Nick Krafft at Open Economics sends us to this IMF working paper by Michael Kumhof and Romain Ranciere, “Inequality, Leverage, and Crises.” In it, the authors develop a model in which income inequality gives rise to different preferences and behaviors within two income groups: workers and investors.
The impacts of the two groups' preferences and behaviors play out differently depending which group is favored in terms of bargaining power within an economy. In the United States, where rising income inequality has been accompanied by erosion of labor union membership and political power and a rise in the political influence of financial and commercial interests, it's no surprise that bargaining power has favored so-called "investors." I say so-called, because usually when one "invests," one produces something, often of value to the rest of us: more productive physical capital; more jobs; innovation; or better and cheaper products. Something that doesn't require a taxpayer bailout and result in a near-10% unemployment rate. But I digress.
Kumhof and Ranciere note that as income inequality has grown in the US, it has fueled a recirculating flow of borrowing by working and middle class families and lending by the "investor" class, borrowing that has been necessary to maintain working and middle class consumption as real working and middle class incomes have stagnated or fallen:
The key mechanism [in the model] 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.
Kumhof and Ranciere's paper is chock full of interesting and thought provoking insights into the dynamics of income inequality and the economic fragility it induces, but I want to highlight one particular aspect of it that really crystallized as I read their paper. Our current situation in which 5% of the population captures and owns a disproportionate share of national output, which it then lends to the teeming masses whose share of output has been stagnant or dwindling, is really just a new variant of the company store.
Miners worked in company mines with company tools and equipment, which they were required to lease. The rent for company housing and cost of items from the company store were deducted from their pay. The stores themselves charged over-inflated prices, since there was no alternative for purchasing goods. To ensure that miners spent their wages at the store, coal companies developed their own monetary system. Miners were paid by scrip, in the form of tokens, currency, or credit, which could be used only at the company store. Therefore, even when wages were increased, coal companies simply increased prices at the company store to balance what they lost in pay.
And just in case you're thinking that this doesn't seem too unfair, consider that:
Miners were also denied their proper pay through a system known as cribbing. Workers were paid based on tons of coal mined. Each car brought from the mines supposedly held a specific amount of coal, such as 2,000 pounds. However, cars were altered to hold more coal than the specified amount, so miners would be paid for 2,000 pounds when they actually had brought in 2,500. In addition, workers were docked pay for slate and rock mixed in with the coal. Since docking was a judgment on the part of the checkweighman, miners were frequently cheated.
I first wrote about company stores last summer:
In Kumhof and Ranciere's model, increasing concentration of wealth in a small "investor" class leads to higher demand for investment assets, such as securitized pools of loans made to wage earners who must borrow to maintain consumption as their real income declines. This sets up the same type of dynamic as a company store. Over time and as wage-earner bargaining power weakens, the investor class is able to capture greater proportions of workers' declining or stagnant real wages. The effect is that an increasing portion of middle-class wages circulate back to the financial sector as interest and fees instead of into the larger economy (except, of course, as it occasionally "trickles down" from the investor class to what over time is likely to become the equivalent of a servant class).
"But wait," you say, "surely dollars that go back to investors are then distributed as investment in new, more highly productive capital that generates new jobs?" And so it may, but probably not in this country, at least not right now when we need it most. K and R's model is a closed economy. Ours is not. Investment will seek the highest return that is compatible with risk preferences. Right now that looks to be India and China (see also here).
"Well, how about managing risk?" you say. Yes, that's an important contribution from the financial sector, but recently it looks more like they collude to obscure it, often to their own benefit and at our expense, rather than manage it. And they may knowingly or unknowingly increase it. But, let's get on with the model.
In Kumhof and Ranciere's model, an eventual crisis causes a collapse of asset values, including those that wage earners have been borrowing to finance. The authors show through a series of simulations that only a restoration of wage-earner bargaining power (and therefore an increase in workers' relative incomes) produces the sustained reduction in worker leverage that is necessary to reduce the probability of another crisis.
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. [Emphasis added]
Unfortunately, as with most technical models, it does not indicate how the restoration of wage-earner bargaining power will occur, only that it should, if we wish to avoid another financial crisis.
The problem as I see it is that after an economic collapse like the one we just barely dodged (so far), high unemployment will continue to undermine wage earner bargaining power. In addition, it appears that even as corporate profits rebound, hiring has not. If this reflects a new normal, then wage-earner bargaining power is not likely to rise anytime soon. The availability of large supplies of cheap labor in a global economy also does little to strengthen the bargaining power of US workers, particularly those who lack higher education and technical skills that are likely to become the comparative advantage of US labor in the coming years.
The authors conclude that any success in reducing income inequality is likely to reduce the likelihood of future economic collapses. They suggest that taxing economic rents, including land, natural resources, and financial sector rents (profits) would be the least distortionary way to achieve this.
I will suggest, in addition to the above, that improving the financial literacy of the US population so that we all manage what income we have better and borrow more wisely; adopting policies and regulation aimed at aligning financiers' private incentives with objectives that serve the public interest; and strengthening the oversight and regulation of consumer financial products should also help to reduce income inequalities going forward. Increasing educational attainment of younger Americans would also better prepare them to enter and compete at the upper end of the global income distribution.
In fact, any policy that increases the incomes of the bottom 95% relative to the top 5% would be beneficial. For example, Obama's original plan to retain the Bush tax cuts for the bottom 98%, while allowing them to expire for the top 2% of wage earners would have moved us closer to this. A higher estate tax with a lower threshold than $5 million would also serve this goal.
If the model is right (it does seem a rather good fit with reality), all of these measures require that a government constituted to be of, by, and for the people enact policies that support wage earners, that its elected representatives start serving 95% of the people rather than the top 5% that has so effectively commandeered it. It also requires that we the people find ways to become less dependent on a financial sector that no longer serves our best interests. Unfortunately, the last will likely contract an already fragile economy, at least in the short run.
For the last 30 years, the government has been part of the problem in this trend to increasing income inequality. It's time for government to become part of the solution in reining in financial sector excesses and restoring workers to something that approximates a fair share of national output. Otherwise, most of us will eventually find out what its like to "owe our soul to the company store."