By Karen Shaw Petrou
In our post on the inequality impact of quantitative easing, we said that QE-driven asset valuations not only favor the rich, but in concert with ultra-low rates also sows the seeds for the type of asset-bubble that all too often leads to crashes and thus still more macroeconomic misery and inequality. A new staff paper from the Federal Reserve Bank of San Francisco finds that, even if the asset-price bubble doesn’t burst, inequality on its own could stoke the next U.S. financial crisis, with heightened inequality also found to be the best crisis predictor of all the other, more typical measures that the paper surveys.
What a perverse result indeed if the crisis cures constructed by central banks spark the next crisis. Here’s how they could do so and what the Fed should do to realign its policy before inequality gets still worse and crisis risk rises still higher.
The San Francisco study’s findings are based on exhaustive research across decades in 17 countries and are largely the result of statistical correlations of inequality, productivity, credit growth, and crises. Although productivity has a strong impact on crisis risk, widened income share of the top 1% is the most powerful antecedent to a crash even when controlling for an array of other possible causes (including the asset bubbles on which macroprudential rules now are premised). The length and depth of recessions after financial crashes are also worse when preceded by a financial crash.
Why? Going beyond statistics to a comprehensive literature survey, the paper posits that the top income share is a good proxy for the capitalization of households and firms. Holding all else equal (including credit growth), an increase in inequality stokes a rise in the debt-to-income ratios of lower-wealth households, leading to less financial-system resilience under stress due to higher default rates and their impact both on borrowers and financial intermediaries. Further, large capital distributions – which we and many others have shown have spiked in concert with QE and post-crisis rules – make the richest richer but undermine firm capitalization and therefore resilience. In short, income inequality travels along the “capitalization channel” to crash financial markets.
Interestingly, the study also finds that inequality only predicts financial recessions (e.g., the Great Depression and Great Recession), not regular business-cycle recessions. That is, changes to underlying market factors – e.g., higher oil prices – are not exacerbated by inequality, but inequality’s impact on the uses to which capital is put causes the crisis and then worsens financial recessions. In our work, we have used a different construct – the “balance-sheet recession” – to explain why the post-crisis recovery has been so slow and unequal. Although the terminology is different in part due to the focus on post-crisis growth, not pre-crisis causality, the capitalization channel characterizes both lines of thinking.
What This Means for Policy
We draw several lessons from these persuasive findings:
- The Fed must immediately cease its “hands-off” view of economic inequality as everyone else’s fault. Any action it takes via monetary or regulatory policy that widens inequality stokes the risk of a financial crisis, a most perverse result not only of all the Fed’s actions since 2008, but also of the goal of all of the tough new rules on U.S. banks.
- The Fed faces unique dangers as it tightens monetary policy because the Fed plans to shrink its balance sheet very slowly even as it raises interest rates. These hikes are of course small and tentative, but the combination of the ever-widening inequality sparked by QE combined with slower growth due to higher rates could reverberate to devastating macroeconomic effect, especially given the huge uncertainties surrounding U.S. fiscal policy and geopolitical risk. The Fed should thus focus on reducing its portfolio so that credit spreads widen naturally to normalized-risk levels that reduce inequality incentives. These higher spreads will reallocate credit availability to productive channels (e.g., corporate loans, business investment) rather than continuing to subsidize stock and bond-price bubbles that favor only the very wealthy.
- The Federal Reserve is right not to posit its counter-cyclical capital buffer (CCyB) on asset bubbles as global regulators have done. However, it is impossible to tell what might trigger the CCyB in the U.S. Were the Fed to impose a costly new capital charge in hopes of reducing crisis risk, the results would be perverse: lots more capital, especially all of a sudden and by fiat, leads to lots less credit availability, at least from banks. A CCyB triggered by widened inequality would likely increase the risk of a financial recession or even a crash because a short-term scarcity of credit sparked by the CCyB would widen economic inequality still more and raise crisis risk accordingly.