Wealth Inequality & Growth a response to Paul Krugman

The financial bubble of the last decade created the housing bubble and along with it the financial crisis with its ramifications along all sectors of the economy and the world at large. Specifically in the US,  already overextended consumers had an unprecedented negative wealth effect to contend with both from a reduction in the value of more liquid assets such as stock holdings but more importantly the collapse in the value of their homes to such a level that more than 50% of all mortgage holders were effectively underwater on what constitutes most probably their biggest lifetime investment. In other words, if they were to liquidate at any time and sell their home they would be short on the amount owed to the bank. Interestingly, most (close to 85%) of these negative equity mortgages were being serviced and non delinquent indicating that owners were willing to adhere to mortgage payments on expectation ( I would contend) of an improvement in their home values.

More importantly however, is what this has meant to the underlying level of demand in the economy and what the government should have done to reinvigorate it. Understandably the FED and government gave precedence to the stability of its financial system as its first and foremost priority for without a solvent banking sector the US and the world for that matter would have experienced an apocalyptic depression. All emphasis then on the financial system which was successfully revamped and returned to health with the FED’S dramatic actions including aggressive QE, still with us today. It was hoped that the salvation of the money lending institutions would also have secured the necessary lending to households and businesses to remobilise the economy; to no avail. On the one hand the banks were in no mood to expand their balance sheet in an environment of conservative restructuring and a consumer already underwater and on the other a consumer faced with negative equity in a defensive mode with a focused purpose, to increase the savings rate and deleverage. It is evident that in such a setting unless balance sheet restructuring takes hold final demand will at best be weak.

How was inequality exacerbated from the above phenomenon? Saving stockholders at the expense of debtors clearly transferred wealth from debtors to creditors. The US population was asked to bailout the financial system by dramatically expanding the US’s budget deficit and the FED’S  balance sheet reinvigorating both bond  and stock prices but without a commensurate knock on effect on the weakest and largest part of the population. This has meant that the ultimate driver of demand the consumer did not receive any direct help to a healthier balance sheet. He was left to the unforgiving effects of the market forces of adjustment. In other words, the consumer would only return to his usual habits if any or all of the following could take place & in such a magnitude so as to substantially improve his balance sheet and its prospects: A rise in home values, debt deleveraging and forgiveness with its accompanying increase in the savings rate, world growth that would induce cash rich companies to substantially increase investment and employment to meet this growth in world demand.

Will reversing this inequality by pursuing policies aimed at creating the aforementioned conditions drive demand and ultimately consumption? Without doubt the liquidity effect aptly described by Paul Krugman is likely to play an important catalyst. I would in fact call it a wealth effect for it is households feeling good about returning to positive equity that should induce them to spend part of this windfall. This would in turn provide impetus to the cash rich companies to increase the utilisation of their existing factors of production and perhaps lead them to increased investment. The economic textbooks should then take over through the multiplier momentum.   

The above deals of course with wealth and not income inequality a more complex issue worth discussing in a different blog.