Inequality and Global Imbalances
European institutions and policy makers seem to share a narrative of the crisis essentially centered on sovereign debt, which they consider as the sole obstacle to a return to a normal state of affairs. Yet, it suffices to look at the other side of the Atlantic, or to go back to the events of 2008, to question this narrative. With the exception of Greece (whose GDP represents 2.5% of that of the eurozone), sovereign debt is today more a consequence than a cause of the crisis. This does not imply that it should be the object of a benign neglect; but understanding why we came to a systemic crisis of this magnitude is crucial for having a coherent discussion of future perspectives.
The contingent causes of the crisis are relatively consensual: a combination of distorted incentives in the financial sector, poor regulation, and sometimes excessively lax monetary policies, led to excessive leveraging and eventually proved unsustainable. Nevertheless, like fever, the crisis is only a symptom, which certainly should be treated (in particular, the need for better regulation is obvious), but without forgetting to diagnose, and to treat, the underlying disease.
The roots of the crisis lie in the elements that fueled, over the past two decades, the accumulation of global imbalances: Excess demand and trade deficits in the US, financed by excess savings from other regions of the world. Cutting off these roots is a precondition for structurally solid growth.
One cause of global imbalances, and ultimately of the crisis that we are experiencing, is the well documented and generalized trend towards increasing inequality that began in the early 1980s. Redistribution took different forms, but in all cases benefited mainly the rich and the very rich (the top one percent of the population). Interestingly enough, while it was well-known to economists, it did not come to the attention to the public until the “Occupy Wall Street” movement made the headlines.
An aspect that is still relatively little studied is the effect of inequality on macroeconomic performance. The transfer of resources from low to high propensity-to-save individuals, resulted in a reduction in the average propensity to consume, and increased aggregate savings, with two major effects: a huge mass of liquidity that with the help of low interest rates fuelled a series of speculative bubbles, and a chronic deficiency of aggregate demand. Notice that we would not speak of excess saving if at the same time there was not a (mis)allocation of saving towards unproductive investment.
But how could inequality, and the resulting compression of aggregate demand, lead in some areas to excess savings, and in others to the contrary? The answer to this apparent paradox lies in the interaction of the common trend in income distribution with different institutions and policy responses. In the US private borrowing surged, thanks to a weakly regulated financial system, and the belief in the possibility of unlimited growth of some sectors (financial, real estate). Consequently, consumption and investment remained high, even if debt-financed. In most of Europe stricter regulation and restrictive monetary policies made borrowing more difficult while fiscal policies were constrained by the treaties. This led the second largest economic block of the world to rely on exports for its growth. In East Asian countries, the weakness of the welfare state and of the financial systems led to precautionary savings of businesses and households, while after 1997 governments accumulated reserves to deal with the risk of new currency or financial crises. Thus, US demand was financed by savings from the EU, East Asia, and oil-producing countries, and in turn lifted these areas with its imports, at least partially compensating their insufficient domestic demand. This delicate balance was sooner or later doomed to break.
To return to a more balanced long-term growth, we must reverse the trend, and start reducing inequalities. This can be done on several fronts, starting with a return to more progressive tax systems. At the European level, we should aim to a real coordination of tax policies, so as to avoid tax competition and social dumping, which benefit high incomes and capital. Furthermore, the social insurance role of the government should be revamped, especially in the US. Last, but not least, a renewed focus on the provision of public goods, particularly intangible ones such as education and health is desirable. Taken together, these measures would reduce income and consumption inequality, thereby stabilizing the economic cycle and allowing for growth rates that would be more sustainable and equitable than in the past. Otherwise, “repressed recession” may continue for long in rich countries (written with Jean-Paul Fitoussi).