Here's the paragraph from Piketty that Sumner critiqued:
"In my view, there is absolutely no doubt that the increase of inequality in United States contributed to the nation’s financial instability. The reason is simple: one consequence of increasing inequality was virtual stagnation of the purchasing power of the lower and middle classes in the United States, which inevitably made it more likely that modest households would take on debt, especially since unscrupulous banks and financial intermediaries, freed from regulation and eager to earn good yields on the enormous savings injected into the system by the well-to-do, offered credit on increasingly generous terms."This paragraph does need some explanation. It is far too easy to interpret Piketty as saying that stagnant labour wages encourage low-to-middle income people to borrow. Clearly this is nonsense: under normal circumstances we would expect stagnating wages if anything to discourage borrowing, since people would delay leveraged purchases until their wages started to improve. But it's not the point. Piketty is doing macroeconomics. This is about sector balances*, not the rational behaviour of households.
When low-to-middle incomes stagnate but top incomes continue to rise, saving naturally increases. This is because people with high incomes spend a lower proportion of their incomes than poorer people do. Since saving = investment, that saving must be invested somewhere. It can be invested in assets such as property, gold, fine art and metals. Or it can be lent out, either as direct lending (perhaps via an intermediary) or in the form of securities purchases**. The balance between lending and real assets in a portfolio tends to depend on the investor's attitude to risk: a more risk-averse investor is likely to have more real assets and fewer financial ones, and the financial assets are likely to be less risky ones - perhaps good quality corporate and government bonds rather than junk bonds and equities. Investors tend to be less risk-averse in boom times and more risk-averse in downturns. During the years before the financial crisis, therefore, investors - including the earners of top incomes - tended to lend out their savings rather than buying real assets.
So far so good. We have explained why US inequality rose during this period: top incomes rose while the rest stagnated, and as high earners have a lower marginal propensity to consume, that increase translated into higher saving and therefore into rising wealth for those people. The corporate sector also ran a structural surplus during this period. There should have been a rising saving ratio.
But there wasn't. In fact the saving ratio actually fell. And this was because, as Piketty notes, the low-to-middle income earners whose wages were stagnating were borrowing heavily. Why were they doing this?
Piketty suggests that it was because of aggressive lending practices by banks. This is probably true. But actually it is beside the point. There had to be high borrowing somewhere in the US economy. With the corporate sector in surplus, either the household sector or the government - or both - was forced to borrow.
To explain this, we need to look beyond the borders of the US. At the time of the crisis the US was running a large and growing trade deficit. This was matched by large trade surpluses in other countries, principally China, Germany and Japan. As I explained in the post linked in the first line of this post, countries that run trade surpluses are net exporters of capital, and countries that run trade deficits are net importers of capital. The relationships are not necessarily bilateral: for example, country A may run a trade surplus with country B (which therefore has a trade deficit), and export capital to country C whose banks lend it on to country B to fund its imports from country A. Whatever the actual flows, however, the effect is the same: country A is a net exporter of capital because of its trade surplus, and country B is a net importer of capital because of its trade deficit. To simplify things, we can regard country A as lending to country B to finance its exports.
Germany, China and Japan can therefore be regarded as lending directly or indirectly to the US. This lending takes several forms: purchases of US Treasuries, purchases of US businesses and real estate, cross-border lending directly into the US economy, and purchases of securities. This last form was particularly important in the years before the financial crisis: German banks had substantial investments in US mortgage-backed securities and their derivatives.
German, Japanese and - above all - Chinese lending to the US is the so-called "savings glut" that is widely blamed for creating the financial instability that led to the financial crisis. But Piketty argues that this source of capital is tiny compared to that generated by rising inequality WITHIN the US (my emphasis):
"...this internal transfer between social groups (on the order of fifteen points of USnational income) is nearly four times larger than the impressive trade deficit the United States ran in the 2000s (of the order of four points of national income). The comparison is interesting because the enormous trade deficit, which has its counterpart in Chinese, Japanese, and German trade surpluses, has often been described as one of the key contributors to the “global imbalances” that destabilized the US and global financial system in the years leading up to the crisis of 2008. That is quite possible, but it is important to be aware of the fact that the United States’ internal imbalances are four times larger than its global imbalances."So the total amount of capital available for investment in the US at this time was far larger than the imported "savings glut" caused by its trade deficit. And because the US was importing capital, all of that capital had to be invested WITHIN the US***. As I've noted already, the corporate sector was (and is) running a structural surplus. That leaves the household sector and the government sector to absorb the capital. No wonder lenders aggressively targeted those households most in need of money. They had to put that capital somewhere****, and poor households were both the easiest to lend to (because they needed the money) and gave the best returns (because they were the highest risk). Financial innovation enabled far more of this capital than usual to find its way to poorer households: the concentration of risk that would normally have limited individual lenders' exposure to poorer quality borrowers was dispersed across the globe through securitisation and amplified with derivatives.
And no wonder government encouraged lending to poorer households and riskier borrowers. The alternative was far higher government borrowing and lower tax revenues. But this was a short-sighted policy: when the whole system crashed, unsustainable household debt was replaced with government debt, while the recession clobbered tax revenues and raised fiscal deficits. Now, government is trying to push the debt it was forced to take on in the crisis back to the household sector again by means of fiscal austerity. And the effect of fiscal austerity when the corporate sector is in surplus and the household sector is damaged is to force down the trade deficit. No bad thing, you might argue - but reducing the trade deficit entirely by means of squashing domestic demand is beggar-my-neighbour economics. If everyone tries to reduce their trade deficit by this means, no-one can.
So we can now understand the story that Piketty's paragraph is telling. During the years before the financial crisis, as top incomes continued to rise while low-to-middle incomes stagnated, capital available for investment grew. Imports of capital from countries with trade surpluses added to the capital pile, though they were not its main source. Lenders faced with trying to generate decent returns from this capital glut offered cheap money and easy lending terms to increasingly risky borrowers, who lapped it up to fund consumer spending. Consumer spending added to corporate and high net worth returns and expanded the surpluses of exporting countries, increasing the capital pile still more, encouraging lenders to lend even more on even easier terms and creating a whole new industry dedicated to finding new ways of dumping risk on the unsuspecting. It is easy to see how this became a toxic feedback loop that eventually imploded in a disastrous crash.
And it is now easy to see why Piketty argues that US inequality contributed to the financial instability that led to Lehman. You may disagree - but it is a compelling argument.
Capital in the 21st century - Piketty
Picking apart Piketty - Money Illusion
* I'll use Godley & Lavoie's sectoral balance equations to explain this if you really want me to. But I warn you I usually get them wrong.
** For the purposes of this post I am including equity investment in a general "lending" category, although strictly speaking equity investment is a purchase not a loan.
*** This is of course net investment. The US could, and did, invest overseas as well. But its net overseas investment position was negative because of the large inflows of capital from trade surplus countries. Therefore we can regard all US domestically-generated capital, together with the net capital inflow from abroad, as invested entirely within the US.
**** I'm aware that I'm departing slightly from endogenous money theory here. But from a macroeconomic standpoint it actually doesn't matter. All saving must be invested: all investment becomes saving. It doesn't matter whether you express this as saving preceding investment, or investment preceding saving. It comes to the same thing in the end.