So, here we are, after a 2010 of economic horrors. There is extensive debate as to whether the standard tools of economics are even valid – as Daniel Davies points out, even Paul Krugman now self-identifies as a heterodox economist – while on the other side, the discipline is coping with the financial crisis experience by clapping louder and imposing ideological censorship. But is anyone at least trying to do something original with the standard toolkit? The DSGE model may be one of John Quiggin’s zombies (buy now for Christmas and support Australian professors’ lifestyles – what’s not to love?), but zombies are notoriously resilient. (Head shots! as a well-known advocate of conservative austerity once said.)
The answer on this occasion is yes, at least as far as Michael Kumhof and Romain RanciÃ©re, go. In a new paper, they present a DSGE model with the following parameters: the top 5% of the income distribution value wealth more than everyone else, for whatever reason, and specifically, they want AAA-rated assets. Further, these are intermediated through the financial sector. Then, they run a simulation of the macro-economy assuming that there is a negative shock to the bargaining power of labour resulting in a shift in the income distribution.
The simulation results were that the financial sector balloons in size, that total private debt in the economy expands hugely, and that credit acts as a substitute for rising average wages in the short run. Eventually, the model produced a massive financial crisis and a brutal recession, followed by a blow-out of the government budget.
Your keen and agile minds will not have missed that flat real wages, an increased share of national income going to the top 5%, enormous growth in the financial sector, and a credit-financed consumer boom are exactly what happened to the macroeconomy in the last 30 years. Also, it would appear that the economic situation has developed not necessarily to our advantage, to borrow the Emperor Hirohito’s remark on Japan’s surrender to the Allies.
So, what should we do about it? Kumhof and RanciÃ©re have something to say about that as well. Specifically, they ran the model for several different scenarios representing different paths out of the crisis. They considered a scenario in which the government took the pain, accepting a large government deficit in order to minimise the impact of the crisis on the real economy. This had the advantage of reducing the fall in GDP, and therefore allowing growth to reduce households’ leverage. They also considered the option of just suffering, which actually increased leverage as incomes fell and the stock of debt remained.
Then they considered two more positive responses to the crisis. One was a debt restructuring, or to be brutal about it, widespread default and bankruptcy. This had the advantage that it does, indeed, reduce the leverage burden and does so cheaply. It also implies the end of the big banks, as they point out that a bank rescue doesn’t constitute a restructuring, just a transfer of debt from the private sector to the public sector. In a policy context, we could caricature this option as “stimulus plus cramdown”.
The other was to shift the labour share of income upwards. They found that this achieved a faster, bigger, and more lasting reduction in leverage and a reduced probability of crises. In their own words:
The main difference to Figure 14 however is observed following period 30, where under a loan restructuring leverage and default probability resume an upward trajectory for several additional decades, while under the bargaining power solution both immediately go onto a declining path. By year 50 leverage is around 20 percentage points lower under the bargaining power solution than under the loan restructuring solution. For long-run sustainability a permanent ï¬‚ow adjustment, giving workers the means to repay their obligations over time, is therefore much more successful than a stock adjustment, unless the latter is extremely large….But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.
They also argue that the inequality-finance-lending transmission mechanism might also explain the global imbalances, with the emergence of a globalised rich elite driving the demand for AAA-rated assets, the growth of the financial sector, and the emergence of persistent large capital account surpluses and trade deficits. (We already know that imbalances in the balance of payments are intermediated through the financial sector.) However, they haven’t extended the model to include the international dimension yet, although it’s on their agenda for further research.
I’ve waited for this moment, 752 words on, to mention the key detail: this cell of dangerous subversive Bolsheviks is embedded in the International Monetary Fund, and their poisonous hate-writings were published as an IMF Working Paper. Perhaps DSK really has had an influence on the institution? In other optimistic news, both IFO and the German Chambers of Commerce expect significantly stronger internal demand next year and a smaller trade surplus, while Daimler Benz’s CEO is promising that this year’s profit share payments will be “attractive”.
It better be…