Michael Lim Mah-Hui, Guest Blogger
Much of the discourse on the structural imbalances of the recent great financial crisis has focused on the current account imbalances between countries. In fact, many Western mainstream economists blame the Asian surplus countries’ “savings glut” as a fundamental cause of the crisis without reflecting on their own “consumption glut” as the mirror image of the problem.
Nevertheless, two other structural imbalances that are equally, if not more important, causes of this crisis, are less discussed. These are: the imbalance between the financial sector and the real economy, sometimes known as “financialization” of the economy; and the imbalance in income and wealth between the rich and the poor and not so rich. These other two imbalances are discussed at length in my recent book with Lim Chin, Nowhere to Hide: The Great Financial Crisis and Challenges for Asia.
Our perspective on the relationship between inequality and financial crisis differs from that of Raguham Rajan’s, which places much of the blame on U.S. government housing agencies’ mortgage programs as contributing to the subprime housing problems. [1]
For us, the key to understanding the long-term structural causes of the present crisis lies in the nexus between economic inequality, debt and financial explosion. Wage stagnation and economic inequality create under-consumption by a large part of the population, while concentrating wealth in the hands of a tiny minority. In other words, under-consumption by many and excess savings by a few are two sides of the same coin. Under-consumption, or lack of demand, puts a drag on the economy. This was counteracted by the increased use of debt to drive the U.S. economy forward.
Between 1960 and 2007 total debt in the U.S. rose 64 times, while GDP grew 27 times. The largest increase in debt was in the financial sector which jumped 490 times, followed by household sector debt which increased 64 times, reaching 100% of gross domestic product by 2007. What this meant was that while the average American’s real wages remained stagnant or rose only marginally over this period she/he was able to “over-consume” by incurring debt – be it credit card, auto-loans or housing loans. This pushed the debt and asset (housing) bubbles to unsustainable heights and sooner or later had to be corrected. As Elizabeth Warren, Chairwoman of the U.S. Congress’s Oversight Panel, said recently, years of flat wages, low savings, and high debt have left the American household extremely vulnerable, and any effective policy has to start with households.
On the other hand, excess savings meant excess liquidity – a pre-condition of almost every boom and bust. Hungry for higher yields, those with excess savings placed them in the hands of bankers and financiers who engaged in leverage and financial innovations to enhance their returns. This was the golden age for private equity funds, hedge funds, leveraged buy-outs, structured products and derivatives. Of course, the non- or self-regulatory environment promoted by policy makers enabled the explosion of financial innovations. For example, after the Commodity Futures Modernization Act was passed, exempting derivatives from regulation (since they do not fall under the categories of gaming activity or securities), the volume of credit default swaps jumped from less than $10 trillion to over $60 trillion in a few years.
In the case of China a similar, though not identical, process is at work. The Chinese economy grew at breakneck speed after 1998 but, according to a World Bank report, the share of GDP accruing to labour dropped from 53% to 41%. During this period, two important sectors that once provided social security to the population – the health and education systems – were run into the ground. The ordinary Chinese was forced to save a large portion of his/her income for rainy days. A serious illness and visit to a hospital could wipe out one or two years’ earnings for the ordinary worker. Given this vast economic imbalance the present effort of the Chinese government to shift towards more domestic, consumption-driven growth is hindered unless they address the glaring economic inequality in society.
What this means is that if the G20 is serious about laying the foundation for stable and long-term prosperity, it must address not only the world’s current account imbalances but also both the wealth and income imbalance.
[1] This argument, also that of the Financial Crisis Inquiry Commission’s, is technically flawed as argued in David Min (2011) “Faulty Conclusions Based on Shoddy Foundations” Center for American Progress, February 2011.
Michael Lim Mah-Hui is a Senior Fellow at the Socio-economic and Environmental Research Institute in Penang, Malaysia, and co-author, with Lim Chin, of Nowhere to Hide: The Great Financial Crisis and Challenges for Asia. He was an international banker at various investment and commercial banks and Lim Chin is an economics professor at the National University of Singapore.