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Is inequality the root cause of global crisis? The World Bank's lead research economist thinks so

August 22, 2011
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Back from my week off (Edinburgh Festival – fab) with a load of holiday reading to review. Here’s the first installment – an eccentric new book by Branko Milanovic, inequality guru and lead economist at the World Bank’s research division. The Haves and the Have Nots: A Colin FirthBrief and Idiosyncratic History of Global Inequality is aimed at people who love playing around with data.

In fact, it makes a perfect toilet book for geeks, an intriguing scattergun collection of ‘vignettes’ covering everything from wealth inequality in Pride and Prejudice (yep, that Pride and Prejudice – the Jane Austen/Colin Firth, puffy shirt one – see left) to a comparison between ancient Romans and today’s super rich (turns out that Carnegie, Rockefeller and Bill Gates are/were a lot richer than fabulously rich Roman Marcus Crassus).

Anyway, the book is so gloriously random and weird, that I am not going to try and review it. Instead, here’s an excerpt that caught my eye – a ‘vignette’ that argues that income inequality caused the global financial crisis.

Here’s how the reasoning goes:

‘In the US, the top 1% of the population doubled its share in national income from around 8% int he mid-1970s to almost 16% in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1% share reached its previous high-water mark. American inequality over the past 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 30 years.

What did the increase mean? Such enormous wealth could not be used for consumption only. There is a limit to the number of Dom milanovic picPerignons and Armani suits one can drink or wear.. So a huge pool of available financial capital – the product of increased inequality – went in search of profitable opportunities in which to invest.’

So the rich hand over their vast piles of spare cash to the financial sector and tell them to invest it well.

‘Overwhelmed with such an amount of funds, the financial sector became more and more reckless, throwing money at anyone who would take it.’

‘The second part of the equation explains who borrowed that money. There again we go back to the rising inequality. The increased wealth at the top was combined with an absence of real economic growth in the middle. The real median wage in the US has been stagnant for 25 years, despite an almost doubling in GDP per capita. Middle-class income stagnation became a recurrent theme in American political life, and an insoluble political problem for both Democrats and Republicans.’

Since they could not increase their wages, they helped them accumulate household debt.

‘Thus was born the great American consumption binge that saw the household debt increase from 48% of GDP in the early 1980s to 100% of GDP before the crisis’ Result? ‘The interests of several large groups of people became closely aligned. High-net-worth individuals and the financial sector were keen to find new lending opportunities. Politicians were eager to ‘solve’ the irritable problem of middle-class income stagnation. The middle class and those poorer than them were happy to see their tight budget constraints removed as if by a magic wand, consume all the fine things purchased by the rich, and partake in the longest US economic expansion since World War II.’

Milanovic book coverConclusion: ‘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 that generated much larger investable funds than could be profitably employed….. in a democratic system, an excessively unequal model of development cannot exist with political stability.’

The IMF has also previously linked inequality and financial crisis, but not as comprehensively as this. Wonder if it’s true?

8 comments

  1. Here is another possible contributory factor to the financial crisis: the assumption among many economists that income measures prosperity without looking at debt.

    The following are from my submission to the current House of Lords Economic Affairs Committee inquiry into development aid:

    “The financial crisis in rich countries showed inferences from economic activity to wealth creation to be irresponsible. Those inferences led economists to overlook the fact that a large proportion of spending was funded by rising debt, not rising wealth.”

    “Where are the academics who point out that the distribution of income does not tell us what people got in return, or whether it was enough to meet needs, or associated with changes in asset or debt levels? If economists had been concerned enough about such problems then perhaps the financial crisis would have not occurred in the same way, and perhaps the objective Millennium Goal indicators would be doing better.”

    http://www.mattberkley.com/MattBerkleytoEconaffairscttee.doc

  2. I have to think a bit about whether the inequality label really gets to the issue here.
    The reason: It reminds me of late 1970s petrodollars which let to the debt crisis for developing countries, which leads me to question if it is inequality as such that is the key problem.
    ???

  3. Yes of course it’s true. Same as the findings of the Spirit Level -almost so obvious that we wonder why it needs to be analysed and justified. But then we realise that the implications are actually so profound and so challenging that most economists and policy makers smply can’t allow themselves to believe it. And we are back to where we started, trying to argue our case in ways that don’t challenge those with money and power and thus doesn’t threaten our funding or access…

  4. Hi Duncan,
    Thanks for another helpful book review which always brings about the conflicting response in me of – ‘oh, I should really read that book’, and ‘thanks, Duncan, I don’t need to’.

    For more on the US and ‘2008 ‘n all that’, and if you are a fan of graphic novels, you should definitely check out “the Adventures of Unemployed Man” – brilliantly drawn and scripted: http://www.unemployedman.com/

    Perhaps we should commission a series based on ‘Development Man’…(who would necessarily be white, male, Northern’, university-educated…)?

  5. I’m feeling like inequity could be a better word that inequality in this context. It is an unjust balance of asset holding that is the problem and inequity has a rather nice resonance to both fairness and assets.

  6. Interestingly, there’s a *sort-of* implicit parallel in Alan Greenspan’s argument about the financial crisis being caused by “excess global savings”, principally in China, used to buy up US Treasury bills and therefore keep interest rates artificially low, fuelling the US housing bubble despite the best efforts of central bankers like him etc. etc.

    Underneath this argument is the idea that in more democratic and equitable polities than China, the extraordinary fruits of China’s export boom would have been redistributed more through funding infrastructure, public goods, civil service salaries…but instead, in Greenspan’s reading, Beijing despots just piled it all into buying T-bills.

    It’s an easy and lazy argument for laissez-faire central bankers like Greenspan (who’s never been a big fan of wealth redistribution) to explain their own failure. But taken together with Milanovic’s argument about US inequality, maybe there’s something in the idea that domestic redistribution (not necessarily the same as reducing inequality, of course) could have acted as some kind of moderator on global imbalances caused by turbo-economies on both sides of the Pacific?

  7. The description of how inequality caused he financial crisis really does come from IMF researchers Michael Kumhof and Romain Rancière who have described it in some detail. See http://www.imf.org/external/pubs/ft/fandd/2010/12/Kumhof.htm for their magazine article “Leveraging Inequality” and http://www.imf.org/external/pubs/cat/longres.cfm?sk=24378.0 for their research paper “Inequality, Leverage and Crises”. Interestingly, they see the best way out as being to increase the bargaining power of workers.

  8. “The real cause of the crisis lies in huge inequalities in income distribution..” – But you can go deeper few more steps to identify that the root cause of this inequality is money. In reality the root cause of all problems is always money.

    Observe that money is not an object of nature, therefore money must be false, free, and abundant at its source, which is the central bank. Since money is free, it can be manipulated, and secretly, as Keynes said to create recessions, which in turn can cause large scale wealth transfer from people to the top 1%. It must also be realized at the same time, that since money is false, money cannot be necessary to run an economy. Thus the solution to all problems is also obvious: – remove money and create money-less economy (MLE).

    MLE can be implemented very easily: I go to my local grocery store and buy my regular things for free, since there is no money. Similarly, I go to my work place and work full time for free. Thus we all work free and get everything for free. The computer networking technology that we have now will help us very smoothly to resolve the rest of all problems. Take a look at the MLE chapter in the blog site at https://theoryofsouls.wordpress.com/

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