How to Create a Financial Crisis in Four Easy Steps

While in a previous blog, I used the blame approach to the financial crisis, there is also a systemic approach to understanding it. In their IMF working paper ‘Inequality, Leverage and Crises‘ Michael Kumhof and Romain Ranciere construct a simple model for financial crises with the following narrative:

  1. Growing inequality produces less money for the middle class and more money for the wealthy
  2. The rich loan much of this money back to the middle class so they can continue to improve their living standards even with stagnant real incomes
  3. The financial sector expands to mediate all this
  4. This eventually results in a credit crisis.
They write in summary:
‘This paper has presented stylized facts and a theoretical framework that explore the nexus between increases in income advantage enjoyed by high income households, higher debt leverage among poor and middle income households, and vulnerability to financial crises. This nexus was prominent prior to both the Great Depression and the recent crisis. In our model it arises as a result of increases in the bargaining power of high income households. 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 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.’
Footnote: Thanks to the amazing book ‘The End of Economic Growth: Adapting to our New Economic Reality’ by Richard Heinberg for this. I will review this book when I have finished it.

About creativeconflictwisdom

I spent 32 years in a Fortune Five company working on conflict: organizational, labor relations and senior management. I have consulted in a dozen different business sectors and the US Military. I work with a local environmental non profit. I have written a book on the neuroscience of conflict, and its implications for conflict handling called Creative Conflict Wisdom (forthcoming).
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2 Responses to How to Create a Financial Crisis in Four Easy Steps

  1. Tracey Yang says:

    The depth and severe adverse consequences of the latest financial crisis have triggered the debates to re-regulate the world’s financial industry. After several decades of financial deregulation, is a tighter state regulation now necessary to improve the stability and functioning of the financial system? Or would re-regulation make a bad situation worse, by slowing financial innovation, introducing perverse incentives and perhaps even increasing risks?

    • @Tracey Yang. Personally, I say ‘God save us from financial innovation‘. None of the products of mass financial destruction that did all the damage, in my view helped in any way vector savings to real productive activity. They were more in nature of casino operations, concealing risk, encouraging reckless lending, trapping consumers in lethal small print conditions to take loans they could not afford. They were an admission that the financial sector could not tell the difference between sensible businesses and Ponzi schemes. The Glass Steagall Act Repeal destroyed the boundary between speculative and retail banking and I see no virtue in that action. I have no confidence in the financial sector’s ability to protect my savings and the financial advisers I speak to are a total joke. I want to see us make the real economy of manufacturing goods and providing value add services central in the US and in Europe. The finance sector should have no other role than supporting this with insurance, stock market capital raising, foreign exchange provision. I strongly advocate the Tobin Tax on financial transactions to slow the market churn down, so buying and selling financial products is not done at the scale of global GNP every day…And I want a save home for my savings with very transparent risk level. And I want the too big to fail banks broken up asap. Risk is risk and there is moral hazard in not letting risk takers feel the consequences of their risk taking, so they need to be small enough to be allowed to fail and separating retail and speculative banking is part of that.

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