Higher income inequality in developed countries is associated with higher domestic and foreign indebtedness

ECONOMISTS have long worried about the growing chasm between countries that borrow heavily internationally and those that dish out the loans. They call it global current account imbalances and, especially since the onset of the global economic crisis in 2007, there has been concern that global markets could be destabilized were there a run on the currencies of those countries that pile up huge deficits. That hasn’t happened, at least so far. In fact, the biggest borrower of all, the United States, is viewed mainly as a safe haven by lenders.

But there is another, domestic dimension to the pileup of international obligations. Domestic debt rises too and could reach unsustainable levels that could lead to domestic financial crises.

Why the United States has built such persistent and large deficits in its current accounte—which covers all noninvestment international transactions, including exports and imports, dividends and interest, and remittancese—is a matter of some debate.

Explanations include a low domestic saving rate, high foreign saving rates, high demand for high-yield U.S. assets from fast-growing but less financially developed countries, excess holding of international reserves in emerging market countries for both precautionary and mercantilist motives, demographics and productivity, and the role of the U.S. dollar as the world’s reserve currency. But the phenomenon of persistently high current account deficits is not limited to the United States; it has also been observed in a number of other developed economies, especially those in the English-speaking world.

In current research we therefore extend the work reported in “Leveraging Inequality” (F&D, December 2010), which dealt with only the United States, to include an open-economy dimension. We find (see Chart 1) that what unites the experiences of the main deficit countries is a steep increase in income inequality over recent decades, as measured by the share of income going to the richest 5 percent of the country’s income distribution.

This increase in inequality has contributed to a deterioration in the richest countries’ aggregate savings-investment balances, as the poor and middle class borrowed from the rich and from foreign lenders. This, along with the other factors mentioned above, can fuel current account deficits.

Indeed, we find that as income shares of the top 5 percent increased between the early 1980s and the end of the millennium, current account balances worsened. For example, in the United Kingdom, an 8.7 percentage point increase in the income share of the richest 5 percent was accompanied by a deterioration in the current account–to-GDP ratio of 2.7 percentage points.

Modeling the facts

An economic model can clearly illustrate these links between income inequality and current account deficits. In our model, based on an open-economy extension of Kumhof and Rancière (2010), households are divided into a top 5 percent income group (“top group”) and a bottom 95 percent income group (“bottom group”) in a medium-sized country .......

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