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From Marx to Morgan Stanley: Inequality and Financial Crises

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FROM MARX TO MORGAN STANLEY: INEQUALITY AND FINANCIAL CRISIS

Michael Lim Mah-Hui and Khor Hoe Ee

December, 2010

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FromMarxtoMorganStanley:InequalityandFinancialCrisis*

MichaelLimMah‐HuiandKhorHoeEelimmahhui@gmail.com

Abstract:Despiterobustgrowth,risinginequalityiswidespreadinmanycountries.At the same time financial instability and crises are occurring with greaterfrequency and severity. These two phenomena are related to the contest for agreatershareofeconomicoutputbetweenlaborandcapital,withcapitalgainingagreater shareover thepast fewdecades.Asaresult, there isa tendency towardsfalling‐consumptionbytheaveragehouseholdandrisingsavingsbyarichminoritythatcouldcause stagnation in theeconomy. Thiscontradictionbetween fallingconsumption and rising saving is “resolved” through the financial system by therecyclingof funds fromtherichminoritytotheaveragehousehold inthe formofcredit. Financial engineering in the U.S. exacerbated this process that led toexcessive lendingandborrowing,and the creationofanunsustainabledebtandassetbubblethateventuallyimploded.Thereisasimilartendencytowardsgreaterinequality,fallingshareofconsumption,andrisingshareofsavingsandinvestmentinChina.However,inthecontextofaglobalizedworldeconomy,thecontradictionis “resolved” through a recycling of the “excess savings” from China to theU.S.addingtothedebtandassetbubbleintheU.S.

Forthcoming,SpecialIssueofDevelopmentandChange,January2011

IntroductionGlobalization in itsmostbasic sense refers to the increasing integrationof theworld’s economies through trade, capital, labor and information flows. Withglobalizationhavecomeincreasesinproductivityandwealthgeneration.Worldtraderosefaster thanworldGDP.Butglobalizationhasalsobeenaccompaniedbyrising inequalitynotonlybetweencountriesbutevenmoresowithinmanycountries(Milanovic,2002;Wade,2004).Atthesametimewithliberalizationofthe financial sector, beginning in theUnited States and later exported tomostcountries,andalsotheliberalizationofcapitalflowsbetweencountries,wehavewitnessedanincreaseinthefrequencyandseverityoffinancialcrises.AWorldBankstudynoted that therewere137banking crisisbetween1970and2007,averaging3.7per year (Caprio et al 2003). Amajorbanking crisis breaksoutevery ten yearswith almost clockworkprecision. In the late 1980s, itwas thesavingsand loanscrisis in theUnitedStates, in the1990s, it wasthe JapanesebankingcrisisandtheAsianFinancialCrisis,andinlate2000s,itwastherecentglobalfinancialcrisisandrecession.1Minsky(1986)hadprescientlyarguedthatas the financial sectormoves increasingly from hedge financing to speculativeandPonzi financing, financial fragilitybecomesmorepronouncedand financialcrisisbecomesmorefrequent.Among themacro‐economic imbalances thathavebeenput forward to explaintheGreatFinancialCrisis(“GFC”),thetradeimbalancebetweencurrentaccount

1WeshallrefertothisrecentfinancialcrisisastheGreatFinancialCrisis(GFC)

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surplus countries like China and other Asian countries, and current accountdeficit countries, most notably the United States, has been cited as the mostimportantcause.Twootherstructuralimbalancesthatareequallyimportantarelessdiscussed;thesearetheimbalancebetweenthefinancialsectorandtherealeconomy, and the imbalance in income and wealth between the rich and thepoor.2InequalityPrecededtheGreatDepressionandtheGreatFinancialCrisisItisinstructivetonotethattheGreatDepressionofthe1930swasprecededbyrisingandextreme inequality. SeeFigure1.Among the structuralweaknessespreceding the Great Depression identified by Galbraith (1997: 177) was highincomeinequality‐in1929,thetopfivepercentofthepopulationreceivedonethird of all personal income. In recent years, the U.S. has reached a level ofinequality higher than that of the pre‐Great Depression period. The Ginicoefficient of U.S was 0.47 in 2006 compared to an estimated 0.45 in 1929(Wikipedia, n.d.). But this phenomenon has been largely forgotten in mostdiscussionsoftheGFCwithafewexceptionslikeMilanovic(2009),Lim(2009)LimandLim(2010),Krugman(2010),Klein(2010),Rajan(2010).

Figure1

Source:Krugman,2010.

2ThesethreeimbalancesarediscussedinLimandLim(2010).

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A key to understanding the long‐term structural causes of the GFC is the linkbetweengrowth,inequality,financial innovationanddebt.ImportantstructuralchangeswerehappeningintheU.S.economyafterWorldWarII.Afteraninitialperiod of robust growth (1940s to 1960s) that saw a rise in real wages anddecline in inequality, economic growth began to decelerate and the economybecame increasingly driven by debt and asset inflation rather than incomegrowth. Between 1960 and 2007, as the U.S. GDP rose 27 times from $526billionto$13.9trillion; totaldebtof theeconomyleaptby64times from$781billionto$49.9trillion.SeeTable1.Evenmoresignificantisthecompositionofthetotaldebt.Financialdebtincreased490times,householddebt64times,non‐financialcorporatedebt53timesandgovernmentdebt24times.Table1:U.S.GDPandDomesticDebtbySectors,1960–2007. DomesticDebtbySector

GDPTotalDebt

FinancialSector

Non‐FinancialCorpSector

HouseholdSector

Government:Local, State,Fed

Rest ofWorld

Dom Fin+ Non‐Fin CorpDebt

US$billions

US$billions

US$billions

US$billions

US$billions US$billions

US$billions

US$billions

1960 526 781 33 201 216 308 23 2341965 719 1,107 62 305 339 365 38 3671970 1,038 1,600 128 514 457 450 52 6421975 1,638 2,619 260 864 734 663 97 1,1241980 2,789 4,725 578 1,478 1,396 1,079 193 2,0561985 4,220 8,623 1,257 2,578 2,278 2,268 243 3,8351990 5,803 13,769 2,614 3,753 3,598 3,486 318 6,3671995 7,398 18,475 4,234 4,134 4,857 4,684 567 8,3682000 9,817 27,143 8,145 6,589 7,011 4,583 815 14,7342005 12,434 41,244 12,969 8,472 11,740 6,556 1,512 21,4412007 13,971 49,882 16,155 10,588 13,815 7,313 2,016 26,743Growth xTime1960 ‐2007

27 64 490 53 64 24 88 114

Source: Economic Report of President (2008): Table B‐1; Federal ReserveSystem,BoardofGovernors,TableL.1CreditMarketDebtOutstandingIncomeandWealthInequalityDuringthisperiod(1970to2006),realwagesofordinaryworkersstagnatedandinequalityworsenedbyanynumberofmeasures.TheGinicoefficientforincomedeteriorated rising from 0.35 to 0.46 putting the U.S. closer to developingcountries like Malaysia and Guatemala (0.48), Argentina (0.52), than todevelopedcountrieslikeCanada(0.33)andJapan(0.25).Thismeantthatthetop2.7%ofhouseholdearned20%oftotalincomewhilethebottom6%earnedonly0.3%. Growth in real income was heavily concentrated in the top 1%. Saez(2008) showed that between 1993 and 2006, the top 1% of income earnerscapturedhalfoftheoveralleconomicgrowth,withtheproblemworseningunder

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the Bush administration’s liberal tax relief for the richwherein they capturedthreequartersofincomegrowth.DistributionofwealthisevenmoreskewedwithaGinicoefficientof0.8,i.e.,thetop20%owned85%,thetop1%owned33%oftotalwealthin2001,whereasthebottom80%ownedonly15%oftotalwealth(Domhoff,2006:2).WagesLaggedBehindProductivityFigure 2 shows the unequal distribution in another form. Between 1990 and2005,federalminimumrealwagefell9%andproductionworkers’payrose4%,whileCEO’saveragecompensation increasedby298%,outstripping therise incorporateprofitsof107%.Figure 2: Cumulative % Change in Economic Indicators, from 1990 (in 2005dollars)

Source: Domhoff: Wealth, Income, and Power, September 2005 (updated May2009)We are taught in Economics that wages of workers are determined by theirmarginalproductivity.Howeverrecenttrendbeliesthistenet.SeeFigure3.

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Figure3

ProductivityversusCompensationintheU.S.1947‐2008

Source:BureauofEconomicAnalysisFrommid1940stomid1970s,therewasatightfitbetweenproductivitygainsandrealwagesintheUnitedStates.ButthisbegantodivergesignificantlyafterPresident Reagan came into power in the late 1970swhen he dismantled theNational Relations Board, broke up the air traffic control labor union, andrenegotiatedtheaccordbetweenlaborandcapitalinfavorofthelatter(Bowlesetal.1986).Capital’sshareofincomerosewithsuccessivetaxcutsindividends,capitalgains,corporateearningandestateduties. Inotherwords,theshareofGDP going to labor versus capital is less a result ofmarginal productivity andmore dependent on labor’s bargaining power that has weakened with theascendanceofneo‐liberalpolicies.Roach(2009:100,143,242)showedthatthiswas happening not only in the U.S. where real wages increased 1.6% whileproductivity rose 3.3% over 2001‐2006 but also in Japan, Canada and 12Europeancountrieswheretheshareof compensationofGDPfell from56%to53.7% between 2001 and 2006 whereas the share accruing to capital is at arecordhigh.Roacharguesthatglobalizationdidnotconferequitablebenefitstoeveryone; one of the great asymmetries in globalization is that in the contestbetween returns to labor and capital, the pendulum of economic returns hasswung from labor to capital in the developed world and that this trend isunsustainableandhastoreverseatsomepointinthefuture.3

3Roachatthesametimeassertsthatinthedevelopingworld,thebenefitsofgrowthhaveaccruedmainlytolabor(p98).However,hisowndataonChinaweakenshisearlierassertion.Hesays“ProductivitygrowthinChina’sindustrialsector…surgedatanaverageannualrateofnearly20percentoverthe2000‐

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Greenspan alluded to the same problem in his recent memoir. He says he ispuzzledby thisdivergencebetweenproductivityandrealwage increaseandisworriedthatifrealwagesdonotrisemorequicklyfortheaverageU.S.worker,politicalsupportforfreemarketsmaybeundermined(citedinGuha,2007).Marx,MorganStanleyandtheGlobalLaborArbitrageLabor’sbargainingpowerhasbeenweakenedbyanotherimportantglobaltrend,whatRoach (2009:98‐102;184‐87) calls thegreat labor arbitrage. WithChina,India and many other emerging markets becoming more integrated into theworldeconomy,globalizationhassuckedinvastpoolsofruralandunemployedworkers into the labor market, putting downward pressure on wages in thedeveloped countries. It was estimated that China, India and the former SovietUnionaddedabout1.5billionnewworkersintotheglobaleconomy(Ibid:144).Entry wages of average Chinese manufacturing workers have remainedrelativelyflatduringthelastthreedecadesofrapidgrowthbecauseofthelargepoolofmigrantworkersfromthecountrysidetothecities. Whilewageshavegrown quite rapidly for the skilled and experienced workers, average wageshave still lagged behind the growth in labor productivity and are still low byinternationalstandards.Indeed,theaveragewageoftheChinesemanufacturingworkerswasestimatedat57centsperhourin2002,whichwasonlyabout3%ofaverageU.S.hourlypay.(Ibid:184).However,thesupplyofmigrantworkershasbeendwindlinginrecentyears,dueinparttotheimpactofChina’sone‐childpolicy on population growth. As a result, there has been increasing upwardpressureonwages in the coastal cities, and factorieshavebeenmoving inlandandsourcingworkersfromthepoorerneighboringcountrieslikeVietnam.Inrecent months, however, pressure and demand for higher wages have led tostrikes and lockout in various foreign owned factories in the coastal cities(Ramzy, 2010; Tabuchi, 2010; Pilling, 2010). This may signal the start of aseculartrendtowardhigherrealwagesinChinainlinewithproductivitygrowthandarisingshareoflaborintheeconomicoutput.WhatRoachcalls thegreat laborarbitragerecallswhatMarxwroteaboutover200 years agowhen he analyzed the dynamics of capitalism. 4 In its constantsearch for markets and profit, capitalism has to ceaselessly expand; it cannot

2004interval.That’swellinexcessofcostpressuresimpliedby12percentgainsinhourlycompensation(Ibid:186).AlsoaWorldBankstudyshowedthatbetween1998and2005,theshareChina’sGDPgoingtolabordroppedfrom53%to41%(citedinEconomist,2007).4ItisinterestingtonotethatsomeWallStreetfinancierspaymoreattentiontoMarx’scontributiontotheanalysisofcapitalismthanmosteconomists.AwealthyinvestmentbankerwasquotedintheNewYorkermagazinesaying,“ThelongerIspendonWallStreetthemoreconvincedIamthatMarxwasright…IamabsolutelyconvincedthatMarx’sapproachisthebestwaytolookatcapitalism.”(Wheen,1999:5).

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standstill.Thebasiccontradictionincapitalismisbetweencapitalandlaborandtheir struggle for a bigger share of the economic pie.While this strugglemayhave been muted and transformed over time, it has not been eliminated andcontinuestodrivethesystem.Initsquesttoenhanceprofitandtoaccumulate,capital must constantly look for ways to reduce the cost of labor, increaseproductivity and appropriate most of the surplus. One way is to use moremachinesandlesslabor–thisnotonlyraisestheproductivityoflaborbutalsoreduces thebargainingpowerof labor to the extent that the excessworkforcearenotre‐employedinotherindustriesandincreasesthepoolofunemployed.StrategiestoEnhanceProfitsOther recent strategies of capital to augment profit and reduce labor costsinclude theuseof temporary,part‐timeandcontractualworkerswhoarepaidlowerwages,havefew,ifany,benefits,andweakbargainingpower.Overthelastdecade,wehavewitnessedthephenomenonof“joblessrecovery”(Akyuz,2006).Charles McMillion, the president and chief economist of MBG InformationServicesinWashington,anexpertonemploymentissues,saidthattherearenow3.4millionfewerprivatesectorjobsintheU.S.thantherewereadecadeago.Inthe last10years,we’veseentheworst jobcreationrecordsince1928to1938(Herbert,2010.)Evenastheeconomyexpanded, full timejobsdidnotgrowasfast.Mostof thenewjobscreatedwereoftemporary,part‐time,orcontractualnature and in the lowwage sectors. These changes occurred not only in theUnited States but also in Japan, a country known for job security. In Japan,between 1991 and 1998, while the ratio of regular to total workforce for allworkers rose slightly, this ratio fell for workers under thirty years of age,creating a chasm between older workers with security and younger workerswithout security (Yuji, 2006:33). This pattern is repeated in many Europeancountriesunderthebannerofincreasinglaborflexibility.InSpain,aboutathirdof the workforce has little job security and benefits, pitted against the olderworkforcewithpermanentstatus(Schuman,2010:21).Anotherfinancialstrategytoenhanceprofitsisthewidespreaduseofleveragedbuy‐out where investors or management borrow heavily to buy out well‐runcompanies, ramp up their leverage, and ruthlessly trim the workforce tomaximizeprofitsandshareholders’value.5Withpoliticalonslaughtwagedbycapital,supportedbyliberalstatepoliciesthatreduce taxes in favor of capital, the introduction of new financial strategies tomaximize profits, the entrants of billions of new workers from emergingeconomies into the global labor force, the economic returns of growth haveaccrued more to capital than to labor, creating greater inequality in mostcountries.InequalityandUnder‐consumption

5SeeLimandLim(2010:31‐36).

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Whatdoesinequalityhavetodowitheconomicandfinancialcrisis?Whenwagesofthemajorityoftheworkforcearestagnatingorkeptlow,thereisastructuraltendencytowardsunder‐consumptionthatputsadragongrowthandprofit.Theproduction and accumulation process of capitalism is interrupted in therealizationprocess, i.e., goods that are produced cannotbe sold due to lack ofeffectivedemand fromthemajoritywhose incomesare lowresulting inexcessproductivecapacityandeventuallyaslowdown in theeconomyandeconomiccrisis.Inotherwords,stagnationresultingfromunderconsumptionisinherentinthedynamicsofcapitalismreflectingtheinabilityofcapitaltorealizethefullvalue of the commodities produced due to rising income inequality and thefallingshareofwagesovertime.6Inequality impactson theeconomy in twoways.On theonehand, it results inunder‐consumption or a lack of effective demand for themajority, and on theother hand, it concentrates income andwealth in thehands of a tinyminoritywithexcesssavings;theformerhasahighpropensitybutlowabilitytoconsume,while the latter has a high propensity to save and a high appetite forinvestments.7Over‐consumptionandDebtBubble,ExcessSavingsandAssetBubbleWeshowedearlierhowunder‐consumptionintheUnitedStateswas“resolved”through the assumption of debt by the ordinary households leading to “over‐consumption”. Even as income andwages stagnated, personal consumption inthe U.S. rose from about 60% of GDP in 1960s to a peak of 72% in 2007,concomitant with a decline in savings rate of about 10%, supported byhouseholddebtthatgrew64timesfrom$216billionto$13.8trillion(equivalentto 100% of U.S. GDP). Financial innovations and some government policies 8fuelledthisdebtbubble:creditcardloans,homeequityloans,andsecuritizationof loans exponentially increased the total volume of loans, with the mistakenbeliefthatthedispersionofloanstootherinvestorswhoareableandwillingto

6DuetoMarx’sunfinishedworkonCapital,thedebateisunsettledoverwhethereconomiccrisesareduemoretothetendencyforrateofprofittofallarisingfromtheincreasingorganiccompositionofcapital,ortheresultofunder‐consumptionintherealizationprocess.Intheauthors’view,itisnotaneitherorpropositionthatcanbesettledtheoretically.Ratheritismoreproductivetoexaminetheempiricalevidencetodiscernwhichtrendismoreevidentindifferenthistoricalsituations,andthemyriadsofcounter‐tendenciestothesetwotrends.Forafullerdiscussionsee,Sweezy(1946).7Krugman(2010)inhisdiscussiononinequalityandfinancialcrisisalsotalksofunder‐consumptionanddebtburdenoftheordinaryhouseholdsbutalsoattributesthecrisisto“over‐consumption”bytheupperreachesofsociety.Itisourviewthatover‐investmentsinfinancialassetsbythericharemoreimportantthantheirover‐consumptionofconsumergoodsincontributingtothiscrisis.8Rajan(2009)attributesaprominentroletogovernmentpoliciestoprovidehousingtothepoorthroughGiniMaeandFreddieMacasanimportantcauseofthecrisis.Hetendstodownplaypoorfinancialpracticesinthisexercise.

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bear the riskswouldmake the financial systemsafer. 9 Homeequity loans, inparticular, became a major source of income for many, and a driver for theeconomy. In 2007, home equity loan totaled $487 billion (EconomicReport ofthe President, 2008: Table B‐72). A Federal Reserve calculation showed netequity extractions fromU.S. homes rose from3% to 9%of disposable incomefrom 2000 to 2006 (cited in Roach, 2009:59). Another estimate has it thatwithouthomeequitywithdrawals,U.S.GDPgrowthwouldhavebeennegativein2001and2002and less than1%between2003and2005 (Wikinvest). Whenhouse prices started to decline in 2006, this boom turned into a bust andtriggeredthegreatfinancialcrisis.Under‐consumptionandexcesssavingsare twosidesof thesamecoin.Ononeendisamajoritywithlimitedincomeand,ontheotherend,atinyminoritywithexcesssavingsandliquidity.Asindividuals,therichcanonlyconsumesomuch;mostoftheirincomegoesintosavingsandfinancialinvestments. Theyarenotcontentwithmeager returns from fixeddeposits,particularly ina low interestrateenvironment.Hencetheexcesssavingsisplacedinthehandsofbankersandfinancierswhochurnoutfinancialinstrumentstomeetthegrowingdemandforhigheryieldsgivingrise to the financialassetbubble. However, thisdebtandasset bubble is a mirage built on what Minsky classified as “Ponzi” financingbecause the escalating household debt is clearly not sustainable given thestagnationinrealwagesandisbuiltontheassumptionthatthedebtneednotberepaidaslongaspropertypricecontinuestorisetomatchthegrowingdebt.RiseandDominanceofFinanceCapitalismWhile the basic dynamics of capitalism has not changed sinceMarxwrote hisCapital,theformsandspecificsofcapitalismhavechangedsignificantly.Amongthe major changes are: the transition from petty‐enterprise capitalism tomonopoly capitalism, andmore recently, the eclipse of the real or productiveeconomybythefinancialindustrywaybeyondwhatMarxcouldhaveimagined.IntheUnitedStates,between1960and2006,thefinancialsector’sshareofGDProse from 14% to 20% of GDP, almost twice as large as the next sector(wholesaleandretailtradeat12%),whilemanufacturingsector’ssharefellfrom27% to 11% (Economic Report of the President: 1997, 2008). The financialsector accounted for 30% of the share of total corporate profits compared to21%forthemanufacturingsector(BureauofEconomicAnalysis:n.d.Tables6.16A‐D).The role of credit and fractional banking is central to the understanding offinancialcrisis.TheGFCandotherrecenteconomiccriseshaveshownthatit isfragilityandinstabilityinthefinancialsectorthatisthecauseofthemostseverefinancialcrisesandnotwageandconsumerprice inflation(Barbera,2009).Totheextent thatcentralbankershave focusedtheireyesonconsumerandwageinflationratherthanassetinflation,theyhavebeennotonlybeenremissintheir

9AlanGreenspanwasamajorcheerleaderforthesefinancialinnovations.Seehisspeech“RiskTransferandFinancialStability.”(2005).

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dutybut alsoweremisguided in theirbelief in theefficientmarkethypothesisthatmarketsalwayspriceassetsefficientlyandareselfregulating.10Financialinnovationsinthefinancialsectorhaveexaggeratedtheeconomicandfinancial crisis by encouraging practices that reduce the margins of financialsafety and increase the risk appetite of investors. In the U.S. inequality andfinancial speculation encouraged two types of bubbles – a debt bubble amonghouseholds, certain sectorsof industry thatengaged in leveragedbuyout, andfinancialinstitutionsthatactivelyusederivativestoleveragetheirexposure;andanassetbubbleinequities,securities,andproperty.11Aswehavedemonstratedearlier, despite stagnating income and wages in the United States, householdcould rack up consumption to its highest level at 72% of GDP. Ironically, thestructural trend towards falling share ofwages and under‐consumption in theU.S. was transformed into over‐consumption for the ordinary households(relative to their income) andover‐investment for the rich through a financialsystem that recycled theexcess savingsof the rich to theordinaryhouseholdsandencouragedexcessive risk taking through innovative financialengineering.Thegoingwasgoodwhile it lasted,buteventually thepartycametoanend in2008China–Inequality,Under‐consumptionandExportSurplusChina’sCurrentAccountSurplusWhataboutChina?Chinahasbeenoftensingledoutandblamedforthefinancialcrisis because of its huge current account surplus. According to manymainstream economists, themost prominent being Ben Bernanke, the presentChairman of the Federal Reserve System, the “savings glut” in Asia hadcontributed to the global trade imbalance and low interest rates causing thefinancial bubble and bust. 12 In discussing the cause of the admittedlyunsustainable global current account imbalances, it is disingenuous to pin theresponsibility on the current account surplus countries and not the currentaccountdeficitcountries.Fromaglobalperspective, currentaccountsurplusesandcurrentaccountdeficitsareflipsidesofthesamecoin,i.e.thetotalvalueofcurrent account surplusesmust be equal to the total value of current accountdeficits for theworldeconomyasawhole.Hencecountriescannotruncurrentaccount surpluses unless other countries are willing to run current accountdeficits.Whetheracountryrunsacurrentaccountsurplusordeficitdependsonthe aggregate expenditure of the country relative to its income. A country incurrentaccountdeficitisspendingmorethanitsincomeandcanthereforetakepolicyactionstoreduceitsoverallspendinginordertoreduceitsdeficit.WhileChina has been accused of pursuing a weak exchange rate policy in order to

10SeeLimandLim(2010:1‐9).11Totheextentthattheordinaryandpoorerhouseholdsparticipatedinthehousingboommadepossiblebygovernmentmortgageguaranteesandsecuritization,theyalsohelpedtofuelthepropertyassetbubble.12Seehisspeech,“TheGlobalSavingsGlutandtheU.S.CurrentAccountDeficit”(2005).

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boostitsexportsleadingtoitscurrentaccountsurplus,theUSisequallyguiltyofpursuingaveryloosemonetarypolicythatencouragedtheexcessiveborrowingandconsumptionbyhouseholds.China’sSavingsInvestmentGapAn alternative way to look at the current account balance of a country is itssavinginvestmentgap,i.e.,anexcessofsavingsoverinvestmentsisequivalenttoacurrentaccountsurplus,whileanexcessofinvestmentsoversavingsresultsina current account deficit. From this perspective, the important questions arewhatcauseacountrytohavemoresavingsthan investmentsandhowcanyouincrease consumption in order to reduce the saving rate for a current accountsurpluscountryandviceversaforadeficitcountry.Why isChina’ssavings inexcessof itsdomestic investmentscausing it tohavepersistent current account surplus?Figure4 shows thatChinahasa veryhighsavingrate,close to50%of itsGDP,and isoneof thehighest in theworld. In2007,thelargestcomponentofChina’stotalsavingsisstillthehouseholdsector,accountingforabout22%;followedbythecorporatesectorat18%andthenthegovernmentsectorat10%.Innationalaccountingterms,savingsistheresidualafter deducting private and government consumption from gross nationalincome.Hencethehigherthesavingrate,thelowertheconsumptionrate.Figure5showsthatprivateconsumptioninChinahasdeclinedfromabout50%in1992to 36% in 2007, well below the 65% norm for most of the world’s majoreconomies; in fact, private consumption was over 70% in the early 1960s inChina(Roach,2009:179).WhyisprivateconsumptionratelowandsavingratehighinChina?Figure4:CompositionofChina’sSavings,1999‐2007

Source:IMF,2010.Figure5:China’sPrivateConsumption,1992‐2007

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Source:KaiandDiaye,2010.China’sGrowingInequalityDespite the impressive economic growth of China over the last three decadesaveragingabout10%yearly, thisgrowthhasnotbeenevenlydistributed,bothfrom the point of view of the share of GDP accruing to labor and from theperspectiveof incomedistribution. Incomeequalityhasworsenedsignificantly,with theGini coefficient almost doubling from0.32 to 0.50between1978 and2006(ChinaNews1).Anothermeasureof the imbalancecanbeseen fromtheshareofGDPgoingtolabor;thishasdroppedfrom57%to37%between1978and 2005 (ChinaNews 2). Roach (2009:186) says that productivity growth inChinahassurgedatanaverageannualrateof20%overthe2000‐2004period,well in excess of cost pressures implied by the 12% gains in hourlycompensation. In other words, like its developed countries counterpart, thependulum in China has swung in favor of capital over laborwithmost of theproductivitygainsaccruingtocapitalratherthanlabor.Withdecliningshareofeconomic output accruing to labor, aggravated by increasing inequality ofincome, private consumption as a percentage of GDP has been declining asshowninFigure5.AlthoughrealwagesofurbanChineseworkersincoastalcitieshasimprovedandreal consumptionhas risenover time, it isdecliningasa shareof totaloutput.Theproblemofunder‐consumptionisaggravatedbyChina’sreformsthatledtoa sharp drop in social consumption of goods and services like health care,housing,andeducation.TheeconomicreformsledtothecorporatizationofSOEsand a sharp reduction in their provision of social goods and services as SOEswere encouraged by government policies and compelled by market forces tobehavelikecommercialenterprisesandtofocusontheirbottomline.SourcesofHighSavingsThere are twomajor reasonswhy saving rate is so high in China. First is theprecautionarysavingofordinaryhouseholds.PriortoChina’seconomicreforms,social services were provided free or at low prices by government and SOEs.ChinawasoncerecognizedbytheWorldHealthOrganizationasprovidingahighlevelofbasichealthservices(notnecessarilytechnologicallysophisticated)toamajority of its population. In the field of education, China after the revolution

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improved its literacy rate to over 90% and provided good basic education tobothmenandwomen,reducingthegendergap.Thesamecanbesaidforbasichousing that was available at very low prices. In the transition from China’svariant of socialism to capitalism, millions of state enterprise workers werethrown out of work, social services such as housing, education and healthservices were drastically cut and economic insecurity mounted for the vastmajority of the population. What used to be free, now cost two years of anaverageworker’swageforaserioushospitalvisit.ThustheordinaryChineseareforcedtosaveforrainydays.Thesecondsourceofhighsavingscomes fromthecorporatesector.Corporatesaving rate is high reflecting in part the behavioral shift of SOEs tomaximizeprofitsbycuttingbackonprovisionofsocialservicestoworkers.Furthermore,ChineseSOEspayverylittletaxanddividends;muchoftheirprofitsareusedtofundinvestmentsresultinginanextremelyhighinvestmentrateofabout40%intheChineseeconomy.Therearetwoissueswiththeinvestments.First,ashighastheinvestmentrateis,itisstillbelowthenationalsavingsrate,givingrisetoanexcessofsavingsoverinvestment.Second,muchoftheinvestmentsaredirectatthe export sector rather than domestic market, resulting in China’s currentaccountsurplus(excessofexportsoverimports).Inequality,Under‐consumptionandCurrentAccountSurplusInboththeU.S.andChina,inequalityresultsinunder‐consumption,i.e.,adeclinein purchasingpower for the ordinaryhouseholds. In theU.S., however, under‐consumptionfortheordinaryhouseholdswas“resolved”bytakingonincreasinglevelsofdebt.Anover‐leveragedandsophisticatedfinancialsystemwasabletorecycleexcessliquidityandon‐lendthemtohouseholds.InChina,banklendingtohouseholds isnotwelldevelopedandbankstraditionally focustheir lendingonstateownedenterprises.Whilebanklendingtohouseholdsforconsumptionand housing have grown in recent years, loans to households still account foronly17.8%ofChina’sfinancialinstitutions’totalloanportfolio(People’sBankofChina,2008).Instead,theexcesssavingsinChinafounditsoutletinthebalanceof payments as current account surpluses and rising foreign reserves of thecentralbanks.SeeFigure6.Figure6: China’s andU.S. CurrentAccountBalances, China’s ForeignReserves,2000‐2009.

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Sources:Chinability,US‐ChinaBusinessCouncil,BureauofEconomicAnalysis.Between1970and2006,exportsasapercentageofGDProsefrombelow5%toabout35%andtogetherwithfixedinvestmentsaccountedforabout75%ofGDP(Roach,2009:173).TheforeignreservesaremostlyinvestedinUSTreasurybillsthatinturnprovidedliquidityfortheUSbankingsystemtolendtothehousingsector. Figure 7 shows that themain issuers of debt between 2004 and 2006weremortgageagenciesandassetbacksecuritiesissuersthathadovertakenthefederalgovernmentasdebtissuers.Figure7:U.S.DebtIssuers:WhoIssuedtheDebt

Source:Duncan,2007.Ironically, under‐consumption and excess savings in apoor country like ChinaarefundingtheexcessconsumptionanddebtbubbleintheU.S.TorecognizethisisnottosubscribetoBernanke’sthesisofglobalsavingglutasthecauseoftheGFC.Worldsavingsasawholehasnotrisensignificantlyabovehistoricalrates.

-400

-200

0

200

400

600

800

1000

$ B

ILL

ION

S

1990 1992 1994 1996 1998 2000 2002 2004 2006

Federal Government

GSEs plus Agency & GSE-backed mortgage pools

ABS Issuers

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Ratherweseeitasataleoftwogluts–theChinesesavingsglut,ontheonehand,andtheU.S.debtandover‐consumptionglut,ontheotherhand,madepossiblebyover‐leveragedandrecklessfinancialinstitutions.The Chinese leaders are concerned about the imbalances in the economy.PremierWenJiabaoinhispressconferenceaftertheNationalPeople’sCongressin 2007warned that China’s economywas increasingly “unstable, unbalanced,uncoordinated,andunsustainable.”(Ibid:229).The imbalancebetweentherichand the poor, and between exports and domestic consumption are notsustainable. Yet, to reduce exports and increase domestic consumption,wagesmustrisewithproductivityandinequalitymustbereduced.Thegovernmentinrecentyearshasalsopaidmoreattentiontoprovidingmoresocialservicesandsafetynettothepoor.Inthe11thFiveYearPlan(2006‐2010),thegovernmentrecognized the need to correct the growing income equality and imbalancebetween consumption and investment. It committed itself to expandingdomestic demand by raising the incomes of the lower and middle incomehouseholds, increasing farmers incomes, providingmore social services to theruralareasandaccelerating thepaceofurbanization,and improving thesocialsecurity system in order to encourage the Chinese households to reduce theirprecautionary savings and increase their consumption. However, despite themeasures that were taken, the trend towards falling wages and consumptionhave continued in the last few years and it appears the government has tointensify its efforts and expand the scope and coverage of its programs toincreasetheprovisionofsocialgoodsandservices.ConclusionWe return to the basic contradiction in growth under capitalism, that is, thecontest for returns between capital and labor. Capital’s unrelenting quest forhigherprofitsandreturnisattheexpenseoflabor’ssharecreatingthetendencytowards under‐consumption that in turn threatens the accumulation process.Capital with the support of the neo‐liberal state enacts political, economic,financial strategies to increase its share of the returns. In the US, Europe andother developed countries, this process was aided by the entrants of hugereservoirof laborfromtheemergingeconomiesintotheglobalproductionandlabormarkets, therebyputtingdownwardpressureonwagesandexacerbatingthe tendency toward under‐consumption. The tendency towards under‐consumption in the US is overcome by household borrowings reflecting therecycling of the excess savings of the richminority to the average household.The spread of capitalism into China has also led to a similar phenomenon offalling share of wages and under‐consumption by the average household inChina. However, the excess savings inChinawas recycled through the globalfinancial system to the averageAmerican household exacerbating the growingindebtednessofthehouseholdsintheU.S.Wedonotpropose that inequality is theonlyordirect causeof economic andfinancialcrisis.Weproposethatitisanimportantfactorcontributingtofinancialimbalance in the economy, which combined with a highly leveraged financialsector that churns out new financial products to increase overall lending,

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increasesthevulnerabilityofthefinancialsystemtosystemicbreakdown.Hencethe rising income inequality issue must be addressed in order to resolveeconomicandfinancialinstability.However,therisingincomeinequalityissueisastructuralproblemthatrequiresamajorshiftinpolicyawayfrommarketfundamentalismtowardssomeformofpolicy to raise real wages concomitant with productivity increases, and toredistribute income from the rich to the poor andmiddle‐income households.For now the prioritymust be to overcome the financial crisis and restore thehealthoftheeconomy.However,thedifficultyandintractabilityofdealingwiththisproblemisevidentinthepresentanemicrecoveryintheUnitedStatesthatmaybe runningout of steamwith the endof the fiscal stimulusprogram.Thestimulus programs have helped to support spending in the economy byprovidingincometotheunemployed,anddebtrelieftohomeownerswhohavenegativehomeequity. The stimulusprogram ismeant tobe temporaryand iseffectiveonlyifthecorporatesectorrecoversandstartstoinvestandhire.Eventhoughthecorporatesectorhasimproveditsfinancialposition,ithasdonesobycutting costs; hencemost of the rise in profits is due to cost reduction ratherthan expansion of business and revenue generation. Cutting costs means nothiring, or making workers work longer and harder. Official unemploymentremainsatahighofalmost10%.“Whenyoucombinethelong‐termunemployedwiththosewhoaredroppingoutandthosewhoareworkingpart‐timebecausetheycan’tfindanythingelse,itisjustfarbeyondanythingwe’veseeninthejobmarketsincethe1930s.”saidMcMillionandtheestimatednumberis30millioninthis“unemployed”group.(Herbert).However, even with improvement in employment, economic recovery will behobbledbyweakness inhouseholdbalancesheet.Hence inorder foreconomicrecoverytobesustainable,itisnecessaryforpolicymakerstoaddresstheissuesofgrowthwithsubstantialemploymentgeneration,reductionof inequalityandstrengtheningofhouseholdbalancesheet.

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