Inequality, global imbalances and crisis

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.

4 thoughts on “Inequality, global imbalances and crisis

  1. All of these points are quite valid to consider regarding ‘The Great Recession of 2008.” After all, if we can learn from the mistakes that led up to it, maybe the next recession will be milder.

    Although many of these points regarding deficits, consumption habits, interest rates, and other variables are good to consider, another key point is that in the past 30 years the “financialization” of many of the economies of the world helped create a liquidity crisis after major financial institutions in America ran into major difficulties. This “financialization” of many of the world’s economies was largely created by deregulation that spawned a growth in derivatives contracts. Therefore, when liquidity froze in 2008, panic set in regarding derivatives contracts. The liquidity crisis in turn led to the controversial “bailing out of banks” in America in 2008.

    This liquidity crisis and it’s aftermath then led to major drops in the stock markets around the world. In turn, this led to a crisis in the business sectors of many countries and a rise in unemployment that in turn led to record low interest rates and QE. Although many have said that all these measures were necessary to restore stability, other economic experts have said that the new normal created by these policies is maybe setting many economies up for a potentially bigger fall.

    And yes…emulation effects from such practices are beginning to set in due to the fact that the bailout mindset, which runs counter to the cleansing effects of the marketplace, has created a false sense of security in governments, businesses, financial institutions, and individual households as well. This is why in some countries, debt in all sectors, is approaching record levels.

    The fact that Germany has less problem with debt than many other western economies is probably due to the fact that Germany was resistant to the trend toward deregulation of finance that America, Britain and others embraced. The fact that Germany, a country which has suffered much economic hardship historically, resisted the drive towards “financialization,” is testimony to the fact that they’re trying to embrace a market economy that is less prone to radical highs and lows.

    Thx for the fascinating post!

    • Thanks for your comment. As regards financialization, I think you are right about the different degrees to which it has become important in different countries. One shouldn’t forget the political economy side of this, in which particular interest groups managed to influence policy, including the deregulation of finance. This has surely had dramatic effects on the business culture in the US and UK, less so in Germany. They saw opportunities for profit making! They could then sustain their influence on policy through lobbying, helped not least by the large incomes achieved working in finance itself.

      Michael Pettis, who I mention in the post, and whose ideas I have drawn on a number of times, makes the important point in his book The Great Rebalancing that different ‘cultures’ in different countries, such as the ‘spendthrift British’ or the ‘cautious German savers’ can be changed by structural economic factors. Globally, the US and UK could not have accumulated so much debt and run large current account deficits if the Germans/Chinese/Japanese etc had not run large surpluses and accumulated wealth via saving relatively more. Policies and institutions, which might include financial deregulation or, on the other side, those which reduce wages and household income and increase savings at the macro level, could produce these economic outcomes and the resultant, apparently different ‘cultures’. Cultures do change, and economics and politics can be a driver of this.

      Thanks again.

      • You’re welcome Nick!

        I really appreciate your blog since its one of the few out there that delve into economics on a deep level. In addition, as you mention in your comment here, you work hard in an objective way to help explain the political drivers with any situation by using a cause and effect, non-partisan approach.

        Michael Pettis is so correct to note how structural economic factors create change in cultures. As you know, America has been leaning quite some time in a mode towards accumulating more debt for various reasons. And as you’re well aware of since you’ve written about Trump, America’s debt, whether its looked at as a trade deficit, or national debt, has had an influence on Trump’s policies.

        In a blog piece on America’s infrastructure I just posted, I briefly delve into the fact that although Republicans are known for adding to debt at times, they often use this as excuse to be cautious about certain policy proposals like infrastructure. On the other hand, Democrats usually are much more open to accumulating debt and are often seeking tax policies that allow for greater revenue collection. This attitude has been shown in the Democratic reaction to Trump’s plan.

        In my new blog piece I also give a very general overview about how each political party responds to Keynesian theory in a different way. Since you have much insight Nick, it’d be much appreciated if you could check out my new blog piece at some point and maybe comment on it from your point of view.

        Once again…thx for putting such a valuable blog out there. I’ve shown it to others many times.

      • Many thanks for your positive comments on my blog, its nice to get such feedback. I have commented on your latest post, hope there’s something in there that you and your readers will find useful.

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