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Sunday, December 19, 2010

"Sunshine: at the IMF, of all Places"

A new paper argues that the best solution to a financial crisis like the one we just experienced is to increase the share of income going to labor:

Sunshine: at the IMF, of all places, by Alex Harrowell, A Fist Full of Euros: So, here we are, after a 2010 of economic horrors. There is extensive debate as to whether the standard tools of economics are even valid... But is anyone at least trying to do something original with the standard toolkit? The DSGE model may be one of John Quiggin’s zombies..., but zombies are notoriously resilient. ...

The answer on this occasion is yes, at least as far as Michael Kumhof and Romain Ranciére, go. In a new paper, they present a DSGE model... Then, they run a simulation of the macro-economy assuming that there is a negative shock to the bargaining power of labor resulting in a shift in the income distribution.

The simulation results were that the financial sector balloons in size, that total private debt in the economy expands hugely, and that credit acts as a substitute for rising average wages in the short run. Eventually, the model produced a massive financial crisis and a brutal recession, followed by a blow-out of the government budget.

Your keen and agile minds will not have missed that flat real wages, an increased share of national income going to the top 5%, enormous growth in the financial sector, and a credit-financed consumer boom are exactly what happened to the macroeconomy in the last 30 years. ...

So, what should we do about it? Kumhof and Ranciére have something to say about that as well. ... They considered a scenario in which the government took the pain, accepting a large government deficit in order to minimize the impact of the crisis on the real economy. This had the advantage of reducing the fall in GDP, and therefore allowing growth to reduce households’ leverage. They also considered the option of just suffering, which actually increased leverage as incomes fell and the stock of debt remained.

Then they considered two more positive responses to the crisis. One was a debt restructuring, or to be brutal about it, widespread default and bankruptcy. This had the advantage that it does, indeed, reduce the leverage burden and does so cheaply. It also implies the end of the big banks...

The other was to increase labor's share of income. They found that this achieved a faster, bigger, and more lasting reduction in leverage and a reduced probability of crises. In their own words:

...For long-run sustainability a permanent flow adjustment, giving workers the means to repay their obligations over time, is therefore much more successful... But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.

They also argue that the inequality-finance-lending transmission mechanism might also explain the global imbalances... However, they haven’t extended the model to include the international dimension yet, although it’s on their agenda for further research.

I’ve waited for this moment, 752 words on, to mention the key detail: this cell of dangerous subversive Bolsheviks is embedded in the International Monetary Fund, and their poisonous hate-writings were published as an IMF Working Paper. Perhaps DSK really has had an influence on the institution? ...

    Posted by on Sunday, December 19, 2010 at 09:54 AM in Academic Papers, Economics, Fiscal Policy, Income Distribution | Permalink  Comments (29)


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