Wednesday, May 9, 2012

The great lending reversal

Historical stereotypes show that the rich owed a great share of their incomes to leverage. They invested borrowed money in remunerative enterprises and leveraged it to raise their incomes. In contrast, the middle-class and poor were seen as debt-averse and relying on debt only when forced into it. However, as this IMF study indicates, the roles, atleast in terms of the debt-aversion of the non-rich, appear to have changed. Sample this evidence from the US,
In 1983, the top 5 percent had 80 cents of debt for every dollar of income, while the remaining 95 percent had 60 cents for every dollar. By 2007, after decades in which an increasing share of income flowed to the top, the situation had reversed. The top 5 percent had 65 cents of debt for every dollar of income, while the remaining 95 percent had $1.40 in debt for every dollar.

The authors use cross-country data and develop models that try to simulate changes in income distribution and household debt to GDP ratios and its impact on the economy. Their DGSE model, where workers income shares decline at the expense of investors, show,
Loans to workers from domestic and foreign investors support aggregate demand and result in current account deficits. Financial liberalization helps workers smooth consumption, but at the cost of higher household debt and larger current account deficits. In emerging markets, workers cannot borrow from investors, who instead deploy their surplus funds abroad, leading to current account surpluses instead of deficits.  
In other words, the only way to sustain high levels of consumption and national aggregate demand growth in the face of stagnant incomes was for poor and middle-class households to borrow. And its result is widening inequality and eventual debt-default which brings down the whole economic edifice. 

They therefore argue that the only sustainable way to reduce this is to address the critical issue of stagnant incomes. It is now well-established that markets do not generate efficient outcomes with income distribution. The prevailing balance of power in the economic structure and its hand-maiden political establishment, are too skewed to generate the desired level of income distribution.

To address the immediate challenge of debt-reduction among households, an "orderly debt reduction" wherein the process takes a few years may be the most appropriate method. In the medium to long-run, given the skewed distribution of incomes between labour and capital, this market failure will have to be addressed through an institutionalized mechanism that restores some element of collective bargaining. 

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