Tuesday, March 22, 2011

Branko Milanovic on Inequality and the Global Crisis

In Inequality and the Global Crisis, Branko Milanovic makes a case that the global financial crisis arose out of the hoard of savings at the top resulting from fiscal policy that reduced taxes at the top, rather than from the Ponzi finance now recognized as the proximate cause.

Milanovic observes:

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.

While the wealthy account for about 40% of consumption, there is a limit to how much the wealthy can consume. The rest is saved. Those who are sophisticated about money know that they cannot compound their savings through their own efforts as well as they can by hiring others to do for them. This generated a demand for above average returns from a bevy of financial professionals. Soon the better opportunities were identified and bid up, leaving a still large pot looking for spaces to occupy. The obvious solution for financial professionals was to "innovate" and create opportunities that did not yet exist.

One avenue would be to invest the funds in new ventures, but that is risky and good primary investments are limited. Clients were looking for regular performance that could be measured period over period. This meant generating credit instruments, such as securitization and other derivatives. This push to innovate in the financial sector lead to financialization.

Financialization exhausted normal channels, so financiers looked for new ways to expand credit. This led to extending credit to poorer and poorer risks as firms reached down into the pool of prospective borrowers. Competition resulted in a race to the bottom. As result credit quantity increased substantially, while credit quality decreased markedly.

Another problem was that real wages were not keeping up with productivity gains. The top was getting richer while the middle was stagnating and the bottom was losing ground, as welfare was cut. In MMT terms, demand leakage was not being offset by sufficiently large deficits, so either incomes had to increase or the economy had to contract, unless net exports increased, or the private sector increased indebtedness. What actually happened was that deficits were too low to offset the increase in net imports, which provided cheaper prices and tamed inflation, along with the increased saving taking place at the top. Worker incomes were held in check by neoliberal policy, e.g., weakening of labor and global labor arbitrage. Lax credit standards and competition for loans led to increasing private debt accumulating at the margin. The result is shown in the rising indebtedness at the middle and bottom that culminated at the cresting of the wave.

So "the first part of the equation" was the gathering of wealth at the top looking for a place to park at an attractive return, and "the second part of the equation" was the predicament of the middle and lower classes, who were not participating proportionately in economic growth. Moreover, they were becoming increasing indebted to maintain their standard of living, or even increasing lifestyle due to easy credit. Eventually, the level of private debt became unsustainable and finally imploded, drying up liquidity and plunging the world into a financial crisis from which it is still trying to recover as the middle class continues to deleverage.

Milanovic concludes:

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.


googleheim said...

how do you differentiate deficits from private debts ?

could the tax system have distributed income in a better manner ? ie small biz wage tax holiday plus more credits to middle and lower enders /

this reflects krugman including USD savings hoarding by China and OPEC

mike norman said...

Good points from Milanovic. The same thing continues today and we see it manifesting in the commodity markets. It's bad enough that income inequality continues to grow under these policies, but now people will starve and freeze to death, too?

Matt Franko said...

Goog, Yes the external sector 'leakage' as Tom calls it has been an increasing factor over this time frame also.

First Japan and then China, both zealous to acquire USD NFAs in the form of Treasury Bonds.

Tom, The interest rate policy backdrop has also been perfect for this type of a progression. As rates have fallen from 20%ish (Volcker) down to now zero under Bernanke. This allows for repeated refinancings and re-leveraging over the 30 year period....


Tom Hickey said...

could the tax system have distributed income in a better manner ?

Absolutely. Since Laffer's Reaganomics, which reversed conservative fiscal conservatism (remember Poppy Bush calling it "voodoo economics"), the neoliberal program has been to encourage deficits from broad tax cuts that primarily favor the wealthy and to increase military spending, while cutting spending on social programs. This funneled money to the top. This agenda is still in place in the GOP Establishment. Look at what the GOP governors are doing, for instance, and what Rep. Ryan is proposing. BTW, this goes against the Tea Party rationale, which is traditionally fiscally conservative, i.e., balanced budget and surplus even better.

I intend to do a post on this, expanding on Milanovic's observation and showing the rationale behind the "global savings glut" (Greenspan) that led to financialization.

Tom Hickey said...

how do you differentiate deficits from private debts ?

This shows up in aggregate in the basic macro equations that MMT uses wrt sectoral balances. Basically, the fiscal deficit is equal to the leakage to private domestic savings and the CAD. If the fiscal deficit is too small to offset the private desire to save and the CAD, then either economy contracts or the private sector becomes more indebted in aggregate. The CAD and private desire to save at the top was not met with a large enough deficit, meaning that the middle and bottom had to go into debt or cut consumption. With easy credit, the incentive was to go into debt.

Tom Hickey said...

could the tax system have distributed income in a better manner ? ie small biz wage tax holiday plus more credits to middle and lower enders

The payroll tax is very regressive. Add that to a favorable tax policy for the top, and the tax regime becomes unbalanced.

Tom Hickey said...

this reflects krugman including USD savings hoarding by China and OPEC

Milanovic's observation is that the problem is international. especially since finance is now cross-border. That's why we call it the "Global Financial Crisis."

Mario said...

fascinating stuff. things really tie together don't they. It's amazing more economists haven't seen this stuff or at least aren't getting aired.

Tom you're doing a great job getting these guys' thoughts out here for us all.

Thanks again.

My only contention is that last paragraph as it is highly speculative. I don't know but it seems like the people I knew probably would have gone into debt more and more anyway if it was offered to them...granted it may not have been offered if the increased savings desire wasn't there. Regardless it's all speculative.

Red Rock said...

Pure speculation. Savings is not evil and the middle class, just like the rich will try and maximize their investment return