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:
- Growing inequality produces less money for the middle class and more money for the wealthy
- 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
- The financial sector expands to mediate all this
- 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.