By Karen Petrou
As 2018 drew to a close, the Federal Reserve Board and the Financial Stability Oversight Council each pronounced financial-stability risk to be comfortingly “moderate,” much as Ben Bernanke and Hank Paulson did in August of 2008. It remains to be seen if market turmoil just days after is more than a bad blip, but there’s a still more worrisome financial-crisis risk lurking beneath volatile financial markets: U.S. economic inequality. Here, we show how current, acute inequality makes 2019 particularly perilous even if markets stabilize, President Trump eschews Twitter, the federal government begins anew, and all seems somehow otherwise right with the world.
The Inequality/Crash Connection
As we noted in an earlier Economic Equality post, it will indeed be ironic if post-crisis monetary policy intended to spur recovery instead precipitates the next financial crisis by dint of exacerbating economic inequality. As we showed in our first post on this blog and in many since, the Fed’s decision to favor borrowers over savers in its quantitative-easing and ultra-low rate framework made the rich still richer because financial assets other than interest-bearing accounts grew ever more valuable as the Fed clung to trillions in lower-return, safer assets. At the same time, the Fed’s touted recovery is the slowest since the Second World War, with ultra-low rates failing to spur productive investment and robbing small savers of whatever wealth they might have hoped to accumulate. As one analyst put it, “Never in the field of monetary policy was so much gained by so few at the expense of so many.”
Theory would have it that low rates spur employment, but theory has turned out to be wrong when it comes to unconventional policy in an economy as unequal as ours in which so many prime-age workers are still sitting on the employment sidelines. Even those low-skill workers now gainfully employed are barely getting by. As previously noted, real lower-income wages have barely budged in the course of the Fed’s “strong economy,” with real median hourly wages for those with no more than a high-school education more than 14% lower in 2017 than in 1979. Household income is up despite negative or low wage growth, but this is because households are working more hours and/or have more workers in them. This of course means not only economic stress causing day-to-day financial shortfalls, but also the need for more debt (e.g., to fund more cars, pay for child care).
The Depths of Debt and High-Flying Asset Bubbles
Faced with scant savings and low wages, lower-and-moderate income households are deep in debt masked in the aggregate data on which the Fed and FSOC rely. All of this debt supports consumption, but not in the productivity-creating ways economists expect. Instead, it powers up a dangerous bubble. In 2008, banks were at the least complicit bubble-blowers; now, much of the debt/asset-price interaction comes from financial institutions with scant ability to sustain even a little financial-market stress.
The depths of debt are evident in more nuanced data: the non-mortgage debt of households measured against their non-financial assets – i.e., how much credit card, student-loan, auto, and similar debt a household has measured against non-residential, liquid assets such as savings accounts or investments. Here, U.S. households since 1988 have generally held non-mortgage debt equivalent to about 5% of financial assets. But, looking at non-mortgage debt to non-financial non-residential assets – i.e., cars, stuff, and other illiquid holdings – shows a jump from 38% in 1988 to over 100% as of the first quarter of 2018. Given that these households are far more likely to be lower-income than those with financial assets, the magnitude of a debt bubble is instantly apparent.
We won’t here go into why there’s all this debt other than to reiterate that student debt has more than doubled since 2009, auto debt is up 76% since 2010, and many other forms of the short-term, high-cost debt on which lower-income households rely for day-to-day survival are also up dramatically since the financial crisis robbed these same households of their ability to handle even short-term financial stress. A recent Reuters study found median expenditures grew more than before-tax income for the lower 40% of earners over the past five years, even as those above the 50% median increased their financial assets. As we have shown, the bulk of this wealth concentration comes as one climbs ever higher above median income and, even then, is concentrated at the top end of the ten percent mostly in the hands of the one percent.
Back to the Crisis
One might argue that all this debt is just hard luck for highly-leveraged households, not necessarily a cause of financial crises. However, acute increases in credit compared to GDP – that is, how much debt there is versus the productivity that supports wage growth – shows the clear equality/crisis link. In the 1960s, when America was less unequal, credit-to-GDP was about 40%; by 2014 – the latest data available – inequality was through the roof and the credit/GDP ratio was almost 80% – that is, no room for systemic error.
The disconnect between debt and productivity makes economic inequality worse because lower-income households become ever more leveraged. The link between this social-welfare scourge and financial crises comes because financial markets are extremely vulnerable to the ill-effects of these same unsustainable debt bubbles. A Federal Reserve Bank of San Francisco paper we assessed early in this blog surveys seventeen countries across the last hundred years or so to find that the most reliable crisis predictor is not fancy network analysis, lost regulatory capital, or other popular hypotheses – it’s economic inequality. Recent Fed staff research also finds that inequality as acute as that now all too evident in the U.S. frustrates monetary policy and raises crash risk.
For all the data and models in these studies, the reason for the inequality/crash nexus is actually intuitively obvious: unequal economies in which vulnerable households support what’s left of national consumption with high-cost debt are prone to asset-price bubbles. These are stoked by large supplies of excess assets flowing into the financial market from wealthy households with no need for much more consumption and little need for debt. In an equal economy, enough households have enough savings to support enough debt to fund enough consumption to spur productivity. But, a U.S. with a hollowed-out middle class now has half of the population with more debt than income and a small group of high-wealth households with both high income and significant financial assets. Concentrated stocks of wealth looking for somewhere to go create yield-seeking debt products that not only pose the market risk the Fed and FSOC discount, but also fund ongoing debt burdens for lower-income households struggling to sustain a reasonable standard of living without enough real wage growth to do so without becoming still more indebted.
The Next Financial Crisis
Same as the old one, the financial-crisis risk of all this higher-risk household debt is two-fold: vulnerable households with no margin of error and a financial system perched atop speculative credit. This time may be different since banks in 2019 are a lot safer than they were in 2008, but then credit is now coming far more from nonbanks, as we have also shown. The Fed and FSOC studies are not only sanguine about financial stability – they’re also positively buoyant about the ability of U.S. households to handle their debt. However, as always, aggregate data about overall debt-service capacity are misleading in a society as unequal as America has become. There’s a strong link between inequality and debt obscured by overall credit data that fail, as the Fed and FSOC did, to take borrower ability to repay or lender capacity to sustain losses fully into account.
A U.S. economy that combines highly-indebted lower-income households and unregulated financial intermediaries is a powder keg. 2019’s combination of debt burdens for those least able to sustain them, lenders with no capital backstops or liquidity facilities, and markets prone to take flight at the height of the cycle looks a lot like 2007, but with even more risks because economic inequality is even worse.
I wonder if there may not be yet another difference, were there to be a recession along the plausible lines you describe. In the last one, banks were ready and able to step forward and pick up the pieces from failing non-bank financial firms (for which they were harshly and frequently punished). I wonder whether significant bank regulatory regimes imposed since then, and memories of the past experience, will allow banks to play the financial cushion role that they have in the past.