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Income Inequality + Financialization + Globalization = Global Financial Crisis

This equation was developed from the reading these Two Views on the Cause of Global Crisis (Here and Here).  These two views on the causes of the global economic crisis are actually not opposing views but can be added together to explain a massive crisis.

Income Inequality

The first part of the equation.  This should be no surprise that there is income inequality in the U.S: a small number of people earn a lot more money than the rest of us.  What is surprising is the magnitude of the inequality.  This magnitude of inequality is not a good thing.

Economists and sociologists often use the Gini Coefficient (or index) to measure income inequality.  The Gini coefficient can range from 0 to 1; it is sometimes multiplied by 100 to range between 0 and 100. A low Gini coefficient indicates a more equal distribution, with 0 corresponding to perfect equality, while higher Gini coefficients indicate more unequal distribution, with 1 corresponding to perfect inequality.  The most recent (2006) Gini Coefficient for the U.S.: .464.  This about the same as Mexico, Malaysia, China and Uruguay.  FYI: Sweden the lowest at .23.

Branko Milanovic summarized income inequality in the U.S. this way:

In the United States, the top 1 percent of the population doubled its share in national income from around 8 percent in the mid-1970s to almost 16 percent in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1 percent share reached its previous high watermark American income inequality over the last hundred years thus basically charted a gigantic U, going down from its 1929 peak all the way to the late 1970s, and then rising again for thirty years.

Notice his comparison to current income inequality to that of the pre-Great Depression.  Very interesting. 

This enormous amount of wealth could not be spent on consumption alone after all as Mr. Milanovic says:

There is a limit to the number of Dom Pérignons and Armani suits one can drink or wear.

So, what do you do with all this excess money?  You invest it.  This huge pool of money or financial capital started looking for the highest returns on investment and this pool turned to the financial sector to invest it.  But the financial sector was overwhelmed by this huge flux of money:

Overwhelmed with such an amount of funds, and short of good opportunities to invest the capital as well as enticed by large fees attending each transaction, the financial sector became more and more reckless, basically throwing money at anyone who would take it.

Bernie Madoff and Allan Stafford and Goldman Sachs and Bear Stearns and Lehman Brothers come to mind.  This leads us to the second part of the equalization.

Financialization

Financialization means the increasing position/size of financial assets and the financial sector in the economy.  This financialization was facilitated by de-regulation of the financial sector.  Professor Ashok Bardhan explains financialization:

Over-financialization could be seen in rise in the size of financial assets relative to the real economy as indicated by gross domestic product. Globally, the holdings of financial assets, comprising equities, government and private bonds and bank deposits ballooned way out of proportion to global GDP, the primary underlying measure of real economic activity (see Figure 1). Similarly, the gross market value of outstanding derivative contracts more than doubled between mid-2006 and mid-2008. The share of financial services in GDP has increased dramatically in the US and UK in recent years; in the latter it has doubled in the last decade alone. In many countries, the financial sector grew to a size disproportionate to its primary raison d’etre - to efficiently bring savers and borrowers together, allocate savings to viable investments, and manage diversification of risk. Liquid and deep financial markets are necessary; indeed, they are the lifeblood of economic activity, but to extend the analogy, not if they cause high blood pressure to the economy!

Fig. 1 (Click to enlarge)

The financial sector has become too big.  But unfortunately we are doing nothing to decrease its size.  Actually, it seems that the Obama Administration is comfortable with a too big financial sector.

Globalization

Globalization can be defined by the free flow of trade and capital from country to country.  There are huge global imbalances as it relates to trade and capital.  The U.S. has a huge trade deficit with other trading partners particularly China: current trade deficit with China is -$84,621,000,000.  This means we are importing a lot of stuff from China and exporting very little.  Imbalances like this are not good.  There is another imbalance that is not good but doesn’t get the public attention that it deserves (in my opinion) and this the U.S. current account deficit.  At the beginning of 2008 our Current Account Deficit was -$179,298,000,000 and our most recent Current Account Deficit: -$101,494,000,000. 

So, how did globalization contribute to this crisis?  Our huge desire for goods, particularly cheap goods, was financed in part by foreign investors who purchased U.S. financial assets such mortgage backed securities.  We turned around and purchased cheap consumer goods from China.  This U.S-China trading axis appeared to be working like a well-oiled machine until the “unthinkable” happened in the U.S. real estate market.

Global Financial Crisis

Time bring all this together.  These two views of the causes of the financial crisis are both correct.  Personal consumption in the U.S. is huge and financial capital from wealthy Americans or from China (or any other foreign country) alone is not enough to fuel the level of consumption that occurred during the past 10 years or more.  However, there is one very important point that Mr. Milanovic makes that cannot be overlooked or overstated:

The increased wealth at the top was combined with an absence of real economic growth in the middle. Real median wage in the United States has been stagnant for twenty five years, despite an almost doubling of GDP per capita. About one-half of all real income gains between 1976 and 2006 accrued to the richest 5 percent of households. The new “gilded age” was understandably not very popular among the middle classes that saw their purchasing power not budge for years. Middle class income stagnation became a recurrent theme in the American political life, and an insoluble political problem for both Democrats and Republicans. Politicians obviously had an interest to make their constituents happy for otherwise they may not vote for them. Yet they could not just raise their wages. A way to make it seem that the middle class was earning more than it did was to increase its purchasing power through broader and more accessible credit. People began to live by accumulating ever rising debts on their credit cards, taking on more car debts or higher mortgages. President George W. Bush famously promised that every American family, implicitly regardless of its income, will be able to own a home. Thus was born the great American consumption binge which saw the household debt increase from 48 percent of GDP in the early 1980s to 100 percent of GDP before the crisis.

Bottom line is that working class people are the ones being more adversely impacted by this crisis.  We are losing our jobs, our homes, our health care insurance and in some cases our families.  Regardless of which of the two views you agree with, one thing is absolutely clear and that is the economic growth of the past nine years was not real and the massive amounts of debt just papered over serious structural problems with our economy.  The question now is what are we going to do about these structural problems.  If we do nothing one thing is certain: the destruction of the middle class in the U.S.