The United States experienced two major economic crises over the past century—the Great Depression starting in 1929 and the Great Recession starting in 2007. Both 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.
The direction of causation between inequality and indebtness seems to be as widely recognized as the correlation itself. Raghuram Rajan, in his book Fault Lines (2010), writes:
Politicians, always sensitive to their constituents, have responded to these worrisome developments [growing inequality] with an attempt at a panacea: facilitating the flow of easy credit to those left behind by growth and technological progress. And so America's failings in education and, more generally, the growing anxiety of its citizenry about access to opportunity have led in indirect ways to usustainable household debt, which is at the center of this crisis. (p. 23-24)
The chapter of the book where Rajan establishes the link between inequality and easy credit is named "Let Them Eat Credit", a choice which in itself suggests a one-way causation running from increasing inequality to growing household debt. Also, in their IMF working paper, Kumhof and Rancière state -- referring to Rajan's book -- that
While not formally modeled there, the link between income inequality, household indebtedness and crises has been recently discussed in opinion editorials by Paul Krugman, and in books by Rajan (2010) and Reich (2010). Both authors suggest that increases in borrowing have been a way for the poor and the middle-class to maintain or increase their level of consumption at times when their real earnings were stalling. But these authors do not make a formally consistent case for that argument. Our model allows us to do so.
Rajan’s argument is that growing income inequality created political pressure, not to reverse that inequality, but instead to encourage easy credit to keep demand and job creation robust despite stagnating incomes.
They also present some interesting statistics:
Figure 1 plots the evolution of income inequality and household debt ratios in the two decades preceding the two major U.S. crises - 1929 and 2007. In both periods income inequality experienced a sharp increase of similar magnitude: the share of total income (excluding capital gains) commanded by the top 5% of the income distribution increased from 24% in 1920 to 34% in 1928, and from 22% in 1983 to 34% in 2007. During the same two periods, the ratio of household debt to GNP or to GDP increased dramatically. It almost doubled between 1920 and 1932, and also between 1983 and 2007, when it reached much higher levels than in 1932. In short the joint evolution of income inequality across high and low income groups on the one hand, and of household debt-to-income ratios on the other hand, displays a remarkably similar pattern in both pre-crisis eras.
Could it be that growing household indebtness is not just an effect of increasing inequality, but actually one of its main causes? I haven't seen anyone even posing this question, not to speak of trying to answer it. Yet, my analysis so far suggests that the answer to this question must be positive.
As the 1990s approached, there was not much talk about stagnating real wages, but households had already started to gorge themselves with credit. The intellectual backing for this was something that first emerged already in the middle of the 20th century. It goes by many names: "intertemporal choice", "intertemporal consumption", "life-cycle hypothesis", "permanent income hypothesis" or "consumption smoothing".
Guy Debelle writes in “Macroeconomic implications of rising household debt” (BIS Working Papers, No 153, June 2004):
"The rise in household debt that has occurred over the past two decades reflects the response of households to lower interest rates and an easing of liquidity constraints. This is likely to have allowed households to achieve a more desirable path for lifetime consumption."
My hypothesis -- the title of this blog post -- is mainly based on the following observation:
How can the value of sales increase if firms in aggregate don't pay their employees -- indirectly their customers -- more? Sales can increase if customers take on debt to finance purchases of firms' products and services. The deposits which are used in these purchases are created when households acquire more debt. An increasingly disproportionate share of these deposits ends up as profits for business owners and as higher salaries, and bonuses, for top earners. These people don't represent a large portion of the customers of our main businesses, our largest employers, and higher payments to the "top 10 %" (I, like Rajan, prefer the no doubt arbitrary 90%/10% division to 99%/1%) accompanied by lower payments to low- and middle-income households would normally -- in the absence of growing household indebtness -- translate to lower sales of many items; for instance, big ticket items like cars. It was clear already to Keynes and his contemporaries that these households, the "masses", are the ones whose consumption ultimately drives the economy.
For the lower income group, the "bottom 90 %", I can't think of a surer way to lose bargaining power than by transferring their future earnings, by way of credit, to their employers when their current earnings fall short of their "desirable consumption". This flow of (indirect; see discussion in comments of my earlier post) IOUs from households to businesses might seem like "windfall income" for the businesses -- income which these businesses can freely distribute to their owners and top employees.
So, I depart from Kumhof and Rancière who write about "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" by arguing that this "additional income" is itself a result of the rest of the population sustaining, and often even increasing, its consumption levels by way of loans.
I'm attending the Annual Conference of the Institute for New Economic Thinking next week, from April 8 to April 11, in Paris. I would be happy to get together and share thoughts with any colleagues, so feel free to contact me via Twitter or e-mail if you are attending too!