Banana Republics, Part 2

Growing Gap, continued…

Economic gains in the U.S. have been spread less equally in recent years as a result of factors including globalization, technological change, the decline of labor unions, changing social norms, and government trade and tax policies, according to World Bank economist Milanovic.

Much of the focus has been on the Gini co-efficient, a measure of personal net worth, but we should not forget the effect of corporates.

“In the aftermath of the 2007-2009 financial crisis, the fortunes of labor and capital have diverged. After plunging in the two years leading to December 2008, total corporate profits have roared back to a new high of $1.5 trillion, 6.5 percent above the previous peak reached in September 2006.” – Bloomberg

Corporate balance sheets are stocked with cash due to these imbalances while US consumers are drowning under seas of debt. The typical American household’s median income of $49,445 at the end of 2010 remained below the level reached in 1997.

Societies with a narrower gap between rich and poor enjoy longer economic expansions, according to research published this year by the International Monetary Fund. Income trends in the U.S., where the wealthy have pulled away from the rest of society, mean that future U.S. expansions could last just one-third as long as in the late 1960s, before the income divide began widening, said economist Jonathan Ostry of the IMF.

“Expansions – or what Ostry and co-author Andrew Berg label “growth spells” – fizzle sooner in less equal societies because they are more vulnerable to both financial crises and political instability. When such countries are hit by external shocks, they often stumble into gridlock rather than agree to tough policies needed to keep growth alive.” – Bloomberg.

Stumble into gridlock? Sound familiar?

Just to be clear, this is no bleeding heart liberal socio-reforming agenda – we are looking at economic efficiency and socio-economic sustainability as our main concerns.

“Very high levels of inequality seem to be associated with slower economic growth,” agreed Michael Feroli, chief U.S. economist for JPMorgan Chase & Co, echoing Raghuram Rajan, the IMF’s former chief economist, who says countries with high levels of inequality tend to produce ineffective economic policies and that political systems in economically divided countries grow polarized and immobilized by the sort of zero-sum politics now gripping DC.

The 30.5 million American households that earned less than $25,000 in 2010 were almost seven times the number making more than $200,000, according to new Census Bureau figures. In 2000, the ratio was 5.6-to-1.

Even Ben Bernanke last year told CBS’s “60 Minutes” that rising inequality was leading to “a society which doesn’t have the cohesion that we’d like to see.”

As I said earlier, this is not a uniquely American problem. Bloomberg reports that, “European capitals, including London, Madrid and Athens, have witnessed street protests in response to reduced government spending and subsidies.” While New York Mayor Michael Bloomberg agrees that persistent unemployment could spark social unrest.

Like us, Bloomberg sees echoes of the past. During both the 1920s and the most recent decade, the extremely rich enjoyed large income gains, much of which were made available to the working poor and middle class via credit channels. According to Rajan in his 2010 book “Fault Lines”, politicians encouraged the resort to credit as a way to bridge the gap for those struggling to sustain living standards amid flat-lining wage income. They did this without thinking of the consequences.

As a result, household debt nearly doubled in both periods, setting the stage for the Great Depression and the most recent financial crisis, says a December 2010 paper by economists Michael Kumhof and Romain Ranciere of the IMF. That increasing debt burden left the economy exposed to widespread defaults when a financial shock hit.

In Europe, this has played out in a Euro context, with the GIPSI countries encouraged to borrow at low interest rates while the real accumulation of wealth took place at the core.

For many consumers, easy access to credit today is a thing of the past. Government fiscal policy – in the form of payroll tax cuts and transfer payments – is filling the gap between income and consumption the way easy credit did during the boom years.

“The missing credit temporarily is being filled in by fiscal measures,” said Feroli, “but we have yet to understand or see how a post-leverage, post-fiscal support household sector will behave.”

The government’s response to the financial crisis may also have exacerbated the rich-poor gap by shifting liabilities from private banks to taxpayers. Households and businesses have trimmed their debts since the 2008 peak while government borrowing – to recapitalize the nation’s banks and battle the recession – has exploded.

As a result, total domestic non-financial sector debt in America topped $36.5 trillion at mid-year, compared with $32.4 trillion in mid-2008. And that massive load leaves the economy vulnerable to future shocks.

Banana Republics, as the Boomtown Rats said, are “all Septic Isles”… The question is, are America and Europe about to join the club?