Leveraging Inequality

AuthorMichael Kumhof and Romain Rancière
Positiona Deputy Unit Chief and is an Economist, both in the IMF's Research Department.

THE United States experienced two major economic crises over the past 100 years—the Great Depression of 1929 and the Great Recession of 2007. Income inequality may have played a role in the origins of both. We say this because there are two remarkable similarities between the eras preceding these crises: a sharp increase in income inequality and a sharp increase in household debt–to-income ratios.

Are these two facts connected? Empirical evidence and a consistent theoretical model (Kumhof and Rancière, 2010) suggest they are. When—as appears to have happened in the long run-up to both crises—the rich lend a large part of their added income to the poor and middle class, and when income inequality grows for several decades, debt-to-income ratios increase sufficiently to raise the risk of a major crisis.

Shifting wealth

We looked at the evolution of the share of total income controlled by the top 5 percent of U.S. households (ranked by income) compared with ratios of household debt to income in the periods preceding 1929 and 2007 (see Chart 1). The income share of the top 5 percent increased from 24 percent in 1920 to 34 percent in 1928 and from 22 percent in 1983 to 34 percent in 2007 (we used fewer years before 1929 than before 2007 because the earlier data were highly distorted by World War I). During the same two periods, the ratio of household debt to income increased dramatically. It almost doubled between 1920 and 1932, and also between 1983 and 2007, reaching much higher levels (139 percent) in the second period.

In the more recent period (1983–2007), the difference between the consumption of the rich and that of the poor and middle class did not widen as much as the differences in incomes of these two groups. The only way to sustain high levels of consumption in the face of stagnant incomes was for poor and middle-class households to borrow (see Chart 2).

In other words, the increase in the ratios of debt to income shown in Chart 1 was concentrated among poor and middle-class households. In 1983, the debt-to-income ratio of the top 5 percent of households was 80 percent; for the bottom 95 percent the ratio was 60 percent. Twenty-five years later, in a striking reversal, the ratio was 65 percent for the top 5 percent and 140 percent for the bottom 95 percent.

The poor and the middle class seem to have resisted the erosion of their relative income position by borrowing to maintain a higher standard of living; meanwhile, the rich...

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