Wealth, Leverage, and Bargaining Power: Another Compelling Model of the Impact of Inequality

May 5th, 2012 at 1:01 pm

I very much liked this economic model linking inequality, wage stagnation, excessive leverage, expansion of the financial sector, and financial instability.

Here’s the breakdown:

–Factors outside the model lead to income stagnation for middle and low-income workers, while high-income households acquire more capital assets.   This increases the savings of wealthy households relative to lower-income households.

–In order to keep their living standards from declining, the middle class borrows more.  Financial innovations, including new types of securitization, increase the liquidity and lower the cost of loanable funds available to the borrowers.  As the authors put it:

The bottom group’s greater reliance on debt—and the top group’s increase in wealth—generated a higher demand for financial intermediation.

–The financial sector thus grows rapidly as do the debt-to-income ratios of the middle class relative to the wealthy.

–The combination of rising middle class debt and stagnant middle class incomes increases instability in financial markets, and the system eventually crashes.

Re this last part, I’d add that some unique US and later European developments (though not Canadian, interestingly—more highly regulated banking sector, ‘ey?) amplified the last step of the model.  The so-called innovations—things like securitization that increased the distance between loan originator and loan holder, which in turn led to loose underwriting standards—interacted in a particularly volatile way with deregulatory zeal and the belief that financial players would self-regulate.

The first way to evaluate a model like this is to ask if the predictions it generates show up in the data.  Their first two charts below show aggregate debt-to-income across all income groups grew consistently with the income share of the top 5% both before the Great Depression and Great Recession.  The third chart shows that, in fact, this increase was a considerably sharper in recent years for the bottom 95% than the top 5%.

None of this is dispositive—there are always other explanations.  It makes sense that strapped middle class families would leverage up more than flush rich ones, but that doesn’t imply an obvious role for inequality.  In that regard, a key causal linkage here is that inequality diverted wage growth from middle and lower income workers.  I’ve made that case in lots of places, but it’s particularly relevant in models like this that assign a causal role to inequality.

Also, while the size of the financial sector did grow relative to GDP over this period, it had been growing for decades, and they need to show it accelerated—there’s some acceleration over this period of growing inequality, but it’s not huge.

Still, their model rings true to me, and it’s compelling to think about the policy implications, as the authors do at the end of the paper.  They argue that greater bargaining power by workers would ensure a more equitable distribution of growth, putting downward pressure on the leverage steps in the model as described above.

I’m all for that, but given that unions represent 7% of the private workforce, and 12% of the total (the public sector, at 37%, is a lot more heavily unionized, but they’re under sharp attack), that’s a long-term solution at best.  In the meantime, I’d push full employment as another way of boosting the bargaining power of the middle class, though that too is obviously an awfully heavy policy lift these days.

Better oversight of the banking sector also pops out of the model—if the income dynamics lead to greater demand for loans, it makes sense to ensure that risk is not underpriced, as was the case during the housing bubble.  Same with tax incentives that incentivize leverage, like favored tax treatment for debt financing.

I’d add this model to the growing body of work, including my own, on the impact of greater inequality on the rest of the economy.  I’d also note recent work by Krugman, Gilens (the political dimension), and Acemoglu/Robinson (sustainable growth).

The importance of this line of thought is that it doesn’t simply point to high inequality as an outcome we don’t like for reasons of fairness or balance.  Instead, this work is looking at historically high levels of inequality as an input into models trying to figure out what’s gone wrong.   That strikes me as precisely the right way to approach the diagnosis.

Source: Kumhof and Ranciere, link above.

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9 comments in reply to "Wealth, Leverage, and Bargaining Power: Another Compelling Model of the Impact of Inequality"

  1. Nylund says:

    Earlier in my grad school career, I had a very similar idea in mind for a model I was working on, but I was never able to put all the pieces together as I was still quite a novice at the time. I got distracted later on and never went back to the idea. I’d be interested in seeing the details of their model. The provided link talks about a model, but doesn’t show the nitty gritty. Is there a link for that?

  2. Jacob AG says:


    My apologies if you’ve responded to this elsewhere (the name “Mason” didn’t turn anything up in your search bar), but have you considered Mason and Jayadev’s paper on the causes of household leverage in the 80s and 90s?

    They argue that not only was there was no increase in borrowing during that period, but that households actually ran a primary surplus. What drove up household leverage was not borrowing per se, but the mechanical effects of higher interest rates and lower GDP growth. That would call into question “the liberal theory explaining it in terms of efforts… to maintain consumption standards in the face of a falling share of income.”

    What say ye?

    (by the way, their argument doesn’t necessarily conflict with the IMF model. You could simply say that rather than increasing borrowing to maintain living standards, households simply refused to borrow less and save as much as was necessary given interest rates and GDP growth)

  3. Geoff Willis says:

    You may be interested in a much more basic model that suggests the link goes in the other direction, increased debt (due to financial deregulation) directly worsens income distribution.

    Inequality is the consequence of a multiplicative process of returns to capital that results in wealth condensation. This is easily captured in a dynamic statistical model.

    Debt is key to influencing both detailed distribution of income and wealth, and also the split between returns to labour and capital; the ‘Bowley Ratio’.

    The solution to the problem is to move capital into the hands of poorer people via some form of compulsory saving. This could be acheived using a variation on the Chicago/Chile/Singapore style pension system, but applicable to all ages.

    For more background information try googling “why money trickles up” or “the Bowley Ratio” or try:



  4. perplexed says:

    “–Factors outside the model lead to income stagnation for middle and low-income workers, while high-income households acquire more capital assets. This increases the savings of wealthy households relative to lower-income households.”

    Great stuff Jared! We need more models that pick up on the wealth concentration leading to income concentration leading to more wealth concentration cycle. Demand for increased borrowing plays a huge role. But why doesn’t the increased risk of lending based on increased debt/income ratio show up in the cost of borrowing? Doesn’t the risk seeking behavior of the lenders have to be increasing as they become more wealthy to keep the price from increasing? If they were risk neutral, the cost of borrowing should increase as the risk does shouldn’t it?

    And isn’t this just another effect of differing MPC’s that Keynes focused on as playing such an important role? Why is there so little discussion of this in recent economics? Has the effect of differing MPC’s been empirically shown to be something we can ignore like we did with our last “stimulus” spending?

  5. Tom Cantlon says:

    Jared, let me try a variation on your explanation and tell me where it goes wrong. Chinese workers flood labor. Workers get paid less but companies are making more both because of paying less and selling to overseas markets. Those increased profits can’t go into much more production because domestic demand is down (and what there is is more debt funded). The increased profits/capital looks for somewhere to go other than production. There’s always financial innovation but it pays off more in a fertile market so big money goes into expanding finance and fighting regs. All of your indicators result. Financial system grows. Wages stagnate. Inequality grows. Leveraging grows. Also demand shrinks. The bubble pops. All of the above amplifies a bubble into a nuclear bomb.

    • Jared Bernstein says:

      I like it–sort of the international relative of the model in my post. The only thing I’m not sure about is “domestic demand is down.” That part doesn’t ring true–we had lots of trade in the 1990s and demand was strong.

  6. Tord Steiro says:

    Thank you for a truly interesting and thought provoking post. Following, I have a few questions:

    1. Do you think a similar model could be developed were certain countries plays the role of the big savers, and certain other (stagnating?) countries plays the role as the big borrowers?

    2. You mention the bargaining power of the middle class. Norwegian professor Karl Ove Moene (among many others, of course) have written interesting papers about equality and bargaining power in Norway and other Scandinavian countries. (A brief summary of the work, originally published in the World Bank development outreach series, is available here: http://www.frisch.uio.no/pdf/TheScandinavianModelandEconomicDevelopment.pdf) However, it appears that this work have received little attention internationally, both from the economics profession and from political circles, including the #Occupy campaigns. Do you have any idea why that is? (I have potential answer: The direct challenge to elite interests that the model poses.)