A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Sunday, February 27, 2011

Transcript: Double, double, oil and bubble, Economies burn, prices' trouble

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“In my view, we’ve got plenty of oil, we’ve got plenty of gasoline, we’ve got plenty of diesel fuel, but if the global oil market stays above $100, and now with the situation of Lybia, which is quites serious, we stay there for quite some time, unfortunately.

“Refining capacity? We have too much. That means we have too much oil, ah, with too much refining capacity, and this is why Sunoco had to last year close down a refinery in my market area, Philadelphia. We had a big refinery in Montreal close. We had another big refinery in Delaware close. All on the East Cost. So here you have the situation: we have too much oil, we have too much refinery capacity to manufacture that oil, and yet, ah, it, ah, I mean, it it’s just amazing, the absolute disconnect and I’ll bet you, if we didn’t have such an active speculator, you have to really wonder if it would really be this distorted.

“I mean you would have on a micro level …, it kind of brings home just how precarious the whole situation is. So gasoline prices, this is going to be probably the ugliest summer since the oil bubble of 2008.”
Today on the podcast, Oil and energy, the absence of relevance in the economic debate these days, and another black swan event, the third in a month, when the Fed and Demand Side actually agree on something. Today we actually agree with Thomas Hoenig.

We led with leading oil analyst Stephen Shork of the Shork Report in an interview, highly edited, from Bloomberg. We had it cued up to display our call of a continuing and growing bubble in oil, not connected to supply and demand. We were favored by a timely note from one of our listeners, Jim, who linked us to the explanation of how futures prices determine physical oil prices.

Paul Krugman, among others, has argued that because futures speculators never take delivery of oil, their activity cannot be connected to the spot price of oil. Perhaps that’s too simplistic. See the link online for the full discussion.


In it, we find that the spot market has become very thin and susceptible to getting cornered with a technique called the “squeeze,” so producers have come to rely on the much deeper and more liquid futures markets. The futures market is the heart of the current oil-pricing regime.

Quoting JD,

“… Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren't a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price literally *is* the price of oil.”
So speculation in futures markets, so kindly assisted by the Fed, does drive up prices. We knew it had to be the case, just from the fact that these markets are much larger and weirder than would be required for legitimate hedging by legitimate business, and there are plenty of anecdotes about people who need them getting priced out, but we thank listener Jim for the tip on the mechanics.

Oil prices are important. One of the worst market tips I ever gave, and one that led me to be very wary of making any more, was that all energy prices are led by oil prices. When oil goes up, natural gas and electricity are sure to follow. That was right before the disconnect between natural gas and oil. So oil no longer leads all energy, but it is still important.

It comprises upward of four percent of household spending. Demand elasticity is low, so when the price goes up, it sucks spending power from other activities and puts a big pinch on the discretionary spending. This means oil prices usually march with consumer sentiment.

More problematic is oil’s influence on perceived inflation. While there is a core CPI which strips out oil prices from the consumer’s basket, it is still true that energy and oil are embedded in all goods and many services, anything that energy to produce or transport. Because this cost is a weak contributor to income of labor, it is a virtual tax. I say virtual, because it corresponds more closely to the reactionary view of taxes: a black hole. With actual taxes, you actually get actual public goods.

Another way to see this is energy as a competitor to labor. Everything is made of labor and energy, primarily. When the price of energy goes up, and prices need to stay the same, the price of labor goes down. Since the price of labor is income, and the major source of demand, when the price of energy goes up, demand tends to be displaced.

So it is a cruel irony that often in the past, the Fed has leapt in at the first sign of energy price, cost-push inflation and attempted to slow the economy. The economy was already being slowed!


The Demand Side View

Does anybody really doubt the following facts:

The Great Recession began with a housing bubble fueled by zero interest rates from the Fed, predatory lending and financial innovation and predation in the financial sector.

The Great Financial Crisis resulted from overleverage by the banking sector and the shadow banking sector.

The central banks of the Western industrial economies kept the financial system from imploding by bailing out the big banks. The Fed and others support and keep solvent almost every financial market with guarantees, low rates and too big to fail insurance.

Unemployment is stalled at a very high level.

The housing market is moribund, prices are still falling, a massive foreclosure epidemic is visiting nearly every community, and households have seen the value of their major investments eviscerated.

Investment and hiring by small business is also stalled at a very low level.

If you doubt any of these facts, please turn off the podcast, visit the appropriate data sites, and return when you have confirmed that we are not making this up.


So, then, Why is the answer to our mess to cut government, neuter unions, roll back entitlements, and cut taxes for the rich?

In what way has the federal debt or state spending on education and social services contributed to the problem?

Has any one of those contributed to the situation in which we find ourselves?

No. None of these matter. Nor does pent-up inflation, immigration pressure, Obamacare, or any of the other bogeymen concocted by charlatans for their political effect. These are just bogeymen at the window that disappear whenever you look at them directly.

On the other hand, they do matter quite a bit, just because they dominate public discourse and apparently prevent people from looking out that window. And because we are talking about the wrong thing, we are going the wrong direction.

Because if we don’t fix the problem, but fix something that is not the problem, we will have two problems and we will have lost the time and effort and money we had to do something about the first problem. The foundation sank, damaging the structural integrity of the house, so we dug a hole in the front yard and removed the roof.

This is exactly what we have done.

The federal deficit is a product of the free rider tax avoiders on one hand, but it is also a symptom of the Great Recession. How can we have a deficit this big in the midst of a recovery. One, we cut taxes for the rich and prosecuted two foreign wars. Two, we can’t. We have this big of a deficit because we are not in recovery.

New lows in house prices and home sales do not mean a healthy housing market is around the corner. They mean that what we have done so far has not worked.

Big incomes on Wall Street do not mean there is a thriving credit market, nor healthy growth in personal, corporate or public pension plans. It means incentives are still screwed up and the Street is bleeding the real economy dry.

High unemployment does not mean the cash on corporate balance sheets is worth it. It means profits are not connected to US economic well-being. What is good for our corporate oligarchy is NOT good for our economy. Insofar, that is, as that economy has anything to do with people.

ZIRP – Zero Interest Rate Policy – does not mean money is growing or investments are being made. It certainly does not mean employment is increasing.

As former Labor Secretary and author of Supercapitalism, Robert Reich said this week:

“as long as Democrats refuse to talk about the almost unprecedented buildup of income, wealth, and power at the top – and the refusal of the super-rich to pay their fair share of the nation’s bills – Republicans will convince people it’s all about government and unions.”
There is a second set of facts which we would like to propose for your consideration. We’re willing to debate them at any length, but your guests might get bored.

One. Low tax rates killed employment growth. George W. came to Washington, elected by the black vote, Clarence Thomas. He had campaigned on the theme “Cut taxes, after all it’s your money.” But it took a recession to convince enough Democrats to vote in the first tax cut in 2001 and another in 2003. The Fed under Greenspan simultaneously brought the interest rate down to one percent – historically unprecedented. Deficits ballooned when wars in Iraq and Afghanistan were prosecuted on credit. High deficits, low interest rates, falling taxes. What followed? A decade of zero growth in jobs. Had he stayed in office since months longer, W would have been the only president in a century to preside over negative job growth. As it is, he easily beats out his father for worst all-time job producer among US presidents. His economic policy again: cut taxes, cut regulation, sic Greenspan on interest rates.

Everyone agrees with the evidence, but only Demand Side, it seems, is willing to pronounce the verdict. Tax cuts, low interest and coddling the financial sector produced unemployment and stagnation. NOT “accompanied unemployment and stagnation” caused by something else. The results were Y. The policy was X. X led to Y. Bad policy led to bad results.

The counter to this argument is – I did you not – something along the lines of “The disease was worse than we thought, so we need to do more of the same. Give banks more. Cut interest rates further, if we only could. And whatever happens, keep cutting those taxes. A fully funded government might work in Sweden or Germany, but it can’t work here. After all, it’s OUR kids money.”

And that counter is carrying the day.


Let’s end with another in our segment, The Fed Agrees with Us Exclamation Point.

First it was Elizabeth Duke agreeing that money is not created the way the Fed has always said. Then it was Dennis Lockhart saying inflation is a general phenomenon, not a rise in a specific or even a category of prices. Now it is Thomas Hoenig, of the Kansas City Fed, quoting.

“Fifteen years ago, I gave a speech entitled “Rethinking Financial Regulation,” which summarized the major threats facing our financial system. My suggestion then was to take steps to reduce interdependencies among large institutions and to limit them to relatively safe activities if they chose to provide essential banking and payments services and be protected by the federal safety net. I also argued that safety net protection and public assistance should not be extended to large organizations extensively engaged in nontraditional and high-risk activities. A final point of those remarks was that central banks must pursue policies that preserve financial stability. I am going to repeat those suggestions today, and as often as the opportunity allows. History is on my side.

“Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis.”
Thomas Hoenig.

Indeed, there are no economies of scale in banking. There are actually significant drawbacks to depersonalizing a personal business and creating complexity that cannot be unwound. The only economies of scale are that if you are large enough you can capture your regulator, in this case the Fed, and the representatives of the citizenry, in this case the Congress and President.

Thursday, February 24, 2011

Transcript: 427 BRIC's falling, North Africa rising -- Made at the Fed?

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Westpac’s James Shugg

Today on the podcast, commodity prices, food prices, global unrest, domestic shots from David Rosenberg and James K. Galbraith, and back to the emerging BRIC’s.

There is a distinction we have been trying to draw over the past few months here at Demadn Side. The commodity bubble now unfolding is a prominent element of our 2011 forecast. We wholeheartedly agree that it is the Fed’s actions that is causing this rise in prices. But we do not agree with the simplistic argument that it is more money chasing the same amount of goods that is creating food inflation, nor that booming demand from emerging markets is bidding up commodity prices. Our argument is quite different. The Fed’s cheap money is available to financial players both to create booms in emerging markets with the carry trade and to invest in the commodities themselves. Commodities are no longer products, they are an asset class. Diversifying into commodities is a strategy, just as it was in the great commodities bubble of 2008.

The proof of this is the fact that all commodity prices are going up together. When you have everything from alfalfa to zinc rising, it is a financial market event. Likewise we see that even as serious weakness begins to show in the BRIC’s – more about this later – the commodity prices continue upward.

The distinction is not a splitting of hairs. It is the difference between actually dropping money from helicopters and giving money to supposedly passive intermediaries. The Fed’s intention is to spur investment by making financing cheaper. But it is spurring speculation, instead, as investors shy from illiquid long-term real investment and pile into liquid, short-term and financial product investment. Hence bonds, stocks, and tradable commodity instruments are preferred to plant, equipment, or R&D. We see it instead as the Fed feeding chips to bankers and speculators who fuel bubbles with financial instruments now favoring emerging markets and commodity output.


So how much do food prices have to do with the outbreak of protest in the Middle East? We suggest it is a great deal, as it fuels a fundamental desperation in these nations. At a minimum, we know unrest is happening at the same time as food price spikes.

On the other hand, it is also happening at the same time is the realization that Barack Obama is not going to be the transformational figure many had hoped, and that policy is basically more of the same, only expressed with more finesse. And the population of the Arab world is young, educated, and without real prospects. In Egypt, and elsewhere, the economic policies of privatization so beloved by the IMF, and which failed so completely in Russia, were instituted in the middle of the decade. The result was the predictable disaster. Well-connected insiders took over state-run businesses for their own account. That is called corruption.
So the regimes of this area are ripe for revolution. As John Kenneth Galbraith said, and we repeat, “All successful revolutions are a kicking in of a rotten door.”

Still, we contend that the food price increases, and the energy price increases, are a product of monetary policy by the central bank of the United States. For three and a half years, the Fed has had its foot to the floorboard. There has been no forward movement for us, but the exhaust is choking our neighbors.
The real private economy, where money grows by investing in a system that is more efficient or provides a product that returns real value, there is no action. In the public economy, where even more gains can be made by investing in bridges, schools, public safety and health, even less is happening – choked off by reactionaries who take advantage of the fact that the returns cannot be captured for public viewing. But in the private financial economy, the Wall Street economy of financial speculation, no real value is produced. And as much as the Fed wants housing or real investment to be spurred by its easy money, it is not happening. Instead liquid financial instruments and short-term speculation have benefitted.

With respect to commodities, just as in 2008, commodities are deemed to be inflation-proof and sound, since after all, people have to survive. But that spending is a subtraction from other sectors. Your speculation may net you a dime, but unless you use that dime to purchase something else, there is a downward movement in real output. And you don’t spend that dime on something else. Your object is the money, the claims on future goods, or another liquid financial asset, not anything to do with real economy activity.
This is casino capitalism. A zero sum game. Many of the losers don’t even know they are playing. It is Wall Street economics.

The dominance of finance is unquestioned by the central bank and the current administration, who facilitate it with chips it uses in its games. But the causal chain is short. Asset and commodity bubbles raise prices for necessities. Desperation turns to the obvious near-at-hand repressive regimes.


Whenever we get glum about being the only doomsayer in the room, we open David Rosenberg’s daily newsletter and take heart. His is a market-driven analysis. Since we see financial markets as basically gaming operations, we are less frustrated than Rosenberg, who wants them to be more coherent and connected to the economy.

First out of the box was his remark on Gallup’s tracking of the U.S. unemployment rate, which puts it at 10.0 percent as of mid-February. This is up from 9.8% at the end of January. The underemployment rate spiked back to a 10-month high of 19.6% from 18.9%. “Nice recovery,” says Rosenberg.

Gallup’s numbers are not seasonally adjusted, but tend to anticipate the Bureau of Labor Statistics by about two weeks.

Rosenberg notes that the four-week moving average at 418k represents a jobs market backdrop that can only be described as pathetic for an economy halfway into year two of a
statistical expansion.

Then , in a segment he called the PHILLY FLYER, Rosenberg took a potshot at the economics media.


The Philly Fed index surged to 35.9 in February from 19.3 in January ― not to mention a massive swing from the -5.6 print last August when the economy seemed to be staring into the abyss. Most of the components were up, including the employment index but that has proven to be a poor indicator for nonfarm payrolls. But the problem was with the six-month outlook component, which really rolled over, sliding from 55.4 in December, to 49.8 in January, to 46.8 in February. Interestingly, hiring intentions sank to a three-month low of 24.4 from 31; and capex intentions plunged to 16.2 from 29 to stand at the lowest level in five months ― and this metric has a decent 75% historical correlation with capital spending from the GDP accounts. See if you find that anywhere in today’s morning papers.


Home prices hit post-bust lows in most big cities according to Case-Shiller. “Muddle through” housing policy did not work, is not working and will not work. Nevertheless, what has worked is the elimination of principle write-down as a means to recreate a healthy housing market. The model was set in the Great Depression with the Home Owners Loan Corporation. In the current crisis, the way was barred by the massive securitization that not only found the capital for the bubble but blocked by complexity this basic exit of renegotiation between borrower and lender. Rather than unpack the process for a front door fix, the Fed opted to buy up the bogus securities to keep their prices up. Well, securitization has dried up, so that didn’t work. The Fed has a trillion and a quarter dollars of them on its balance sheet and the previous owners have cash. That worked for some. Debt IS being reduced by foreclosure and bankruptcy. Policy makers have moved on to muddle through somewhere else. The key to this notation is that muddle through really means sink deeper.

Does anybody doubt that it was a huge credit bubble and enormous excesses in private residential real estate that are the proximate causes of the Great Financial Crisis? Why then is it sovereign debt and fiscal tightening by governments that is the solution?

There is a reason. Well, two. One, the leverage of insolvent financial players is migrating to governments where it can be criticized by the private side, and two, the real solution which involves letting the private financial players take their hit is not popular with them.

As succinct a summary as can be found was offered this week by James K. Galbraith


And finally today,

From Bloomberg

Stocks in developed countries are rising the most since 1998 while emerging markets slump, a sign the U.S. is returning to its role as the engine of world growth aided by a recovery in Europe.

The MSCI World Index of equities in 24 countries rose 6.1 percent for 2011 through yesterday, the best annual start in 13 years, and the MSCI Emerging Markets Index of shares in nations such as Brazil, Russia, India and China lost 2.7 percent.


While emerging-market equities beat developed countries every year except 2008 in the past decade, they’re falling now as Brazil, Russia, India and China battle inflation.

Econ Intersect phrases it this way.

“The question then becomes one of de-coupling again but under a different guise … than that usually depicted. If the most dynamic economies of the world – where final demand is increasing more rapidly than in North America, Japan and most of Europe – are being forced to tighten monetary policy to preserve purchasing power of their currencies, and to avoid the political and social fallout of higher food costs, then for how much longer is it safe for the USA, UK and Eurozone to maintain the confidence trick that ZIRP is not a hazardous policy which will eventually lead to troubling and ubiquitous global inflation?”
“There are several ETF’s that enable investors to have exposure to some key emerging markets and these include EWZ, which tracks the MSCI Brazil index; INP, which tracks the MSCI India Index; IDX, which tracks the MSCI Indonesian market; ILF, a fund which tracks the Top 40 Latin American equities, and which provides exposure to Brazil as well as Mexico. These are all relatively large and liquid exchange traded funds and there are also inverse funds for taking a short position with respect to BRIC and emerging markets in general.”
Happy Gaming

But again, it is Demand Side’s contention that the transmission of price hikes to commodities is not a consumer demand thing, but a “lever up in the U.S. and carry your trade to emerging markets” thing. To some extent emerging economies may have higher demand than they used to, but developed economies have lower demand. The question facing the BRIC’s is whether their capital controls will withstand the inevitable meltdown in their currencies.

Wednesday, February 16, 2011

Transcript: 426 Inequality, Inflation, Investment and Instability

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We begin with epidemiologists Richard Wilkinson and Kate Pickett

[Note, the podcast contains audio from Tom Ashbrook's On Point interview. The following is an exerpt from the book "The Spirit Level."]

Inequality: the enemy between us?

As if to overcome their reputation as practitioners of the ‘dismal science’, economists are now producing an economics of happiness. Ironically, what they find is that most of the determinants of happiness are beyond the grasp of the market. Happiness, rather than being determined primarily by income and possessions, is, at least in rich countries, more significantly affected by social relationships – by friendship, marriage, giving and volunteering.

And it’s not just happening in economics. Researchers across a range of academic disciplines are discovering how fundamentally social we are. Neurologists tell us how the pleasure centers in our brains light up when we co-operate with one another, and that feeling socially excluded activates the same areas of the brain as physical pain. Evolutionary psychologists have explained how reciprocal altruism developed. Epidemiologists have discovered that health is strongly protected by friendship and damaged by low social status – findings which are backed up by research on monkeys conducted by primatologists. And psychologists have shown that the kinds of stress which really get under our skin and elevate our stress hormones are those which contain a ‘social-evaluative threat’, such as threats to self-esteem or social status, in which others may judge our performance.


Egypt. Friday, February 11, 2011, a nonviolent mass demonstration removed the head of a corrupt police state. What will follow? Will it be Iran? Something worse? Or will it be Poland? Something better? We led with audio from two British epidemiologists. Not economists, who have done a statistical study across dozens of parameters and found that – however you get there – the more equal your society, the healthier it is in virtually every category. That is not such good news for the U.S., which has fallen into last place among developed economies on measures of income and wealth disparity. But it is great news for Egypt, if they can squeeze themselves into a democratic future. The first Mid-East state which achieves democracy and the rule of law will become the economic and commercial hub of the region. Egypt has that opportunity.

The Financial Crisis Inquiry Commission headed by Phil Angeledes released its report to general criticism, as we’ve already noted. The findings that, one, it could happen again, because (two) nothing is fixed were swallowed up in the current of news. Which causes us finally to abandon our hope for Barack Obama’s presidency. Fundamental change will not happen because the same people are in charge. Wall Street is calling the shots in the Capitol. The clarity of all the campaign rhetoric has stepped in the bog of the continuous campaign. There will be no solution with this regime in charge. Clear systemic and institutional problems need radical action. Not going to happen here. Demand Side blew the political call. We wasted this crisis. Now on to the next one.


A second Fed governor has stepped forward to echo a Demand Side point. A couple of weeks ago we quoted Elizabeth Duke suggesting money is not being created as our textbooks and the procedures manuals of the Fed say it is, implying the authorities we need to look up from their maps and watch the road, because that is not a bridge.

Now, Dennis Lockhart, president of the Atlanta Fed, in a February 8 speech to the Calhoun County Chamber of Commerce agrees that inflation is a general rise in prices, not specific price spikes.

Quoting and abridging that speech to the CCCofC
So what about inflation? … The retail price measures jumped at year end as the price of gasoline rose. But looking beyond the rise in gasoline prices, consumer price increases remained exceptionally modest.
Yet inflation anxiety is rising. There seems to be a disconnect between what the Fed is saying and what people are experiencing when they fill up their gas tanks or read about rising food prices around the world.
… we may be talking about different things. … the term "inflation" is misused in describing rising prices in narrow expenditure categories (for example, food inflation). Nonetheless, recent price news has encroached on the public consciousness with the effect that any price rise of an important consumption item is often taken as signaling inflation.
Inflation affects all prices. Inflation is not the rise of individual prices or the rise of categories of prices.
The Fed, like every other central bank, is powerless to prevent fluctuations in the cost of living and increases of individual prices. We do not produce oil. Nor do we grow food or provide health care. We cannot prevent the next oil shock, or drought, or a strike somewhere —events that cause prices of certain goods to rise and change your cost of living.
DS: Well, maybe. The Fed is certainly proving its powerlessness, since it is trying like hell to increase house prices by forcing down interest rates. The principle objects of this exercise, we think, is to support the value of loans it took onto its own balance sheet and to keep those still held by the banks from blowing holes in their balance sheets. On the other hand, stock markets, emerging economies and commodity futures have all seen price rises that must be laid at the door of the Fed.

Question: IF inflation were going to happen, why wouldn’t you financial geniuses lock in zero interest?

Bonus question: IF restrictive monetary and fiscal policy cuts inflation and spurs growth, explain the U.K.

Former U.S. Treasury Department undersecretary John Taylor has called for overhauling the Federal Reserve’s dual mandate of ensuring stable prices and maximum employment, saying that the central bank should focus on prices.
“It would be better for economic growth and job creation if the Fed focused on the goal of “long run price stability within a clear framework of economic stability,’” Taylor told the House Financial Services Committee. ...

Taylor said that “too many goals blur responsibility and accountability.” ...
Two is too many, says Taylor. Never mind that one is also too many when the Fed has no clue. Or that the Great Moderation of price stability that the Fed congratulated itself for ad nauseum was the curtain hiding a great explosion of debt. Well, housing is not counted when they count prices.

To the credit of Ben Bernanke and others at the Fed, they are resisting the inflation hawks who – only marginally muted by years of below target inflation -- are seizing on the latest commodity bubble as proof of their hysterical imaginings. Bernanke is focusing on core inflation. Core inflation excludes energy and food, hence many commodities. So far, so good. But what does that leave for core inflation to include? Labor. So we see core inflation stagnating and, yes, labor income is stagnating.

But what will happen if core inflation ticks up, as it must do when investment returns? Bernanke will no doubt put the screws to the economy. At least that is the Demand Side prediction. We note that we predicted this the last time, too, in early 2008. But the economic collapse occurred prior to core inflation ticking up. The same thing might happen again.


Nowhere is the absence of real change in the Wall Street Culture more evident than in Goldman Sach’s $2 billion deal for Facebook, announced last month, which valued the social networking site at $50 billion.
As Martin Hutchinson from Prudent Bear said at the time, this
combines the worst elements of the 1997-2000 and 2004-07 bubbles. It sets a grossly excessive valuation on an Internet company with modest revenues and prospects. It also involves an investment bank structuring a complex deal to maximize its own fees, while driving a truck through two major elements of financial services regulation. Add a third element, that it places a company controlling personal information on 500 million users in close business partnership with a Russian billionaire with a criminal record and you can see the deal is truly groundbreaking. It should also raise important red flags about current market conditions.

Cheap money always does this; it feeds the worst instincts of the Wall Street crowd. When prolonged for almost 16 years, as currently, it cements the Wall Street speculative worldview into revealed truth, against which no contradiction can stand. The opposing approach, of sound investment only in projects that make economic sense, appears quaint and outdated, like Republicanism in the late 1940s or Marxism in the 1990s. After all, in a period in which leverage and speculation have proved generally profitable for 16 years, who’s to say that they may not indeed be the appropriate way to finance economic expansion? A bubble that lasts for almost two decades becomes increasingly difficult to distinguish from reality, because skeptics have been marginalized and battered for so long.

Like all bubbles, this one will end. What’s more, it will end fairly quickly because there is a limited remaining supply of rocket fuel to give it impetus. Commodity prices have now risen to levels mostly above the peak of the 2008 boom, and in doing so have fueled inflationary and contractionary forces that will destabilize the U.S. economy within a matter of months. No doubt Wall Street, the Fed and the politicians will use every artifice to prolong the mania, but it may not be prolongable. Nobody wanted the housing bubble to burst in 2007, or Lehman Brothers to fail in 2008, but market forces eventually proved too powerful for the optimists. Similarly in this case, the market will prove too strong for those attempting to keep the bubble inflated. By the end of this year, the bubble’s contradictions will already be fully apparent, although judging by past experience it may be late 2012 before catastrophe finally hits.

One can only hope that, unlike in 2008, the response of the political class will not be to try and re-re-inflate the bubble by any means possible. It is long past time for sound monetary policy, for sound fiscal management and for investment driven by solid value rather than by speculative excess.
Martin Hutchinson

Who goes on to recommend a regime where liquidity is eye-wateringly expensive. Such a regime would wring the excesses out of the system. Demand Side says it is too late for that. The excesses are so large and dangerous that they have to be cut out. Public goods, equality, debt reduction, healthy Main Streets are the only hope.
Also at Prudent Bear. Doug Noland joins Demand Side in remarking on similarities between this year and the GFC year 2008. Noland focusing on financial markets. Quoting,

The first few weeks of 2011 have me recalling early-2008. It’s as if someone reached over, flicked a switch and changed market dynamics. Abruptly, last year’s outperformers have come under heavy selling pressure, while the underperformers have in many cases caught strong bids. Things are unsettled and there are divergences. And I’m not just talking U.S. equities.

The dollar index jumped 2.5% the first week of the year, sank 2.3% the second week and declined a further 1.3% this past week. Reminiscent of currency market volatility back in January 2008, the euro has gained 1.8% y-t-d against the dollar, this despite a 3.5% decline the first week of the year. …
Players began 2008 out of synch, with trading conditions across various asset classes turning challenging - and progressively frustrating. Almost overnight, uncertainty seemed to take root throughout equities, fixed-income, currency and commodities markets. Breathtaking moves and abrupt market reversals began to subtly take their toll. Things that had worked quit working. An increasingly uncomfortable crowd of speculators saw their various long exposures lag and their shorts outperform.

And it wasn’t all that long before losses began to mount and defensiveness became the order of the day – with inflated markets hanging in the balance. De-risking and de-leveraging then fueled atypically high correlations amongst various markets, causing considerable angst for the leveraged players and others dependent upon "quant" models. The “wrecking ball” of high volatility and highly-synchronized global risk markets began working against systemic stability. This dynamic fed - and was being fed by - the concurrent rapid slowing of mortgage Credit. Instability took on a life of its own, as markets dependent upon abundant liquidity and speculation began to suffer withdrawals.

There have been various recent reports suggesting that hedge fund assets and leverage have returned to near pre-crisis levels. Record industry assets seem reasonable to me; near record leverage does not. A major increase in speculative leverage is not apparent from ongoing stagnation in Wall Street balance sheets, bank Credit, and reported “repo” positions. There is, at the same time, the huge unknown of “carry trade” leverage embedded throughout global currency and fixed-income markets. And while I doubt the leveraged players are today the marginal source of marketplace liquidity to the extent they were in 2008, they are surely a major force to be reckoned with.

With parallels to 2008, the success or failure of the leveraged players takes on additional prominence now that there are cracks in the global government finance Bubble. On the margin, global yields continue to have an upward bias.

I have argued [says Noland] that the Fed’s “activist” policymaking from the second-half of 2007 actually exacerbated systemic fragilities and contributed directly to the severity of the 2008 crisis. The overabundance of liquidity, coupled with the perception that policymaking would restrain the unfolding debt crisis, proved destabilizing and, inevitably, devastating. They fostered intense speculative excess, inflated market prices, unsustainable financial flows, and Bubble Dynamics. Myriad booms were fun while they lasted, although the heavy costs included heightened uncertainty and fragilities. Last year’s discussion and then implementation of “QE2” has had similar effects.

Marketplace liquidity can be steadfast or fickle. Market confidence varies between incredibly resilient to stunningly fleeting. To be sure, crises of confidence are difficult to predict. But one can monitor and gauge the forces that create susceptibility to abrupt shifts in market sentiment and altered trading conditions. Policymaker responses to structural problems (i.e. zero rates, massive monetization, federal stimulus and “Build America Bonds”) created distortions in risk perceptions and the flow of finance to the muni sector, while in the process delaying needed structural reform. The muni debt issue was allowed to fester; financial market distortions worsened.

For now, QE2 reliably generates additional liquidity for the liquidity-dependant markets. Somewhat ironically – yet altogether Bubble-like - rising bond yields and unfolding problems in municipal finance have bolstered flows into equities. And on the back of ongoing federal spending excess, economic prospects look ok and earnings appear swell. Yet recent developments do beckon for heightened diligence when it comes to monitoring for fissures developing below the surface of our fragile financial system. At least from my perspective, one can now discern unsettling parallels to early 2008
That’s Doug Noland, Prudent Bear, all links online.

Now for a few minutes more of British authors and epidemiologists Richard Wilkinson and Kate Pickett. This is lifted from an On Point interview by Tom Ashbrook. You have heard us here at Demand Side arguing the economic inefficiency of inequality, but these people are describing the social effects of inequality.

[Podcast audio continues with the Ashbrook interview.  Below for blog readers is a continuation of the exerpt from the book.]

Where it once took studies of babies’ weight gain to discover that they needed attentive and loving care, it is now studies of death rates which are forcing us to recognize the social needs of adults. What matters most now for health, happiness and well-being is, from early childhood onwards, social relationships, the quality of the social environment, and how we experience ourselves through each others’ eyes.

For thousands of years the best way of improving the quality of human life was to raise material living standards. But we, in the rich world, are the first generation to have got to the end of that process . The evidence on life expectancy, happiness and measures of wellbeing show that there are rapid improvements in the early stages of economic growth, but the gains then diminish until, among the richest countries, all three cease to be responsive to economic growth. The ‘diseases of affluence’ – like heart disease – become the diseases of the poor in affluent societies and, for the first time in history, the poor are fatter than the rich.

At some point in the long history of growth it was inevitable that we would reach a point where diminishing returns set in. That we have passed this point has been masked by consumerism. But what drives consumerism – and makes it an insatiable but zero-sum game – is that rather than being driven by genuine human need, it is driven by status competition, by the need to have goods that show other people how well we’re doing and to keep up with the Joneses. When a large majority, even of the 10 or 15 percent of Americans below the Federal poverty line, have air conditioning, a car and a DVD player, growth has done its work.

In their bones people know this. We know that consumerism is hollow and cannot satisfy our deeper and more important social needs. Similarly, the romantic nostalgia for the 1950s reflects our recognition that, despite our societies being so much richer, people are no happier now than they used to be.

No wonder then that Gross National Income per head has been falling out of favor as a measure of progress in rich countries. Almost twenty years ago the United Nations introduced its Human Development Index and scored each country according to a combined measure of Gross Domestic Product per head, education and life expectancy. Since then, economists have developed many other measures of wellbeing, the ‘Genuine Progress Indicator’, the Happy Planet Index and the like. Most recently, Nobel laureates Joseph Stiglitz and Amartya Sen produced their report on measures of economic performance and “social progress” for France’s President Sarkozy.

But if you thought the Stiglitz-Sen report would tell us how to increase human wellbeing, you’d be disappointed. Rather than showing us how to improve wellbeing, they focus only on how to measure it. Even within this limited scope, the suggested improvements are remarkably pedestrian. Despite the sharp contrast between the material success and social failings of modern societies, they keep Gross National Income per head at center stage. The changes they propose are limited to various subtractions from GNI per head to take account of costs which boost economic growth such as longer commuting times, pollution and loss of leisure, while making additional adjustments, such as for the fact that we do not share the proceeds of growth equally. But this report is nevertheless important because it confirms the growing awareness that we have got to the end of the real benefits of growth.

So if the priority really has shifted from our material to social needs, what can be done in affluent societies to raise the real quality of life? Rather to our surprise, we believe we have found a crucially important part of the answer to this question.

Like others, we had been working for some years trying to understand the tendency for health to be better in countries with smaller income differences between rich and poor. There are now around 200 studies of income inequality and health. Other researchers working on violent crime had shown that homicide rates were lower in more equal countries. We started to wonder whether this pattern applied to other health or social problems. To find out, we collected internationally comparable figures on levels of trust, mental illness, life expectancy, infant mortality, prevalence of drug use and levels of obesity, homicide rates and rates of imprisonment, teenage birth rates, children’s educational achievement, and measures of child wellbeing – for each of 21 rich developed market democracies.

To measure inequality we used the ratio of the incomes of the top 20 percent in each country compared to the incomes of the bottom 20 percent. In the more equal countries (Japan, Finland, Norway, Sweden) the top 20 percent have 3.4 to 4.0 times as much. In the more unequal societies (USA, Portugal, UK) they have between 7 and 8.5 times as much. By this measure they are twice as unequal as the more equal countries.

Although people have often regarded inequality as divisive and socially corrosive, that did not prepare us for what we found. The frequency of all these problems was systematically related to income inequality. The bigger the income differences between rich and poor in each society, the worse these health and social problems became. And rather than things being just a bit worse in more unequal countries, they were very much worse. More unequal countries tended to have three times the level of violence, of infant mortality and mental illness; teenage birth rates were six times as high, and rates of imprisonment increased eight-fold.

The sense that inequality is divisive was shown by the fact that in more unequal countries, only about 15 percent of the population feel they can trust others, compared to around two-thirds in the more equal ones. That evidence was supported by relationships with social capital and levels of violence – all showing that inequality damages the social fabric of society.
Although the statistics told us that these relationships could not be dismissed as chance, we thought we should check in a second, independent, test bed to see if the same relationships held true. We looked at data for the 50 states of the USA, asking exactly the same question: did the more equal states, like the more equal countries, also do better on all these health and social problems than the less equal ones?

The pattern was extraordinarily similar. What the evidence shows is a tendency for more unequal societies to be socially dysfunctional right across the board. It is not that one country or state has good health but high levels of violence, or high teenage birth rates but low levels of drug abuse. Instead, the pattern is for most problems to become better or worse together.

Our interpretation of these findings is that bigger income differences lead to bigger social distances up and down the status hierarchy, increasing feelings of superiority and inferiority and adding to status competition and insecurity. Some of the causal links are known: the effects of chronic stress on the immune and cardiovascular system are increasingly well understood and must underpin the relationship of income inequality to health. Similarly, the reason why violence increases in more unequal societies is because inequality makes status even more important and the most common triggers to violence are loss of face, disrespect, and humiliation.

What the evidence shows is that problems that everyone knows are related to social status within our societies become much more common when the social status differences are increased. But, surprisingly, the benefits of greater equality are not confined to the poor. While the benefits are much bigger lower down the social ladder, even well paid middle class people live longer and do better in more equal societies. Their children too are less likely to become victims of violence, to drop out of high school or become involved in drugs. The reasons why the benefits of greater equality extend to a large majority of society is, of course, that we are all caught up in status differentiation and we all worry about what others think of us and how we are judged.

How can income differences be reduced? There seem to be two quite different routes. While countries like Sweden start off with large differences in earnings and then redistribute, countries like Japan have much smaller earnings differences to start with – before taxes and benefits. Within the US, Vermont and New Hampshire provide a similar contrast. It doesn’t seem to matter how you get greater equality so long as you get there somehow.

Politics in the future are likely to be dominated by the need to reduce carbon emissions. But there too greater equality has a role to play. Consumerism is probably the greatest obstacle to achieving sustainability. Because the pressure to consume is intensified by status competition, greater equality will be necessary to reduce it. Reigning in carbon emissions depends, more than any other problem, on concern for the greater good. But as inequality weakens trust and community life, it also weakens public spiritedness and concern for the greater good. An international survey of business leaders found that those in more equal countries regard environmental issues as more important. It is also the more equal societies that do best on recycling and foreign aid.

Both our social and environmental wellbeing require that developed societies turn their attention from material accumulation to the quality of the social environment. What is exciting is that greater equality may be the key which brings solutions to the most important problems of our day within our reach.

Wednesday, February 9, 2011

Kumhof and Ranciere answer the question, “Does income inequality lead to crisis?”


Inequality, Leverage and Crises

From Global Economic Intersection

Guest Authors:  Michael Kumhof, International Monetary Fund and Romain Ranciere, Paris School of Economics and International Monetary Fund.  Contact information available here.

Authors’ notes:  The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. We thank George Akerlof, Kemal Dervis, Douglas Laxton and Thomas Piketty for helpful comments, and Troy Davig for help with the MATLAB codes.  JEL Classifcation Numbers: E21,E25,E44,G01,J31


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 1983-2007 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 United States experienced two major economic crises over the past century–the Great Depression starting in 1929 and the Great Recession starting in 2007. Both were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis. In this paper, we first document these facts, and then present a dynamic stochastic general equilibrium model in which a crisis driven by income inequality can arise endogenously. The crisis is the ultimate result, after a period of decades, of a shock to the relative bargaining powers over income of two groups of households, investors who account for 5% of the population, and whose bargaining power increases, and workers who account for 95% of the population.

The model is kept as simple as possible in order to allow for a clear understanding of the mechanisms at work. The key mechanism is that investors use part of their increased income to purchase additional financial assets backed by loans to workers. By doing so, they allow workers to limit their drop in consumption following their loss of income, but the large and highly persistent rise of workers’ debt-to-income ratios generates financial fragility which eventually can lead to a financial crisis. Prior to the crisis, increased saving at the top and increased borrowing at the bottom results 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, as measured by the ratio of banks’ liabilities to GDP, increases.

The crisis is characterized by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. financial crisis. Because crises are costly, redistribution policies that prevent excessive household indebtedness and reduce crisis-risk ex-ante can be more desirable from a macroeconomic stabilization point of view than ex-post policies such as bailouts or debt restructurings. To our knowledge, our framework is the first to provide an internally consistent mechanism linking the empirically observed rise in income inequality between high income households and poor to middle income households, the increase in household debt-to-income ratios among the latter group, and the risk of a financial crisis.

This paper integrates two strands of literature that have largely been evolving separately:  the literature on income and wealth distribution and the literature on financial fragility and macroeconomic volatility. The first literature is mostly focused on accurately describing long run changes in the distribution of income and wealth (Piketty and Saez (2003), Piketty 1 (2010)). One of its main findings is that the most significant changes in the income distribution concern the evolution of top income shares. This feature is taken on board in our model, where income heterogeneity is introduced by considering two groups representing the top stratum and the remainder of the income distribution.

A companion literature in labor economics seeks to uncover the fundamental factors shaping the change in the income distribution in the United States over the last thirty years.

Lemieux, MacLeod and Parent (2009) find that an increase in the share of performance pay (e.g. bonuses) can explain 20% of the growth in the variance of male wages between the late 1970s and the early 1990s, and almost all of the growth in wage inequality at the very top end of the income distribution. Lemieux (2006) shows that the dramatic increase in the return to post-secondary education plays an important role in the increase in income inequality and can explain why wage gains are disproportionately concentrated at the top of the distribution. Card, Lemieux and Riddell (2004) find that changes in unionization can explain around 14% of the growth in the variance of male earnings in the United States.

Finally, Borjas and Ramey (1995) and Roberts (2010) point to the role of foreign competition and jobs offshoring in the rise of income inequality.

Our paper focuses only on the macroeconomic implications of increased income inequality.

Therefore, rather than taking a stand on the microeconomic reasons for that increase, it represents more fundamental shocks by way of a shock to the relative bargaining powers of the two income groups. A similar reduced-form modeling device is employed by Blanchard and Giavazzi (2003), where labor market deregulation is formalized as a reduction in the bargaining power of workers.

The literature on financial fragility has so far ignored the role of income heterogeneity in creating crisis risk. In the canonical Diamond and Dybvig (1983) crisis model, the heterogeneity that matters is that between patient and inpatient consumers. Differences between impatient and patient consumers also feature prominently in financial accelerator models applied to household debt and housing cycles (Iacoviello (2005, 2008)). In this paper we argue that, because increases in household debt-to-income ratios, which increase financial fragility, have been strongly heterogenous across income groups, as documented in Section 2, heterogeneity in incomes is a key additional feature that should be explored in models of household debt and financial crises.

While not formally modeled there, the link between income inequality, household indebtedness and crises has been recently discussed in opinion editorials by Paul Krugman, and in two books by Rajan (2010) and Reich (2010). Both authors suggest that increases in borrowing have been a way for the poor and the middle-class to maintain or increase their level of consumption at times when their real earnings were stalling. But these authors do not make a formally consistent case for that argument. Our model allows us to do so.

There are of course other candidate explanations for the origins of the 2007 crisis, and many have stressed the roles of excessive financial liberalization and of asset price bubbles.1


1Keys, Mukherjee, Seru and Vig (2010) discuss the adverse effects of increased securitization on systemic risk.  Taylor (2009) claims that the interaction of unusually easy monetary policy with excessive financial liberalization caused the crisis. Obstfeld and Rogoff (2009) claim that the interaction of these factors with global current account imbalances helped to create a “toxic mix” that helped to set off a worldwide crisis.


Typically these factors are found to have been important in the final years preceding the crisis, when debt-to-income ratios increased more steeply than before. But it can also be  argued, as done in Rajan (2010), that much of this was simply a manifestation of an underlying and longer-term dynamic driven by income inequality.  Rajan’s argument is that growing income inequality created political pressure, not to reverse that inequality, but instead to encourage easy credit to keep demand and job creation robust despite stagnating incomes.

It has also been suggested that the increase in wealth of the richest households has played a role in increasing the demand for investment assets. In our model, the financial sector intermediates funds between the increasingly richer top fraction of the population and the increasingly more indebted bottom fraction of the population.  The size of the financial sector, as measured by total assets or total liabilities over GDP, the flow of funds between the two groups increases. This fact is consistent with recent findings by Philippon (2008).  The size of the demand by the top 5% for bank deposits, in other words for assets backed by household debt, is quantified by directly introducing wealth into their preferences, reflecting a “capitalist spirit” motive stressed by a number of authors starting with Carroll (2000).

Recent literature has attempted to relate the rise in income inequality to the increase in household debt (Krueger and Perri (2006), Iacoviello (2008)). There is an important difference between our approach and that followed by these authors. In their approach an increase in the variance of idiosyncratic income shocks across all households generates a higher demand for insurance in credit markets, thereby increasing household debt. Their approach therefore emphasizes an increase in income inequality experienced equally within each household group, while our paper focuses on the rise in income inequality between two household groups. There is a lively academic debate concerning the relative roles of within- and between-group factors in shaping inequality. But our paper only focuses on one specific type of between-group inequality that can be clearly documented in the data, namely inequality between high income households and everyone else.

The rest of the paper is organized as follows. Section 2 presents a number of key stylized facts. Section 3 presents the model. Section 4 presents model simulations to study the effects of increasing income inequality, and to discuss policy implications. Section 5 concludes.

2. Stylized Facts

This section documents a number of key stylized facts regarding the evolution of the distribution of income, wealth and consumption, changes in household debt-to-income ratios overall and for different groups, the size of the financial sector, and household debt default risk during the financial crisis of 2007. The model presented in the next section will be calibrated to broadly replicate these facts.

Income Inequality and Household Debt: 1929 vs. 2007

Figure 1 plots the evolution of income inequality and household debt ratios in the two decades preceding the two major U.S. crises – 1929 and 2007. In both periods income inequality experienced a sharp increase of similar magnitude: the share of total income (excluding capital gains) commanded by the top 5% of the income distribution increased from 24% in 1920 to 34% in 1928, and from 22% in 1983 to 34% in 2007.

During the same two periods, the ratio of household debt to GNP or to GDP increased dramatically. It almost doubled between 1920 and 1932, and also between 1983 and 2007, when it reached much higher levels than in 1932. In short the joint evolution of income inequality across high and low income groups on the one hand, and of household debt-to-income ratios on the other hand, displays a remarkably similar pattern in both pre-crisis eras.

Income Inequality and Consumption Inequality

In order to model the consequences of rising income inequality, it is important to clearly document the respective dynamics of income inequality, consumption inequality and wealth inequality. To do so we use a recent comprehensive dataset compiled by Heathcote, Perri and Violante (2010).2


2The rise in U.S. income inequality has been documented since at least Gottshalk and Moffit (1994).


Figure 2, top panel, plots the cumulative percentage changes of male hourly real wages between 1967 and 2005 for three deciles of the distribution of wage earnings: the bottom 10 percentile, the percentile surrounding the median, and the top 10 percentile.

Figure 2, bottom panel, plots the cumulative percentage change in real male annual earnings for the same three deciles. Both graphs illustrate the large widening of wage inequality over recent decades. The real hourly wages of the top 10 percentile increased sharply by a cumulative 70%; the real hourly wages around the median declined by 5%; while the wages of the bottom 10% declined strongly, by around 25%. The widening in earnings inequality is even more pronounced when annual earnings are considered reflecting the role of hours and unemployment in the bottom percentile. In the context of our theoretical framework, we take this change in the relative distribution of earnings as the key shock to our model economy.

Figure 3 documents the evolution of inequality in disposable incomes and in non-durable consumption between 1980 and 2006. The graph plots the ratio of disposable incomes and the ratio of non-durable consumption levels between the top and the bottom 10 percentile of the disposable income distribution.

An important finding, already stressed by Slescnik (2001) and Krueger and Perri (2006), is that the rise in income inequality has been much more pronounced than the increase in consumption inequality.

Income Mobility

To better understand the differences between income inequality and consumption inequality, it is important to assess the importance of intra-generational income mobility. In theory, if increasing income inequality was accompanied by an increase in income mobility, the dispersion in lifetime earnings might be much smaller than the dispersion in annual earnings, as agents move up and down the income ladder throughout their lives. This is a potential explanation for why consumption inequality has been lower than income inequality.

However, the data show that, if anything, income mobility has been declining in the United States over the last 40 years, particularly mobility between the top income group and the remainder that we care about in this paper.

A recent study by Kopczuk, Saez and Song (2010)3, using micro-level social security data with the sample restricted to men, shows that measures of short-term income mobility (mobility at a five year horizon) and long-term income mobility (lifetime mobility) have been either stable or slightly worsening since the 1950s. As a consequence the evolution of annual income inequality over time is very close to the evolution of longer-term income inequality.


3 See also Bradbury and Katz (2002).


They also find that the surge in top earnings is not due to increased mobility between the top income group and other groups. The probability of staying among the top 1% of earnings after 1,3 or 5 years shows no overall trend since the top share started to be coded in Social Security Data (1978).

In addition, Kopczuk, Saez and Song (2010) show that increases in the variance of annual earnings have been due to increases in the variance of permanent earnings, with only modest increases in the variance of transitory earnings. Figure 4, which uses their data, illustrates this result by plotting, starting in 1970, the variance of annual log earnings, the variance of five-year log earnings (the permanent variance) and the variance of the five-year log earnings deviation (the transitory variance).

These findings together provide support for one of our key simplifying modeling choices, the assumption of two income groups with essentially fixed memberships.

Wealth Inequality and Household Debt-to-Income Ratios

In the absence of any change in the valuation of household assets and liabilities, a smaller increase in consumption inequality relative to income inequality must imply that households at the bottom of the distribution of income and wealth are becoming more indebted than households at the top. Figure 5 shows the evolution of debt-to-income ratios for the top 5% and bottom 95% of households, this time ranked by wealth rather than income, between 1983 and 2007. In 1983, the top wealth group is somewhat more indebted than the bottom group, with a gap of around 15 percentage points. In 2007, the relative debt situation is dramatically reversed: the debt-to-income ratio of the bottom group, at around 140%, is now twice as high as the debt-to-income ratio of the top group.

Between 1983 and 2007, the debt-to-income ratio of the bottom group has therefore more than doubled while the ratio of the top group has remained fluctuating around 70%. As a consequence almost all of the increase in the debt-to-income ratio at the aggregate level comes from the bottom group of the wealth distribution. Once again this provides very strong motivation for introducing income heterogeneity into a model of household indebtedness and financial fragility.

The Size of the U.S. Financial Sector

In our theoretical framework, the increase in debt of the bottom 95% of the distribution generates an increasing need for financial intermediation. Figure 6 plots two measures of the size of the U.S. financial sector between 1980 and 2007. The left panel plots the standard measure of private credit by deposit banks and other financial institutions to GDP. It more than doubled over the period, increasing from 90% in 1981 to 210% in 2007. The right panel plots the share of the financial sector in GDP as constructed by Philippon (2010).

According to this measure the financial sector almost doubled in size between 1981 and 2007, and most recently accounted for an extraordinary 8% of U.S. GDP.  A similar pattern was again observed prior to the Great Depression.

Debt-to-Income Ratios, Risk and Financial Crises

As shown in Figure 7, top panel, most of the increase in debt-to-income ratios for the bottom 95% group in the period preceding the crisis was associated with mortgage debt. In the mortgage market, the growing share of subprime loans as documented in Figure 7, bottom panel, is an indicator of the increased riskiness that has accompanied higher indebtedness.

Figure 8 shows evidence of an increase in mortgage debt default risk following 2007 of a magnitude unprecedented since the Great Depression.

Default probabilities that increase with debt-to-income ratios, and default rates of the magnitude observed recently, are key ingredients of our model and its calibration.

3. The Model

The model economy consists of two groups of households, referred to as investors and workers, and of a production technology that combines the inputs provided by investors and workers.

Editor’s note:  Because of formatting problems with the mathematical symbols, the reader is referred to the authors’ PDF formatted paper for the discussion of the model, available here.  This article is an update of that manuscript, but Section 3 appears to be identical.

Further editor’s note:  An important discussion in the Model Section relates to the probability of crisis as a function of leverage which appears to have an asymptotic function, as shown in Figure 9.

4. Simulated Scenarios

Figures 10-15 present a baseline simulation and a number of alternatives that explore the sensitivity of our main conclusions to the calibration of the model. In each case the perfect foresight simulation is shown as a black solid line, and the monotone map simulation as a red dashed line. The horizontal axis represents time, with the shock hitting in year 1 and the final period shown being year 50. Simulations are initiated, both under perfect foresight and under uncertainty, at the steady-state vector of the deterministic steady state (more on this below). The vertical axis shows percent deviations from the initial deterministic steady state for real stock and flow variables, percentage point deviations for rates of return, percentage points for leverage, crisis probability, the interest expense to income ratio, and the income and consumption shares of investors, and simple ratios for the relative per capita income and consumption levels of investors and workers.

A. Baseline Scenario

Figure 10 presents our baseline scenario, with a cumulative 7.5% decline in workers’ bargaining power over the first 10 years9, followed by a very slow reversal back to η = 1 determined by the autogressive parameter ρ = 0.96. The crisis event happens in year 30, and features 10% collapses in loans and capital, γ = γk = 0.9.


9This corresponds to a shock of one half of one standard deviation in each year.


Apart from some important details that we will discuss in the next subsection, the monotone map and perfect foresight simulation results are very similar. The real wage over the initial decade collapses by close to 6%, while the return to capital increases by over 2 percentage points. Workers’ consumption however declines by only around two thirds of the decline in wage income, as workers borrow the shortfall from investors, who have surplus funds to invest following their increase in bargaining power. Over the 30 years prior to the outbreak of the crisis, loans more than double to bring workers’ leverage, or debt-to-income ratio, from 64% to around 140%, with the crisis probability in year 30 exceeding 3%. The loan interest rate for most of this initial period is up to 2 percentage points above its initial value, as lenders arbitrage the return to lending with the now higher return to capital investment.

Investors’ share of the economy’s income increases from initially less than 30% to over 35%. They have three ways to dispose of the extra income, and they utilize all three in a way that equalizes their marginal contributions to utility. First, their consumption increases by eventually over 20% prior to the outbreak of the crisis. Second, capital investment increases by over 15%, and so does the physical capital stock. The increase in capital raises the economy’s output by eventually close to 4%. And third, loans increase by over 100%, which means that investors’ consumption share increases by only around 2 percentage points, compared to 5 percentage points for their income share. These last two points are closely related, because with 71% of the economy’s final demand coming from workers’ consumption, this output cannot be sold unless a significant share of the additional income accruing to investors is recycled back to workers by way of loans.

With workers’ bargaining power, and therefore their ability to service and repay loans, only recovering very gradually, the increase in loans is extremely persistent.

The initial gain in investors’ rate of return of more than 2 percentage points is thereafter pared back by two factors. First, the large increase in investment reduces the marginal product of capital, and second, the gradual return of workers’ bargaining power increases their wage and thus reduces what is left for capital. By year 30, profitability has in fact declined below its initial level. At that point there are two ways to again raise the return to capital. One would be another round of increasing investors’ bargaining power. And the other is a major crisis that destroys large amounts of existing capital. We assume that the latter happens in year 30, but the respite for investors is only temporary in the presence of the ongoing recovery in workers’ bargaining power. Unless this changes, the inevitable result will be a prolonged period of low profitability, in the sense of rates of return that remain below those in the initial steady state.

We interpret the crisis as a release of the increasing pressure built up on workers’ balance sheets, with the interest portion of debt service increasing from initially around 3% to 6% of their income at the time of the crisis, and prospects for an early reduction in leverage very low given the slow recovery in bargaining power. 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.

It is however clear that this last result depends critically on the relative sizes of the loan default versus the collapse in the real economy. As we will see below, when the crisis mainly affects loans, it does bring more significant relief to workers.

B. Uncertainty

The simulations based on the monotone map method, which take uncertainty concerning future levels of bargaining power into account, show a number of interesting differences to the perfect foresight case.

One is that at the outset investors briefly but sharply reduce consumption to permit a boost in capital investment, thereby supporting a faster increase in the capital stock. Loans also initially increase at a faster rate. The reason is that we have initialized both simulations at the state vector of the deterministic steady state. Under uncertainty however, investors would prefer higher capital and loan stocks even in the absence of realized negative shocks to η. This is because volatile bargaining power, by affecting incomes, increases consumption risk and thus lowers the expected utility of consumption. Investors can reduce their exposure to that risk by switching from consumption to holdings of capital and loans, which also offer utility but which are not equally affected by changes in bargaining power. In our baseline simulation the long-run value for workers’ leverage is therefore around 90% rather than 64%, and around a third of the increase in leverage observed over the pre-crisis period is due to convergence to this higher long-run value, with the other two thirds accounted for by the realized shocks to η. The relative effects of uncertainty versus realized η on the capital stock are similar.

Putting this differently, if our simulations under uncertainty were initialized at the stochastic rather than the deterministic steady state, the effects of realized bargaining power shocks on leverage and the capital stock over the first 30 years would be relatively smaller, but still very large in absolute terms.

Another interesting difference between the uncertainty and perfect foresight simulations concerns the longer-run behavior of capital and especially loans, which under uncertainty are noticeably lower at the 50-year horizon. The reason is that, at the very high levels of debt and capital reached by that time, the convexity of the crisis probability function assumes increasing importance. It implies that under uncertainty about future bargaining power the expected probability of a crisis is significantly higher, and therefore the willingness of investors to be exposed to such a crisis, through high stocks of loans and capital, is significantly lower.

Of course in the very long run this picture is again reversed, as the perfect foresight economy returns to a leverage of 64%, while the economy under uncertainty settles at a leverage of around 90%.

C. High Leverage – Aggravating Factors

The baseline scenario has leverage increasing to around 135% by the time of the crisis (125% under uncertainty), and remaining in the neighborhood of that value for decades afterwards, with a crisis probability hovering in the neighborhood of 3.5% for several decades (2% under uncertainty). This outcome however depends on a number of aspects of the calibration of the model and of the specification of shocks, and changes to these can make the outcome for leverage worse or better. We begin by describing the factors aggravating crisis risks in this subsection, and in the next subsection we turn to possibilities for bringing down leverage.

In the baseline workers are partly compensated for their loss of bargaining power by the fact that investors invest part of their additional income in physical capital, which over time helps to raise the real wage. Figure 11 considers an alternative calibration where the marginal benefit to investors of doing so is reduced, so that more of their gains from higher bargaining power are either consumed or invested in loans.

Specifically, by setting .k = −33 instead of .k = −30, capital accumulation is reduced by one third over the first 30 years, and output growth is reduced accordingly.10 One result is a further 2 percentage point increase in the consumption share of investors, as they consume instead of investing. The other is that leverage now reaches around 145% by the time of the crisis, and thereafter keeps growing to 175% by year 50 under perfect foresight, while it stays near 135% under uncertainty.


10 It can therefore be seen that setting .k much closer to zero would imply a massive and clearly implausible response of capital accumulation to income shocks.


Editor’s note:  .k is a constant in the model that determines the sensitivity of desired capital investment to changes in income.  For other parameters that follow in the text below, the reader should refer to the full paper (Section 3, Model, here.)

Furthermore, the crisis itself is now characterized by a small increase rather than a decrease in leverage and in crisis probability. The longer-run crisis probabilities (almost 8% by year 50 under perfect foresight, 3% under uncertainty) are far higher than in the baseline. The use of the additional income by investors is therefore a critical determinant of the sustainability of lower worker bargaining power. If a large share of the funds is invested productively, higher debt is more sustainable because it is supported by higher income.  If instead the majority of the funds goes into investors’ consumption, or into loan growth, in other words an increasing “financialization” of the economy, the system becomes increasingly unstable and prone to crises.

A second aspect of the baseline calibration that might be too optimistic is the rate at which workers’ bargaining power is restored, after the initial period of declining bargaining power of 10 years. With ρ = 0.96, 50% of the loss of bargaining power is reversed by year 27.

This was not an obvious feature of the pre-1929 and pre-2007 periods. Figure 12 therefore considers an alternative scenario with ρ = 0.99, which is close to permanent, with the half-life of bargaining power equal to 80 years instead of 27 years.

In this case the initial loss of bargaining power is assumed to be smaller, with η dropping to 0.95 by year 10, rather than to 0.925 as in the baseline. Given the smaller initial drop in η, the increase in leverage and crisis probability by year 30 is of course smaller. But more interesting for our purposes is the fact that, thereafter, leverage keeps increasing further, including under uncertainty, and the crisis probability keeps climbing. It can in fact be shown that for this scenario the crisis probability does not peak until 50 years after the first crisis under uncertainty, and another 30 years later under perfect foresight. This illustrates a key concern. If workers see virtually no prospects of restoring their earnings potential even in the very long run, high leverage and high crisis risk become an almost permanent feature of the economy.

The third modification of the baseline that can give rise to higher crisis risk is a higher subsistence level of consumption. For most households it probably takes far less than a halving of consumption levels to arrive at what they perceive to be a disastrous event. A large number of households in modern economies, and not only the relatively poor, does in fact live paycheck to paycheck and would have to radically rearrange their affairs if faced with even a small drop in income.11


11In a recent survey by the largest U.S. employment website (CareerBuilder (2010)), 77 percent of respondents report that they live paycheck to paycheck, up from 61 percent in 2009.


The scenario in Figure 13 therefore raises the subsistence level to 80% of initial steady-state consumption, but allows for that subsistence level to change gradually over time in response to realized consumption levels.

Editor’s note:  A paragraph has been skipped because of formatting problems with the mathematical equations.

We observe that, under this specification, households borrow much more aggressively than in the baseline to avoid a drop in consumption. As a result leverage reaches 155% at the time of the crisis, and close to 170% around year 40, with a crisis probability that reaches 8% at its peak. However, under this specification workers are eventually willing to significantly reduce consumption, as their subsistence level comes down in the light of a prolonged experience of low consumption. Over the longer run this stabilizes leverage and avoids near explosive debt.

We have also explored the sensitivity of our results to alternative calibrations of the crisis probability function (9). We found that, even when the perceived probability of a crisis around year 30 and beyond is twice as large as in the baseline, the qualitative results are identical, and the quantitative results change very little. The reason is that a 2 percentage point increase in crisis probability, at a 10% default rate, adds at most around 10 to 20 basis points to real interest rates. This is small relative to the overall changes in real interest rates that the economy experiences in our scenarios.

D. High Leverage – Solutions

The currently much talked about deleveraging of households can in the present model take only two forms, a debt reduction, and ideally an “orderly” debt reduction, or an increase in workers’ earnings to allow them to work their way out of debt over time. We address each of these in this subsection.

We first consider the option of an orderly debt reduction. What we have in mind here is a situation where a crisis and large-scale defaults have become unavoidable, but policy is used to limit the collateral damage in the real economy. Figure 14 illustrates the case where the destruction of physical capital at crisis time only equals 1% instead of 10%, leaving all other aspects of the baseline calibration unchanged. The main difference to the baseline is that in this case the debt reduction is not accompanied by a significant income reduction, as the real wage drops very little.   As a result, leverage drops by 13.5 percentage points, compared to 3 percentage points in the baseline.  Minimizing spillovers from the financial to the real sector during a widespread debt restructuring to deal with excessive leverage is therefore critical to the success of that restructuring.

In this context it should be mentioned that a financial sector bailout such as the one recently performed in the United States does not represent a debt restructuring in the sense of Figure 14.

A bailout principally benefits the creditors of financial institutions, in other words the investors of our model, by compensating them for loan losses. The financing for such a bailout however comes from higher future general tax revenue that will be used to service higher government debt, and will therefore fall to a very significant extent on workers.  The proper definition of workers’ indebtedness in an extended model including the fiscal authorities would then include the present discounted value of future taxes.  In such a world the beneficial effects of debt default on leverage would be mostly offset by the negative effects of higher future taxes.

Figure 15 illustrates the alternative to a debt restructuring, an increase in workers’ earnings through a restoration of their original bargaining power.

In this case the evolution of the economy is identical to the baseline until period 30, but at that time a program is implemented whereby workers’ bargaining power immediately and permanently returns to η = 1. The assumption is that this is sufficient to head off a crisis event. The first result is an upward jump in the real wage to about 4% above its value in period 0, due to the now much higher capital stock.  Leverage drops by 8 percentage points on impact (both under perfect foresight and under uncertainty), but this is now not due to a lower, restructured loan stock, but rather to a higher income level, which is of course helped by the fact that this turn of events is assumed to head off a collapse in capital and output.  The main difference to Figure 14 however is observed following period 30, where under a loan restructuring leverage and default probability resume an upward trajectory for several additional decades, while under the bargaining power solution both immediately go onto a declining path.  By year 50 leverage is around 20 percentage points lower under the bargaining power solution than under the loan restructuring solution. For long-run sustainability a permanent flow adjustment, giving workers the means to repay their obligations over time, is therefore much more successful than a stock adjustment, unless the latter is extremely large.

Any success in reducing income inequality could therefore be very useful in order to reduce the likelihood of future crises. Clearly however this will not be easy to achieve, as candidate policies are subject to many difficulties. For example, downward pressure on wages is driven by powerful international forces such as competition from China, while a switch from labor to capital income taxes might drive investment to other jurisdictions.  But  a switch from labor income taxes to taxes on economic rents, including on land, natural resources and financial sector rents, is not subject to the same problem.  And as far as strengthening the bargaining powers to workers is concerned, the difficulties of doing so have to be weighed against the potentially disastrous consequences of further deep financial and real crises if current trends continue.

E. Further Discussion

Our model has been kept deliberately simple, first in order to clearly identify the key transmission channel from higher income inequality to higher leverage to a higher probability of crises, and second for computational reasons, as a higher number of shocks or endogenous state variables would quickly make the monotone map method impractical.  It is nevertheless useful to close this section by commenting on how various additions to the model could improve details of its predictions.

By adding an open economy dimension, with net foreign assets as an additional state variable and foreign savings preferences as an additional shock, the model would be better able to replicate the fact that the United States experienced a consumption boom over much of the period of interest, much of which was facilitated by the availability of foreign savings.

The addition of contractionary technology and investment demand shocks would generate the large and persistent post-crisis reduction in investment observed in the United States after 2007.

Finally, the addition of a shock to workers’ labor supply would help to address an important issue raised by Reich (2010), who emphasizes that in the United States households faced with higher income inequality have employed two other important coping mechanisms apart from higher borrowing, namely higher female labor force participation and longer hours.

This allowed them to replace some of the lost income, and therefore to limit the amount of additional borrowing.

5. Conclusions

This paper has presented stylized facts and a theoretical framework that explore the nexus between increases in the income advantage enjoyed by high income households, higher debt leverage among poor and middle income households, and vulnerability to financial crises.

This nexus was prominent prior to both the Great Depression and the recent crisis. In our model it arises as a result of increases in the bargaining power of high income households.

The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while.  But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.  More importantly, unless loan defaults in a crisis are extremely large by historical standards, and unless the accompanying real contraction is very small, the effect on leverage and therefore on the probability of a further crisis is quite limited.

By contrast, restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis.

The framework we have presented uses a closed economy setting. In future work we aim to extend this to an open economy.  It is clear that the same mechanism presented in this paper, namely the increase in lending by high income households in the country that is subject to a bargaining power shock favoring high income households, would then extend not just to domestic poor and middle income households, but also to foreign households.

The counterpart of this capital account surplus in the foreign country would of course be an increase in its current account deficit. In other words, this provides a potential mechanism to explain global current account imbalances triggered by increasing income inequality in surplus countries.


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