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Inequality and the Financial Crisis

By PASQUALE TRIDICO 26/02/2015

The objective of this brief essay is to show that the institutional and structural changes which occurred in the labor market and in the economy over the last two decades in Europe, and over the past 30 years in the US, were functional to the financialization of the economy and have culminated in the current economic crisis. These changes allowed for labor flexibility, wage moderation and ultimately inequality and profit soar. All this occurred with the demise of Keynesian policies and the simultaneous creation of a financial-led growth model, which crashed in 2007-08.

1. The Labor Market and the Crisis under the Financial-led Growth Model

First, the financial-led model, epitome of the neoliberal approach which has been dominant in the UK and the US since the 1980s, requires higher degrees of labor flexibility because the massive shift from the industrial sector to the service, technology and innovation sector brings about rapid structural changes, which demand quick responses from firms. Therefore, labor should adjust to the firms’ needs rather than the other way around. The financial sector in particular, because of its peculiarities, requires a very flexible workforce and fast adjustments (Tridico, 2012). The financial sector was an early and eager promoter of deregulation under the Thatcher and Reagan administrations (Chang, 2014).  Moreover, after the fall of the Soviet Union, Alan Greenspan, who was appointed Fed chairman by President Reagan in 1987 and remained until 2006, believed that the world economy could expand greatly through the globalization of the financial sector. The rest of the economy then followed the financial-led regime of accumulation, with flexible labor and compressed wages. 

Table 1 – Financial-led Model of Accumulation

Financial-led model of accumulation

In this model, shareholders want higher dividends because they invested their own capital in firms, taking on a higher level of risk. Since the economic growth and productivity of advanced economies in the post-Fordist era has not been much higher than during the Fordist era, it follows that wages should be compressed in order for shareholders to obtain higher dividends (see Figure 1 and 2). Labor flexibility and wage contraction is a means to obtain this result.

Average GDP Growth in the EU15 and the US (1961-2013)Source: author’s elaboration using the World Bank database
Tridico Graph2Source: OECD Employment Outlook 2011

The highest percentage of financialization, as a share of GDP, has taken place in Switzerland. However, in absolute value, the US is the most financialized market, followed by the UK. The US promoted neo-liberalism through global, multi, and bilateral measures, under pressure from all of the major international financial institutions, multinational corporations, and Wall Street institutions. The trend of hyper-financialization spread around the world, first to Europe and then to emerging markets. Financialization is beneficial, Wall Street argued, to facilitate innovation and economic growth, despite a paucity of evidence supporting the claim (Lowenstein, 2010). In fact, quite the opposite is true: there is clear evidence of a correlation between financialization and inequality as can be seen in Figure 4.

Figure 3 compares the financialization of the OECD economies since 1988.  The variable of comparison here is the value of market capitalization in the stock exchange as a percentage of GDP. One can observe a huge increase among all the countries, in particular the US, UK, Switzerland, Australia, and Canada.

Source: World Bank, 2010 online database Source: World Bank

A clear and concise story is emerging from these figures. There is a positive correlation between the level of market financialization and income inequality. In the top right corner of Figure 4, one can see the US and other Anglo-Saxon countries, which have traditionally higher levels of financialization and income inequality. In contrast, in the bottom left of the chart we have the Scandinavian and Germanic nations, typically more equitable regarding income distribution. As a general rule Anglo-Saxon countries have higher levels of inequality and financialization than Continental and Scandinavian European countries, who typically have larger welfare states. An exception is represented by the Mediterranean countries (Spain, Portugal, Greece, Italy) which have a more ineffective State, with inadequate redistributive policies, and a large informal economy contributing to higher degrees of inequality (higher than Australia and Canada,  for instance, and to some extent the UK).

Source: Own elaboration on the OECD and World Bank database
Source: Own elaboration on the OECD and World Bank database
Tridico Graph5
Source: Own elaboration on the OECD and World Bank database
TridicoGraph6
Source: Own elaboration on the OECD and World Bank database

As Figures 4 and 5 clearly illustrate, high financialization is typically associated with high income inequality as well as  with high labor flexibility. More interesting is the parallel trends of these variables: when financialization increases, one notices both increased flexibility and inequality.

An idea about the increase in labor market flexibility is offered by the Employment Protection Legislation (EPL) from the OECD, which is used in Figure 5 and 6. This indicator quantifies the level of protection offered by national legislation with respect to regular employment, temporary employment and collective dismissal. In other words, it captures the extent to which an employer’s freedom to fire and hire workers is regulated.  The indicator decreased consistently in the last two decades (which indicates more labor flexibility). Historically, European economies have maintained higher levels of EPL in comparison with Anglo-Saxon economies. Although labor flexibility has increased everywhere, the European policy agenda is moving toward so-called “flexicurity” which would promote some type of job and income security (i.e., employability) while accounting for the need for flexibility on the part of firms (OECD, 2013). Typically, the case of Denmark represents a situation where a lower EPL is associated with income and job security. Thus, income inequality did not increase.

2. Credit consumption and inequality: the contradiction of the system

A flexible labor market with compressed wages needs to be supplemented by available financing. Hence, financial tools were developed to sustain consumption, which otherwise was compressed by low and unstable wages. It is difficult to establish a causal relation though: we cannot be certain whether financialization required labor flexibility or if increased labor flexibility brought about hyper-financialization. A simple correlation between these two complementary institutional forms of neoliberalism seems more likely.

A large number of financial tools were invented to finance consumption, to postpone payments, to extend credit, and to create extra-consumption. Interestingly enough, while income inequality increased in the US dramatically in the last 30 years, consumption inequality did not increase, just because borrowing opportunities allowed for workers to consume using credit channels (Kimhof and Rancière, 2010).

On the other hand, this kind of “credit-consumption” in the context of the financial-led model was needed by the economy,otherwise the saving glut in Asia and the low income capacity of domestic workers would leave firms with un-bought goods and services and would create aggregate demand imbalances. Workers could now afford to buy cheap goods from China and, thanks to financial innovation and cheap money, expensive houses, luxury cars, and other durable goods at home. Such a model of consumption is however unstable as the financial crash of 2007-08 showed. Paradoxically, the causes of the crisis lie within the financial-led model: it creates credit consumption, which causes both its development and its failure.

Conclusion

In this short essay I have discussed  on one hand the strong correlation between inequality and labour flexibility, and on the other hand the interconnection between these two variables and the financialisation of the economy which has taken place over the last 3 decades in the US and the UK, and in the last two decades in the rest of Europe. In brief, the financialization of the economy, relying mostly on credit consumption rather than on wage nexus and income distribution, has inside an internal contradiction, that is the continuous need for credit consumption which in turn is also the reason for instability and the cause of the financial crash in 2007-08, and of the current economic crisis.

PASQUALE TRIDICO

Jean Monnet Professor in European Economic Integration at the Department of Economics at the University Roma Tre.

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