Rights: Inequality may contribute to financial crises, says UN expert

There are strong indications that inequality may substantially contribute to and exacerbate the emergence and the course of financial crises, even if other factors, in particular financial deregulation, obviously also play a crucial role, according to a United Nations human rights expert.

This finding has been highlighted by Mr Juan Pablo Bohoslavsky, the Independent Expert on the effects of foreign debt and other related international financial obligations of States on the full enjoyment of all human rights, particularly economic, social and cultural rights, in a thematic report for the UN Human Rights Council, currently holding its thirty-first session.

According to Mr Bohoslavsky, there are manifold linkages between inequality, private and sovereign debt and the occurrence of financial crises.

"Inequality erodes States' tax base, thereby impacting sovereign revenues.
Inequality also appears to prompt increased levels of private credit, which in turn may adversely affect sovereign debt and stability of the financial markets," he said.

This phenomenon is mainly explained by rising credit demand and credit supply.
Aggregate under-consumption in conjunction with corresponding low interest monetary policy may be a contributing factor to an increased credit supply.

According to most studies, financial crises and the subsequent policy measures commonly implemented to alleviate their consequences, for example, fiscal retrenchment and stabilization policies, enhance inequalities, with devastating social consequences.

"A debt crisis may have a massive depressive impact on output, which may in turn affect the level of inequality."

According to the report, most studies concur that financial crises result in an increase in income inequality. Fiscal consolidation following a sovereign debt overhang may also have strong distributional consequences, both directly and indirectly, for example, through the increase in the unemployment rate and social spending cuts.

The social effects of crises, hitting in particular the most vulnerable, are often catastrophic, with widespread poverty, the emergence of health issues, rising unemployment, to name only a few common problems.

"The finding that inequality may contribute to the occurrence of financial crises, which in turn exacerbate inequality and adversely affect human rights, has far reaching policy and legal implications. It underscores that human rights, social and economic aspects are inseparably intertwined, calling for a holistic approach to preventing and confronting financial crises."

The report suggests that financial crises may not be prevented without addressing the contributing human rights shortcomings, including those connected to inequality. Any reaction to financial crises that neglects the effects on human rights and inequality does not only run afoul of human rights duties and responsibilities but also risks creating the same problems again and again, preventing any economically sustainable future.

"Preventing and responding to financial crises and combating inequalities must thus go hand in hand. Hence, policymakers must ensure that they tackle dangerous destabilizing developments in the financial sphere while addressing inequality directly."

According to the report, severe economic inequality frequently affects the enjoyment of particular civil, political or social, economic and cultural rights as well as the principle of non-discrimination enshrined in all international human rights treaties.

Human rights law imposes certain legal obligations on States to address economic inequalities affecting the enjoyment of human rights and bestows effectual guidance for reducing inequalities, including prioritization of policy responses in this field.

For several years, increased attention has been paid to the continued rise in income and wealth inequalities. In this context, top incomes dramatically increased from the 1980s, mostly in developed countries but also in emerging economies, such as India and China.

In addition to wealth transmitted through inheritance, top wages have increased dramatically, outpacing increases in average wages many times and resulting in an unprecedented accumulation of wealth by a small but powerful elite.

Global inequality currently stands at extremely high levels and is further increasing. The UN Development Programme (UNDP) has reported that the richest 8 per cent of the world's population earns half of the world's total income, leaving the other half for the remaining 92 per cent. Over the past two decades, income inequality has increased by 9 per cent in developed countries and 11 per cent in developing countries.

In 2015, the richest 1 per cent of people in the world owned more than 50 per cent of global wealth, up from 44 per cent in 2010. Furthermore, the 80 richest individuals currently own as much wealth as the bottom 50 per cent of the entire global population.

The Independent Expert noted that international human rights law addresses inequality on many levels. First, there are economic and social rights that clearly recognize the duties of States to address and/or prevent inequality as a threat to human rights realization. These include fundamental worker's rights - in particular the right to form and join trade unions and the right to fair remuneration - and social rights - in particular the rights to education, health and social security.

Moreover, he said, the principles of non-discrimination and equality apply in the context of socioeconomic disadvantages. All international and regional human rights treaties include a broadly constructed principle of non-discrimination, that covers formal discrimination on prohibited grounds in law or official policy documents as well as substantive discrimination, meaning discrimination in practice and in outcomes.

"The prohibition of discrimination extends not only to the grounds explicitly enumerated in article 2 (2) of the International Covenant on Economic, Social and Cultural Rights, such as race, colour, sex or religion, but also to grounds based exclusively on economic and social status."

Inequality implies a violation of the rights enshrined in the Covenant when a significant number of individuals within a society cannot enjoy minimum essential levels of each of the rights enumerated in the Covenant, while other individuals within the society have more than sufficient resources available to guarantee a basic enjoyment of those rights.

The violation in such cases appears to be twofold: States may fail to meet their minimum core obligations, and to mobilize maximum available resources for the progressive realization of rights.

According to the views of the Committee on Social, Economic and Cultural Rights, when a significant number of individuals living in a State party are deprived of critical foodstuffs, essential primary health care, basic shelter and housing or the most indispensable forms of education, there is a prima facie case of failing to discharge its obligations under the Covenant.

States are furthermore obliged to use maximum available resources for the progressive realization of economic, social and cultural rights. Progressive realization implies that States have to ensure the enjoyment of minimum essential levels of rights on a non-discriminatory basis first and without retrogression.

The Independent Expert was of the view that States may also fail to use their maximum available resources if they neglect to undertake reasonable efforts to ensure domestic revenue generation and redistribution to address income inequality that violates human rights, such as if a State fails to address inequality through appropriate taxation or social policies.

Human rights law requires a certain degree of redistribution of resources and support based on available capacities within and among nations.

This encompasses an organization of the local and global economies that prevents and eradicates extreme poverty.

Violations of this principle are pervasive: With 795 million people worldwide being undernourished, at least one out of nine persons on Earth is currently excluded from enjoying essential minimum levels of the right to food. The United Nations Human Settlements Programme has estimated that close to one billion people currently do not have adequate housing but instead often live in informal settlements in developing countries.

"Inequalities within and among nations are an important contributing factor to these unsettling outcomes. Inequality is both a cause and a symptom of massive violations of economic, social and cultural rights."

Interaction between inequality and debt crises

According to the Independent Expert, inequality may affect sovereign debt both directly and indirectly. In short, the direct impact proceeds from the "corrosive" influence of inequality on the tax base, as well as from its enhancing effect on demand for redistribution through debt default.

As for the indirect impact, it is mainly private debt that acts as an interface between inequality and sovereign debt. Increasing inequality may lead to private over-borrowing and over-lending.

The resulting excessive private leverage can accumulate over many years, destabilize the financial system and even become so volatile for the economy that the debt can trigger a banking crisis, leading to both output losses and massive bailout costs for Governments. In addition, both the direct and the indirect channel may simultaneously prompt a currency crisis if external debt is involved.

Inequality may exert a considerable direct influence on the structure and the level of government revenues and spending. Increased levels of inequality also mean that the income tax base of the State concerned is rather small, at least if income taxation is not progressive.

This diminishes sovereign revenues and consequently makes the State more dependent on borrowing. Thus, inequality contributes in many cases to sovereign debt, which may eventually result in sovereign default and financial crises.

The report pointed to a growing body of evidence for this mechanism. Empirical studies point to a clear nexus between inequality, income tax base and sovereign debt. One study, using data from 50 countries in 2007, 2009 and 2011, found a negative correlation between income inequality and the tax base and a positive correlation with sovereign debt.

An analysis of a panel of 17 countries of the Organization for Economic Cooperation and Development (OECD) covering the period 1974-2005 found a positive correlation between the top 1 per cent income share, a widely used indicator of income inequality, and fiscal deficit.

The erosion of the income tax base following an increase in inequality is also likely to affect the structure of tax revenue. "The alternative to experiencing a fiscal deficit would be to increase other types of taxes, such as import or export duties and indirect or corporate taxes. This would, however, lead to higher revenue volatility, consequently increasing the risk of sovereign debt crisis."

Increased inequality is also found to contribute to the degeneration of sovereign debt into sovereign debt crises, said the report, noting that a number of studies show that high inequality increases the probability of default significantly.

In one research paper, it was emphasized that sudden, rapid rises in inequality, in particular, can considerably increase the sovereign default risk. The authors specify that such "inequality shocks" generate a far higher probability of default than collapses of domestic production of the same scale. Several authors have also established that progressive income taxes, which decrease income inequality, can decrease the default risk.

According to the Independent Expert, inequality can also indirectly contribute to increased sovereign debt and consequently to sovereign debt crises.

There are at least two avenues to such outcomes: (a) high levels of inequality contribute significantly to the generation and increase of private debt, with strong inter-relationships between excessive private debt, sovereign debt and financial crises; and (b) inequality adversely affects social and political stability, thereby hampering growth and eventually affecting both government revenue and spending.

A boom in private debt is usually considered a more accurate predictor of financial instability than the level or development of sovereign debt. However, depending on the circumstances, sovereign debt may be a major factor for triggering or worsening financial crisis.

For example, excessive sovereign debt in some countries has been a prominent contributor to the recent global financial crisis. Public and private debts are linked in many ways, often reinforcing the other's negative effects, which may be described as a diabolical loop between both. Even when financial crises are not necessarily driven by public debt, such debt has an impact on the aftermath of crises, leading to more prolonged periods of economic depression.

The consequences of a financial crisis on public finances are immense.
Nationalization of private debts along with bailout and re-capitalizing costs for the banking system have contributed to an explosion of sovereign debt.  Even more important factors to the aggregation of sovereign debt are generally the fall in production, the consecutive contraction in the tax base and counter-cyclical policies set to fight the downturn resulting in higher government spending.

"If the country instead uses consolidation policies to reduce its debt, this often turns out counterproductive because of a negative impact of reduced government spending on economic growth and employment, as the International Monetary Fund (IMF) has recently acknowledged," said the report.

There are several channels through which inequality affects private debt and financial crises, the report added, noting that household debt and top income share - a standard indicator of inequality - are strongly correlated: in many countries, household debt and top income share have grown simultaneously and at similar pace over many years.

Recent research has focused on credit demand and supply channels for explaining the nexus between private debt and inequality. According to the credit-demand line of reasoning, private debt increases as households try to maintain certain absolute or relative levels of consumption, while facing growing inequality.

In other words, people borrow more extensively to maintain their absolute or relative standard of living. Data collected for the United States of America confirm this interpretation: a study from 2006 revealed that, over the previous 25 years, income inequalities in the United States had increased without being followed by an increase in consumption inequalities.

"Another theory connects inequality, credit demand and monetary policy. It holds that highly unequal income distribution leads to over-reliance on investment and luxury consumption. This may not be sufficient for a sustainable level of economic output, prompting low interest rates which itself allows private debt to increase beyond sustainable levels."

In turn, the rise in the incomes of the richest will also increase their savings, leading to a huge accumulation of private wealth. This rising supply of capital requires more investment opportunities and consequently boosts the credit supply, even for riskier borrowers.

Moreover, a possible consequence of this accumulation of private wealth is creditor-led lobbying to favour policies that may lead banks to issue risky loans and eventually to a massive distribution of sub-prime loans to low income individuals.

According to the report, it is not surprising that an examination of 18 OECD countries over the period 1970-2007 revealed a positive link between income inequality and credit growth. Moreover, over the period 1980-2010, a large majority of banking crises were preceded by persistently high levels of income inequality.

Concerning the United States specifically, one study that investigated the period 1980-2003 found a "strong positive effect of income inequality in household debt relative to disposable income as well as the components of the household debt (mortgage debt, revolving debt, e.g. credit cards, and non-revolving debts, e.g. car loans)".

According to Mr Bohoslavsky, inequality may also reduce social and political stability. This creates disincentives for investment, disruptions in business activity, disunity, threats to property and policy uncertainty and may even raise the probability of coups and mass violence.

The result is a lower level of growth, which consequently provokes higher level of debt, he said, noting that the link between inequality, political instability and investment has been confirmed by an empirical study made on 70 countries over the period 1960-1985.

Recent cross-country evidence supports the notion that inequality reduces economic growth. Based on vast data for both OECD and emerging countries, an IMF study from 2014 provides a solid case that lower inequality is robustly correlated with faster and more durable growth.

A further IMF study supports these conclusions using a sample of 159 advanced, emerging and developing economies. The authors conclude that the income distribution itself matters for growth. Specifically, if the income share of the top 20 per cent increases, then GDP growth actually declines over the medium term, suggesting that the benefits do not trickle down. In contrast, an increase in the income share of the bottom 20 per cent is associated with higher GDP growth.

Impact of financial and debt crises

The report said that financial crises generally have enormous distributional consequences, originating in several factors. To start with, financial crises may massively hamper economic growth, principally because of decline in investment in production, as a result of credit contraction. Banking crises usually lead to a significant output drop.

On average, the real per capita GDP drop amounts to over 9 per cent, with a recovery time of two years. An analysis of financial crises, taking into account both banking and currency crises, has revealed that the average output loss is 20 per cent of GDP, with a recovery time of three to four years.

However, isolated currency crises as such may have mixed effects: they usually increase the price of imported goods and may lead to a contraction of available credit, considerably encumbering growth. At the same time, currency crises may also benefit the exporting sector of a country.

According to the rights expert, the consequences of sovereign-debt crisis on economic growth are difficult to isolate, as they are generally preceded by or coincide with banking crises.

"However, there is a strong negative correlation between extreme levels of sovereign debt or sovereign default on the one hand and growth on the other. One study, for example, has found that debt crises lead to significant and long-lasting output losses, reducing output by about 10 per cent after eight years."

In addition to this slowdown in economic activity, there are several other channels through which financial crises affect income and wealth distribution. Currency crises exert their influence by leading to relative price changes, fiscal retrenchment and changes in assets.

The report said devaluation leads to the fall in earnings of those employed in the non-tradable sector, while it increases the demand for exports and therefore may benefit employment and earnings in this sector. The poor may also be affected by the price increase of imported goods, especially food prices. In the aftermath of banking crises, the associated unemployment rate rises on average by about 7 percentage points, with a duration of over four years.

In total, currency crises have a magnifying impact on both the spread of poverty and inequality. Based on the Gini coefficient, one particular study found inequality to increase by 0.63 per cent relative to the pre-crisis year.

Moreover, the association between crises and income distribution/poverty was stronger when crises were followed by average income losses. This fall of income accounted for 15-30 per cent of the variations in the poverty and inequality indicators.

Another study concluded that on the average inequality rises by 16.2 per cent in the two-year period immediately following a currency crisis as opposed to 3.2 per cent in years without crises. The Great Recession, best described as a systemic banking crisis, which has been followed by a debt crisis, especially in the European Union, has led to massive inequality jumps.

Using the ratio 90 to 10 as a proxy of inequality, United States income inequalities have risen by 11 per cent between 2007 and 2011.

The report said other factors have significant influence on the size of the effects of financial crises. For example, it appears that crises raise inequalities more in the most deregulated labour markets, and financial crises have had worse effects on Latin American workers than on Asians, and stronger adverse impacts on Asians than on the organized workers of Northern economies.

This finding suggests that there is a crucial interaction between labour market institutions and the specific effects of financial crises.

In most countries, said the report, financial crisis is followed by fiscal consolidation, which may also have a strong distributional impact. Several studies on OECD countries and other emerging and advanced economies have demonstrated that fiscal consolidation is usually associated with a rise of inequalities, a fall of the labour share and a rise of long-term unemployment. One study came to the conclusion that 15-20 per cent of the increase in inequality following a fiscal consolidation is explained by the rise of unemployment.

Social spending cuts are another substantial contributor to rising inequalities. A 1 per cent decrease in social spending is associated with a rise of 0.2-0.7 per cent in inequality.

"Crises usually have strong effects on social spending, with lowest income countries being more likely to cut social spending during crises. The Great Recession, for example, has led to broad and deep cuts in social security spending."

As to debt crises, it is challenging to disentangle the specific effects of default from those of the stabilization policies, such as those that tend to follow IMF interventions in developing countries. What seems clear is that IMF programmes are associated with a worsening of income distribution and a reduction in the incomes of the poorest citizens when external imbalances were high prior to the programme. These programmes may only decrease income inequality when external imbalances are less severe.

According to the report, dynamics of inequalities in Latin America in the 1980s offer good insights into the potential distributive impact of debt crises.

A study on this region during that decade provided strong evidence confirming that income inequality "mirrors the economic cycle, rising during recessions". The costs of the crises have not been borne equally and most adjustment programmes resulted in "overkill" leading to increases in poverty and inequality beyond what was necessary (and legal).

The Independent Expert said that financial crises and the austerity measures adopted in response also have a robust negative social impact that, in turn, perpetuates or exacerbates inequality.

"Overall, adjustment plans without consistent debt reliefs have proven to be detrimental to human development and human rights, at least in the short term.
Alternatively, substantial debt relief has allowed targeted countries to scale up ‘poverty-reducing' expenditures," he said.

By Kanaga Raja.

Source: SUNS - South North Development Monitor #8194 Friday 4 March 2016.