One year later - No real reforms to correct economic imbalances

The various economic imbalances which contributed to the current crisis, such as the imbalance between the financial and real economies and the wealth and income imbalances, have yet to be effectively addressed, says Michael Lim.

LAST year in September, the world financial system came close to a breakdown after the US government did not bail out Lehman Brothers, a venerable century-old Wall Street firm, and allowed it to collapse. Credit spreads shot through the roof as no financial institutions wanted to lend to one another, and yields on US Treasury securities briefly came close to zero.  Another larger institution, AIG, then stood on the brink of collapse and this time the US government could not take the risk of a complete meltdown of the financial system and came to its rescue. Trillions of dollars have since been pumped into the financial system (not including massive fiscal stimulus packages) through direct injection of capital, provision of guarantees to fresh loans and all commercial paper, loans given to financial institutions secured by risky assets, purchase of distressed assets, etc.

The financial system has been saved from total collapse and given a new lease on life. Suddenly banks are making money again, stock prices of financial institutions have doubled or tripled in a matter of months, huge bonuses are being dished out to bankers again, and lobbyists are working full steam to stem any effort for meaningful reforms to the financial system.

The latest G20 summit in Pittsburgh is an important first step in terms of replacing the G8 as the most important body for deliberation of international economic issues. Now 20 countries accounting for 90% of the world's GDP are in this body. But this expansion must go further and include voices from the smaller countries. Instead of simply enhancing the status of the IMF, the body should increase the role of the United Nations in this process, and serious attention must be given to the recommendations of the Stiglitz Commission sponsored by the office of the President of the UN General Assembly to reform the international financial system.

Imbalances

The Pittsburgh summit discussed increasing banks' risk capital ratios and limiting bankers' bonuses but did not reach anything conclusive. The G20 also noted the need to redress the current account imbalances involving reducing US debt and deficits and decreasing China's current account surplus and hence domestic consumption and investments. However, one of the most important imbalances that has been neglected and that the G20 need to tackle is the rising income and wealth inequality that has contributed to this financial crisis.

The world and the US have experienced tremendous economic growth over the past few decades. But this growth was accompanied by growing inequality. In the US income inequality as measured by the Gini index rose from 38 to 47 (1970 to 2006), putting the US in the company of Latin American countries. Wealth distribution is even more skewed, with a Gini index of 80. Another measure of inequality is the share of GDP accounted for by profits versus compensation, with the former increasing and the latter declining over the past three decades. The same trend is captured in the ratio between the growth in productivity and average compensation. For a long time these two grew in tandem, but they began to diverge after the 1970s.

Alan Greenspan, former chairman of the US Federal Reserve, was aware of - and troubled by - the fact that the share of worker compensation in national income in the United States and other developed countries was unusually low by historical standards. In a Financial Times interview in 2007 he said: 'We know in an accounting sense what is causing it . but we don't know in an economic sense what the processes are.' He added that in the long run real wages should parallel increases in productivity, but for now they had veered off course for reasons he was not clear about. He also worried that if wages for the average US worker did not start to rise faster, political support for free markets might be undermined.

The key to understanding the long-term structural causes of the present crisis lies in the nexus between economic inequality, debt and financial explosion. Wage stagnation and economic inequality create under-consumption by a large part of the population, while concentrating wealth in the hands of a tiny minority. In other words, under-consumption by many and excess savings by a few are two sides of the same coin. Under-consumption, or lack of demand, puts a drag on the economy. This was counteracted by the increased use of debt to drive the US economy forward. 

Between 1960 and 2007 total debt in the US rose 64 times, while GDP grew 27 times. The largest increase in debt was in the financial sector that jumped 490 times, followed by household sector debt that increased 64 times, reaching 100% of gross domestic product by 2007. What this meant was that, while the average American's real wages remained stagnant or rose only marginally over this period, s/he was able to 'over-consume' by incurring debt - be it credit card, auto-loans or housing loans. This pushed the debt and asset (housing) bubbles to unsustainable heights and sooner or later had to be corrected. As Elizabeth Warren, Chairwoman of the US Congress's Oversight Panel, said recently, years of flat wages, low savings, and high debt have left the American household extremely vulnerable, and any effective policy has to start with households.

Excess liquidity

On the other hand, excess savings meant excess liquidity - a precondition of almost every boom and bust. Hungry for higher yields, those with excess savings placed them in the hands of bankers and financiers who engaged in leverage and financial innovations to enhance their returns. This was the golden age for private equity funds, hedge funds, leveraged buy-outs, structured products and derivatives. Of course, the non- or self-regulatory environment promoted by policy makers enabled the explosion of financial innovations. For example, after the Commodity Futures Modernisation Act was passed,  exempting derivatives from regulation (since they do not fall under the categories of gaming activity or securities), the volume of credit default swaps jumped from less than $10 trillion to over $60 trillion in a few years.

In the case of China a similar, though not identical, process is at work. The Chinese economy grew at breakneck speed after 1998 but, according to a World Bank report, the share of GDP accruing to labour dropped from 53% to 41%. During this period, two important sectors that once provided social security to the population - the health and education systems - were run into the ground. The ordinary Chinese was forced to save a large portion of his income for rainy days. A serious illness and visit to a hospital could wipe out one or two years' earnings for the ordinary worker. Given this vast economic imbalance, the present effort of the Chinese government to shift towards a more domestic-consumption-driven growth is hindered unless they address the glaring economic inequality in society.

What this means is that if the G20 is serious about laying the foundation for stable and long-term prosperity, it must address not only the world's current account imbalances but also both the wealth and income imbalance and the imbalance between the financial and real economies.                             

Michael Lim has a PhD in Economic and Social Development studies. He was a post-doctoral fellow at Duke University and Assistant Professor at Temple University. Subsequently he became an international and investment banker in various banks in New York, Singapore, Hong Kong, Jakarta and Manila. His recent positions included being Vice President at Credit Suisse First Boston, Director at Deutsche Bank and Senior Restructuring Specialist at the Asian Development Bank. Presently he is a senior fellow at the Socio-economic and Environmental Research Institute (SERI) in Penang, Malaysia.

*Third World Resurgence No. 228/229, August-September 2009, pp 25-26