Income Inequality, Household Debt and Financial Fragility

I really like this article, not least because it backs some of my instincts regarding some of the underlying issues underlying Malaysia's low-wage problem:

Inequality, leverage and crises
Michael Kumhof & Romain Rancière

Of the many origins of the global crisis, one that has received comparatively little attention is income inequality. This column provides a theoretical framework for understanding the connection between inequality, leverage and financial crises. It shows how rising inequality in a climate of rising consumption can lead poorer households to increase their leverage, thereby making a crisis more likely.

The US has experienced two major economic crises during the last century – 1929 and 2008. There is an ongoing debate as to whether both crises share similar origins and features (Eichengreen and O'Rourke 2010). Reinhart and Rogoff (2009) provide and even broader comparison.

One issue that has not attracted much attention is the impact of inequality on the likelihood of crises. In recent work (Kumhof and Ranciere 2010) we focus on two remarkable similarities between the two pre-crisis eras. Both were characterised by a sharp increase in income inequality, and by a similarly sharp increase in household debt leverage. We also propose a theoretical explanation for the linkage between income inequality, high and growing debt leverage, financial fragility, and ultimately financial crises.

You can access the working paper on which the article is based at the IMF.

There’s a groundswell of criticism regarding the increasing indebtedness of households in Malaysia. I personally don’t consider it to be a problem – yet – for a couple of reasons. First because as a ratio to total financing (bank and non-bank lending to corporations and households), believe it or not aggregate household borrowing has fallen in the last five years, and secondly because indebtedness has increased in tandem with ownership of assets i.e. an expansion of household balance sheets, rather than an unsustainable increase in  consumption.

Nevertheless the situation is not ideal as we’re still talking about an increase in household leverage, and a corresponding increase in financial system fragility. Also a problem is that the increase in absolute household debt might be – actually, almost certainly must be – different across the income spectrum, with the bulk of it concentrated at the lower end. I’m fairly confident about this in the complete absence of any definitive information about the actual situation on the ground here, because this has been a global phenomena across the last three decades, not a localised one.

The paper uses US data, but the underlying trends are shared in many other countries, if not to such a great degree. And of course, Malaysia starts off with an already high degree of income inequality in the first place, which makes us more vulnerable to the type of crisis this paper examines.

So we’ve established that we might possibly, conceivably be in the early stages of a potential financial crisis somewhere in the distant future. What can be done?

The theoretical model in the article predicts that even with a financial crisis, leverage barely drops as the crisis cuts into household incomes and raises real interest rates. In fact, post crisis leverage ratios initially return to their pre-crisis level before gradually reducing. That means financial fragility remains high and household balance sheets remain weak, even assuming if financial institutions survive high loan defaults during the crisis.

What about macro-prudential measures to restrict credit supply? That has the effect of reducing leverage, but at the price of also reducing consumption (i.e. slower economic growth and/or recession). Assuming the level of leverage reduction is small enough to maintain consumption yet large enough to have an impact on debt, the effect does not last – leverage continues to climb afterwards.

Long term, the solution the authors favour is the one that I’ve increasingly felt is the one we should pursue – reduce the imbalance in bargaining power between owners of capital and workers. This is a socialist solution that grates my nerves, as it implies a far more intrusive role for legislation and regulation than I’m fully comfortable with, and would result in a less flexible and more costly labour market.

Yet its also clear to me that the pendulum has gone too far towards free-market capitalism in the last three to four decades. And the government’s plan under the New Economic Model is to further increase the nimbleness and flexibility of the domestic labour market…which is code for “its easier for companies to fire people”. That in turn implies a reduction in employee bargaining power, the exact opposite of what we should be thinking of and doing.

Technical Notes:

Kumhof, Michael & Romain Rancière, "Inequality, leverage and crises", IMF Working Paper No. 10/268, November 2010