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Data Shows Income Inequality Increases Probablities of Major Economic Crisis

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Much has been written and said about income inequality and lack of social mobility in the U.S., but until now I’ve not seen actual statistics – or data – on how similar the current situation is to that of the 1920’s just before the Great Depression. ATAXINGMATTER, a blog about taxes and tax policy, posted the following on this subject. Rather than summarize the data presented, I’m reposting the entire blog post.

Comments on Inequality, Leverage, and Crises–Kumhof & Ranciere Nov 2010 IMF working paper

[guest post by Clifford D. Clark]

Michael Kumhof’s and Romain Ranciere’s November 2010 paper relates income inequality to national economic crises, particularly those experienced as the Great Depression and the Great Recession. They conclude that increases in income inequality –comparing the top 5% of households to the bottom 95%–in the years leading up to the two crises exerted a determining influence on the economy.

First, income inequality grew in similar ways in the years before the depression and the recent deep recession. From 1920 to 1928 the share of national income received by the top 5 percent of households increased from 24% to 34 % and from 1985 to 2007 the share of the top 5% increased from 22% to 34 %. Between 1920 and 1932 and between 1983 and 2007 the ratio of household debt to GDP nearly doubled, although the ratio was higher in 2007 than in 1932. The authors find a link between the two phenomena: income inequality increased at a greater rate than consumption expenditures in the years before the two crises. The public was spending at rates greater than increases in their income.

Second, in the years before the recent downturn the growth in household debt was due almost entirely to the bottom 95%. Real hourly wages of the top 10% of households increased by an accumulated 70% between 1967 and 2003, while the median households decreased by 5% and wages at the bottom 10% decreased by about 25%. A similar pattern, but with greater widening, is shown in annual earnings (less capital gains). Yet the change in inequality of consumer expenditures (for non-durable items of the kind tied closely to income) was considerably less. Can one infer that smaller changes in consumption are due to upward mobility? Their answer to the question is “income mobility has been stable or slightly worsening since the 1950s.” Id. at 7. Further, they find that households “at the bottom of the distribution of income and wealth are more indebted than households at the top.” Id. at 7. That represents a clear switch: whereas in 1983 the top wealth group was more indebted than the bottom 95%, by 2007 the reverse was true. By then the bottom 95% had debts equal to 140 % of income, nearly twice that of the top 5%. They conclude that almost all of the change in the debt to income ratio in aggregate was due to the bottom 95%.

Third, an increase in debt requires and increased need for financial intermediation: accordingly, the size of the financial sector between 1980 and 2007 increased considerably. Measured by the ratio of private credit of deposit banks and other financial institutions to GDP, that quantity increased from 90% in 1981 to 210% in 2007. By Philippon calculations the magnitude of the financial sector in GDP almost doubled to 8% of GDP during that period–that is, there was nearly the same rate of increase as experienced in the years before the Great Depression. There are also further indicators of risk such as defaults and income to debt ratios.

Their conclusion is succinctly stated.

“The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while. 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.” Id. at 22.

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Written by Valerie Curl

November 18, 2011 at 9:16 AM

One Response

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  1. So true along with the fact that those who control this country, corporations and the financial sector are slowly strangling the life out of the USA. Already the financial sector is in a panic as the days of over-compensation and bonuses are falling to the wayside. Those recently graduated MBAs are seeing their futures thrown into question along with the rest of the sector. Why these people in the financial markets’ cannot see that without sharing a little of the pie with the rest of the populace you cannot grow an economy.

    Pj

    November 24, 2011 at 10:12 AM


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