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Business News/ Money / Personal-finance/  How playing Robin Hood can prevent economic crises
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How playing Robin Hood can prevent economic crises

How playing Robin Hood can prevent economic crises

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Inequality, Leverage and Crises By Michael Kumhof and Romain Ranciere, IMF Working Paper ( https://www.imf.org/external/pubs/ft/wp/2010/wp10268.pdf )

Mainstream theories of the economic crisis have identified loose monetary policy leading to asset bubbles, wrong incentives, a failure of regulation, excessive leverage or the explosion in opaque derivatives as the underlying reason for the crisis. More radical explanations have said, following the iconoclastic economist Hyman Minsky, that the financial system is prone to boom-bust cycles. It has so far been only the political left that has identified inequality as one of the reasons for the increase in debt in the US. Because workers’ incomes have not increased in real terms, so runs the argument, they have been forced to borrow and the banking system has been happy to oblige. It’s a sign of how far the dominant discourse has shifted, therefore, to see the International Monetary Fund carrying an article in its Finance and Development magazine that says “long periods of unequal incomes spur borrowing from the rich, increasing the risk of major economic crises". The article, by Kumhof and Ranciere summarizes an earlier research paper authored by them.

The authors point out that inequality increased sharply both before the Great Depression and the current crisis. 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. This led to a rise in the debt-income ratios of the working and middle classes.

While income inequality increased, inequality in consumption did not rise to the same extent for the simple reason that those at the bottom of the pyramid were borrowing more, while the rich people at the top were saving more. And because the poor borrowed more to keep up their consumption, their debt-income ratios went up, increasing financial fragility. The authors find that nearly all of the increase in the debt-to-income ratio at the aggregate level comes from the bottom group of the wealth distribution. Also, the rise in debt levels leads to the financial sector becoming more important and accounting for a larger size of the economy. This explains the laments about the “financialization of the economy". In essence, the authors are saying that the richest 5% of the US population, who are investors, lend to the bottom 95% of the population.

Seen in this fashion, the origin of the crisis is at the bottom a political problem, based on the distribution of income. That, in turn, is dependent on the relative power relations between the rich and the poor. Kumhof and Ranciere write: “The crisis is the ultimate result, after a period of decades, of a shock to the relative bargaining powers over income of two groups of households, investors who account for 5% of the population, and whose bargaining power increases, and workers who account for 95% of the population." Economists such as Morgan Stanley’s Stephen Roach had pointed out long ago that labour’s share of national income had been going down in the US many years before the crisis.

Bank bailouts help investors and, therefore, the rich, while the cost of the bailouts is borne by the taxpayer, most of whom are from the poor and middle classes. So what’s the solution? Write the authors, “Because crises are costly, redistribution policies that prevent excessive household indebtedness and reduce crisis risk ex-ante can be more desirable from a macroeconomic stabilization point of view than ex-post policies such as bailouts or debt restructurings."

Their conclusion: “Restoring equality by redistributing income from the rich to the poor would not only please the Robin Hoods of the world, but could also help save the global economy from another major crisis."

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Published: 17 Dec 2010, 11:01 PM IST
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