Surging wealth of the ultra-rich triggers financial crises: IMF

The International Monetary Fund (IMF) published a study asserting that growing income inequality in the U.S. triggered the two most severe financial crises and economic downturns of the last 100 years by creating unsustainable imbalances.

Under free-market mechanisms, production is balanced when the unfettered distribution of profits to businesses efficiently allocates resources to the appropriate players.

Using the same thought framework, private consumption and investment is similarly balanced when income is distributed proportionally between the broad society and the wealthy. However, when wealth disproportionately goes to the ultra-rich, balanced is distorted.

The ultra-rich, or the investor class, don't spend all of their wealth, or even the majority of it. Instead, they need to find channels to invest it. As their wealth grows, they demand more financial products to accommodate that need.

Wall Street happily complies with this demand and finds more and more ways of offering loans to the broad soceity. In the past crisis, its primary innovation is slicing and dicing residential mortgages into packages of investment products. In the process of performing this work, the financial sector itself gets bigger and richer.

Meanwhile, as the middle- and lower-class borrow from the rich, they are able to temporarily keep their consumption on pace with economic growth. However, without a corresponding increase in real income, they cannot pay down their debt, which piles and grows to unsustainable levels.

Finally, the bubble pops, the financial sector has a crisis, and the real economy contracts.

Kemal Dervis, a director at the Brookings Institution, presents a similar thesis. In a Financial Times op-ed, he said widening income inequality stunts natural consumer demand, so policy makers are forced to enacted distortive policies to prop it up. In China, they chose to undervalue the yuan to boost demand from foreign consumers. In the U.S., policy makers allowed extremely low interest rates, irresponsible subprime mortgage practices and staggering credit card debt.

Dervis and the IMF economists cite data to back up their assertions.

Dervis said in the late 1970s, the top 1 percent richest Americans had 8 percent of total income. Now, they have 24 percent of all income.

Michael Kumhof and Romain Rancière, the economists who authored the IMF study, said the private credit-to-GDP more than doubled between 1980 and 2007. In 2007, it stood at a staggering 2010 of GDP.

Email Hao Li at hao.il@ibtimes.com