Sunday, 16 July 2017

Income inequality & Junk Social Science

Kumhof & Rancierre, published a paper in 2010 linking inequality and financial crashes-
The United States experienced two major economic crises over the past century—the Great Depression starting in 1929 and the Great Recession starting in 2007. Both were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis. In this paper, we first document these facts, and then present a dynamic stochastic general equilibrium model in which a crisis driven by income inequality can arise endogenously. The crisis is the ultimate result, after a period of decades, of a shock to the relative bargaining powers over income of two groups of households, investors who account for 5% of the population, and whose bargaining power increases, and workers who account for 95% of the population

The U.S has experienced a number of economic crises over the last hundred years. Two of these are linked to poor regulation and incredible stupidity on the part of Economic pundits.  The Great Depression led to unemployment peaking in 1933 at an unprecedented and never repeated 25 %. The 2007 crisis, by contrast, led to unemployment peaking at just 9.8 % in 2010- i.e over half a percent less than it had been in 1983. Why was the early 80's recession worse for America (it took fifteen years for Unemployment to fall back to its 1973 level) than the recent one where Unemployment has quickly gone back to its 1999 level in half the time? The answer is that cost-push inflation mattered in the Eighties. Monetary policy proved an ineffective panacea because inflationary expectations weren't the only problem- distributional issues, different interest groups trying to increase their share of the pie, were highly salient. Since inflation favours borrowers over lenders, we would expect the rich, or those with more institutional power, to favour a credit rationing regime which permits them to have higher leverage. Once inflationary bias is removed, however, absent effective Regulation or Prudential screening, we expect the reverse. Instead of credit rationing, we expect Banks to over-lend so as to increase fee income. This, by itself, fuels a speculative bubble.
 In 1983, the top 5 percent exhibited a debt-to-income ratio of just over 80 percent and the bottom 95 percent a ratio of just over 60 percent. Twenty five years later, the situation is dramatically reversed, with a ratio of 60 percent for the top 5 percent and almost 150 percent for the bottom 95 percent. 
One big change between '83 and 2007 was that a global savings glut sought a home in the seeming inflation proof US dollar. Clearly, certain asset classes were over-valued. After the US Government took over the downside risk, even this constraint was removed. Thus household deleveraging- and the associated output contraction- could be reversed or otherwise compensated for. The American story is not now one about rich people trapping poor people into debt. It is about poor Chinese savers lending to rich Americans.

Kumhof & Ranciere's model is as follows-

 The key mechanism is that top earners, rather than using all of their increased income for higher consumption, use a large share of it to accumulate financial wealth in the form of loans to bottom earners.
Notice, if inflationary bias exists, that 'top earners' may end up earning a negative real return. Wealth distribution becomes more equal if they persist in such behaviour.
By accumulating financial wealth, top earners allow bottom earners to limit the drop in their consumption, but the resulting large increase of bottom earners’ debt-to-income ratio generates financial fragility that eventually makes a financial crisis much more likely.
Financial Wealth represents a Present Value on an income stream. If top earners lend money to bottom earners just for present consumption, then, unless bottom earners' real wages rises more rapidly than their debt service burden, the Net Present Value will be negative. Moreover, if real wages are rising, it is likely that Technology is improving. It would be better to invest in Technology than to engage in usury- more particularly to NINJA (no income, no job, no assets) creditors. If real wages are falling, then it is folly to lend to people who are barely solvent as it is.

No financial crash has ever occurred because rich people lent money to poor people. The Wall street Crash happened because of highly leveraged speculation by people who were rich or hoped to become so very soon. There was a stock market bubble which led brokers to jump off skyscrapers and the banks which had lent them money to become insolvent. There was no widespread default in either consumer or mortgage credit which triggered the Crash.

Similarly, in 2007-8, it was not the case that the poor defaulted on 'subprime' while the rich did not on 'prime' mortgages. On the contrary, prime mortgage default greatly exceeded subprime default. This was a speculative bubble- not a story about poor people borrowing to feed themselves and then having to go bankrupt because they couldn't meet the interest payments.

Though both share a background of incredibly stupid Punditry and poor Regulation, there are two big differences between the Great Depression and our own more recent Recession.

1) Our Monetary authorities coordinated efforts to bail out the Banks. Thus, there was no repeat of the disastrous collapse of credit and economic activity which marked the three years preceding F.D.R taking office. Fiscal policy, too, has been more elastic. There has been no great increase in tax and tariff rates. However, some small countries with fixed exchange rates or those lacking monetary sovereignty- like Greece- did experience simultaneous fiscal and monetary contraction. 

2)  F.D.R was able to turn the economy around within months of taking office by passing the Emergency Banking Act. Within a year, the Banking sector was restored to health with only about a 15 percent haircut for depositors. Similarly, in our own era, the US essentially nationalised the downside risk on mortgages and supplied enough liquidity through Quantitative Easing to permit deleveraging on a wide class of assets.
By contrast, F.D.R's Government was not Keynesian and resisted fiscal reflation. One reason for this was because the superior alternative appeared to be that of directly tackling structural inequality. However such initiatives proved to be contentious, difficult to administer and yielded little in the way of a 'multiplier' effect. Thus, the New Deal ran out of steam before politically or racially sensitive distributional questions gained salience.  In effect, some workers and enterprises gained at the expense of others through Cartelisation. Push-back from the Courts gave policy makers a good excuse to drag their feet on more substantive measures.

Very wealthy people in 1933, were prepared to, in the words of Joe Kennedy, 'sacrifice half their wealth, in order to keep the other half under the Rule of Law'. There was a genuine fear of Revolution in the air. Nothing similar happened after 2008. The very rich viewed the crisis as a shake out of wannabes. Many in the Media pushed a narrative about the crisis having been caused by Government action forcing 'sub prime' mortgages on an unwilling market. In other words, an attempt to improve the distribution of wealth had backfired causing financial chaos. Moreover, our recent Economic recovery- in the narrow sense of unemployment headcount- has been predicated on, if not a lower then a less secure, real wage whereas by the second half of the Thirties many workers in manufacturing were seeing an increase in real wages and living standards.

Bearing this in mind, let us return to Kumhof & Ranciere's thesis. What does it amount to? Essentially, it asserts that a bad loan made to a poor person will make you rich while a bad loan made to a rich man will make you poor.

This is nonsense. Stupidity and a piss-poor Regulatory Environment will lead to bad Loans. We all know that it doesn't matter whether those loans are made to poor people buying worthless properties out of desperation or to the inventors of perpetual motion machines or to a country which is about to lose a War or undergo a Communist Revolution. A bad loan is a bad loan is a bad loan.

Some rich people as well as some poor people borrow money imprudently to invest in a bubble. There are some lenders who turn up their noses at poor people who want to get in on a bull market. Those lenders will still go bankrupt if they lend to imprudent rich people who over-leverage to cash in on that same bull market.

Even if Banks started employing bouncers to chuck out poor people who approach them for a loan, still, those poor people's savings get pooled by Institutional investors and thus are at risk from a bubble. Moreover, even if all poor people are excluded from credit markets altogether, they would still be affected by the negative wealth effect on aggregate demand of a speculative bubble.

Kumhof & Ranciere believe that poor people are 'Loan Liars'. They think it rational to cheat their way to credit and then to 'rationally' default. 
The crisis is the result of an endogenous and rational default decision on the part of bottom earners, who trade off the benefits of relief from their growing debt load against output and utility costs associated with default. Lenders fully expect this behavior and price loans accordingly. The crisis is characterized by partial household debt defaults and an abrupt output contraction, a mechanism that is consistent with the results of Philippon and Midrigan (2011) and Gärtner (2013) for the Great Recession and the Great Depression, respectively. When a rational default occurs, it does provide relief to bottom earners. But because it is accompanied by a collapse in real activity that hits bottom earners especially hard, and because of higher post-crisis interest rates, the effect on their debt-to-income ratios is small, and debt quickly starts to increase again if income inequality remains unchanged.
So that's what happened in 2008. Lying cheating scumbags- the poor whom we shall always have with us- made a rational decision to default on loans and become homeless. This led to an economic contraction which affected the rest of us.

Damn those pesky poor people! They deliberately go to all the trouble and expense of acquiring a subprime property only to get thrown out onto the streets a couple of years later. Why? Poor people like being homeless. Sleeping rough is great. Why pay utility bills when you can sit under a street lamp for free?

Lenders weren't irresponsible at all in getting suckered by these pesky poor people. They fully expected poor people to default because ...urm... that's the assumption built into this model.

Kumhof & Ranciere updated their paper in 2015. They must have known that nothing of the sort they hypothesised actually took place. Poor people who bought property before 2002 did not default or sold up at a profit. Rich people who bought after 2006 did default. Timing was everything because only timing matters in a speculative bubble.

It is true, poorer people have higher default rates but overall, because they have poorer access to credit, they contribute proportionately less to delinquency.

In Kumhof & Ranciere's stylised world, poor people are gaming the system. There is a 'bargaining game' at the general equilibrium level. Why? It is because, in their world, there is no quantitative credit rationing. Lenders always correctly compute risk and borrowers accept these terms with the intention to strategically default. Since borrowers are poor and worse hit by an output contraction, a brake is put upon their sociopathic behaviour. Still inequality will tend to increase because poor people are lying little shits and thus bound to fuck up.

There can be a bargaining game between employees and employers- workers can go on strike for higher wages while employers can shut down operations and shift production overseas.

By contrast, there can't be a bargaining game between poor and rich in financial markets if lenders can always screen correctly for risk. Furthermore the market works to coordinate default on badly screened asset classes such that predatory lending carries higher risk. One caveat may be mentioned. , Where there is an uncertain inflationary bias such that credit rationing creates rents and has regressive distributional consequences, there could be a bargaining game. However, it is likely to feature a decrease in nominal wealth inequality because the rich will borrow from the poor at a negative interest rate.

 However, that is a special case with 'embedded' information asymmetry. In practice, no Brokerage can legally and systematically differentiate or price discriminate between funds whose beneficial owners are mainly poor and those whose owners are generally rich. No doubt, there is some risk of 'insider trading' or of excessive management fees. Regulators may stipulate that a rich guy suspected of this sort of conduct be confined to a 'Family office'- i.e. he can only manage his own money, not leverage his position by tapping the market. 

Suppose there is no inflation and a positive real interest rate. If poor people are stupid, they can be fooled into borrowing more and more money for current consumption. The moment they default on payments, the evil usurers swoop in and sell off their assets so as to recoup their loans. The poor are forced onto the streets where they eke out a miserable existence by giving blow jobs to rich bankers. That's the real story behind 'Occupy Wall Street'. Those weren't protesters at all. They were ordinary working class people whose homes had been repossessed and who needed to suck off a Banker or two just to be able to afford a crust of bread.
In our model, the financial sector intermediates funds between the increasingly richer top fraction of the population and the increasingly more indebted bottom fraction of the population. As the flow of funds between the two groups increases, so does the size of the financial sector as measured by total assets or total liabilities over GDP.
Since poor people, by definition, don't have infinite funds, they are going to default on their interest payments sooner or later- unless of course they aren't stupid and don't get into debt in the first place. If the economy features ubiquitous riskless assets with a real rate of return above the interest rate this process can run and run till all the stupid poor people have no assets and are sleeping in the streets and sullenly sucking off Bankers to avert starvation.
Why hasn't it happened?
The answer is that riskless assets with a positive rate of return don't exist in an ubiquitous or un-problematic way. Models may pretend otherwise but they are bankrupt and probably sleeping on the streets sucking off Bankers to avert starvation.

Why are Kumhof & Ranciere pretending that capitalists have super powers while the poor are as stupid as shit?
 Michael Hudson- the son of a Trotsykite Labour leader unjustly jailed for 'trying to overthrow the Government' and a famous Cassandra of the Housing bubble- offers us this definition- Junk Economics: A public relations exercise promoted by vested interests to depict their behaviour in a positive light instead of as exploitative zero-sum rent-seeking. Junk economics is a kind of “as if” science fiction with assumptions appropriate to a utopian parallel universe in which rentiers are the heroes. Much as a good novel or play must have characters that act consistently, the criterion of this economic pseudo-science is merely the internal consistency of its assumptions, not worldly realism. Many of the most applauded economists reason logically by a priori axioms about a world that might hypothetically exist.'

No doubt, Hudson was taking aim at Right Wing Economists. Yet his stricture applies equally well in this context. Rentiers don't have super-powers. If they do, it is pointless to resist them.

Suppose there was some mechanism such that a bargaining problem between workers and capitalists could worsen the position of the former through debt. Then a scenario like the following would be feasible-
The real wage over the initial decade collapses by close to 6%, while the return to capital increases by over 2 percentage points. Workers’ consumption however declines by only around two thirds of the decline in wage income, as workers borrow the shortfall from investors, who have surplus funds to invest following their increase in bargaining power. Over the 30 years prior to the outbreak of the crisis, loans more than double to bring workers’ leverage, or debt-to-income ratio, from 64% to around 140%, with the crisis probability in year 30 exceeding 3%. The loan interest rate for most of this initial period is up to 2 percentage points above its initial value, as lenders arbitrage the return to lending with the now higher return to capital investment.

Suppose you are a Capitalist and find the above model convincing. You should go in for Capital widening- i.e. increase production keeping the Capital to Labour output constant. There's no need for Capital deepening or automation or offshoring. So long as you are rich, you'll just keep getting richer by investing in employment generation. As a matter of principle, you may insist that workers sleep on the streets and suck off a Banker or two before showing up at work. That is a matter of personal taste.

Why have real wages increased not fallen since 2010?

The answer, of course, is that Inequality increased between '79 and 2007 to such an extent that the poor were too poor to make the rich richer by getting any poorer.  




What policy conclusion are the author's pushing?

restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis. 

But bargaining power has been declining since 1979 if not earlier! Should the Government 'restore bargaining power' by increasing property rights in jobs and passing pro Union legislation? Some workers may support this notion. However, they would do so irrespective of its impact on household debt because what they really value is higher income. If Debt is an issue, the favour statutory write-offs- a 'debt Jubilee'.
A guy who is told he has cancer is worried by a lot of things- not just being forced to borrow. Nobody says, 'I don't want to get cancer because I'm afraid of getting into debt'. They say 'I don't want to get cancer because I'm afraid of dying a painful death.'

More voters are now net lenders and non workers than ever before. It seems unlikely that democratically elected Governments will choose to boost the 'bargaining power' of a minority of voters.

'Bargaining power' is a red herring.  We can't assert much control over it without letting a lot of other genies out of the bottle. Reforming the tax code by looking again at interest deductions and bogus depreciation schedules, on the other hand, is perfectly sensible. However, we should be doing this sort of reform even if Inequality is falling because it is good in itself.

Kumhof & Ranciere's paper features a wholly unrealistic model and makes a politically infeasible policy prescription. Clearly it is not 'economic' in any sense of the word; rather it is a virtue signalling type of advocacy. Junk Social Science of this sort is counterproductive.  It raises up a bogeyman- 'Inequality' in this case- without providing any corresponding remedy or rite of exorcism. No doubt, this contributes to its own success as part of an availability cascade but it is still a waste of resources.

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