The UN commission on reforms of the International Monetary and Financial System, led by Nobel-Laureate Joseph Stiglitz, has said that growing inequality was a major source of the financial crisis. Reducing inequality must be part of the solution. Real wage rates for middle-income earners across much of the globe have stagnated or shrunk relative to top income earners. Unless real incomes improve for the majority of households, a robust and sustained recovery is unlikely. However, addressing inequalities between and within countries requires changes in policy at both the national and global levels. Otherwise we may well see a return to the pre-crisis consumption and borrowing boom. But what types of policies will make a difference?
Reducing inequalities at the national level
There are two key consequences of rising income inequality. First is social and political instability. A study of several Latin American countries, for example, found that higher polarisation, combined with weak institutions, turned quickly into social tension and conflict. The second consequence is a reduction in demand. The Stiglitz report states that ‘money was transferred from those who would have spent to meet basic needs to those who had far more than they could easily spend. This created a tendency toward reduced levels of aggregate effective demand’.
To avoid such consequences, policy-makers in many countries (especially industrialised countries) allowed, even encouraged, policies that fuelled financial instability. These included lax regulation and loose monetary policy – manifest in easy credit for poor consumers and complex financial instruments and practices to maximise profit (e.g. derivatives, swaps, and flash-trading where investment banks manipulate stock prices to their benefit by buying-up stocks tenths of a second ahead of a large client’s order, then reselling the stocks at the higher market price, pocketing the difference).
Two sets of policy recommendations are essential at the national level. First: those that address the structural issues behind rising inequality. These could include strengthening the public provision of basic services (e.g. education, health and housing), investments in infrastructure and human capital, supporting a more progressive form of taxation and implementing countercyclical policies to reduce vulnerability. However, in a highly unequal setting, powerful interests are also more likely to dominate politics, entrenching special interests and, therefore, delaying policy reforms. Addressing the issues underpinning rising inequality will not be easy, but it is essential for financial stability (among other benefits). Second: policies that would generate institutional reform in the finance sector, to enable stronger regulation and an early warning system.
Reducing international inequality
Inequality within countries contributes to financial instability, but so do gaping global imbalances. Inequalities within and between countries are mutually reinforcing. There are three main reasons for increasing global imbalances:
- Capital flows in an unregulated market can be destabilising. Unrestrained capital flows, combined with monetary policy targeting domestic price levels, create lucrative arbitrage opportunities for international financial agents. Hedge funds, private equity funds and sovereign wealth funds have brought the flow of capital to a level beyond any historical precedence – so large that, in an unregulated international financial market, shifts in flows of capital can destabilise national economies (e.g. the collapse of Iceland’s economy in 2008).
- The use of the US dollar as an international borrowing standard. In the wake of the East Asian crisis, countries have accumulated net dollar assets (i.e. reserves) as a form of self-insurance. For countries to be able to do this, the US must run a current account deficit which can become unsustainably large, thus reducing confidence in the US dollar as an international borrowing standard.
- Constrained public budgets restrict the abilities of countries to act. Widening imbalances constrain the fiscal space that developing countries need to implement countercyclical policies. Repeated rises and falls of confidence become difficult to avoid in countries with high debt-to-GDP ratios. This can mean severe constraints on social spending and human development, at the very moment when they are most needed. Such investments have long-term countercyclical effects.
Addressing the causes of global imbalances should, therefore, be central to international action. Policy recommendations include:
- diversifying the international borrowing standard beyond the US dollar;
- Reducing incentives for developing countries to ‘self-insure’ by accumulating reserves
- Strengthening and democratising international financial governance (the G-20 meetings in the wake of the financial crisis, instead of the usual G-8 meetings, are a step in that direction); and
G-20 members must prioritise addressing the structural drivers of inequality in their own countries. This will reduce some of the pressures driving global imbalances. Global imbalances must also be reduced. Without addressing inequality, both within and between countries, a robust and sustained recovery is unlikely.
This blog is based on the paper ‘Within-Country Inequality, Global Imbalances and Financial Instability’, funded by ECORYS."