan Chase's "hedging" unit). If the investment stories being touted by the financial sector seem unrealistically optimistic, investors may find the proof lacking and just turn them down. Result: less investment and slower economic growth rather than a bubble.

Meanwhile, the high level of household debt also continues to slow down the economic recovery. We could continue to get growth, but growth of say 2% a year, too slow to re-absorb the unemployed into the work force. This might be tolerable from the point of view of business (and the wealthy) if steady growth leads to increased profits without increasing inflation and interest rates. But things would not be as good as they could be, because this scenario would fall far short of a boom in investment projects, profits and stock prices. And things would be bad for labor, given that the rate of unemployment would stay high, and labor's bargaining power would be weak.

Temporary increases of consumer borrowing and spending could mask the underlying weakness of the economy, as they did in the years before 2008, but they will not put the economy on a sustainable growth path, they will merely create the preconditions of another financial crisis.

In Kumhof and Ranciere's view, the excessive amount of debt of the bottom 95% of households remains the principal impediment to economic recovery. There are two ways to reduce the ratio of household debt to income, the one being to write down the debt. If large-scale debt defaults have become inevitable in the ongoing sluggish economy, what they call "orderly debt reduction" becomes a desirable option.

The other policy option is "a restoration of workers' earnings," i.e., a reversal of the shift of income from workers to employers and other high-income earners. We note that this is clearly the best long-term policy strategy. In any event, a rebalancing of the economy would reduce vulnerability to financial crisis.

In our paper, we dealt with a range of policy options. Without going into them here, we note that they try to address the difficulty of increasing take-home wages in an era of strong international competition, and shifting taxes off of the backs of labor.

On this last point – shifting taxes from labor – Kumhof and Ranciere include a thoughtful proposal regarding which taxes could be increased ,without being self-defeating or causing adverse side-effects. They propose "a switch…to taxes on economic rents, including on land, natural resources, and financial sector rents." This suggestion warrants extensive research.

Thanks to Kumhof and Ranciere, the analysis of extreme inequality in the U.S. and the macroeconomic harm it causes has taken several steps forward.

2 comments:

  1. this paper fom the bowels of the imf
    nicely demonstrates
    the shadow knows

    the staff at the imf know how it all works

    and yet policy goes against the best options
    for the planets broad masses

    taxing economic rents like taxing
    to reduce pigou third party cost

    is well understood by the egg heads on the payroll

    but don't expect policy to follow some path
    that boosts
    the earth's general social welfare function

    ReplyDelete
  2. i note the blog of arch fuzzy wuzzy
    reginald mcbottom-smythe-jerry-lewis
    is on the button boy list at right

    warning to the innocent
    this mental june bugporduces
    little more
    then
    the well intended
    drip drip drip
    of conventional class cross eyed muddlement

    ReplyDelete