The neglected imbalances in the financial crisis

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The key to understanding the long-term structural causes of the present crisis lies in the nexus between economic inequality, debt and financial explosion, writes Michael Lim Mah Hui.

The current financial crisis is no doubt the worst since the Great Depression. To explain a crisis of such proportions, one must look beyond poor industry practices like the lack of supervision and regulation or greed of financiers, important in themselves, to more fundamental causes. Much has been written about current account imbalances in the global financial system as a major structural cause. Less discussed are two other structural imbalances that are equally important: the wealth-and-income imbalance, and the imbalance between the financial and real economies. I shall focus on the first of these imbalances in this article.

The world and the US have experienced tremendous economic growth over the past few decades. But this growth was accompanied by growing inequality. In the US income inequality as measured by the Gini index rose from 38 to 47 (1970 to 2006), putting the US in the company of Latin American countries. Wealth distribution is even more skewed, with a Gini index of 80. Another measure of inequality is the share of GDP accounted for by profits versus compensation, with the former increasing and the latter declining over the past three decades. The same trend is captured in the ratio between the growth in productivity and average compensation. For a long time these two grew in tandem, but they began to diverge after the 1970s.

Alan Greenspan, former chairman of the US Federal Reserve, was aware of – and troubled by – the fact that the share of worker compensation in national income in the United States and other developed countries was unusually low by historical standards. In an FT interview in 2007 he said: “We know in an accounting sense what is causing it …but we don’t know in an economic sense what the processes are.” He added that in the long run, real wages should parallel increases in productivity, but for now they had veered off course for reasons he was not clear about. He also worried that if wages for the average US worker did not start to rise faster, political support for free markets might be undermined

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Stagnation in real wages

The key to understanding the long-term structural causes of the present crisis lies in the nexus between economic inequality, debt and financial explosion. Wage stagnation and economic inequality create under-consumption by a large part of the population, while concentrating wealth in the hands of a tiny minority. In other words, under-consumption by many and excess savings by a few are two sides of the same coin. Under-consumption, or lack of demand, puts a drag on the economy. This was counteracted by the increased use of debt to drive the US economy forward.  

Between 1960 and 2007 total debt in the United States rose 64 times, while GDP grew 27 times. The largest increase in debt was in the financial sector which jumped 490 times, followed by household sector debt which increased 64 times, reaching 100 per cent of gross domestic product by 2007. What this meant was that, while the average American’s real wages remained stagnant or rose only marginally over this period, s/he was able to “over-consume” by incurring debt – be it credit card, auto-loans or housing loans. This pushed the debt and asset (housing) bubbles to unsustainable heights and sooner or later had to be corrected. As Elizabeth Warren, Chairwoman of the US Congress’s Oversight Panel, said recently, years of flat wages, low savings, and high debt have left the American household extremely vulnerable, and any effective policy has to start with households.

On the other hand, excess savings meant excess liquidity – a pre-condition of almost every boom and bust. Hungry for higher yields, those with excess savings placed them in the hands of bankers and financiers who engaged in leverage and financial innovations to enhance their returns. This was the golden age for private equity funds, hedge funds, leverage buy-out, structured products and derivatives. Of course, the non- or self-regulatory environment promoted by policy makers enabled the explosion of financial innovations. For example, after the  Commodity Futures Modernisation Act was passed,  exempting derivatives from regulation (since they do not fall under the categories of gaming activity or securities), the volume of credit default swaps jumped from less than $10 trillion to over $60 trillion in a few years.

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In the case of China a similar, though not identical, process is at work. The Chinese economy grew at breakneck speed after 1998 but, according to a World Bank report, the share of GDP accruing to labour dropped from 53 per cent to 41 per cent. During this period, two important sectors that once provided social security to the population – the health and education systems – were run into the ground. The ordinary Chinese was forced to save a large portion of his income for rainy days. A serious illness and visit to a hospital could wipe out one or two years’ earnings for the ordinary worker.  Given this vast economic imbalance, the present effort of the Chinese government to shift towards a more domestic consumption driven growth is hindered unless they address the glaring economic inequality in society.

What this means is that if the G20 in its recent communiqué is serious about laying the foundation for stable and long-term prosperity, it must address not only the world’s current account imbalances but also both the  wealth and income imbalance and the imbalance between the financial and real economies.

The writer is a visiting senior fellow at the Institute of Southeast Asian Studies, Singapore, and a fellow at the Socio-economic and Environmental Institute, Penang. This article first appeared in The Straits Times, Singapore (18 August  2009).

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