Three ways in which inequality causes financial instability


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10:43 am - January 12th 2012

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contribution by Stewart Lansley (speaking at Fabian conference)

The pursuit of a more equal society has long been one of the fundamental principles of social democracy. For 40 years from the mid-1930s – the period of the ‘great leveling`- the wealth and income gap narrowed sharply in the UK and across the rich world.

This long-term trend came to a halt at the height of the global crisis of the mid-1970s and then went into reverse, driven by a new economic philosophy, one that argued that egalitarianism had gone too far.

But between 1980 and 2007, average real wages in the UK rose by only a little over half the rate of growth. So have the architects of market capitalism been proved right?

History shows a clear link from inequality to instability. The main outcome of the post-1980 experiment has been an economy that is both much more polarised and much more fragile and prone to crisis, and the two most damaging recessions of the last century – the Great Depression of the 1930s and the Great Crash of 2008 – were both preceded by sharp rises in inequality.

So what are the mechanisms through which excessive concentrations of income trigger economic malfunction?

The first stems from changes in the relationship between wages and productivity, a key link in the way economies function. If they get out of line in either direction, they create imbalances that lead to economic failure.

The significance of a growing ‘wage-productivity gap’ is that it upsets the natural mechanisms necessary to achieve economic balance. This is because de-linking earnings and output sucks demand out of the economy and imposes deflation. In most rich economies, wage-enabled consumption accounts for around two-thirds of economic demand. Consumer societies suddenly find they lack the capacity to consume.

The second mechanism occurs because concentrating the proceeds of growth in the hands of a small global financial elite eventually leads to asset bubbles. From the early 1990s, rising corporate surpluses, uncontrolled bank lending and burgeoning personal wealth led to a giant mountain of global footloose capital. By 2008, the assets – loans, credit advances and derivatives – held by the ten largest UK banks had grown to nearly five times the size of the UK economy.

Only a tiny proportion of this sum ended up in productive investment. Far from creating new wealth, a tsunami of hot money raced around the world at speed in search of faster and faster returns, creating the bubbles – in property, commodities and business – that eventually brought the British and global economies to their knees.

The third factor at work has been an increasing divorce between the process of enrichment and economic dynamism. It became easier to make big money through business strategies that were essentially unproductive. This enriched a generation of financiers but only by the expansion of activity which stifled the ‘real economy’.

The central lesson of the last thirty years is that a widening income gap and a more productive economy do not go hand in hand.

What has been built is an increasingly wealth-diverting model of capitalism – Ed Miliband’s ‘predatory capitalism`. The great experiment in unequal market capitalism has failed on its own terms.

The lesson – for the right as well as the left – is that capitalism that shares its output proportionately between profits and wages, and fairly amongst all citizens, is not just likely to be politically more stable, it will also deliver a more productive economy, faster growth and less turbulence.

A generation ago, the baton of economic philosophy was passed from the social democrats to the market theorists, with disastrous consequences. It is now time it was passed back.

—-
Stewart Lansley is the author of The Cost of Inequality: Three Decades of the Super-Rich and the Economy. A longer version appears in the winter 2011/12 Fabian Review.

Stewart Lansley will be appearing on a panel discussion about inequality, class and the crisis alongside Lord Glasman, Owen Jones, Baroness Lister and Emma Burnell on the 14th January at the Fabian New Year Conference 2012.

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The lesson – for the right as well as the left – is that capitalism that shares its output proportionately between profits and wages, and fairly amongst all citizens, is not just likely to be politically more stable, it will also deliver a more productive economy, faster growth and less turbulence.

To be fair, this is a reasonable conclusion. It is how we bring this about that is the question – how do we break the boardrooms if you like (without breaking the pension funds, which are another financial institution that needs protection it appears, but which like the big banks is then irresponsible)? I would suggest the problem here is one of capitalism (a system where money equals power) and that it could be overcome by establishing in its place a proper market (effectively knowledge equals power, with ideally free access to knowledge). Others might suggest this requires state intervention, although this seems to me to be messing around with minor details when it is the actual system that is the problem.

The period that has seen income inequality rise within Western nations is also the period in which incomes have been rising in the developing world.

The same economic processes that have made the Chinese, Africans and Indians richer have exacerbated income inequalities at home.

Seems to me an acceptable price to pay for not having so many live on < 2 dollars a day.

What on earth is the OP talking about?

First he makes the usual lefty claim, comparing real wages to GDP growth, without stopping (as ever) to realise that some component of GDP growth is from increased Labour and productivity which would cause upward pressure on wages, yet some increase in GDP is due to increasing population, which causes downward pressure on wages.

GDP is a very crude measure, given it is simply total economic activity. It is the same slightly flawed reason proponents of immigration said it would boost GDP – it will, simply because there are more people. It takes into no account any of the costs, including depressing wages.

“This is because de-linking earnings and output sucks demand out of the economy and imposes deflation”

Eh? No, what is sucking at demand is a combination of inflation, recession and a roll-back from the huge over-reliance on credit. If you actually look at the data in many parts of the economy, especially the public sector, wages have been increasing faster than productivity.

“Far from creating new wealth, a tsunami of hot money raced around the world at speed in search of faster and faster returns, creating the bubbles – in property, commodities and business”

Hot money did this? Hot money is normally hedge fund style investors. Arguably there might be a bit of a commodity bubble, but certainly it wasn’t hot money causing a housing bubble. The people who caused a housing bubble (and are the original instigators of the financial crisis) were the general population who bought too many too expensive houses with the hope of their prices ever going higher, and became unable to pay their mortgages once the (admittedly enabling) cheap mortgages ran out, pulling the prop away from the entire housing market.

“The lesson – for the right as well as the left – is that capitalism that shares its output proportionately between profits and wages, and fairly amongst all citizens, is not just likely to be politically more stable, it will also deliver a more productive economy, faster growth and less turbulence.”

Again, another “lesson” for us all, totally unproven. Just a belief system. A belief system which looks suspiciously like communism lite, or socialism. Which, as we know, doesn’t have a particularly successful track record.

Tyler

” The people who caused a housing bubble (and are the original instigators of the financial crisis) were the general population who bought too many too expensive houses with the hope of their prices ever going higher”

As usual with the far right attempting to weasel out of its responsibilities for the catastrophe we’re living through, it’s blame the victim time! No mention here of ludicrously jettisoning regulation!

Honestly, you’ve had 3 decades to prove your extreme version of capitalism and it has palpably failed. This financial crisis is the outcome

Time to stick it in the dustbin of history where it sorely belongs.

@4 BenM

This would the right wing LABOUR government that jettisoned regulation would it?

As for the dustbin of history, it would seem we’ve had far longer to test communism to destruction, and left-wing european style high spending social democracy has left nothing but hugely debt ridden governments, with no possible way of supporting their ever expanding welfare states. Had the crisis jsut been a housing bubble, it would probably be over by now, but it exposed the huge overspending both in private credit and on government balance sheets, which is in essence what the euro crisis is now about.

6. Frances_coppola

The OP is confusing correlation with causation.

It could equally be argued that the essential instability of the financial system, the ever-growing leverage creating not only debt mountains but savings mountains too (since the other side of debt is savings), is responsible for the extreme inequality the OP has identified – not the other way round.

Or, of course, the two might be completely unrelated, and the fact that they have occured together simply coincidental. After all, high levels of savings don’t have to be concentrated in the hands of a very few – they could be spread out among millions of people with modest pensions, modest houses and modest long-term investments, but they would still in aggregate be a savings glut looking for a home. Excessive leverage leading to instability doesn’t have to occur because a very few people are trying to milk the system for a lot of money – it can just as easily be a consequence of an awful lot of not-very-wealthy people trying to make a fast buck out of rising house prices.

This is not to say that inequality is not a major social problem, just that the OP has not proved that it causes instability.

7. So Much For Subtlety

Does that close these italics?

4. BenM

As usual with the far right attempting to weasel out of its responsibilities for the catastrophe we’re living through, it’s blame the victim time! No mention here of ludicrously jettisoning regulation!

Well I agree that Brown should not have moved responsibility from the Bank of England, who knew what they were doing, to the FSA, who did not. But what jettisoning of regulation? The failure occurred in the most heavily regulated sector of the banking industry – home loans – and the banks had been subject to rafts of new legislation over the years leading up to the crisis.

Honestly, you’ve had 3 decades to prove your extreme version of capitalism and it has palpably failed. This financial crisis is the outcome

In those three decades average income in Britain has roughly doubled. That is a pretty good record. Even if we have a 5 or 10% dip in income now, it is a small price to pay for the massive growth we have had.

Time to stick it in the dustbin of history where it sorely belongs.

It works. It will continue to work. Mostly because it works. But also because the Left has not been able to come up with anything like a viable alternative.

8. Frances_coppola

7 SMFS

Crikey. The Bank of England knew what it was doing, did it? Don’t think the people who lost savings when BCCI failed would agree with you. Or the directors of Barings bank, for that matter.

9. So Much For Subtlety

8. Frances_coppola

Crikey. The Bank of England knew what it was doing, did it? Don’t think the people who lost savings when BCCI failed would agree with you. Or the directors of Barings bank, for that matter.

Hard to know how the Bank of England could have stopped a Luxemburgh registered bank owned by Gulf Prince and controlled by some Pakistanis getting into trouble. But I do note that when the Bank of England was sued, they won. The Courts did not think they had any responsibility.

It is even harder to see how the Bank of England could have stopped someone in Singapore trading as he pleased. So the Directors, if they object, should be told to go, well, f**k themselves as it was their problem, not the Bank of England’s. They are the ones that did not supervise their employees properly.

Yes, the Bank of England knew what it was doing. As the small scale of these problems show. They went over 100 years without a bank run. The FSA could not manage three.

Flowerpower: “The same economic processes that have made the Chinese, Africans and Indians richer have exacerbated income inequalities at home. Seems to me an acceptable price to pay for not having so many live on < 2 dollars a day."

Really?

Relative wealth matters. The presence of a mega-wealthy minority in a country is a major problem for people living on low incomes. They outbid them for housing, for example. Have you ever wondered why builders these days – in the middle of a housing shortage – prefer to use a field to build five grand executive homes than fifteen small starter homes?

In the case of those living on $2/day in places like Kenya, things are a little more extreme: the European elite's pet cats outbid their need for basic food supplies. Inequality matters.

If the price of raising the lowest incomes in poverty-stricken countries to $2/day, under your proposed system, is the creation of a level of competition for resources which increases the cost of basic survival to $4/day, it would seem a fundamentally flawed plan.

11. So Much For Subtlety

10. jungle

Relative wealth matters. The presence of a mega-wealthy minority in a country is a major problem for people living on low incomes. They outbid them for housing, for example. Have you ever wondered why builders these days – in the middle of a housing shortage – prefer to use a field to build five grand executive homes than fifteen small starter homes?

That would be an interesting comment if there was any obvious constraint on housing. There isn’t – except what the government puts in the way. We can have much or as little housing as we like. It has nothing to do with how many people are rich. We have the Green Belt, we have planning laws. All these restrict the number of houses that get built. Remove the rules and the rich could no more out bid the poor for homes than they could for water. I have no idea what builders prefer to build what you claim, but given virtually everyone enforces minimum size requirements on building proposals, this is likely to be regulations again.

In the case of those living on $2/day in places like Kenya, things are a little more extreme: the European elite’s pet cats outbid their need for basic food supplies. Inequality matters.

Yet again inequality does not matter. People are not outbid by pets because there is no fixed amount of food. You pay for more, people produce more. If all those pets were put down, poor Kenyans would still be too poor to afford food. It is just that less food would be produced.

Also there is one way in which it matters – it is easier to get rich around other rich people than among people who are poor. It is easier to make a decent living in London than it is in Mombasa because London has a lot more rich people. Some of whom may invest in your ideas, others who may buy your product, all of whom contribute to a productive society.

There is one more way as well – rich people pay tax. The more rich people, the more services there are for poor people.

Excellent analysis. The neoliberal consensus which held sway for the last 30 years failed to recognise that consumer capitalism requires consumers – the clue’s in the title guys. Purchasing power needs to be maintained by equitable wages and redistributive taxation. Instead the neoliberal ideologues – Conservative and Labour – allowed real wealth to build up in fewer and fewer hands, and just hoped the economy could be kept running by the rest of us getting into debt. It’s like allowing cholesterol to build up in the arteries – it restricts blood flow and sooner or later the patient flatlines.

The tragedy for our times has been neoliberals’ failure to acknowledge the slightest responsibility for the events of 2008. They’ve been like the innocent puppy pretending the mess on the rug is nothing to do with them. Worse than that, they’re telling us the only way to clear up the mess is more of the same. At least puppies can be trained…


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