The Great Recession of 2007-9, like the Great Depression in 1929-33, was triggered by a massive financial crisis: stock market crash, falling asset prices, bank failures, and liquidity crisis. One of the key triggers of instability in banking and the resulting financial crises is what economists call “over-leverage”, meaning too much (private) credit and too much (private) borrowing relative to incomes. When the crisis hits, people start to “de-leverage”, that is pay-off debts and/or write-them-off in bankruptcy. The process of de-leveraging forces people to use more of their incomes to pay off debt and less on spending. The decline in spending causes a decline in GDP, leading to layoffs, and a downward spiral.
Many of us have been intuitively saying that this over-leveraging (over-borrowing and going into debt) is the result of rising income inequality. Now Michael Kumhoff and Romaine Ranciere have published a study and a formal model to explain how such a process works. They note:
Of the many origins of the global crisis, one that has received comparatively little attention is income inequality. This column provides a theoretical framework for understanding the connection between inequality, leverage and financial crises. It shows how rising inequality in a climate of rising consumption can lead poorer households to increase their leverage, thereby making a crisis more likely.
They further show the similarities between 1929 and 2008. It’s striking. As income inequality increases, i.e. the rich get richer faster, the rest have to go further into debt to maintain lifestyle or lifestyle progress. Overall debt and leverage rises until a crisis happens and the crash begins.
Figure 1 plots the evolution of the share of total income commanded by the top 5% of households (ranked by income) against household debt to GNP or GDP ratios in the two decades preceding 1929 and 2008. The income share of the top 5% increased from 24% in 1920 to 34% in 1928, and from 22% in 1983 to 34% in 2007. During the same two periods, the ratio of household debt to GNP or to GDP increased dramatically. It almost doubled between 1920 and 1932, and also between 1983 and 2008, when it reached much higher levels than in 1932.
Figure 1. Income Inequality and Household Leverage