"When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals.
We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues"

( JM Keynes, "Economic Possibilities for our Granchildren" 1930 )

Sunday, February 22, 2009

Financial Crisis and Wealth Distribution

It is commonly agreed that the detonator of the current crisis was the collapse of the credit bubble which have been developing since the 80. During that period the US Credit/ GDP ratio increased from a stable level up to 350% (a level not seen since the 30). The lion share of the debt increase was at financial institutions and households sectors

By definition debt is a temporal transfer of resources between a lender and a borrower .From the borrower side our approach claims that the debt expansion, especially of the American household sector, served to counterweight the detrimental effects related to the stagnation of the median household incomes on consumption (ap. 70% of GDP). The magnitude of the trend is reflected in the widening gap of income distribution since the 80 : just for the illustration , “Top 1% Pre Tax Income Share” ascended from 9% in 1976 up to 21.8% in 2005 ( the previous peak in 2008 was 23.9%). From the lender side, the vast accumulation of wealth among higher income stratus (Fed surveys show a rather high saving ratios among the higher quintile) was channeled to the financial markets and consumption (Corporations apparently did not need finance due to their positive cash position along the last decade). It seemed that the circle was squared: Stagnating labor cost combined with expanding consumption means higher profits.

An additional source of finance was the foreign sector as a result of their own lack of effective demand which obliged them to keep financing the US economy by purchasing American obligations. The case of China is interesting since the country development policy as the workshop of the world is based upon low labor cost , and high saving ratios which means weak internal demand (“Let some people get rich first“ Deng Xiao Ping ) The consequence was an inevitable accumulation of reserves (almost 2 Trillion USD as of 12/2008) much above the real needs of the economy.

At some point the scheme began to be sustained by increasing real estate prices (and low interest rates). The expectations served to guarantee mew mortgages ( which were packed and sold for a commission) and a source of wealth effect for the costumer reflected in wide use of MEW finance scheme which explains up to 3% of GDP growth since 2001 (J. Kennedy and A. Greenspan). Since the real economic yield of that scheme is rather low (analyzing the ROE in contrast ROA of investment banks for example) the huge leverage and lack of regulation was essential to maintain decent yields (and high bonuses for top managers) and to turn dubious debt into respectable stuff. The collapse of real estate values marked the beginning of the debt contraction (deleveraging) which sustained the consumption generator and the value of collaterals.

Public institutions are nowadays engaged in pouring trillions of public money on bailout plans for financial institutions, various industries, consumers, etc, and public projects to reactivate aggregate demand. Leaving aside the question regarding the effectiveness (and fairness!) of these efforts, the extra expense will be financed somehow and here the distribution specter returns to the debate. If we accept the basic lines of the above analysis, the reactivation of the economy must include a major income and wealth redistribution mechanism on global scale ( income redistribution on national scale is a close relative to protectionism) to ensure a lasting demand generation based upon sound economic principles.

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