Commenter Tomboktu tipped me to an IMF working paper from last month by Michael Kumhof and Romain Ranciere, “Inequality, Leverage, and Crises.” I referenced it in my previous post about plutonomy. In this paper, the authors use conventional tools like a DSGE model to explain the curious fact that,
Both [the Depression and current recession] were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis.
How? Their mechanism actually flows through financial channels, rather than through slacking aggregate demand, which I’ve mainly promoted as the key driver on this blog; however, the two explanations need not be exclusive. The main insight derived from their model is that,
Prior to the crisis, increased saving at the top and increased borrowing at the bottom results in consumption inequality increasing signiﬁcantly less than income inequality. Saving and borrowing patterns of both groups create an increased need for ﬁnancial services and intermediation. As a consequence the size of the ﬁnancial sector, as measured by the ratio of banks’ liabilities to GDP, increases. The crisis is characterized by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. ﬁnancial crisis.
As their title indicates, they also describe this process in leverage terms in the conclusion:
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.
I also enjoyed the paper because of bits like this:
And as far as strengthening the bargaining powers to workers is concerned, the difﬁculties of doing so have to be weighed against the potentially disastrous consequences of further deep ﬁnancial and real crises if current trends continue.
The takeaway for policymakers is that,
More importantly, unless loan defaults in a crisis are extremely large by historical standards, and unless the accompanying real contraction is very small, the effect on leverage and therefore on the probability of a further crisis is quite limited. By contrast, restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis.
I shouldn’t be so surprised that a relatively heterodox conclusion is coming from the IMF, which last year produced a working paper rethinking capital controls. The crisis is undoubtedly causing some serious rethinking in some scholarly circles. Even if this paper is using relatively conventional tools, it is asking an unconventional question is the mainstream. The key question for the economics discipline is whether papers like this, which ask the right questions, will receive the attention (and scrutiny) that they warrant.