HOW INCOME INEQUALITY AND TRADE IMBALANCES FUEL BUBBLES AND LEAD TO CRISES Robert Wade, LSE

Frequency of financial instability much higher in Post Bretton Woods era (since 1980) than during BW era (1945 – 1973). 2 drivers of higher instability: high & rising income inequal in US/UK; high global imbalances (relative to BW era). Global imbalances  income inequality

Income inequality US & UK high relative to other high-income c’ies. CHART They are the major international financial centers.

High & low within-country inequality, 1960 - 2005

Role of income inequal Great Depression: US, 1922 –1929, income of top 1% rose by almost two thirds; 90% of h’holds lower real incomes in 1929 than in 1922. Squeeze on mass demand -- economic growth in US increasingly dependent on speculative investments and household over-borrowing, fuelled by credit derived from surging incomes at top.

Role of Y inequal Since 1980: US share of top 1% rose from 8% 1980 to 22% 2005. CHART Bottom 80% dollar incomes constant. CHART

US income share of top 1%, 1913 - 2005

US income of top 1%, middle 60%, bottom 20%, 1980 - 2005

As in 1920s, resulting “underconsumption” problem was “solved” by government opening floodgates of credit. Bottom 80% increased consumption by borrowing against appreciating value of houses, on assumption that house prices would keep appreciating. Surge of h’hold indebtedness, especially over the 2000s, making economy increasingly fragile and prone to rupture of the credit recycling mechanism.

Imbalances & Y inequality Deficit in 2006 = India’s GDP Deficit & inequal: (1) Helped to depress money wages at the bottom, as low-wage imports competed against higher-wage domestic substitutes. (2) Boosted top incomes by inflating prices of stocks, bonds & real estate, whose ownership concentrated in hands of high-income people. Polarization + stable democracy b/c (1) cheap imports raised real wages, (2) capital inflows boosted real estate market & permitted higher h’h borrowing.

Alternatives? Calling for “tougher regulation” when Y inequal high and global imbalances high = whistling in wind Measures to reduce Y inequal. Measures to reduce global imbalances: Governments shd move away from standard “corner solution” prescription of either floating exchange rate or fixed exchange rate with no capital controls, towards combination of (1) selective capital controls, (2) managed exchange rate, and (2) some degree of monetary policy autonomy.

Exchange rate should be managed so as to maintain sustainable balance of payments, with a trade balance high enough to meet obligations resulting from debt service and profit remittances. Question: how to achieve international agreement to coordinate exchange rates in line with objective of sustainable balance of payments across countries?

Alternatives? Independent surveillance organization: (1) no lending (cf IMF); (2) independent of wishes of nation states. Replace US dollar as international reserve currency with international currency unit. Pie in sky?