Monday, September 20, 2010

Income Inequality: A Necessary But Insufficient Condition for Financial Instability

Recently, a lot of people (including the IMF) have been looking to income inequality as a potential cause of the current economic situation.  There are certainly a lot of data that indicate a correlation between periods of severe income inequality and financial crises.

While income inequality certainly played a roll in the recent credit crisis, financial speculation caused it. What income inequality did was (1) increase demand for household debt for those in the lower 90% of household incomes and (2) increase demand for financial speculation for those in the top 10% of household incomes.

When income and specifically wages are spread more evenly across all income levels, more people are able to accumulate savings and, therefore, are able to avoid incurring debt.  On the other hand, fewer people accumulate savings of sufficient size that they are willing to risk some or all of their savings by engaging in financial speculation.

When income inequality is as high as it is now, it aligns the interests of both the savers and the non-savers with those of the financial sector.  The non-savers in the bottom 90% of households earn 65% of the wages, which provides a diversified base across which to extend credit at the highest rates possible (the top decile won't pay a premium for access to credit).  On the other hand, the top 10% are confronted with the possibility that their savings are a wasting asset in face of potential inflation.  As we know from Prospect Theory, losses "loom larger" than gains, and inflation is perceived as a certain loss, so "putting your money to work" making more money is a no-brainer.  Add to the mix things like hedge, which can make outsized gains due to leverage, and it is very easy for a high net-worth individual to be enticed to participate in financial speculation (which he has been taught to think of as just a higher risk form of "investing"). 

Things got really dangerous when asset-backed derivatives coupled the increased debt of the bottom 90% of households to the financial speculation of the top 10% of households and the financial sector.  Ever increasing savings increased the demand for asset-backed derivatives, which increased the demand for new borrowers, which further incrased savings, and so on.

The primary reason that I think we need to consider finance (or speculators) as separate and distinct from capital and labor in economics is that finance's interests compete with both capital (who must choose between investing capital in increasing productive output and speculation) and labor (whose stagnant wages encourage taking on an increasing debt burden to maintain the illusion of making progress).  Because finance ostensibly serves both capital (through investment banking) and labor (through commercial banking), they bridge the gap and provide a feedback loop that can potentially be self-reinforcing, particularly as demand for financial speculation becomes large enough due to the increased concentration of wealth in a small portion of households.  Classifying finance as part of either capital or labor prevents its influence on the economy from being adequately understood (all we can understand now are aggregates of debt and income after the fact).