Michael Kumhof, Stockholm, 2 nov

Inequality, Leverage and Crises Michael Kumhof, International Monetary FundRomain Ranciere, International Monetary Fund and Paris School of Economics

The views expressed herein are those of the authors and should not be attributedto the IMF, its Executive Board, or its management.

1 IntroductionEmpirical Motivation: Similarities of the decades preceding the 1929 and 2007crises • Sharply increasing income inequality. • Sharply increasing debt leverage among lower and middle classes. • Perception of unsustainably high leverage was a key factor causing a large ﬁnancial and real crash.

2 Literature on Alternative Causes of the 2007 Crisis • Most recent literature focuses on the ﬁnal years preceding the crisis: — Excessive ﬁnancial liberalization. — Easy monetary policy. — Global current account imbalances. • Rajan (2010), our work: Much of this was simply a manifestation of an underlying and longer-term dynamics driven by income inequality — Rajan: Growing inequality created political pressure for easy credit. This stresses the demand for credit. — Our work: Growing income inequality simultaneously created 1. Additional demand for credit to sustain living standards of the lower and middle class. 2. But also additional supply of credit due to the extra income of the top income group looking for a place to go.

Companion Literature on Causes of Changes in the Income Distribution • Hacker and Pierson (2011): Government intervention in support of the rich. • Card, Lemieux and Riddell (2004): Changes in unionization. • Borjas and Ramey (1995): Role of foreign competition. • Roberts (2010): Role of jobs oﬀshoring. • Lemieux, MacLeod and Parent (2009): Increased use of performance pay. • Lemieux (2006): Increase in the return to post-secondary education.

3 Stylized Facts

1920-1931 60 35 55 33 50 31 45 Percent Percent 29 40 27 35 25 30 Private Non Corporate+Trade Debt to GNP Share of Top 5% in Income Distribution 25 23 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 Source: Statistical Abstract of the United States, U.S. Department of Commerce. 1983-2008 150 36 Household Debt to GDP 140 Share of Top 5% in Income Distribution 34 130 32 120 30 Percent Percent 110 28 100 26 90 24 80 22 70 20 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Sources: Income shares from Piketty and Saez (2003, updated). Income excludes capital gains. Debt-to-income ratios from Flows of Funds database, Federal Reserve Board. Income excludes capital gains.Income Inequality and Household Leverage:(i) Moved up together pre-crisis.(ii) Both pre-1929 and pre-2007. 2

50 Top Decile of Earnings Distribution 50 Median Decile of Earnings Distribution 40 40 Bottom Decile of Earnings Distribution Cumulative Percent Change Cumulative Percent Change 30 30 20 20 10 10 0 0 -10 -10 -20 -20 -30 -30 -40 -40 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Source: Heathcote, Perri and Violante (2010), based on micro-level data from the U.S. Consumer Population Survey. Male annual earnings includes labor income plus two-thirds of self-employment income. Male hourly wages are computed as male annual earnings divided by annual hours. The price deflator used is the Bureau of Labor Statistics CPI-U series, all items.Male Annual Earnings by Income Decile:(i) Over 40% cumulative increase for the rich.(ii) Over 30% cumulative decrease for the poor.(ii) 5%-10% cumulative decrease for the median.

150 150 Bottom 95% of the Income Distribution Top 5% of the Income Distribution 130 Aggregate Economy 130 Percentage Points Percentage Points 110 110 90 90 70 70 50 50 30 30 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Survey of Consumer Finance (triennal), 1983-2007. Debt corresponds to the stock of all outstanding household debt liabilities. Income corresponds to annual income before taxes, including capital gains and transfers, in the year preceding the survey.Debt to Income Ratios:(i) Lower or ﬂat for the rich.(ii) Sharply higher for the remainder.

240 8.5 Private Credit to GDP 220 Value Added GDP Share of Financial Sector 8.0 200 7.5 180 7.0 Percent Percent 160 6.5 140 6.0 120 5.5 100 5.0 80 4.5 1985 1990 1995 2000 2005 Sources: Private Credit to GDP from World Bank Financial Structure Database (real private credit by deposit banks and other financial institutions, relative to GDP). Value Added GDP Share of Financial Sector from Philippon (2008).Size of the U.S. Financial Sector:(i) Private Credit to GDP more than doubled.(ii) Banks’ share in GDP more than doubled.

4 A Theoretical Model to Explain The Data • Economy consists of two separate household groups, the top income group (“investors”) and the lower and middle class (“workers”). • Economy experiences a highly persistent decrease in the income bargaining powers of the lower and middle class. • Response of the top income group (top 5% of incomes): 1. Higher consumption. 2. Higher physical (equity) investment. 3. Much higher financial investment = recycling gains back to lower and middle class as loans. • Response of the lower and middle class (bottom 95% of incomes): 1. Lower consumption, but consumption drops by less than income. 2. Much higher borrowing from the top income group = higher leverage over decades. • Result: Higher financial fragility ⇒ risk of financial crisis ⇒ eventual crash.

- Real wage drops persistently. - Return to capital increases persistently. Baseline Scenario• Highly persistent decrease in workers’ bargaining power.• Financial and real crisis in year 30. Bargaining Power Real Wage Return to Capital 0 2 −2 0 2 pp deviation% deviation % deviation −4 −2 1 −6 −4 0 −6 −1 −8 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Investors‘ Consumption Investors‘ Physical Investment Investors‘ Loans 20 80 15% deviation % deviation % deviation 10 60 10 40 0 5 20 0 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Workers‘ Consumption Workers‘ Debt−to−Income Ratio Crisis Probability 140 3 0 120% deviation level in % level in % −2 2 100 −4 1 80 −6 60 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50

- Investors consume more. - Investors invest more in equity. - Investors make more loans. Baseline Scenario• Highly persistent decrease in workers’ bargaining power.• Financial and real crisis in year 30. Bargaining Power Real Wage Return to Capital 0 2 −2 0 2 pp deviation% deviation % deviation −4 −2 1 −6 −4 0 −6 −1 −8 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Investors‘ Consumption Investors‘ Physical Investment Investors‘ Loans 20 80 15% deviation % deviation % deviation 10 60 10 40 0 5 20 0 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Workers‘ Consumption Workers‘ Debt−to−Income Ratio Crisis Probability 140 3 0 120% deviation level in % level in % −2 2 100 −4 1 80 −6 60 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50

Baseline Scenario • Highly persistent decrease in workers’ bargaining power. • Financial and real crisis in year 30. Bargaining Power Real Wage Return to Capital 0 2 −2 0 2 pp deviation % deviation % deviation −4 −2 1 −6 −4 0 −6 −1 −8 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Investors‘ Consumption Investors‘ Physical Investment Investors‘ Loans 20 15 80 - Workers % deviation % deviation % deviation 10 10 60 leverageWorkers 40 increases. 0 5 20reduce 0 - This 0consumption. 10 0 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 increases the Workers‘ Consumption Workers‘ Debt−to−Income Ratio Crisis Probability 140 3 probability of 0 120 crises. % deviation level in % level in % −2 2 100 −4 1 80 −6 60 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50

An Improved Scenario: Orderly Debt Restructuring• Highly persistent decrease in workers’ bargaining power, as before.• Financial crisis in year 30, but real crisis is mostly avoided. Real wage Bargaining Power Real Wage Return to Capital collapse at 0 2 0 2 crisis time is −2 pp deviation% deviation −4 −2 1 % deviation now very much −6 −4 0 smaller. −6 −1 −8 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 The drop in Investors‘ Consumption Investors‘ Physical Investment Investors‘ Loans leverage at 100 20 15 crisis time is% deviation % deviation % deviation 15 10 therefore 10 50 5 5 much more 0 0 0 substantial. 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Workers‘ Consumption Workers‘ Debt−to−Income Ratio Crisis Probability But 0 140 3 immediately 120 afterwards% deviation level in % level in % 2 −2 100 1 leverage −4 80 starts rising 60 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 again.

A Much More Sustainable Scenario: Restoration of Workers’ Bargaining Power• Highly persistent decrease in workers’ bargaining power, as before.• But in year 30 workers’ bargaining power is restored to its original level.• Financial and real crisis is thereby avoided. Bargaining Power Real Wage Return to Capital Recovery in 0 4 2 real wage 2 gives workers pp deviation −2% deviation % deviation 0 1 −4 −2 0 the means to −6 −4 −1 −8 −6 service their 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 debts. Investors‘ Consumption Investors‘ Physical Investment Investors‘ Loans 20 15 80% deviation % deviation % deviation 10 10 60 Leverage 40 0 5 20 therefore goes 0 0 on a sustained 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50 Workers‘ Consumption Workers‘ Debt−to−Income Ratio Crisis Probability downward 140 3 path. 0 120% deviation level in % level in % 2 −2 100 1 80 −4 60 0 0 10 20 30 40 50 0 10 20 30 40 50 0 10 20 30 40 50

Leverage Comparison Across Scenarios• Orderly debt restructuring can help in the short run, but with inequality unchanged debt starts to trend up again.• Restoration of workers’ bargaining power puts leverage on a sustained downward trend. 140 120level in % 100 80 Baseline Orderly Debt Restructuring Restoration of Workers‘ Bargaining Power 60 0 10 20 30 40 50

• Discussion: How Can This Policy Be Implemented? 1. Higher Pre-Tax Wages through Higher Bargaining Power: — Strengthening collective bargaining rights? — Difficulties: Wage competition from China and other countries. — Payoffs: Avoiding further crises. 2. Higher After-Tax Wages through Lower Taxes: — Switch from labor income taxes to other taxes? — Difficulties: Higher capital income taxes would drive investment else- where. — Ways Out? Taxes on rents (land, natural resources, financial sector).

5 Summary • Empirical Link in 1929 and 2007: Higher income inequality ⇒ higher leverage ⇒ large crises. • Theoretical Model: — Key shock: Decrease in workers’ bargaining powers over incomes = smaller “share of the pie”. — Key mechanism: Recycling of investors’ income gains back to workers as loans. • Conclusion: — Only an improvement of workers’ bargaining power leads to a sustained reduction in crisis probability. — Solutions to ﬁnancial fragility that leave bargaining power (or alterna- tively taxation) untouched run into the problem that investors’s surplus funds will keep pushing loans and therefore crisis probability higher.

6 Is Government Debt a Separate Issue? • Not really. • A signiﬁcant share of government debt has just been another (indirect) way for the lower and middle classes to borrow from the top income group. • Much spending was on governmental programs that went to the majority, while much of the resulting debt is held by the top income group. • In other words, problems of high government debt have an important income distribution dimension. • Major exception: Government debt held by foreigners.

Financial Asset Shares of the Top 5% Income Group Direct Bond Holdings Share (in %) Mutual Funds Holdings Share (in %) Retirement Accounts Share (in %) 90 90 70 70 42 42 85 85 65 65 40 40 80 80 60 60 38 38 75 75 55 55 36 36 70 70 50 50 65 65 45 45 34 34 60 60 40 40 32 32 1990 1995 2000 2005 1990 1995 2000 2005 1990 1995 2000 20052

7 How About Foreign Debt? • Empirical regularities for major economies: — More inequality almost always accompanied by CA deterioration. — Major exception: China. • Explanation in general: — Workers borrow from both domestic and foreign investors. — Capital account surplus implies current account deﬁcit. • Explanations for China: Chinese workers face borrowing constraints, so Chi- nese investors deploy their savings overseas.

Change in Income Share of Top 5% (x-axis) and Change in CA Balance (y-axis) 12 10 Switzerland 8 6 Sweden 4 Netherlands Japan France Canada 2 Italy Germany 0-2.00 0.00 2.00 Spain 4.00 6.00 8.00 10.00 12.00 14.00 Australia -2 New Zealand United LKingdom -4 United States Portugal -6 R² = 0.6321 -8

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Michael Kumhof, Stockholm, 2 nov

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