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Two views on the cause of the global crisis

Branko Milanovic
THE current financial crisis is generally blamed on feckless bankers, financial deregulation, and crony capitalism. While that may be true, this purely financial explanation of the crisis overlooks its fundamental reasons. They lie in the real sector, in the distribution of income across individuals and social classes. Deregulation just exacerbated the crisis; it did not create it.
To go to the origins of the crisis, one needs to go to rising income inequality within practically all countries in the world, with US in particular, over the last thirty years. In US, the top 1% of the population doubled its share in national income from around 8% in the mid-1970s to almost 16% in the early 2000s. That eerily replicated the situation that existed just prior to the crash of 1929, when the top 1% share reached its previous high watermark American income inequality over the last hundred years going down from its 1929 peak all the way to the late 1970s,and then rising again for thirty years.
What did the increase mean? Such
enormous wealth could not be used for consumption only. There is a limit to the number of Armani suits one can wear. It was not reasonable either to "invest" solely in conspicuous consumption when wealth could be further increased by judicious investment. So, a huge pool of available financial capital went in search of profitable opportunities into which to invest.
But the richest people and the somewhat less rich could not invest the money themselves. They needed intermediaries, the financial sector. Overwhelmed with such an amount of funds, and short of good opportunities to invest the capital as well as enticed by large fees attending each transaction, the financial sector became more reckless, basically throwing money at anyone who would take it
While one cannot prove that investible resources eventually exceeded the number of safe and profitable investment opportunities, this is strongly suggested by the increasing riskiness of investments that the financiers had to undertake.
But this is only one part of the equa-
tion. The second part of the equation explains who borrowed that money. There again we go back to the rising inequality. The increased wealth at the top was combined with an absence of real economic growth in the middle.
Real median wage in US has been stagnant for 25 years, despite an almost doubling of GDP per capita. About one-half of all real income gains between 1976 and 2006 accrued to the richest 5% of households. The new "gilded age * was understandably not very popular among the middle classes that saw their purchasing power not budge for years.
Middle class income stagnation became a recurrent theme in the American political life, and a political problem for both Democrats and Republicans. Politicians obviously had an interest to make their constituents happy. Yet they could not just raise their wages where the alternate was to increase their purchasing power through accessible credit.
People began to live by accumulating ever rising debts on their credit cards. President George W. Bush famously promised that every American family will be able to own a home. Thus was born the great American consumption binge which saw the household debt increase from 48% of GDP in the early 1980s to 100% before the crisis.
The interests of several large groups of people became closely aligned. High net-worth individuals and the financial sector were keen to find new lending opportunities. Politicians were eager to "solve" the irritable problem of middle class income stagnation. The middle class and those
poorer than them were happy to see their tight budget constraint removed as if by magic wand, consume all the fine things purchased by the rich. Suddenly, the middle class too felt like the winners.
This is what more than two centuries ago, the great French philosopher Montesquieu mocked when he described the mechanism used by the creators of paper money in France: "People of Baetica," wrote Montesquieu, "do you want to be rich? Imagine that I am very much so, and that you are very rich also; every morning tell yourself that your fortune has doubled during the night; and if you have creditors, go pay them with what you have imagined, and tell them to imagine it in their turn."
The credit-fueled system was further helped by the ability of the US to run large current account deficits, to have percentage points of its consumption financed by foreigners. The consumption binge maintained the American dream of a rising tide that lifts all the boats. But it was not sustainable. Once the middle class began defaulting on its debts, it collapsed.
We should not focus on the superficial aspects of the crisis, on the arcane of how "derivatives" work. If "derivatives" they were, they were the "derivatives" of the model of growth pursued over the last quarter a century.
The real cause of the crisis lies in huge inequalities in income distribution which generated much larger investable funds than could be profitably employed. The political problem of insufficient economic growth of the middle class was then "solved" by open-
ing the floodgates of the cheap credit.
And the opening of the credit floodgates was needed because in a democratic system an excessively unequal model of development cannot coexist with political stability.
Could it have worked out differently? With the same overall national income, income of the middle class would have been greater. People with middling incomes have many more priority needs to satisfy before getting preoccupied with investment opportunities.
Thus, the structure of consumption would have been different.
More equitable development would
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have removed the need for the politicians to look around in order to find palliatives with which to assuage the anger of the middle-class constituents.
In other words, there would have been more equitable and stable development which would have spared US, and increasingly the world, an unnecessary crisis.
Branko Milanovic is an associate scholar with the Camege Endowment for InternationalPeace and a Ija^ economist in ' the V/orto Bank's research department where he has been working on the topics of income inequality and globalisation.