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A Model of the Financial Crisis: Inequality, leverage and crises

February 10, 2011

World Bank economists Michael Kumhof and Romaine Ranciere have recently put forth a relatively simple economic model that paints an interesting picture of the financial and housing crisis of 2008. The model takes the rise in both debt and  inequality during the great depression and the last recession as its starting point:

“Figure 1 plots the evolution of the share of total income commanded by the top 5% of households (ranked by income) against household debt to GNP or GDP ratios in the two decades preceding 1929 and 2008. The income share of the top 5% 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 2008, when it reached much higher levels than in 1932.”

Figure 1. Income Inequality and Household Leverage

The model looks at the links between income inequality, household debt, lending to explain the how decreasing wages for working families and increasing wages for the rich lead into a cycle of increased leverage (borrowing) which can create an asset bubble.

“Borrowing and higher debt leverage appears to have helped the poor and the middle-class to cope with the erosion of their relative income position by borrowing to maintain higher living standards. Meanwhile, the rich accumulated more and more assets and in particular invested in assets backed by loans to the poor and the middle class. The consequence of having a lower increase in consumption inequality compared to income inequality has therefore been a higher wealth inequality.”

Basically as the working-class become poorer they borrow from the rich. The rich want to loan because they have become richer and need to invest this money. This increases the sway of the financial sector:

“In our closed economy set-up, the increase in leverage of the bottom 95% is made possible by the re-lending of the increased disposable incomes of the top 5% to the bottom 95%, resulting 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 increases. The rise of poor and middle income household debt leverage generates financial fragility and a higher probability of financial crises. With workers’ bargaining power, and therefore their ability to service and repay loans, only recovering very gradually, the increase in loans and therefore in crisis risk is extremely persistent.”

Click here for the solution to this model of the financial crisis:

The model shows that the only way for the cycle to be broken is either for debts to be written off, or workers to exercise their bargaining power to raise wages.

There are, however, two possibilities for a successful deleveraging of households.

  • The first is an orderly debt reduction that is not accompanied by a large real crisis. This can be shown to reduce leverage much more powerfully than in the baseline because debt reduction is not accompanied by a significant income reduction. But, for an unchanged pattern of bargaining power, a trend towards higher leverage resumes after the debt reduction, and only reverses much later.
  • The second possibility… is a restoration of workers’ bargaining power and therefore income that allows them to work their way out of debt over time. Leverage drops immediately, but due to a higher income level rather than a reduced loan stock. More importantly, and unlike under a debt reduction, leverage goes onto a declining path that immediately starts to reduce the probability of a further crisis.

Unfortunately, the model implies that even after debt reduction this crisis may resurface because high inequality ensures the rich are short of investment opportunities and the poor need to borrow. This is a self-perpetuating type model. The second possibility they mention, that workers band together to raise wages is a diminishing possibility as unions in the U.S. have represented a declining share of the work-force since the mid-1970s. What we are left with is a bleak picture, workers salaries have been flat or falling, the rich have reaped the benefits of rising GDP and productivity, and all this feeds into the need to borrow to maintain living standards of the working-population who have no market or political power.

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