Tracing a connection between rising inequality and the Great Recession of 2008 is appealing to leftist economists. It suggests that what they see as two of the potential downsides of capitalism and in particular the neoliberal economic order can perhaps be mitigated via appropriate policies. Thus, a more egalitarian capitalism can become less prone to crisis or recession.
Of course, what is appealing as social and economic outcomes is not a good enough reason to investigate linkages between them, though I suspect that I am far from the only one who is drawn to particular ideas as a matter of bias.
Perhaps there is nothing wrong with that as a starting point, followed by economic analysis of the chosen object of study.
An article in the latest issue of the heterodox Cambridge Journal of Economics explores the potential linkages between the distribution of income and current account imbalances in a simplified model of the global economy consisting of the US, Germany and China, prior to the 2008 recession.
These three countries had the largest current account imbalances in absolute terms in the run-up to the recession. The US ran a deficit, and Germany and China were running surpluses. Since these imbalances have been pinpointed by some economists as a cause of the recession itself, analysing them is important.
The authors of the paper distinguish between the functional distribution of income, which is that between wages and profits for the economy as a whole, and the personal distribution, or that between the individuals in a population.
Prior to the crisis, the functional distribution was fairly stable in the US, while the personal distribution increased substantially, beginning in the 1980s. The authors argue that the strong increase in relative income at the top of the distribution, particularly for the top 1%, led to emulation effects as those further down the distribution tried to match the consumption lifestyle of those above them by borrowing.
This may have been a contributor to the rise in consumer credit and the fall in household saving, in an economy with a liberalised financial system. This helped to cause the rise in the current account deficit, particularly in the 1990s, when the government’s budget deficit was falling and subsequently in surplus at the end of the decade.
In Germany and China, a falling share of wages and, more generally, household income, in overall GDP, in countries in which consumer credit was less accessible, led to a weakening of consumption growth and hence domestic demand. This can be described as a shift in the functional distribution of income from wages to profits. The corporate sector moved into surplus as retained earnings grew faster than investment.
To put it another way, companies spent much less on investment than they earned in profits. This contributed to the two countries’ growing current account surpluses, as exports grew strongly relative to imports and surplus capital was lent abroad.
In any model of the world economy, the current account deficits and surpluses between all the countries must balance. In this example, US households borrowed and consumed German and Chinese exports, while US exporters had a harder time penetrating the markets of the latter two countries, with their relatively weak growth in domestic demand, consumption and imports.
Of course, the Chinese economy was growing very rapidly during this period, so that the weakness of consumption growth was only relative. Nevertheless, this weakness did contribute to the current account surplus.
The paper makes a strong case that changes in income distribution can affect the current account. If large current account imbalances helped to cause the Great Recession, this is an important conclusion.
Michael Pettis is another economist who has written extensively on the role of global imbalances in causing the crisis. However, his book The Great Rebalancing is aimed at the general reader and does not have a single chart, table or equation in it. But his argument is clear: financial and economic crises are often caused by imbalances between savings, investment and consumption in individual countries, which are transmitted between them via the current account and can lead to financial fragility and instability.
For Pettis, government policies and institutions affect the distribution of income, which in turn affects the balance between savings and investment. In China, a weak currency, relatively weak growth in wages and a repressed financial system which keeps the cost of corporate borrowing low, have reduced household income growth relative to GDP, and hence the growth in consumption.
These policies have transferred income from households to corporations and the government, which have invested heavily in manufacturing capacity and infrastructure. Chinese economic growth has been not so much export-led as investment-led. The state has played a major role in allocating an enormous volume of investment since economic reforms were initiated in 1978 and this has driven rapid expansion.
However, Pettis thinks that this development ‘model’, which worked very well for more than two decades, has reached its limits, and it seems that the Chinese government thinks so too. The economy needs to rebalance income growth towards households, raise the consumption share in GDP and reduce the investment share, with the aim of improving the allocation of the latter. This will be politically difficult, but it will have to happen if China’s per capita income is to continue catching up with the advanced nations.
Germany continues to run a large current account surplus today, and the latter played a role in the onset of the Great Recession and the eurozone crisis of 2011. The cause of the repressed growth in household income is probably due to the collapse of Germany’s own dot-com bubble in 2000, which led to companies paying off debt instead of borrowing to invest, and the ‘Hartz’ labour market reforms, which led to weakening wage growth during the 2000s.
These policies sustained business profits, and the resultant weaker growth in consumption reduced companies’ incentive to invest in production capacity which served the domestic market.
As the dominant economy in the eurozone, weak German growth led the European Central Bank to cut interest rates, which proved inappropriate for the eurozone peripheral nations, and created debt-fueled consumer and housing booms in countries such as Spain and Portugal. Consumers in the periphery borrowed and spent on German exports, completing the circle.
The German current account surplus, representing excess domestic savings relative to investment, was lent to the peripheral eurozone nations, and the US and UK, fueling the aforementioned booms. When the rising private debt burdens proved unsustainable, the whole edifice collapsed.
Pettis’ book, despite its verbal exposition, goes into more detail regarding the links between changes in income distribution, current account imbalances and the Great Recession. The paper outlined in the first half of this post constructs a ‘simplified model’ and uses real world data to test it. For the paper to encompass Pettis’ arguments would require a model of huge complexity and possibly intractability. Nevertheless, the arguments are persuasive.
In sum, the above suggests that shifts in income distribution, due to the interaction between economic forces, government policies, and domestic institutions, can produce a build-up in global imbalances which ultimately prove unsustainable. The Great Recession was the beginning of the unwinding of such imbalances as the private sector began the deleveraging process and started to pay down debt.
The resolution of these imbalances will determine the sustainability of global prosperity. This could take many more years, despite the current global upturn, since levels of private debt as a share of GDP remain high in many countries. It is likely to continue to involve tensions between the world’s major economic countries and regions, affecting domestic and international politics for some time.