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IMF economist: Crisis begins with inequality

An interview with Michael Kumhof

Unless countries reduce income disparities the next financial collapse is inevitable, argues economist Michael Kumhof. Perhaps a surprising conclusion from a senior researcher at the IMF. In interview he argues that equality is the best recipe against crisis.

International Monetary Fund rescue packages are usually associated with "structural adjustment", privatisation and liberalisation. But IMF economist Michael Kumhof's recipe for avoiding crunches is increased equality – a conclusion that has brought him worldwide attention.

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Kumhof considers the cause of the financial crisis in 2008 and the debt crisis in 2011 to be increased inequality, especially in the United States. He has argued that in order to avert future crises, the negotiating position of the majority vis-à-vis the very rich needs to be strengthened. "I bet you've never heard an IMF economist call for increased salaries before. This is highly controversial", he says. But for an economist with hands-on experience in corporate banking who is vexed by economists who fail to anchor their theories sufficiently in the way the world actually works, it makes perfect sense.

In a article co-written with Romain Rancière in 2010,[1] Kumhof argues that increased gaps in income have led to increased household debt ratios. Nations with major income disparities tend to have the highest debt quotas, the largest financial sectors and often the biggest trade deficits. The richest five per cent of the population lends parts of its wealth to the remaining 95 per cent via an inflated financial sector. The rich try to find ways to invest their surplus wealth, while the less well-off majority attempt to maintain the level of consumption they have grown used to but no longer can afford. The result is increased indebtedness and the gradual build-up of a debt crisis. The only way of sustainably minimising this debt is to reduce income inequality.

Kumhof comes across as your typical theoretical economist. A former assistant professor at Stanford, he currently holds the position Deputy Division Chief of the IMF Modelling Unit, the department responsible for developing economic models. Consequently, he is cautious when commenting on issues that may be politically charged. Well aware that he is representing the IMF, he avoids discussion of developments in specific countries. Nor does he suggest concrete measures to lessen inequality. This is a task for tax experts, he says.

Nevertheless, he has arrived at a conclusion that contrasts with everything that the IMF has previously been associated with. His message is simple: if income gaps are not reduced, the next crisis will happen as surely as autumn follows summer.

Mikael Feldbaum: Could you describe the fundamentals of your research on inequality and debt?

Michael Kumhof: It started in 2009 when I attended a seminar on the financial crisis. I felt that too much attention was being directed at managing the crisis, rather than at looking at the underlying causes. Since the 1970s, the disparity between the very rich and the great majority of the population in the United States has increased tremendously. There are striking similarities to what went on before the Great Depression in the US in 1929. Indebtedness rose dramatically during both periods. Instead of discussing how to use inflation to get out of the crisis, I figured we should determine the mechanisms behind it.

Up until now, there have been two main approaches to explaining how the crisis came about. According to former IMF chief economist Raghuram Rajan, politicians who saw the drop in majority income chose not to deal with the inequality but rather to make more money available. Thus, people could take out loans to maintain the consumption they were accustomed to. The banks were granted permission to lend more money and the liberalisation of the financial market made big loans possible.

What is new about our model is that it combines these approaches. It is based on the idea that the wealthiest five per cent have increased their incomes to the extent that they cannot possibly spend it all. You can only own so many Armani suits. Neither can the very rich find enough companies that are sufficiently profitable for them to invest in. The only thing left for them to do is to lend the money through the banking sector. Meanwhile, the remaining 95 per cent get a smaller slice of the pie. They have to borrow money to keep up the consumption they feel entitled to. They still believe that they are going to get a larger slice of the pie in the long run and want to even out their spending. A great supply of money from the richest five per cent and a great demand to borrow among the remaining 95 per cent creates the type of debt burden we are seeing right now. The state has borrowed money, at home or abroad, to finance the consumption of the less affluent.

MF: If inequality leads to severe indebtedness, what has caused the increase in inequality?

MK: There have been several attempts to explain the disparity. Some claim it is because politicians have weakened unions in the US. It's hard to think of anything to counter this assertion. Some believe the cause to be increased international competition and the fact that technological advancements have benefitted the well-educated, along with excessively low interest rates, imbalances in global trade, a deregulated finance sector, and capital having been transferred to tax havens. However the causes are irrelevant to our model.

MF: But it is the banks who are providing the loans. Would it not be possible to restrict lending in order to lessen the debt?

MK: Restricting lending will not solve our problems at this point. But a tax on lending could have decreased the indebtedness. But I'm not sure taxing financial transactions is a good idea.

In the 1930s, after the Great Depression, more attention was paid to the role played by banks play in the economy than is the case today. Banks have a lot to do with the fluctuations of trade cycles. If they are willing to take risks, money is made available in the system. If they want to avoid risks, there will be less money. The problem with huge gaps in income is that it may be in the best interests of individuals to lend and borrow money, even though increased lending is not optimal for society as a whole. One might think that politicians would take measures to promote the common good and moderate lending. On the other hand, it may not be right to prevent people from doing what is in their best interests.

MF: If inequality and debt were prerequisites for the crisis, what made the load topple over?

MK: It was initially the huge debts among individuals and later states that caused the explosion. Personally, I withdrew all my money from the market in 2005. It wasn't hard to see what was happening. I have personal experience from lending at a bank. The financial sector doubled in the period before the crisis. The debt burden accelerated in the ten years preceding the crisis. Insufficient regulation was the triggering factor. But it's a mistake to focus on the straw that broke the camel's back. My view is that it is a phenomenon that spans a generation, rather than a single business cycle.

MF: How do we get out of the crisis?

MK: It's possible to reduce inequality by increasing the majority's slice of the pie either before tax or after tax. Let us first look at increasing incomes before tax. One might argue that if political decisions could lower wages, they could also raise them. But increased wages may cause jobs to move abroad. On the other hand, if nothing is done and wages are not raised, inequality will continue to grow. These are two bad alternatives, but we need to find a solution.

Reducing inequality through taxation is the other way. Taxes imposed on the rich must be intelligent. Tax experts usually suggest taxes be raised in a way that does not alter the behaviour of individuals. It is therefore wiser to impose tax on land or raw materials, which are less mobile than jobs and capital. It is not my place to say how this is to be done; we should assign tax experts to look into this.

MF: Would not increased workforce productivity, for example through education, justify higher wages?

MK: Yes, but education is a long-term solution, it will not help us right away. Besides, computer engineers are currently out of work since those jobs are being outsourced. But of course, it would be a good thing to raise the productivity of the majority and strengthen their leverage in negotiations.

MF: Do you see the distribution of wealth in society as a question of democracy?

MK: Debt patterns in given a country may look complicated, but there is always a structure. A large proportion of loans are provided by the very rich to the poorer majority. The incomes of the majority have not been high enough, whereas those of the rich have been very high. Some claim the problem is insurmountable, since the incomes of those who have taken the loans are too small to pay the money back. But the problem is not insurmountable. A country can redistribute income through democratic parliamentary decisions.

But in cases where, for instance, the national debt is held by foreign creditors, parliaments cannot solve the problem through legislation. The Chinese are not represented in the parliament.

MF: Small, open economies tend to have better social security systems. The economist Dani Rodrik argues that this may be because smaller countries are more vulnerable to technological shifts and need to protect their citizens. Is this something bigger countries should adopt, bearing in mind that nowadays they might be more vulnerable to competition?

MK: I'm actually not familiar with this, so I would rather not comment on it. But off the top of my head, I do not see it as a good solution.

MF: So you don't want to comment on the Greek and Italian austerity packages either?

MK: No.

MF: But you do you believe in austerity packages in general?

MK: I think stimuli can do a lot of good as long as state revenues do not cause imbalances in the economy. We should be trying to bring more money into the public treasury to stimulate the economy rather than cutting costs.

MF: What are your views on the worldwide reactions to the Occupy movement?

MK: The movement is in part a reaction to high student loans. It's an indication that a lot of people cannot cope with the situation that has arisen.

MF: But it also involves the issue about who should pay the debts?

MK: Yes.

MF: How is your research being received?

MK: Of all the research I have carried out so far my research on inequality has received the greatest media attention. It is a topical subject. I'm met with sympathy, but among economists there is still a focus on short-term explanations and measures. More people need to acknowledge the research if it's to have any real impact. If more problems arise in the economy, we may finally realise that something has to be done. Perhaps we need to get hit in the head twice; we've not been taking the issue of inequality seriously for a long time.

But the great change within the IMF, partly because of the crisis, is openness towards new ideas, and not only at the IMF research department. These days, the IMF listens to heterodox theories. Christine Lagarde has, for instance, encouraged countries that have the leeway to stimulate their economies.

MF: But isn't the problem the countries that lack that leeway?

MK: That may be the case. But where countries that can afford it do stimulate their economies, they help countries in crisis by buying their products and services, thus improving the trade balances of these countries.

MF: Do you believe your conclusion that inequality should be addressed will have impact on real politics?

MK: That remains to be seen.

MF: Economists have been heavily criticized for not foreseeing the crisis. How do you perceive the future of economics as a science?

MK: Macroeconomists failed to foresee the crisis, even though it was quite apparent. Former IMF chief economist Raghuram Rajan was mocked when he predicted it. There is a problem. We are still not getting to the roots of what has happened. It is said to be all about psychology – people's beliefs about the future. To me, this is a highly unsatisfactory explanation since it does not take the fundamentals into account.

There is nothing inherently wrong with economists developing mathematical models. Economists have developed useful tools in the last thirty years. In our case, in the article "Inequality, Leverage and Crises", we learned a lot from developing our model. The issue is not whether we should have more models or fewer models, but rather whether we let the tools take over to the extent where we no longer care about the reality. The fundamental questions need to always be at the core of the issues at hand.

MF: You often stress the importance of getting to the bottom of things and want to avoid focusing on "the straw that broke the camel's back". Is this a fundamental part of your personality?

MK: Yes of course, I'm German! No, that's stereotypical, but I think there may be some truth to it. I did leave Germany 25 years ago, but still. I think you need to be both theoretical and practical. I get annoyed by theories that aren't rooted in reality.

MF: What are you currently researching?

MK: I'm working several fields at the moment. For example, I'm studying the roles of banks in the economy. With my hands-on experience in banking, this is an excellent way of combining theory and practical knowledge of how banks actually work. I'm also conducting research on the deficit in raw materials. In this case, I'm consulting geologists and engineers to get their views on the issue at hand. They are very important to me. Many economist fail to do the basic research.

MF: What are your predictions about the future of inequality?

MK: I will continue my research on inequality, developing a model for small, open economies. I can reveal that we have found that inequality in a country that has a financial sector that can offer credit within the country leads to higher debt in that country. A large proportion of the balance of trade deficits can also be explained in terms of inequality, foreign credit is used to buy foreign products.

However, an unequal country that lacks a banking system that can distribute debts domestically, but allows the rich to lend money abroad, will have a trade balance surplus. I'm sure you realise that this corresponds to the developments in the relationship between the US and China quite well. And if China deregulates its market, thus enabling the majority to borrow money, we will be facing the next challenge. In that case, the gaps in income in China must be reduced to prevent a Chinese debt crisis.

Michael Kumhof was talking during his visit to Stockholm on November 2011 at the invitation of the think tank Global Utmaning (Global Challenge).


  • [1] Michael Kumhof, Romain Rancière, "Inequality, Leverage and Crises", IMF working paper, 2010.

Published 2012-03-09

Original in Swedish
Translation by Erik MacQueen
First published in Arena 6/11 (Swedish version); Eurozine (English version)

Contributed by Arena
© Mikael Feldbaum / Michael Kumhof / Arena
© Eurozine

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