5534P GLOBAL ECO CRISIS-A/rev/lb Royal A Sabon/Sue/hyphn

5 Changes in IncomeDistribution, FinancialDisorder and Crisis

Aldo Barba and Massimo Pivetti

Introduction1

This essay intends to discuss the main interpretations of the current crisisadvanced over the last two years, as well as the main policy lines that havebeen suggested to overcome the crisis. As we shall see, the dominant per -spective tends to confine both the causes and the solutions of the crisis withinthe financial sphere. Contrasting this approach, we shall put forward aninterpretation based on a contribution we wrote before the outbreak of the crisison the long-term implications of the rising US household debt. From thatcontribution, an explanation of the crisis can be derived that locates its sourcein the real sphere of the economy, and in which the current ‘financial disorder’is viewed in primis as an effect rather than a cause. The ‘real’ nature of thecrisis is arrived at by connecting the growing US household debt to themarked changes in income distribution recorded over the last three decades.Changes in distribution are thus seen as the fundamental determinant of thecrisis, rather than as a consequence of the increased weight of the financialsector, with its wealthy remunerations. Confronting the prevailing explanationsof the crisis with our own, alternative policy implications emerge, which arediscussed in the concluding section of this essay.

On the main current interpretations of the crisis

Determination versus propagation

The analysis of the current economic and financial crisis raises two different– albeit related – issues: the first one concerns its ‘proximate’ vs. its ‘ultimate’determinants, while the second one concerns the mechanisms and the channelsthrough which the crisis propagated itself. The current debate is focused onthe latter issue, where the central stage is occupied by such questions as theinversion of financial leverage, the evaporation of liquidity in markets formerlyconsidered as extremely thick,2 and the several forms of central bankintervention aimed at coping with the state of financial emergency.3 Current

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analyses of the propagation mechanisms have also encompassed the impactof the financial crisis on the real economy, as well as the feedback of thecontraction in activity levels on the hardships of the financial sector. But thisbelief of a mutually reinforcing interaction between the real and the financialsphere has hardly shaken at all the generally held conviction that the financialdisorder does constitute the ultimate source of an otherwise regular course ofaffairs.4 And when some sources of real instability do happen to be hinted atin recent literature, there is barely much more to be found than a genericacknowledgment that the possibilities of systemic risk had been under -estimated, perhaps due to an excessive reliance on the notion that the system’scyclical macroeconomic instability had been eradicated for good.5

However, the need to trace the roots of the crisis cannot be evaded even ifit is believed that they are confined to the monetary and financial sphere. Puttingaside those contributions in which the analysis of the origin of the crisis actuallycoincides with a mere description of its propagation, the explanations that aregaining weight revolve around two themes. The first one concerns the role ofcentral banks and the policies they followed in the years that preceded thecrisis. Central banks would have accommodated the appetites of irrationalborrowers by setting interest rates ‘too low for too long’, thus inducing themto become increasingly indebted with a view to obtaining speculative capitalgains sufficiently large so as to cover their exposition and generate consider -able profits. With slightly different accents, this explanation is shared both byeconomists in the Keynesian tradition (see, for example, Leijonhufvud 2009)and by economists who instead rule out the idea that demand may play anyrole in the determination of output levels, except for in the short run or in thepresence of disturbances of an accidental nature. The second explanation centreson the monetary and financial repercussions of global imbalances in savingflows. According to this explanation, it was an excessive supply of savingsin the international financial market – and not an ill-conducted monetary policy– that would have forced US interest rates down, thereby generating an over-extension of credit and the eventual degradation of borrowers’ solvency. Letus discuss these two views in greater detail.

Financial deregulation, risk management and cheap money

According to several authors, the crisis is the result of the changes thatoccurred over the last two decades within the financial sector and its riskmanagement practices. On the one side, the new deregulated context is referredto, together with the development of new financial institutions; on the other,the tendency is highlighted of the whole financial and banking system movingrisk away from official balance sheets towards off-balance entities (structuredinvestment vehicles – SIVs) and the market (the so-called ‘originate to distribute’model – OTD).6 These changes would have made financial intermediaries moreexposed to competition, forcing them to assume and distribute remarkably highrisks in order to increase expected profits and thus beat competitors. Cheap

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money policies would have enhanced this tendency, lowering the return onrisk-free assets and increasing the incentive to move away from prudentialinvestments toward more risky portfolios, in view of their significantly higherreturns.7 From this, a perverse chain of events would have developed, goingfrom the extension of subprime lending to the exuberance in consumption andincreasing current account deficits, passing through the real estate boom, wealtheffects and massive equity withdrawals. The solution to all this is seen in afinancial regulation and in a monetary policy capable of preventing marketforces from generating excessive risks, while at the same time avoidingexcessive government intervention in the economy.8

Apart from the proposal of forcing financial managers to increase their stakein the funds they manage, so as to help in solving the shareholder/managerconflict,9 this characterization of the issue in terms of ‘satisfactory riskmanagement’ does not seem to offer promising lines of action. On the onehand, the bare technical complexity of any effective system of control offinancial risk management must be taken into account10; on the other, and more importantly, it is hardly conceivable that monetary policy, and interestrate policy in particular, might be targeted towards reducing the risk of financial instability – that is, according to the point of view underconsideration, to be so managed as to check the financial institutions’ incentiveto take on excessive risk.11

The implementation of a new system of risk management, to be put in placethrough the establishment of a new financial architecture designed to protectthe entire population, is suggested even by those who see the current crisis asthe result of a process of contagion of irrational human ideas and behaviours,in a state of affairs dominated by uninformed choices.12 Since this lack ofinformation cannot be fully overcome by enforcement and regulation, it isbelieved that, in order to prevent it from becoming too damaging, furtherdevelopments in financial engineering should be promoted to keep at bayfinancial disorders such as the one we are experiencing. It is thus suggestedthat a net of institutions capable of providing generalized insurance coveragemight take on and enlarge the role already performed in the past by ‘charitableinstitutions’.13 What this solution basically presumes is that, thanks to the ‘lawof great numbers’, generalized insurance coverage can be granted unlessexceptional catastrophic events occur – events, that is, whose natures make themintrinsically uninsurable. And in fact the current crisis is ultimately regardedas such an event, with the corollary that the proposed insurance scheme isconsidered viable in spite of what AIG’s experience would seem to suggest.14

From this literature that sees the origin of the crisis in financial and monetaryprocesses, and in improvements in financial engineering its solution, theapprehension surfaces that a rejection of the social system as a whole mightfollow from the loss of faith engendered by the crisis in the proper function -ing of the market economy. Acemoglu is in this respect particularly explicit,when stating that the ‘risk that the belief in the capitalistic system maycollapse should not be dismissed’:

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Changes in income distribution 83


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We may see consumers and policy makers start believing that free marketsare responsible for the economic ills of today and shift their support awayfrom the market economy. We would then see the pendulum swing toofar, taking us to an era of heavy government involvement. [. . .] I believethat such a swing and the anti-market policies that it would bring wouldbe the real threat to the future growth prospects of the global economy.Restrictions on trade in goods and services would be a first step [and]more systematic proposals on trade restrictions and industrial policy maybe around the corner. [. . .] What we are experiencing is not a failure of capitalism or free markets per se, but the failure, in particular, ofunregulated financial sector and risk management.

(Agemoglu 2009: 5)

Some form of regulation in the financial sector thus tends to be regardedas most welcome, providing that globalization, competition and flexibility inthe markets for labour, goods and capitals remain unquestioned. In sum,return to greater government intervention should not be so extended as tojeopardize the balance of power and the distributional status quo that advancedcapitalism has succeeded in establishing over the last three decades.

Excessive global saving

The second explanation of the crisis is centred on the idea that countries withvery high growth rates (China in particular) exhibit also very high saving rates,without proportionate domestic investment opportunities. As a result, hugesaving flows would have been attracted by the developed Anglo-Saxonfinancial markets. According to this line of reasoning, this excess of globalsaving would have prompted the fall in US long-term interest rates and hencethe irresponsible lending practices of US financial intermediaries. From this,the self-sustaining interaction between excessive lending and the real estateboom would have resulted, to be followed, in due course, by the fall in houseprices and the degradation in the solvency position of financial institutions.15

The very process of the creation of new securities, characterized by toweringlevels of both uncalculated risk and opaqueness, would have been forced bythe spasmodic search for adequate returns in the global financial market, in asituation of scarcity of investment opportunities relative to huge saving flows.

So here we have the two main explanations of the financial disorder face-to-face: low interest rates brought about by an ill-conducted monetary policy,on the one side, and by a global saving glut, on the other. For the former, itwas a domestic situation of overly easy credit that fostered the externalimbalance; for the latter, it was an unbalanced external position that resultedin excessive domestic lending.

The latter explanation suggests that the crisis, owing to its external origin,cannot be overcome solely through a shift in the orientation of monetary policyand interventions aimed at a stricter financial market regulation. However, what



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this suggestion looses sight of is that, without the changes in incomedistribution recorded over the last few decades, growth in US domesticdemand might well have occurred without increasing levels of householdindebtedness. Hence, the same excess of domestic uses over resources andthe same trend in US net external debt would have come about, but the crisiswould have not occurred in the way in which it did actually occur – that is,as the effect of an unsustainable rise in household indebtdeness.

The point we are stressing here is that the growth in the household debt-to-income ratio was totally independent of the current surpluses of China andother developing countries. The external imbalance could have occurred evenwith no changes in income distribution and the consequent growth inhousehold debt-to-income ratio; by the same token, the growth of householddebt-to-income ratio might well have occurred without any substantial externalimbalance. US household debt has been funded by credits from the domesticprivate sector, not by China current surpluses. Current Chinese surpluses havebeen used instead to buy US government debt. And up until the outbreak ofthe crisis no casual relationship can be established between US private andgovernment debt.16

The global imbalance, in sum, was not the cause of the rise in householddebt, and it can be affirmed that it would have occurred without any such‘generous’ lending to households, although perhaps remaining in a state oflatency due to a possible lower global demand and lower growth. The pointis that any sustained growth of domestic demand is likely to bring about externalimbalances – if goods, labour and capital can move freely – regardless of themeans by which aggregate demand is actually sustained: rising wages vs. risingpublic or private debt. Of course, these means differ significantly from eachother, in that a process of substitution of private debt for wages and publicdebt is unsustainable in the long run, as proved by the outbreak of the currenteconomic and financial crisis.

Our line of reasoning disputes the above explanations of the crisis, whichare the prevailing ones today. It is our view that this is not a crisis caused byoverly low interest rates; the root of the crisis should to be traced instead inthe way aggregate demand had actually been insulated from the markedchanges in income distribution experienced by advanced capitalism over thelast thirty years.

Our own interpretation: connecting the financial disorder

to the changes in income distribution

Low wages and rising household debt

Up until the outbreak of the crisis, the phenomenon of rising householdindebtedness had been viewed with favour by a large section of the economicprofession. And in the contributions that explicitly addressed the theme, suchfavour was rationalized in terms of utility maximization behaviours: household


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debt allowed consumption to be smoothed, in the face of hump-shaped time-earning profiles and erratic income flows. Against this perspective, we arguedthat the rising household debt should have been viewed as the outcome ofsluggish real wages and a shrinking welfare state – that is, as the outcome ofpersistent changes in income distribution toward greater inequalities. Wenoted, in this respect, that in the USA the following three phenomena hadmanifested themselves, starting from the early 1980s: a substantial shift inincome distribution away from low- and middle-income classes, an exceptionaldrop in the personal savings rate and marked increases in households’ liabilities(see Figure 5.1, and cf. Barba and Pivetti 2009:121–126). In our analysis, thefactors capable of sustaining consumption in the face of rising incomeinequalities were singled out in the inelasticity of consumption with respectto reductions in households’ real incomes, the availability of new goods andservices, the drive for a continuous rise in the standard of living and imitationof the upper classes.17 The lessening of liquidity constraints on low- and middle-income households – financial deregulation and the whole set of circumstancesthat had increased households’ accessibility to credit, starting from theirenhanced capability to extract liquidity from the value of their houses – wouldhave acted, in our view, as the permissive factor, thanks to which the above-mentioned aspects of consumption behaviour were allowed to actually exerttheir positive impact on consumption expenditure.

Through household indebtedness, therefore, it seemed possible to bring aboutthe best possible outcome from the point of view of the capitalistic system,that is, that through household debt low wages could be brought to coexistwith high levels of aggregate demand, without it being necessary, for thiscoexistence to be persistently ensured, to have recourse to state interventionand bigger government. Household debt thus appeared to be capable ofproviding the solution to the fundamental contradiction between the necessityof high and rising levels of consumption, for the growth of the system’s actualoutput, and a framework of antagonistic conditions of distribution, which keepswithin limits the real income of the vast majority of society.

The failure of substituting loans for wages

We argued, however, that things were not quite so simple, as actual eventshave eventually confirmed. In our view the gist of the question was the sus -tainability over time of the process of substitution of loans for wages: althoughhousehold debt had actually been exerting a significant positive impact onaggregate demand and activity levels, the problematic aspect of the processconcerned the long-run solvency of the indebted workers. In this regard, wemaintained that while the widespread worries about the sustainability of risingdebt levels were generally ill-placed when referred to public debt, they did onthe contrary retain their relevance with respect to household debt.

The algebra we used for analyzing the problem was substantially the sameas that which is normally used to analyze the ratio of public debt to gross



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domestic output and the determinants of its dynamic. We argued that also withrespect to household debt the crucial factor could be singled out in thedifference between the rate of interest and the rate of growth of income, butthat while in the case of public debt the rate of growth of total income cannotbe regarded as exogenous with respect to the dynamic of the debt, in the caseof indebted households the course of their incomes had to be regarded asindependent of the course of their debts. The budget deficits of the individualworker’s family, as well as the course of his debt, obviously did not affect hiswage. In the conditions we were considering this was substantially true alsofor the whole of wage earners, since the growth of their debt was the veryreflection of the fact that real wages were not growing or that their growthwas not keeping pace with productivity – a situation, that is to say, in whichthe growth of output, sustained also by debt-financed consumption expendi -tures, resulted in total income increases that tended to concentrate on the upper10 per cent of income distribution. And even when the real income of low-and middle-income households was to some extent positively affected by thegrowth of their debt and of actual output,18 the difference between the debtburden and the rate of growth of wages remained in any case too large to becompensated for without having to cut down eventually on consumption, inorder to stabilize the household’s debt-income ratio. We stressed that in thecontext under consideration the relevant rate of interest was not the rate to beearned on long-term riskless financial assets, but the significantly higher ratesto be paid on the different types of consumption credit. Moreover, that in thecase of private debt, differently from what can in principle be achieved in the case of public debt, the possibility to burden the very lender with the costof the debt service must obviously be ruled out (cf. on this Barba and Pivetti2009: 130).

We thus maintained that beyond certain indebtedness levels the service ofhousehold debt would have actually become no longer collectable; therefore,that the process of substitution of loans for wages could not go on indefinitely,for the individual wage earners already involved in it, unless one couldrealistically assume that the credit system might have ended up extending themsunk sums deliberately, counting on systematic interventions in its favour onthe part of the lender of last resort. But this would have amounted to assuminga sort of monetization of household debt, by which, in practice, the lender oflast resort would have ended up providing wage earners, through the banks,with the sums needed to maintain and increase their standards of living.

In actual fact, the macroeconomic sustainability of the process of substi -tution of loans for wages had been protracted over time essentially by twomeans: (1) by the expansion of the population caught in it, that is by involvingan increasing number of wage and salary earners in the indebtedness process– we noted in this regard how the marked expansion of subprime loans overthe last few years prior to the outbreak of the crisis could be regarded as themost conspicuous aspect of this first means of protracting the process; (2) bya policy of progressive lowering of interest rates, such as that actually followed



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by the Federal Reserve over the 1995–2004 decade. We pointed out, however,that the shrinking scope for a cheap-money policy, or the emergence of asituation in which the value of houses dropped faster than interest rates couldbe lowered, would have rapidly exacerbated the financial distress of low- andmiddle-income households, thereby determining the fall in their borrowingsand igniting the redde rationem of the process of substituting loans for wages.

Moving thus from directing attention to the limits of this process ofsubstitution of loans for wages, our analysis did put the progressive deteriora -tion in household debt position at the origin of the crisis, though in a sensevery different from that of just acknowledging that a relatively circumscribedsegment of the financial market – that of subprime loans – could eventuallyact, through spillovers across markets, as the detonator of a significantly deeperfinancial disorder. In our interpretation, the extension of loans to subprimeborrowers was not to be viewed as the cause of the crisis; it was rather to beviewed as a way to delay the impact on consumption, hence on activity levels,of a more general precariousness in household solvency conditions. Muchrecent literature, in which the diffusion of the crisis has been analyzed, hasactually acknowledged that the growing difficulties into which financial insti -tutions plunged owing to the ‘structured finance’ instruments (cf., for example,Coval et al. 2008) must be traced back to the very appearance of unforeseenlevels of insolvency, not only among subprime borrowers but especiallyamong households that had continued to be regarded as ‘prime borrowers’.19

Illiquid assets’ monetization

On a second failure: the attempt to substitute private debt for public debt

In addition to the long-run failure of a growth process based on the substitutionof loans for wages, it can be affirmed that the outbreak of the crisis has broughtto light also a second failure: that of the attempt to substitute private debt forpublic debt as a tool for sustaining activity levels. Especially over the 1990s,in fact, the rapid expansion of household debt was accompanied by a prolongedas well as unusual stagnation in the absolute level of public indebtedness (see Figure 5.2). This seems strongly to suggest that the negative impact ondemand of the distributive changes that had been occurring since the early1980s might have been checked, alternatively, through the expansion of publicspending financed by recourse to government debt.

According to the prevailing line of reasoning, however, the rise in privateindebtedness was to be preferred to the rise in public debt. This view was notbased on the analysis of their respective long-run sustainability (such ananalysis, as argued above, would lead to conclusions in favour of public debt);rather, it was based on the idea that while private debt is but the result of theeconomic agents’ free choice, public debt constitutes instead an ‘intrusion’ ofthe government on the consumption and savings decisions of households, and


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is inexorably bound to cause a deviation from that best possible distributionof consumption over time deemed capable of ensuring the greatest possibleadvantage to society. According to this line of reasoning, household debt mighteventually have revealed itself excessive, but only to the extent that anexuberant behaviour on the part of irrational consumers had led them to expandconsumption beyond their permanent income.

What is now worth observing is that the substitution of private debt for publicdebt, justified by the dominant view on such theoretical grounds, has broughtabout a paradoxical result. It was not difficult to predict that as soon as theunsustainability of household debt became apparent, the government wouldhave been compelled to step in, by injecting liquidity into the system to buyno longer collectable outstanding debts, so as to check the impact on financialintermediaries – and, through them, on the real economy – of the indebtedhouseholds’ state of insolvency (cf. Barba and Pivetti 2009: 129). As isknown, this has produced over the last two years an unprecedented rise in publicdebt, aimed at avoiding the collapse of the system rather than at fosteringgrowth, thereby bringing to light the inanity of the attempt to restrain publicdebt through private debt. Note that the current growth of public debt reflectsonly in small part a taking over of household debt on the part of the govern -ment – essentially that portion of government intervention destined to theindemnification of creditors involved in household bankruptcy cases, togetherwith that utilized to fund expenditure programmes aimed at facilitating debtrenegotiation on the part of insolvent households.20 To a very large extent,therefore, the burden of private debt persists and adds to that of an increasingpublic debt with the effect of hindering a resumption of the growth process(more on this below).

The temptation to enlarge the role of a politically independentcentral bank

The massive recourse over the last two years to the monetization of illiquidassets of the financial sector, aimed at avoiding the collapse of the system,brings to front stage the role of the central banker. The question, in our view,does not concern the necessity for interventions by the central bank; rather,it concerns its status as a politically independent body. Over the last thirtyyears, central bank independence has been defended and largely achieved onthe basis of the almost universally shared conviction that monetary policy doesnot have real effects in the long run, and that it is safer to entrust it to a technicalorganism that, shielded against political interferences, aims at achievingmonetary stability through the use of a priori established rules. Now,independently of the judgement one may make about the plausibility of theidea that monetary policy is neutral in the long run, recourse by the bank torules established a priori would have actually led, in the current conditions,to the collapse of the system. But once it is acknowledged that massive dosesof discretion – not rules – had necessarily to inform the central bank’s action,

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then the justifications for its independence are jeopardized – the morejeopardized the more one takes into account the kind of interventions that theeffective use of discretion has prompted.21 We refer especially to the questionof whether and in whose favour to intervene, as well as to the obstacles thatthe interventions have actually raised against the disciplinary power ofcompetition within the financial sector, up to the point of allowing the survivalof private institutions ‘too big to fail’.

Nowadays, the temptation is strong to defend central bank independence,not by restricting its scope, but rather by extending it so as to encompass thetarget of ‘financial stability’, to be meant in a double sense: on the one hand,as recalled at the beginning of this discussion on the interpretations of the crisis,by using the bank’s independent power to establish the level of the interestrate not only to control the course of money wages and goods prices but alsothe dynamic of real and financial asset prices – that is, as a tool to ensure thestabilization of asset markets, together with monetary stability; on the other,by formally endowing the central bank with the power to bail out individualinsolvent banks and maintain in operation, through potentially unlimitedlending, troubled institutions that cannot fail.22 In this way, the dichotomybetween autonomy and discretion would be settled by expanding the formerup to the inclusion of the latter. In other words, a power already freed frompolitical accountability in the name of the neutrality of its decisions with respectto such real phenomena as the production and distribution of income, wouldnow actually find in non-neutrality and a wider scope of its action the veryjustification of its autonomy. The short circuit between central bank andrepresentative institutions would thus become all-too pervasive to be mended.23

Policy implications of our view

The inappropriateness of an overall more restrictive monetarypolicy

Alternative economic policy lines naturally emerge from the comparison ofthe prevailing interpretations of the crisis with our own.

We have seen in the first section of this article how low interest rates arefrequently indicated in the recent literature as one of the chief factors that wouldhave enhanced the financial intermediaries’ tendency to take on overly highrisks, often hidden to investors, thus favouring both speculation andconsumptionistic frenzy. According to our interpretation instead, the cheap-money policy at length followed by the Federal Reserve would have playedthe significant role of making the process of substitution of loans for wageslast longer, by checking over the 1990s household debt service as a share ofdisposable personal income, notwithstanding the continuous rise in the overallhousehold debt-to-income ratio.

Now, the concept of low interest rates as paramount in the outbreak of thecrisis is actually setting the stage for a monetary policy stance aimed not only



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at the stabilization of the general level of goods prices but also at thestabilization of asset prices. In practice, what the concept under considerationstrongly prescribes for the future is that, even under conditions of lowdomestically originated inflation, it would be inappropriate to pursue cheap-money policies. It goes without saying that to those who have reached theconclusion instead that the ultimate causes of the crisis are of a real nature,in primis to be found in the changes undergone by income distribution, anoverall more restrictive monetary policy stance may hardly appear as likelyto reduce in the future the risk of recessions such as the current one; quite thecontrary, such a stance will appear as most likely to increase it.

Similar considerations can be advanced also about the thesis that the crisiswould have originated in a few countries’ excessive savings. In fact, alsoaccording to this interpretation, as we have seen, low interest rates would havecaused the boom in asset prices and the excessive recourse to debt on the partof households; low rates of interest, however, rather than having been broughtabout by an ‘inappropriate’ monetary policy, are viewed as the product of aglobal imbalance. The policy lines to be adopted should then aim at a lessthan well-specified resolution of this imbalance – in a context, however, inwhich the free mobility of both goods and capitals should be safeguarded. Oncloser examination, a solution of the crisis consistent with its interpretationin terms of imbalances in national saving rates would come out as cruciallydepending on the possibility of forcing creditor countries (China in the firstplace) to ‘save less’ – to force them, that is to say, either to absorb domesticallytheir current exportable surpluses or undergo major contractions of theiractivity levels.24

In our view, it is not because of the excess of foreign savings that domesticimbalances developed, which eventually led to the crisis. They were on thecontrary domestically originated imbalances – namely, the efforts to insulateactivity levels of advanced capitalism from its growing income inequalities –that eventually brought about the current crisis, together with the currentaccount deficits. What really matters here, however, is only the former of thesetwo effects, since the latter, the external deficits, would have come aboutwhichever route had been chosen to sustain aggregate demand in the face ofthe growing income inequalities.

On the obstacles to reversing the trend towards growinginequalities

Let us now try to make explicit the policy implications of our point of view.First of all, having indicated the origin of the crisis in factors of a real nature,it is our conviction that it cannot be solved solely with interventions aimed atthe cessation of the economy’s financial disorder. As already observed, whatis under discussion is not in our view the obvious necessity of interventionscapable of rescuing the financial system from collapsing. Our point is that thisrescuing cannot by itself ‘reset’ the growth process in motion.

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Once the necessary condition of the cessation of the financial disorder hasbeen met, the return to a normal state of growth would in any case continueto be hindered by a complex of adverse circumstances. First, there is the factthat households persist in being heavily ballasted with debt – monetization,as already pointed out, has mostly concerned debts of financial institutionsrather than household debt; this is now acting as a checking factor uponaggregate demand. Second, there is the persistent fall in employment, whichproduces a further containment of demand through both the reduction in thenumber of wage earners and its negative impact on the course of wages. Thecrisis, in other words, tends to amplify the real imbalances that have broughtit about, thereby feeding on itself. Third, there isthe fact that an expansivestance in budgetary policy is currently being jeopardized by the markedincrease in public debt generated by the bailing out of financial institutions.

The latter point is worthy of special attention. Changes in the ‘primary’distribution of income, contrary to those which occurred over the last threedecades, would in any case require a very long incubation period – this, evenif today the awareness was already widespread of the importance for growthof a marked shift in distributive conditions. Such a shift would indeed requirenothing less than correcting all of the factors back to which the breakdownof wage earners’ bargaining power can be traced: from declining union-density levels and a rising ‘flexibility’ of labour-market institutions – shiftsaway from collective bargaining arrangements, full-time employment andemployment protection legislation – to the almost complete internationalliberalization of trade, as well as of labour and capital movements.

The question of the obstacles to an expansive stance of budgetary policyand a robust expansion of social spending then becomes vitally important, sincethis expansion can be singled out in the current conditions as perhaps the onlyremaining means to reset the growth process in motion. Indeed, where theresumption of the growth process is viewed as an objective that simply cannotbe given up – as in the USA – one can hardly think of public spending on,say, some new military adventure as representing a viable alternative today.

Notes

1 We wish to thank our discussant, Marco Passarella, and others participants in theconference for comments.

2 See Adrian and Shin (2009) for a discussion of the ‘inversion’ of financialleverage, and Coval et al. (2009) for an examination of the role of ‘structuredfinance’ securities in driving the financial distress. EU (2009) provides a generalaccount of the ‘set chain of events’.

3 For a review of the main interventions of the Federal Reserve and the ECB, seeBernanke (2009) and Trichet (2009).

4 Especially during the first year of the crisis, countless references were made tothe healthy outlook of the real economy, which, when confronted with the eruptionof the financial disorder, would have proved the truly financial origin of the crisis.By emphasizing that firms had been credit rationed, it was suggested that withoutthis credit rationing, investment spending would have been larger, and the belief



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was thus strengthened that factors of a financial character were those that kept onchecking the natural tendency of market forces to adjust output to potential. Foran examination of changes in bank lending attitude since 2008, see Ivashina andScharfstein (2008).

5 Cf. on this Acemoglu (2009: 1–3).6 See, on this, Finanacial Stability Forum (2008: 9–10).7 For an examination of the channels through which a policy of low interest rates

would have increased the degree of risk of lending activities, see Gambacorta(2009).

8 See on this also the fourth section below ‘Policy implications of our view’.9 As a matter of fact, in the light of actual experience, the limited relevance of such

a proposal is usually acknowledged, for example: ‘The managers of LTCM didhave substantial stakes in their enterprise’ (Rajan 2005: 357).

10 The complexity of supervision becomes apparent as soon as some effort is madeto detail the proposal. According to Rajan, for example, it would be necessary ‘forsupervisors to gauge the risk management structure of the institution, the risksmodels the institution uses, as well as to require stress tests/reports of sensitivitiesof portfolios to changes in macro variables or correlations with other asset prices’(Rajan 2005: 354).

11 On the connection between financial stability and monetary policy, see Adrianand Shin (2008). Moving from the consideration that the financial system as awhole finances the acquisition of long-term illiquid assets by means of short-termliabilities, the two authors argue that the debt position of financial intermediaries,as well as the amount of their liquid provisions, affect credit supply and is thuscapable of exerting real effects. (They stress, in particular, the influence of creditsupply on consumption of durables and on investment in residential construction.)Monetary policy should then be managed in such a way as to avoid frictions andrestrictions in credit supply – i.e. interest rate policy should be managed with aview to preventing marked increases in indebtedness within the financial sector,with the ensuing deleveraging and collapse of credit supply.

12 Shiller, for example, states that ‘Those who bought residential mortgage-backedsecurities based on subprime mortgages typically did so with little moreinformation than that contained in the ratings given by the rating agencies. [. . .][It is necessary] to develop new presentation modes, going beyond the traditionalsecurities ratings. There should be more simple, standardized disclosure modes,analogous to the standardized nutrition labelling on packages of food, that makeit very easy for people to assess risks’ (Shiller 2008: 135 and 137).

13 Cf. Shiller (2008: 174–175). It should be noted, however, that some uncertaintyabout the soundness of such an approach does not fail to touch its very supporter:‘The long-term solution that I have offered here may strike some as ratherunexpected. Suggesting as it does the further development of our financial marketsand institutions, freeing them to work better, the solution may seem to be movingus in exactly the wrong direction’ (172). For a convinced defence of the idea thatthe prevention of financial disorders like the current one would require furtherinnovations in financial techniques – especially further development in the marketfor derivatives – see Scholes (2009:109).

14 It is indeed the notion of uncertainty, rather than that of risk, that is the properone to refer to if the crisis is conceived as an exceptional catastrophic event towhich the law of probability cannot be applied. And once the focus has been puton uncertainty, then the main economic issue will appear to be the necessity of an enquiry into the potential damages caused by unforeseeable eruptions ofexceptionally destabilizing events, in order to prepare organization collectivelyfor them. In dealing with uncertainty futures, in other words, the analysis should

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be conducted by asking questions such as ‘what happens if buyers default on loansand house prices stop rising?’ (cf. Hodgson 2009: 2117; see also Posner 2009).And no room is thus left for an analysis of the routes through which certaineconomic conditions – for example an increased income inequality – mightengender a widespread economic crisis.

15 Cf., for example, Caballero et al. 2008. The explanation of the crisis in terms ofglobal savings glut is the one towards which American official political andeconomic circles seem to be orientated (cf. ERP 2009: 63–64).

16 We do not deny the potential destabilizing effects of growing external imbalances.However, it should not be overlooked that the ‘unsustainability’ of US currentaccount deficits (that is, the surpluses of China and other developing countries)could have led to a domestic private debt crisis only with difficulty; at most, itmight have led to an exchange rate crisis. And an unlikely abrupt flight from thedollar, as distinct from a controlled devaluation, could perhaps have led to aneconomic crisis as general as the current one, whose course, however, would havebeen completely different. It has been observed, on the other hand, that in spiteof the crisis ‘central banks and other non-resident investors continue to hold andrapidly accumulate US Treasury Securities at even lower yields than before thesubprime crisis appeared’ (Dooley et al. 2008: 5).

17 We made use of a consumption function a la Duesenberry: consumption choicesof low- and middle-income families depend not only on their current disposableincome, but also on their past disposable incomes, as well as on the incomes ofthe upper classes. Increased income inequalities are thus likely to bring about arise, rather than a fall, in the society’s propensity to consume. See on this Barbaand Pivetti (2009: 123–126 and App. I).

18 Essentially, through the increase in the number of hours worked by men and thenumber of wives and mothers working outside the home.

19 While at the appearance of the first financial disorders the rise in the ‘delinquencyrate’ (the percentage of households having a delay of more than 60 days on theirpayments) and in foreclosures had predominantly involved subprime borrowers,beginning from the second quarter of 2008 – i.e. when the crisis had not even startedto affect employment levels – the rise in the ‘delinquency rate’ and in foreclosureswas fuelled almost exclusively by ‘prime borrowers’. Among the latter, more than50 per cent are currently late on their payments – a percentage that is growing andis today significantly higher than the decreasing one concerning subprimeborrowers. Foreclosures have been displaying a similar course (see, on this, Sidel2009).

20 For an overview of the interventions in support of indebted households, ascompared to the much wider action in support of financial institutions, seeElmendorf (2009, esp. pp. 17–20).

21 The defence of the theoretical underpinnings of central bank independence hasrecently become intertwined with the idea that the financial crisis is ultimately tobe imputed to errors in the conduction of monetary policy. In fact, if the crisis hadreally been caused by an incorrect application of a priori established rules, thenthe current events would in no way jeopardize the justification for central bankindependence based on the advocated ‘non-discretionary’ character of its choices.For an interpretation of the crisis centred on an erroneous application of the ‘Taylorrule’ in the years that preceded it (namely, on a presumed delay of a couple ofyears in the raising of interest rates, which was actually started in the second halfof 2004), cf. Taylor (2008, 2009).

22 For an analysis of the new financial-stability tasks to be attributed to the centralbanker, cf. Crockett (2009: 140–144). For a different concept of financial stability– a concept at all times included among the central bank’s objectives, which is



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connected with its classical role of lender of last resort and does not include thestabilization of asset prices nor the bailing out of institutions ‘too-big-to-fail’ –cf. Capie and Wood (2007: XI–XXIV); see also Fratianni (2008: 187–191).

23 On this topical issue there is currently a significant difference between the caseof Europe and that of the United States. While in Europe the political independenceof the central bank appears today to be in no way under discussion, a lively debatehas begun instead in the USA centred on the notion that the already more limitedindependence of the Fed should be further restricted (see, for example, Paletta andHilsernath 2009, and Andrews 2009). The Fed’s chairman, however, remains firmlypositioned in favour of ‘autonomy cum discretion’, his conviction being that forthe best possible management of a monetary policy capable of protecting financialstability from the menaces of this new and uncertain era, ‘maintaining flexibilityand an open mind will be essential’ (Bernanke 2010: 22).

24 A sufficiently marked decline in the value of the dollar might succeed in forcingthe creditor countries to ‘save less’. Given, however, their domestic distributiveconditions, a severe contraction of their activity levels would be the almost sureoutcome of this means to resolving the existing international imbalances. For aconvinced defence of a lower dollar as the best way to resolving the globalimbalance, see Feldstein (2008).

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