Saturday, October 17, 2009

Inequality and the economic crisis

Financial crises are considered being inherent to capitalism. As J. Stiglitz* put it, the roaring 90s of boom contained the seeds of self-destruction. Deregulation, excessive risks, creative accounting and tax cuts in favour of the wealthy led to the current disaster. But there is another factor which is often neglected in the analysis of the current crisis. Rising income inequality since the beginning of the 90s not only in the US but in almost all developed countries has been an important driving force in the global financial crisis.

The wealthiest - the top ten per cent - receiving a growing share of national income, directed huge financial resources into asset markets causing asset price bubbles. The middle class - say 60%- experienced a drop in real wages- especially in the anglo-saxon world and started borrowing massively as house prices rose, which helped postpone the problem of underconsumption or excess in production capacity. But eventually the gap between rising debts and less disposable income increased dramatically.

The same mechanism operated in the US during the 30s in the build up to the Great Depression. J.K. Galbraith* writes that the GNP (total production of the economy) was nearly less than a third in 1929. The overwhelming majority of tax payers had lower disposable income, while the top 1 per cent increased their revenues and corporate profits significantly. Speculation on a large scale went on during subsequent years : rising profits went into real estate and stock markets feeding the asset bubble. In the aftermath of the great crash, the majority of workers is confronted with less income and greater uncertainty about jobs.

What should be done to tackle income inequality? Huge fiscal stimulus programs were launched in the US, Japan, China and most European countries to sustain global demand. But the key to reduce inequality is to combine measures to sustain employment with income redistribution through the State. But other policy areas need careful attention. They include inter alia reforms of corporate governance as well as capping to bonuses for traders in order to put limits on maximising shareholder returns at the expense of wages.

More fundamentally, a new balance between capital and labour needs to be restored. Governments should act as a matter of urgency to tackle widening inequality as rightly pointed out by Matthew Slaughter (FT October 7). The steps taken by the Obama administration, particular on healthcare and taxation go in that direction but what about the European countries where only temporary measures are taken to prevent social explosion with unprecedent rise in unemployment?

¨* J.E.Stiglitz, The Roaring Nineties, Norton , New York, 2003
** J.K.Galbraith, The Great Crash 1929, published for the first time in US in 1954. This classic book is an illuminating essay on the causes of the Great Depression.

Wednesday, October 7, 2009

Misconceptions about the crisis

We must be worried that the crisis has not been fully understood despite all the energy put into it. GDP growth is turning positive, stock market prices rise again, banks make profits. Governments start preparing exit strategies hoping to turn back to normality.

In fact, the notion of 'exit strategy' does have a different meaning: it just refers to the state of economic affairs, not redesigning the global economic system. The accumulation of public debt and liquidity are creating fears of rising inflation. But this situation has been caused by the disfunctioning of markets. In a world without memory of the past, we tend to create a confusion between causes and effects.

Should we then take seriously this pledge for a return to normality? The danger is that economic agents ( for instance banks) continue to act as if nothing happened and then the actual conditions of the crisis will be reproduced. In effect, the origin of the crisis is not associated with public debt nor inflation; it is primarily a financial crisis, which reflects a huge disfunctioning of financial markets. Consequently, it is only partially attributable to myopic markets and predatory behaviour of financial agents. The bust of the financial system, has indeed, more profound causes.

In rich countries, the last quarter of century has in most cases been unfavourable to the working class. Inequality has risen everywhere; and it is not a coincidence that the crisis bursts at the heart of the capitalist system, in the United States where the increase of income inequality has been higher than elsewhere. The other countries have followed a similar path, but to a lesser extent due to social resistence. The consequence is that global demand weakens, due to the fact that most individuals with less purchasing power spend their whole income in consumption whilst a small minority will spend a lower fraction of their income. In that context, monetary policy is used to expand global demand: lower interest rates lead to wider access to credit and therefore an increase in private debt. The other side of the coin is that a tiny minority of individuals (probably less than 1% of the population) benefit from a susbtantial increase of their incomes and seek further opportunities for investing in financial markets. The result is the formation of asset bubbles through huge increases of asset prices. The system appears (although temporarily) to be in equilibrium since private debt corresponds more or less to the value of assets. Hence the impression that the net wealth of households has increased in value. However, when the market turned to a more realistic valuation of assets, then the system collapsed because debts could not be paid off.

Then comes the implacable mechanism of the crisis : the increase in inequality leads inevitably to a loose monetary policy, which in turns increases the systemic risks in unregulated financial markets as asset prices are set to increase continuously.

This is only part of the explanation of the current crisis. There are probably other causes which need to be taken into account, such as the accumulation of reserves (in dollars) by the emerging countries to protect themselves against macroeocnomic instability and which have further aggravated the crisis of demand.

The return to growth in GDP in most countries is certainly a good thing: it means essentially that the drop in global demand has been offset by the fiscal stimulus measures implemented through the States. However, world GDP is today at least 4-5 percentage points lower than its level before the crisis. Several years of continuous growth will be necessary to return to that level. In the meantime, unemployment - which is a key indicator of the 'end' of the crisis- will continue to grow.

In these circumstances, an 'exit strategy' might allow to turn back to economic conditions which prevailed before the crisis, but will not address the fundamental causes which led to the collapse of the capitalist system. The exacerbation of economic inequalities is not accidental, but it is the poisoned fruit of a particular conception of ' economic virtue' which puts at the heart of the model of society fiscal and social competition as the engine of growth.

The economic crisis is not a natural disaster, although many journalists and economic analysts present the financial turmoil as a 'tsunami'. All natural events occur in a limited timespan and cause damage and pain mainly to the weak categories of the population. It has to be seen on the contrary as a sign of profound disfunctioning of the capitalist system. Unorthodox economists, from Marx to Keynes and most post-keynesians like Harrod, Kalecki and Minsky have shown that this system is structurally unstable.

In his 'Theory of business cycles' (1939), Schumpeter wrote :"Cycles are not like tonsils, separable things that might be treated by themselves, but are like the beat of the heart, of the essence of the organism that display them".

We will not get out from the crisis if we fail to understand its underlying causes and if accordingly the right economic policies are not put in place in a coordinated way among States to tackle them.