Inequality, Leverage and Crises
Michael Kumhof, International Monetary Fund Romain Ranciere, International Monetary Fund and Paris School of Economics
The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.
1
Introduction
Empirical Motivation: Similarities of the decades preceding the 1929 and 2007 crises
• Sharply increasing income inequality.
• Sharply increasing debt leverage among lower and middle classes.
• Perception of unsustainably high leverage was a key factor causing a large financial and real crash.
2
Literature on Alternative Causes of the 2007 Crisis • Most recent literature focuses on the final years preceding the crisis: — Excessive financial liberalization. — Easy monetary policy. — Global current account imbalances. • Rajan (2010), our work: Much of this was simply a manifestation of an underlying and longer-term dynamics driven by income inequality — Rajan: Growing inequality created political pressure for easy credit. This stresses the demand for credit. — Our work: Growing income inequality simultaneously created 1. Additional demand for credit to sustain living standards of the lower and middle class. 2. But also additional supply of credit due to the extra income of the top income group looking for a place to go.
Companion Literature on Causes of Changes in the Income Distribution • Hacker and Pierson (2011): Government intervention in support of the rich. • Card, Lemieux and Riddell (2004): Changes in unionization. • Borjas and Ramey (1995): Role of foreign competition. • Roberts (2010): Role of jobs offshoring. • Lemieux, MacLeod and Parent (2009): Increased use of performance pay. • Lemieux (2006): Increase in the return to post-secondary education.
3
Stylized Facts
60
1920-1931
55
35
33
50 45 29 40
Percent
Percent
31
27 35 30 25
Private Non Corporate+Trade Debt to GNP Share of Top 5% in Income Distribution 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931
25
23
Source: Statistical Abstract of the United States, U.S. Department of Commerce.
Percent
140
1983-2008 Household Debt to GDP Share of Top 5% in Income Distribution
36 34
130
32
120
30
110
28
100
26
90
24
80
22
70
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Percent
150
20
Sources: Income shares from Piketty and Saez (2003, updated). Income excludes capital gains. Debt-to-income ratios from Flows of Funds database, Federal Reserve Board. Income excludes capital gains.
Income Inequality and Household Leverage: (i) Moved up together pre-crisis. 2 (ii) Both pre-1929 and pre-2007.
Cumulative Percent Change
40
Top Decile of Earnings Distribution Median Decile of Earnings Distribution Bottom Decile of Earnings Distribution
50 40
30
30
20
20
10
10
0
0
-10
-10
-20
-20
-30
-30
-40
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Cumulative Percent Change
50
-40
Source: Heathcote, Perri and Violante (2010), based on micro-level data from the U.S. Consumer Population Survey. Male annual earnings includes labor income plus two-thirds of self-employment income. Male hourly wages are computed as male annual earnings divided by annual hours. The price deflator used is the Bureau of Labor Statistics CPI-U series, all items.
Male Annual Earnings by Income Decile: (i) Over 40% cumulative increase for the rich. (ii) Over 30% cumulative decrease for the poor. (ii) 5%-10% cumulative decrease for the median.
Percentage Points
130
Bottom 95% of the Income Distribution Top 5% of the Income Distribution Aggregate Economy
150 130
110
110
90
90
70
70
50
50
30
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Percentage Points
150
30
Source: Survey of Consumer Finance (triennal), 1983-2007. Debt corresponds to the stock of all outstanding household debt liabilities. Income corresponds to annual income before taxes, including capital gains and transfers, in the year preceding the survey.
Debt to Income Ratios:
(i) Lower or flat for the rich. (ii) Sharply higher for the remainder.
8.5
Private Credit to GDP Value Added GDP Share of Financial Sector
Percent
220
8.0
200
7.5
180
7.0
160
6.5
140
6.0
120
5.5
100
5.0
80
1985
1990
1995
2000
2005
Percent
240
4.5
Sources: Private Credit to GDP from World Bank Financial Structure Database (real private credit by deposit banks and other financial institutions, relative to GDP). Value Added GDP Share of Financial Sector from Philippon (2008).
Size of the U.S. Financial Sector:
(i) Private Credit to GDP more than doubled. (ii) Banks’ share in GDP more than doubled.
4
A Theoretical Model to Explain The Data • Economy consists of two separate household groups, the top income group (“investors”) and the lower and middle class (“workers”). • Economy experiences a highly persistent decrease in the income bargaining powers of the lower and middle class. • Response of the top income group (top 5% of incomes): 1. Higher consumption. 2. Higher physical (equity) investment. 3. Much higher financial investment = recycling gains back to lower and middle class as loans. • Response of the lower and middle class (bottom 95% of incomes): 1. Lower consumption, but consumption drops by less than income. 2. Much higher borrowing from the top income group = higher leverage over decades. • Result: Higher financial fragility ⇒ risk of financial crisis ⇒ eventual crash.
- Real wage drops persistently. - Return to capital increases persistently.
Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Real Wage
−2
0
−4 −6 −8
Return to Capital
−2 −4 −6
0
10
20
30
40
50
10
20
30
40
0
Investors‘ Physical Investment
10
20
30
40
5
50
level in %
% deviation
−2 −4 −6 0
10
20
30
40
50
10
20
30
40
20
50
120 100 80 60
50
40
0
Workers‘ Debt−to−Income Ratio 140
0
40
0 0
Workers‘ Consumption
30
60
level in %
10
20
80
15
0 0
10
Investors‘ Loans
% deviation
% deviation
% deviation
0
0
50
20 10
1
−1 0
Investors‘ Consumption
2
pp deviation
2 % deviation
% deviation
Bargaining Power 0
0
10
20
30
40
50
10
20
30
40
50
Crisis Probability 3 2 1 0
0
10
20
30
40
50
- Investors consume more. - Investors invest more in equity. - Investors make more loans.
Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Real Wage
−2
0
−4 −6 −8
Return to Capital
−2 −4 −6
0
10
20
30
40
50
10
20
30
40
0
Investors‘ Physical Investment
10
20
30
40
5
50
level in %
% deviation
−2 −4 −6 0
10
20
30
40
50
10
20
30
40
20
50
120 100 80 60
50
40
0
Workers‘ Debt−to−Income Ratio 140
0
40
0 0
Workers‘ Consumption
30
60
level in %
10
20
80
15
0 0
10
Investors‘ Loans
% deviation
% deviation
% deviation
0
0
50
20 10
1
−1 0
Investors‘ Consumption
2
pp deviation
2 % deviation
% deviation
Bargaining Power 0
0
10
20
30
40
50
10
20
30
40
50
Crisis Probability 3 2 1 0
0
10
20
30
40
50
Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Real Wage
−2
0
−4 −6 −8
Return to Capital
−2 −4 −6
0
10
20
30
40
50
10
20
30
40
0
Investors‘ Physical Investment
40
−4 −6 20
30
40
50
10
20
30
40
40 20
50
120 100 80 60
40
60
0
Workers‘ Debt−to−Income Ratio 140 level in %
% deviation
−2
30
0 0
0
10
5
50
Workers‘ Consumption
0
10
level in %
30
20
80
15
0 20
10
0
10
20
30
40
50
50
Investors‘ Loans
% deviation
% deviation
% deviation
Workers 0 reduce 0 10 consumption.
0
50
20 10
1
−1 0
Investors‘ Consumption
2
pp deviation
2 % deviation
% deviation
Bargaining Power 0
10
20
30
40
Crisis Probability 3 2
- Workers' leverage increases. - This 50 increases the probability of crises.
1 0
0
10
20
30
40
50
An Improved Scenario: Orderly Debt Restructuring
pp deviation
% deviation
% deviation
• Highly persistent decrease in workers’ bargaining power, as before. • Financial crisis in year 30, but real crisis is mostly avoided. Real wage Bargaining Power Real Wage Return to Capital collapse at 0 2 crisis time is 2 0 −2 now very much 1 −2 −4 smaller. −4 0 −6 −8
−6 0
10
20
30
40
50
−1 0
Investors‘ Consumption
10
20
30
40
50
0
Investors‘ Physical Investment
10
20
30
40
50
Investors‘ Loans 100
% deviation
10 5 0
5
50
0 0
10
20
30
40
50
level in %
−4 0
10
20
30
40
50
10
20
30
40
50
0
Workers‘ Debt−to−Income Ratio 140
0 −2
0 0
Workers‘ Consumption % deviation
10
120
level in %
% deviation
15
% deviation
15
20
100 80 60
0
10
20
30
40
50
10
20
30
40
Crisis Probability 3 2 1 0
0
10
20
30
40
50
The drop in leverage at crisis time is therefore much more substantial.
But immediately afterwards leverage starts rising 50 again.
A Much More Sustainable Scenario: Restoration of Workers’ Bargaining Power
Investors‘ Consumption
Investors‘ Physical Investment
20
Investors‘ Loans
15
10 0
80
% deviation
% deviation
% deviation
pp deviation
% deviation
% deviation
• Highly persistent decrease in workers’ bargaining power, as before. • But in year 30 workers’ bargaining power is restored to its original level. • Financial and real crisis is thereby avoided. Recovery in Bargaining Power Real Wage Return to Capital 4 0 real wage 2 2 −2 gives workers 1 0 −4 −2 0 the means to −6 −4 −1 service their −6 −8 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 debts. 10 5
60 40 20
0 10
20
30
40
50
0
−4 0
10
20
30
40
50
10
20
30
40
50
0
Workers‘ Debt−to−Income Ratio 140 level in %
% deviation
Workers‘ Consumption
−2
0 0
120
level in %
0
100 80 60
0
10
20
30
40
50
10
20
30
40
Crisis Probability 3
Leverage therefore goes on a sustained 50 downward path.
2 1 0
0
10
20
30
40
50
Leverage Comparison Across Scenarios • Orderly debt restructuring can help in the short run, but with inequality unchanged debt starts to trend up again. • Restoration of workers’ bargaining power puts leverage on a sustained downward trend. 140
level in %
120
100
80 Baseline Orderly Debt Restructuring Restoration of Workers‘ Bargaining Power 60
0
10
20
30
40
50
• Discussion: How Can This Policy Be Implemented? 1. Higher Pre-Tax Wages through Higher Bargaining Power: — Strengthening collective bargaining rights? — Difficulties: Wage competition from China and other countries. — Payoffs: Avoiding further crises. 2. Higher After-Tax Wages through Lower Taxes: — Switch from labor income taxes to other taxes? — Difficulties: Higher capital income taxes would drive investment elsewhere. — Ways Out? Taxes on rents (land, natural resources, financial sector).
5
Summary • Empirical Link in 1929 and 2007: Higher income inequality ⇒ higher leverage ⇒ large crises. • Theoretical Model: — Key shock: Decrease in workers’ bargaining powers over incomes = smaller “share of the pie”. — Key mechanism: Recycling of investors’ income gains back to workers as loans. • Conclusion: — Only an improvement of workers’ bargaining power leads to a sustained reduction in crisis probability. — Solutions to financial fragility that leave bargaining power (or alternatively taxation) untouched run into the problem that investors’s surplus funds will keep pushing loans and therefore crisis probability higher.
6
Is Government Debt a Separate Issue? • Not really. • A significant share of government debt has just been another (indirect) way for the lower and middle classes to borrow from the top income group. • Much spending was on governmental programs that went to the majority, while much of the resulting debt is held by the top income group. • In other words, problems of high government debt have an important income distribution dimension. • Major exception: Government debt held by foreigners.
Financial Asset Shares of the Top 5% Income Group 90
Direct Bond Holdings Share (in %)
90
70
85
85
80
Mutual Funds Holdings Share (in %)
Retirement Accounts Share (in %)
70
42
65
65
40
40
80
60
60
38
38
75
75
55
55
70
70
50
50
36
36
65
65
45
45
34
34
60
40
40
32
60
1990
1995
2000
2005
1990
1995
2000
2005
1990
1995
2000
2005
42
32
2
7
How About Foreign Debt? • Empirical regularities for major economies: — More inequality almost always accompanied by CA deterioration. — Major exception: China. • Explanation in general: — Workers borrow from both domestic and foreign investors. — Capital account surplus implies current account deficit. • Explanations for China: Chinese workers face borrowing constraints, so Chinese investors deploy their savings overseas.
Change in Income Share of Top 5% (x-axis) and Change in CA Balance (y-axis) 12
10 Switzerland 8
6 Sweden 4
Netherlands Japan France
Canada Italy
2 Germany 0 -2.00
0.00 -2
-4
2.00
Spain 4.00
6.00 Australia
8.00
10.00
12.00
New Zealand United LKingdom United States Portugal
-6 R² = 0.6321 -8
14.00