Working Paper. Income inequality and Germany s current account surplus. February Patrick Grüning 1, Thomas Theobald 2 and Till van Treeck 3

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1 Insiu für Makroökonomie und Konjunkurforschung Macroeconomic Policy Insiue February 25 Working Paper 47 Parick Grüning, Thomas Theobald 2 and Till van Treeck 3 Income inequaliy and Germany s curren accoun surplus Absrac Germany enered he euro wih a curren accoun defici bu over he enire pas decade has run large and persisen curren accoun surpluses. Besides joining he common currency, he increase of Germany s curren accoun since he lae 99s has been accompanied by srong shifs in he personal and, in paricular, he funcional income disribuion. In his paper, we argue ha income inequaliy should always be analyzed wih respec o boh he personal and he funcional disribuion of income. We presen a dynamic sochasic general equilibrium (DSGE) model in which a curren accoun surplus arises as an endogenous resul of a decrease in he share of household income in naional income. On he one hand, his resul complemens exising lieraure where curren accoun deficis resul from rising personal income inequaliy. On he oher hand, we find ha curren accoun imbalances will be more pronounced when accompanied by changes in he financial sysem. Accordingly, if we link Germany s accession o he European moneary union o lower exchange rae coss for German bank lending, he curren accoun surplus becomes larger. Keywords: income inequaliy, funcional income disribuion, household deb, financial sysem, curren accoun JEL-Code: D3, E7, F32 We would like o hank Michael Kumhof and Romain Rancière for sharing heir codes. Special hanks o he whole IMK research eam, in paricular o Ansgar Rannenberg and Jan Behringer, for many helpful commens and o Sven Harjensein for excellen research assisance. All remaining errors are ours. Affiliaions and conacs are Goehe Universiy Frankfur. Conac: parick.gruening@finance.uni-frankfur.de. 2 Macroeconomic Policy Insiue (IMK) Düsseldorf. Conac: homas-heobald@boeckler.de. 3 Universiy of Duisburg-Essen. Conac: ill.vanreeck@uni-due.de.

2 Income inequaliy and Germany s curren accoun surplus Parick Grüning Thomas Theobald Till van Treeck February 7, 25 Absrac Germany enered he euro wih a curren accoun defici bu over he enire pas decade has run large and persisen curren accoun surpluses. Besides joining he common currency, he increase of Germany s curren accoun since he lae 99s has been accompanied by srong shifs in he personal and, in paricular, he funcional income disribuion. In his paper, we argue ha income inequaliy should always be analyzed wih respec o boh he personal and he funcional disribuion of income. We presen a dynamic sochasic general equilibrium (DSGE) model in which a curren accoun surplus arises as an endogenous resul of a decrease in he share of household income in naional income. On he one hand, his resul complemens exising lieraure where curren accoun deficis resul from rising personal income inequaliy. On he oher hand, we find ha curren accoun imbalances will be more pronounced when accompanied by changes in he financial sysem. Accordingly, if we link Germany s accession o he European moneary union o lower exchange rae coss for German bank lending, he curren accoun surplus becomes larger. Keywords: income inequaliy, funcional income disribuion, household deb, financial sysem, curren accoun JEL CLASSIFICATION SYSTEM: D3, E7, F32 We would like o hank Michael Kumhof and Romain Rancière for sharing heir codes. Special hanks o he whole IMK research eam, in paricular o Ansgar Rannenberg and Jan Behringer, for many helpful commens and o Sven Harjensein for excellen research assisance. All remaining errors are ours. Affiliaions and conacs are Goehe Universiy Frankfur. Conac: parick.gruening@finance.uni-frankfur.de. 2 Macroeconomic Policy Insiue (IMK) Düsseldorf. Conac: homas-heobald@boeckler.de. 3 Universiy of Duisburg-Essen. Conac: ill.vanreeck@uni-due.de.

3 Conens Inroducion 3 2 The daa 5 2. Rise in income inequaliy Inequaliy and componens of GDP by expendiure Credi demand and bank lending The model 8 3. Pros and Cons of DSGE Models wih Heerogeneous Agens Incorporaing he corporae veil ino he Kumhof e al. (22) framework... 4 Simulaions 5 4. Calibraion Increased inequaliy wihou changes o he financial sysem Germany inequaliy scenario UK inequaliy scenario Increased inequaliy accompanied by changes o he financial sysem Germany joining he moneary union Financial liberalizaion in he UK Robusificaion analysis: Invesmen dynamics as an alernaive explanaion of curren accoun imbalances? Policy Implicaions Conclusion 2 2

4 Inroducion Curren accoun imbalances were an imporan conribuing facor o he financial and economic crises since 27 a boh he global level and wihin he European Moneary Union. Germany enered he euro wih a curren accoun defici bu over he enire pas decade has run large and persisen curren accoun surpluses. Besides joining he common currency, he increase of Germany s curren accoun since he lae 99s has been accompanied by srong shifs in he personal and, in paricular, he funcional income disribuion. In his paper, we presen a dynamic sochasic general equilibrium (DSGE) model in which a curren accoun surplus arises endogenously as a resul of rising corporae income a he expense of household income, financial liberalizaion, and moneary inegraion. An imporan weakness of many DSGE models is heir reliance on he represenaive agen assumpion which assumes away he issue of income inequaliy. Recenly, some aemps were made o address his shorcoming and o incorporae household heerogeneiy. Charpe and Kühn (23) developed a wo-counry DSGE model in which a fracion of households is credi consrain or follows a rule-of-humb in heir consumpion decisions. In his model, a decline in he bargaining power of workers induces non-convenional effecs. Firs, lower domesic real wages lead o a negaive domesic consumpion effec - even hough his effec is overcompensaed by he posiive impac on domesic oupu hrough boh compeiiveness and he domesic ineres rae channel. Second, lower domesic real wages creae a beggar-hy-neighbor effec when lower domesic impors overcompensae he posiive impac on foreign oupu hrough reduced inflaion generaed by he lower price of impored goods. Finally, he overall effec of lower real wages is negaive when moneary policy his he zero lower bound and reduced wages and prices ranslae ino higher real ineres raes. The model presened in his paper primarily builds on previous work by Kumhof and Ranciere (2); Kumhof e al. (25) and Kumhof e al. (22). In his work, a very similar version of he model was used o explain he rise in household leverage and he decrease in naional saving-invesmen balances in a number of counries combining rising income inequaliy and a developed financial sysem. The basic mechanism is ha poor households ( workers ) borrow from he domesic rich ( invesors ) and foreign financial markes o mainain heir consumpion despie a fall in income. This phenomenon was especially imporan in he Anglo Saxon counries, mos noably he Unied Saes and he Unied Kingdom, in he run-up o he 27 financial crisis. As he model is calibraed o he UK, we call his he UK scenario. Kumhof e al. (22) also analyze he effecs of rising inequaliy in emerging economies wih underdeveloped 3

5 Germany differs from oher developed economies wih developed financial sysems in a number of imporan aspecs. Firsly, shifs in income disribuion are refleced no only in higher personal inequaliy, bu also and imporanly in he increasing share of corporae income in he naional income a he expense of he household secor. In fac, he larges conribuion o he rise in he curren accoun since he lae 99s has come from he corporae secor (see Ruscher and Wolff, 22; Behringer and van Treeck, 23, Belabed e al., 23). Higher corporae reained earnings adversely affec domesic demand o he exen ha hey are no fully offse by a reducion of saving by shareholder households. In he lieraure, his effec is known as he corporae veil (Poerba, 99; Sumner, 24; Monogios and Pielis, 24; Akinson, 29). 2 In Germany, he conservaive reenion policies of small and medium-sized enerprises, which are ofen family-owned, also helps explain he growing imporance of corporae reained earnings and a he same ime he relaive consancy of op household income shares. Secondly, households demand for credi has been very weak in pre-crisis imes, while inequaliy was on he rise. This can be explained by a pronounced precauionary savings moive in he conex of labor marke deregulaion and social securiy reforms during he 2s (see Carlin and Soskice, 29). Thirdly, he banking sysem has played a very imporan role in inermediaing he excess financial savings of he corporae and household secors o he res of he world. Financial credis, especially o he euro area, have been one of he mos imporan driving forces of Germany s capial accoun over he pas 5 years (Lindner, 23). Besides he weak domesic credi demand, he increased financial inegraion resuling from he inroducion of he euro also helps explain why he excess financial savings of rich households and he corporae secor have been invesed abroad (wihin Europe) raher han len domesically o poor and middle class households. This specific insiuional environmen is aken ino accoun in he model simulaions. In order o cover boh he UK scenario and he Germany scenario, we modify he Kumhof e al. (22) model in he following ways: Firsly, because in he model here is no difference beween personal and funcional income disribuion, we consruc a synheic shock aking ino accoun informaion on op household income shares and on he share of wages (household disposable income) in naional income. We calibrae he model o boh UK and German daa and simulae he effecs of he synheic income disribuion shocks. Secondly, in order o capure he financial sysems. Here, he domesic poor do no have access o borrowing, and so he rich inves heir addiional savings in he inernaional financial markes, hereby financing he curren accoun deficis of he rich world. This mechanism helps explain he rising curren accoun surplus of China and oher emerging economies prior o he global financial crisis. 2 The growing imporance of corporae secor saving was highlighed by IMF (26), Andre e al. (27) and European Commission (24). 4

6 counry-specific differences in consumpion behavior and credi demand, we refine he invesors uiliy funcion. The uiliy weigh for invesor consumpion is made dependen on he composiion of he synheic shock, i.e., invesor consumpion reacs less o an increase in corporae reained earnings han i reacs o an increase in curren invesor income. Moreover, as we do no find any evidence in he daa for invesmen booms as a consequence of rising income inequaliy, we exogenize gross capial formaion in he model and calibrae i o he counries invesmeno-gdp raios. We also show ha wihin he model unrealisically large variaions in domesic and foreign capial invesmen would be required o obain effecs on curren accoun balances ha are similar o he effecs of changes o income disribuion. Thirdly, for Germany we run an addiional scenario, where banking spreads 3 are shocked o capure he sark reducion of exchange rae risks afer Germany joined he European moneary union. As a consequence, he curren accoun surplus becomes much larger, amplifying he effecs of he income disribuion shocks afer he Euro was inroduced. This effec plays a similar role o financial liberalizaion in he UK (Kumhof e al., 22). The remainder of he paper is organized as follows. Secion 2 discusses imporan sylized facs abou inequaliy, he curren accoun and credi in Germany and compares hose facs o he siuaion in he UK. Secion 3 briefly discusses problems underlying DSGE models wih heerogeneous agens and hen presens he main modificaions of he model. Secion 4 presens he model simulaions and discusses policy implicaions. Secion 5 concludes. 2 The daa 2. Rise in income inequaliy Germany is one of he counries wih he sronges increase in overall income inequaliy since he mid-98s (OECD, 22). As shown in Figure a, he Gini coefficien of boh gross and ne equivalized household income has increased o a similar degree in Germany as in he Unied Kingdom, wih an acceleraion in he rise of inequaliy during he 2s. When i comes o he modeling of inequaliy, however, he Gini coefficien of household income is no he mos appropriae measure: As is well known, he same Gini coefficien can be compaible wih raher differen disribuions. Also, he Gini coefficien aribues only a small weigh o op incomes, due o boh is mahemaical consrucion and he underesimaion of op incomes in volunary 3 Banking spreads reflec he difference beween credi and deposi rae or more generally beween borrowing and lending coss. 5

7 households surveys, on which Figure a is based (Behringer e al., 24). To keep he model manageable and following Kumhof e al. (22), he disribuion of income has o be mapped o income differences among a parsimonious number of agens. In his respec, a cenral feaure of he Kumhof and Ranciere (2) and Kumhof e al. (22) models is he heerogeneiy beween op (5%) income class households ( invesors ) on he one hand and middle and boom income class households ( workers ) on he oher hand. Because invesors also decide abou capial accumulaion, hey represen simulaneously rich households and firms. I herefore seems appropriae o use informaion from boh he personal and he funcional income disribuion o calibrae he income shares of invesors and workers. Firsly, we consider he World Top Incomes Daabase (WTID). Figure b shows he share of oal pre-ax household income accruing o he op 5% of ax unis in Germany and he Unied Kingdom, based on he WTID. Secondly, we consider he shares of wages and profis in GDP (Figure c) and he share of corporae disposable income in privae disposable income (Figure d). In he Unied Kingdom, he wage share has been roughly sable over he pas decades. Also, despie a higher volailiy, corporae disposable income has remained roughly sable as a share of oal privae disposable income. The deermining feaure of rising inequaliy has hus been he specacular rise in op household income shares. In Germany, by conras, he rise of inequaliy wihin he household secor has been accompanied by a srong decrease of wages relaive o capial income (Figure c) and by a decrease of aggregae household disposable income relaive o corporae disposbale income (Figure d). The share of corporae disposable income in naional disposable income has increased by 6-7 percenage poins boh during he 98s and since he lae 99s unil oday. The redisribuion of income owards he corporae secor was, however, inerruped for an enire decade following he German re-unificaion. As a consequence of his developmen, during he 2s he corporae financial balance (Figure 2 a) becomes posiive conribuing o he German curren accoun surplus (Behringer and van Treeck, 23). 2.2 Inequaliy and componens of GDP by expendiure Germany s curren accoun already increased srongly during he 98s, and hen again since he early 2s. Germany is he only large surplus economy which has no been par of he global re-balancing of curren accouns as a resul of he recen crises. Figures 2 a and c show he curren accoun balance of Germany and is decomposiion ino he financial balances of he privae household, corporae and governmen secors. Figure 2 b 6

8 and d show he corresponding daa for he UK. The larges conribuion, in accouning erms, o he rise in he curren accoun in Germany since he early 2s has come from he corporae secor. As can be seen in Figure 3 c, he srucural increase in he curren accoun balance canno be aribued o a larger ne ouflow of foreign direc invesmen, which as share of GDP is a essenially he same level as in he mid-99s. This raises doubs abou he noion ha Germany s weak domesic demand is due o is unaraciveness as an invesmen locaion. This laer asserion is someimes invoked on he basis of Figure 2 e, which shows a declining rend in he overall invesmen-o-gdp raio in Germany over ime. 4 Ye, as shown in Figure 2 e, his declining rend is no apparen in business invesmen in equipmen and machinery which should be mos srongly affeced by business and invesmen condiions. 5 Germany is also one of hose developed economies whose produc and labour markes have been deregulaed mos during he pre-crisis decade (van Treeck and Surn, 22). I herefore appears odd o aribue he srucural weakness of domesic demand in Germany o unaracive business condiions. 6 Finally, Figure 2 f shows he consumpion-o-gdp raios for boh Germany and he UK. While his raio on a relaively low level seems o be very sable over ime for Germany, i shows an upward slope in he UK, saring from a higher level. Theoreically, he effec of higher inequaliy on aggregae consumpion is ambiguous (see Belabed e al., 23; Behringer and van Treeck, 23). If rich households save a higher raes han poor households, i may be expeced ha increasing (personal) inequaliy leads o an increase in he aggregae savings rae. Empirically, we do no observe his for he UK and oher counries. Raher, prior o he crisis, he income losses of he poor were o a large exen compensaed by lower saving and higher deb. The fac ha his is no he case for Germany can be aribued o he differen naure of income 4 On he one hand, his downward rend in he invesmen-o-gdp raio migh be seen as srong relaive o oher developed economies (e.g. OECD, 22, p.4). In real prices, his rend can be explained mosly by he developmen of public and residenial invesmen (Lindner, 24). On he oher hand, he decline in he nominal invesmeno-gdp raio can be explained parly by he decline in he relaive price of invesmen goods. See IMF (26, p. 42). 5 Looking a he non-financial corporae secor, European Commission (24) repors ha of he oal increase of he secoral financial balance of 5.7 percenage poins of GDP in 2-27, 4.8 percenage poins were due o higher corporae saving, and only.9 percenage poins o lower invesmen spending. In 27-22, boh invesmen (-2.4 percenage poins) and saving (-2.) have decreased. Given he increased and coninuing uncerainy following he global and euro are financial crises and business cycle condiions, his recen rise in corporae ne lending is, however, far less surprising han he increase over he previous peak-o-peak business cycle. In paricular, noe ha he decrease in he invesmen-o-gdp raio in was o a large exen due o negaive invesmen in invenories (-.2 percenage poins of GDP for he oal economy, according o he AMECO daabase). 6 The World Economic Forum s Global Compeiiveness Repor 23-24, which analysed more han indicaors of compeiiveness for 48 counries, ranked Germany fourh. According o he repor, Germany especially sands ou for is hird bes infrasrucure qualiy, he sophisicaion of he business secor, ranking 4h, and is significan marke size (5h place). Likewise, German companies are considered o be he hird mos innovaive in he world. 7

9 shocks, as well as differen insiuions and he absence of an Anglo Saxon syle deb culure. In Germany, shocks o he funcional disribuion of income have been dominaing while credi demand remains a a relaively low level. 2.3 Credi demand and bank lending During he decade following he re-unificaion of Germany, privae consumpion increased in line wih oal oupu, accompanied by a residenial invesmen boom. Since he early 2s, privae household spending has remained on a low level (Figure 2 f) and households have even reduced heir leverage (Figure 3 a), while he coss of he recen financial marke crisis were mainly borne by he governmen secor (see he difference beween Figures 3 a and 3 b). Weak consumpion spending and privae household borrowing have likely been due o a combinaion of demand-side and supply-side facors. On he demand side, he implemenaion of reforms o make he labour marke more flexible and unemploymen and old-age benefis less generous has conribued o he rise in precauionary saving in he conex of a producion model hisorically based on firm-specific skills and long-erm employmen relaions (Carlin and Soskice, 29). On he supply side, he inroducion of he euro has reduced he exchange rae risk and inermediaion coss for cross-border financial invesmens wihin he European Moneary Union. This, ogeher wih he subdued credi demand of he privae household, corporae and governmen secors, has induced banks o increase heir foreign ne lending a he expense of domesic lending. Figure 3 c shows ha he German capial accoun has been primarily driven by he balance of oher financial ransacions, and no by foreign direc invesmens or invesmen in securiies. This reinforces our view ha domesic invesmen has no been crowded ou by foreign invesmen owing o supposedly unaracive business condiions in Germany. Furhermore, Figure 3 d shows ha he balance of oher financial ransacions has been dominaed by bank lending especially o oher European Union counries. 3 The model 3. Pros and Cons of DSGE Models wih Heerogeneous Agens Heerogeneiy among households is a necessary condiion o model he macroeconomic effecs of income and wealh inequaliy. In his regard, DSGE models wih heerogeneous agens can overcome some of he weaknesses of he represenaive agen framework. However, wihou 8

10 furher changes o he modeling design, such models reain several characerisics which are exposed o jusified criicism in he lieraure. Among he mos imporan o be menioned are raional expecaions 7 and he limied role of effecive demand 8. In our view, he Kumhof e al. (22) model lacks demand-side effecs in wo imporan insances. Firs, invesors do no ake ino accoun heir sales expecaions when deciding on he amoun of invesmen in he physical capial sock. Ye, a decrease in he share of income going o he boom 95% of households, which are an imporan source of finance for he larges componen of aggregae demand (consumpion goods and residenal invesmen), may be linked o over-capaciies from he poin of view of firms. Second, whenever op income class households decide o use heir rising incomes for addiional deposis, banks are able o lend he corresponding amoun of credi o low income household. Bu, depending on counry-specific insiuions and norms, credi demand may be he limiing facor. Albei in an indirec fashion, we consider such demand-side effecs in he nex secion. Because household heerogeneiy is ypically associaed wih a higher number of sae variables, wih only very few excepions, dynamic heerogeneous-agen general equilibrium models do no have any analyical soluion or allow for he derivaion of analyical resuls (Heer and Maussner, 29, p. 338). Indeed, hese models, including our model, become difficul o solve and he oucome is sensiive o he numerical soluion mehod applied. This in urn prevens simulaneous changes o several criical characerisics in one model a he same ime. In order o illusrae he general rade-off beween higher complexiy (and more realism) on he one hand and limied solvabiliy on he oher hand in DSGE models, we briefly refer o wo examples from he lieraure: Heer and Maussner (29) inroduce a simple heerogeneous-agen model wih aggregae cerainy (in Chaper 7). Unlike a sandard Ramsey problem, he value funcion here includes he individual sae variables employmen saus and wealh, (ɛ, a), while for a feasible soluion of he model also he disribuion of he individual sae variables has o be compued and he aggregae consisency condiions mus hold. In oher words, because households now differ in wheher hey are employed or no and hence in erms of heir wealh, i is no enough o compue 7 Raional expecaions sae ha marke paricipans are no subjec o sysemaic misakes in erms of heir expecaion formaion. In conras o so-called Agen-based Models (ABM), his rules ou one source of endogenous fa ails in he disribuion of (macro-)economic oucomes. 8 If households canno supply he inended amoun of labor for reasons usually no capured in a sandard DSGE model, he correspondingly lower demand (in our case for consumpion goods and residenial invesmen) leads o diminished producion and increased unemploymen. Hence and in conras o so-called sock-flow consisen (SFC) models, demand-side effecs end o be underesimaed in DSGE models. A leas, in our model we emphasize he role of demand-side effecs for invesmen and credi. 9

11 he individual consumpion and wealh policy funcions, c (ɛ, a) and a (ɛ, a). Addiionally, one has o look for a good numerical proxy of he household disribuion funcion (assumed o be saionary), as he corresponding densiy funcion, f (ɛ, a), hen allows o deermine aggregae capial (and labor force). As a possible soluion, he auhors menion discreizaion of he disribuion funcion, while concluding ha i is raher he excepion han he rule ha (he suggesed algorihm) converges (Heer and Maussner, 29, p. 346). Algan e al. (23) highligh he imporance of accuracy ess for models wih heerogeneous agens. The auhors sudy several algorihms o solve he model by Krusell and Smih (998), which in paricular complemens he model menioned in he previous paragraph so ha i includes aggregae produciviy as an addiional sochasic driving process (aggregae uncerainy). In general, hey conclude: Ideally, one would documen as well ha he resuls are robus o using a differen ype of algorihm.... And generaing he same se of resuls wih boh a grid and a non-grid mehod would be a persuasive indicaion ha he generaed series are accurae (Algan e al., 23, p.35). Even hough i could be argued ha our model does no feaure a coninuum, bu a finie number of agens, he criicism of a lack of robusificaion via an alernaive soluion mehod a he curren sage also applies o our model. 3.2 Incorporaing he corporae veil ino he Kumhof e al. (22) framework We can use 9 he Kumhof e al. (22) model essenially in is exising form, wih some adjusmens being made o capure he imporance of he corporae veil in he invesors uiliy funcion and of he above-menioned demand-side effecs. Invesors maximize lifeime uiliy ( E ) ( ) ( ) ) ( ) β i ξ c i σ i σ c i (d + log + ξ f ξ d e f () σ i = wih respec o he vecor ( c i, d, f ) subjec o heir budge consrain given by e f q e f + d q d d = r k k + Π bank p cons i c i p inv (k ( δ) k ), (2) 9 We solve he model in DYNARE using a hird order approximaion. Policies are compued as annual log deviaions from he seady sae (DYN.SS vecor generaed by DYNARE++). Wih he excepion of financial sock variables, all variables in our model are saionarized and expressed in log-unis in he DYNARE++ code. In order o check model consisency, we reverse hose ransformaions, in paricular for he seady sae soluion, and conduc plausibiliy checks. Using he Kumhof e al. (22) equaions we can reproduce heir resuls and conclude ha he model is properly solved. Figures 6 and 8 are similar o he resuls by Kumhof e al. (22), bu resuls are no exacly he same as we modified he invesors firs order condiions. In paricular, we obain a higher curren accoun defici by shocking workers bargaining power. Boh deposis and foreign bonds represen money-in-he-uiliy componens ofen derived from a beques moive.

12 where c i is invesors consumpion, d are invesors deposis, f is foreign bond posiion in foreign currency, e is he exchange rae and k he capial sock. p variables denoe prices while he price of he previous period is here normalized o. r k sands for he renal rae of capial and δ for he depreciaion rae. Invesors own boh banks and firms and do no receive any income from wages. q is he credi rae and q d denoes he deposi ineres rae so ha bank profis are given by Π bank = d ( q d q ). Physical capial accumulaion is defined by k = I + ( δ) k, and he amoun of period s invesmen are exogenized by applying he following auoregressive sochasic processes for boh domesic and foreign invesmens: I = ( ρ) Ĩ + ρi + ɛ, wih ɛ i.i.d. N (, σ), I = ( ρ) I + ρi + ɛ, wih ɛ i.i.d. N (, σ). (3) In conras o Kumhof e al. (22) we do no presume in general a consan consumpion uiliy weigh, i.e. ξ c =, bu ξ c is assumed o be a linear funcion of workers wage, ξ c := ξ c + ξ 2 cw. (4) Calibraion of ξ c and ξ 2 c according o he composiion of he income shock (eiher linked more o he funcional or more o he personal disribuion of income) will hen allow us o consider counry-specific income shock characerisics. Sraighforward Lagrangian opimizaion delivers firs order condiions for domesic deposis, foreign bonds, and invesor consumpion: ( β i ) + E ( λ+ ( β i ) + E λ + λ λ q d e + e q f ) + + ξ d ( d + ξ f ξ d e f ) λ q d ξ f ( ) d + ξ f e ξ d f λ q f = = ( c i = λ i pcons ) σ i (ξ c) σ i, σ i <. A his sage, noe ha invesors do no maximize heir uiliy funcion wih respec o workers wage, albei in erms of he ξ c funcion his could heoreically help hem o opimize oal uiliy. In principle, one leaves perfec foresigh behind here and eners ino bounded raionaliy. Invesors face a veil hey are no able o pierce fully. To be more precise, he reason why o make he consumpion uiliy weigh, ξ c, dependen on workers income is he composiion of our synheic income shock. Suppose he greaer par of he income shock can be aribued o shifs in (5)

13 he funcional disribuion of income, while op income shares do no increase proporionally. Such a siuaion ypically describes a high amoun of corporae reained earnings. If hose earnings are no invesed, corporae saving as well as he corporae financial balance as illusraed in Figure 2a will be posiive wihou increasing consumpion of corporae owners. In ha case ξ c should no reac o he income shock, i.e., invesors consumpion demand does no reac. ξ 2 c will be relaively low and ξ c will remain consan corresponding o a relaively low uiliy from consumpion (Figure 4). The raionale behind his mechanism is he fac ha i does make a difference for shareholders consumpion demand wheher hey obain virual capial gains as a resul of posiive corporae ne saving or wheher heir curren income really increases as a resul of high bonuses or profi payous (e.g. Akinson, 29). We ake he combinaion of srong increases in corporae disposable income and relaively fla op income shares as an indicaion ha op income class households will no fully pierce he corporae veil and heir consumpion preference in oal should no change a lo. In conras, if he greaer par of he income shock resuls from shifs in he personal disribuion of income (op income shares), shareholders consumpion is assumed o reac more srongly (wih a relaively high ξ 2 c and a relaively low ξ c as a resul of declining wages). In his case higher income will lead o sronger consumpion preference as a smaller ξ c simulaes consumpion (Figure 4). Simulaneously, i is imporan o explore he role of credi demand. In he model, his analysis is reduced o he quesion of wheher invesors prefer deposis (a higher uiliy weigh ξ d ) or foreign bonds (a higher uiliy weigh ξ f ). For he calibraion, we will herefore refer o he observed correlaion beween changes in op income share and household deb. In Anglo- Saxon counries, where shifs in he personal disribuion of income dominaed, i.e., where op income shares increased dramaically, household deb also wen up (Secion 2). In ha case, a growing credi demand in he logic of he model will be refleced in a higher uiliy weigh of invesors deposis relaive o foreign bonds. As invesors are he only domesic agens who are involved in inernaional rade, credi demand (he preference of home deposis) can be so srong ha hey sar inermediaing credis from abroad o he domesic workers. This corresponds o a siuaion, in which invesors obain more uiliy from addiional deposis as hey lose from he more negaive foreign bond posiion. We prefer he relaive income hypohesis (RIH) incorporaing raional consumpion emulaion as an explanaion for he observed difference beween income and consumpion inequaliy in Anglo-Saxon counries. In conras o he RIH, consumpion smoohing moives as an explanaion ypically consider income shocks o be ransiory. However, in his paper we sick o he consumpion smoohing mechanism jus for simpliciy and comparabiliy reasons. 2

14 In Germany, where shifs in he funcional disribuion of income dominaed, i.e., where op income shares did no increase dramaically, household deb almos remained consan. Correspondingly, he lower domesic credi demand in he logic of he model will be refleced in a lower uiliy weigh of invesors deposis relaive o foreign bonds. This effec direcly poins owards a curren accoun surplus. All oher pars of he model are he same as in Kumhof e al. (22). For compleeness we lis he main characerisics here. Workers maximize lifeime uiliy ( E β w ) ( c w) ( σ w ) = (6) σ w wih respec o he vecor ( c w, l ) subjec o heir budge consrain l q = l + p cw c w w. (7) l denoes he amoun of credi supplied by banks. Producion follows a Cobb-Douglas funcion y = A (χk ) α (( χ) h ) α, (8) where χ sands for he fracion of invesors and ( χ) for he fracion of workers. Labor supply is se inelasically equal o h =. Following he raionale of he model, one derives he marginal produc of labor as given by y =: f h = ( α) y h ( χ) (9) Labor markes are characerized by a very simple maching process. Specifically, he number of firms and workers is idenical and boh paries bargain over real wages wihou any form of cenralized informaion process. Each and every period bargaining is resared wih an ouside opion of zero (if bargaining fails, no wage will be paid and no oupu will be produced). Workers bargaining power is denoed by η. Under cerain condiions he Nash bargaining soluion will selec an oucome ha maximizes he produc of he individual gains over he discordan wage. If he workers Lagrange muliplier capures he number of consumpion unis corresponding o he wage, he arge funcion supposed o be maximized will be he following MAX {w } ( λ w w ) η ( f h w ) η =: G, () whereby ( ) f h w denoes invesors surplus as he difference beween he marginal produc of labor and he realized wage. The firs order condiion delivers G w! = η f h = w. () 3

15 Consequenly, he bargaining condiion saes ha real wages direcly depend on workers bargaining power deermining he share of he marginal produc of labor ha workers obain, while he renal rae of capial resuls from his residually, i.e. r k = y w ( χ) χk. (2) Moreover, bargaining power η, which represens our variable of ineres for he inequaliy shock, is assumed o follow an auogressive sochasic process given by η = ( ρ) η + ρη + ɛ wih ɛ η i.i.d. N (, σ η). (3) The aggregae credi bundle ha borrowers demand follows a Dixi-Sigliz form which can be wrien as follows: ( ) θ+ l = l (z) θ+ dz, (4) whereby θ sands for he elasiciy of subsiuion. Using ( ) l (z) θ+ l = q (z) q bank profis, he spread beween deposi and credi rae is hen given by = q q d s, and he definiion of while i is assumed ha he spread also follows an auogressive sochasic process given by s = ( ρ) s + ρs + ɛ, wih ɛ i.i.d. N (, σ). (6) The spread represens our variable of ineres for shocks o he financial sysem (UK reinforcing financial liberalizaion and Germany joining he moneary union). Trade echnologies for I, c i, cw, are also assumed o be of he Cobb-Douglas ype, i.e., I = ( I h ) γi ( I f ) γi, c i = ( c ih ) γc i ( c i f ) γc i, c w = ( c wh (5) ) γc w ( ) w f γc w c, (7) while prices for each of he goods only depend on he size of he home bias for domesic producion, γ, and on he exchange rae. For insance, prices for domesic invesmen goods are given by p inv = γ γ I I ( γ I ) ( γ I) e γ I. (8) Foreign agens maximize lifeime uiliy ( E β ) ( c ) ( ) σ + ξ f log ( κ f + f ) (9) σ = 4

16 wih respec o he vecor ( c, f ) subjec o he budge consrain f = f + rk k + w p cons c p inv I, (2) where denoes he variables from he foreign perspecive. The represenaive agen assumpion is mainained for he foreign secor. Like in he domesic economy, producion process and rade echnology follow a Cobb-Douglas form. w represens he size of he domesic economy relaive o he res of he world. Hence, domesic and foreign GDP ideniies are given by wy = wχ ( c ih + I h ( w) y = ( w) ( c f ) + w ( χ) c wh + I f ) ( i f + wχ c + ( w) ( c h ) + I h (2) + I f ) + w ( w f χ) c. (22) Credi amouns len by domesic invesors o domesic workers mus be equal o he bank deposis (domesic bank balance ideniy) χd = ( χ) l. (23) Inernaional credi amouns mus find heir offseing iem, while all credi ransacions are inermediaed by domesic invesors (foreign bank balance ideniy) wχ f = ( w) f. (24) Finally, ne expors (from domesic perspecive) mus be equal o he corresponding financial flows wχ ( e f q f ) ( e f = ( w) c h 4 Simulaions 4. Calibraion χe f q f = χe f + ) ( ( + I h i f w χ c ( w) w ( c h + I h + I f ) e ( χ ( c i f ) ) + ( w f χ) c e + I f ) + ( χ) c w f ). (25) We analyse he effecs of hree shocks: Firsly, we reduce workers bargaining power, η, so as o mach he observed change in income disribuion. For his purpose, we calculae an adjused invesors income share by using informaion on he op household income share in oal household income and he corporae income share in oal privae income. The adjused invesors income share, Yad 5 j. is calculaed in he following way: Y 5 ad j. = ( Y 5 WT ID Y HH + Y F) / ( Y HH + Y F) (26) 5

17 where Y 5 WT ID is he op 5% income share obained from he WTID, Y HH is he ne disposable income of he privae household secor obained from he naional accouns (AMECO), and Y F is he ne disposable income of he corporae secor. Depending on he saring poin, we obain an increase of he adjused op 5% income share of 6. (998-27) o 8.8 (995-27) percenage poins for Germany. In Kumhof e al. (22), he simulaed bargaining shock of -.4% for he U.K. yields an increase in he op 5% income share of abou 9 percenage poins afer 2 years. Hence, in order o make simulaions comparable by applying he same simulaion period for boh he UK and Germany 2, we use he same inequaliy shock as Kumhof e al. (22) for he UK scenario and a bargaining shock of -8.8% over 2 years for he German scenario. Secondly, we shock he banking spread, s, in order o consider imporan changes o he financial sysem. In order o map he ongoing process of financial liberalizaion in he UK scenario, we presume ha he banking spread declines by 25 base poins over years. As credi raes display ineria in he model, he raionale behind a negaive spread shock is ha deposi raes and credi supply increase. By conras, in he Germany scenario we increase he banking spread (5 base poins over years) corresponding o lower exchange rae coss of German bank lending. As a consequence, deposi raes and domesic credi supply decrease, while domesic credi demand is weak. 3 Thirdly, we also run scenarios in which we generae curren accoun posiions for Germany (UK) semming from shocks o capial accumulaion ha are similar in size as hose obained from he inequaliy shocks. The corresponding shocks o foreign invesmen (domesic invesmen) add up o % (6%) over en years relaive o baseline. We will conclude from his analysis ha empirically invesmen dynamics are no he main driver of he German persisen curren accoun surplus and of he Briish defici. While mos of he parameers refer o sandard values aken from he lieraure (respecively hey are idenical o hose already used by Kumhof e al. (22)), in five cases - besides ξ c already deal wih in deail above - parameers are se o obain observable raios from naional accouns daa. Firs, invesmen Ĩ, I is calibraed o obain consan invesmen-o-gdp raios of 7.5% (UK) and 9.5% (GER), which works very well and is close o he sample average for Second, he home bias for invesmen goods aims a 99 invesmen goods 2 We are roughly aiming a a simulaion period In general, a srong and highly persisen increase of inequaliy (defined by boh he funcional and he personal disribuion of income) could already be observed in many counries since he 8s. Of course, here are counry-specific characerisics, like he German re-unificaion, overlapping he basic inequaliy dynamics. The increase in he op 5% WTID income share for he U.S. was abou.7 percenage poins in , which is he period used in Kumhof and Ranciere (2). 3 This is one example of how o ranslae a demand-side effec ino a supply-side effec so ha afer all he effec can be incorporaed ino he DSGE model. 6

18 impors-o-gdp raios of 7% (UK) and 2% (GER). Despie all effors, our seady sae soluion underesimaes he level of hese raios, while we correcly obain a significanly larger raio for Germany as compared o he UK. Third, he home bias for workers and invesors consumpion goods aims a a 99 consumpion goods impors-o-gdp raio of 6% for boh counries. Again, we underesimae hese raios, while he counry-o-counry relaion is realisic so ha in boh cases he resuling value is almos idenical. Fourh, parameers ξ f, ξ f, κ f are se o obain a ne-foreign-asse-o-gdp raio of -8% for he Unied Kingdom, which corresponds o he 99 observaion. For Germany we aim a a raio of 7%. Despie all effors, our seady sae posiion overesimaes his value. Fifh, calibraion for ξ d aims a a 99 deb-o-income raio of % (9%) for he UK (Germany). While our seady sae soluion overesimaes his level for he UK, i underesimaes i for Germany. The relaive counry size w is se o 4.5% (6.5%) of world GDP for he UK (Germany) based on World Bank daa. Following Kumhof e al. (22) he populaion size of invesors is equal o 5%. In Table we lis all parameers and daa sources involved in he calibraion of he model. 4.2 Increased inequaliy wihou changes o he financial sysem 4.2. Germany inequaliy scenario Figure 5 presens he simulaion oupu for Germany showing he effecs of a decline in workers bargaining power over 2 years, where he larger par of he inequaliy shock derives from he funcional disribuion of income (a relaively low ξc). 2 The decline in he bargaining power direcly leads o a real wage drop of abou 7% relaive o baseline a he end of he shock period, while he renal rae of capial residually increases by more han 5%. As a resul of higher income, invesors consumpion increases by more han 4% relaive o he baseline calibraion a he end of he depiced impulse response funcion. The ongoing increase in invesors consumpion, afer he bargaining power shock has run ou, is due o he fac ha workers leverage has risen in he meanime so ha workers deb service secures addiional invesors income for some exra periods unil all variables reurn o he seady sae level. In his scenario, neiher changes o domesic nor o foreign invesmen ake place. Workers consumpion declines because of he real wage drop bu no proporionally as workers use credi o parly compensae for he income losses. Bu noe ha he increase in workers leverage (up o % a he end of he depiced simulaion period) is lower han in he Briish case (above 5% a he end of he period). This can be raced back o he higher ξ f -ξ d raio reflecing relaively low credi demand in Germany. Given he missing domesic credi demand, invesors sar buying 7

19 foreign bonds so ha he curren accoun urns ino a surplus and he ne-foreign-asse posiion rises. A he same ime (in he model raher implicily), here is enough foreign demand for domesic goods so ha he addiional domesic credi and goods supply maches foreign demand. A he peak of he simulaion period, he op 5% income share (represening boh op household income and corporae reained earnings) has risen up o more han six percenage poins. This is much more han he observed increase of he op 5% income share (Figure ), bu in line wih our synheic income shock including corporae reained earnings UK inequaliy scenario Figure 6 depics he simulaion oupu for he Unied Kingdom for a decline in workers bargaining power over 2 years, where he larger par of he inequaliy shock derives from he personal disribuion of income (a relaively high ξc). 2 The resuls are similar o hose already found by Kumhof e al. (22). Higher credi demand (a lower ξ f -ξ d raio) leads o a higher workers leverage. Invesors even sar inermediaing loans from abroad o domesic workers so ha he curren accoun urns ino a defici and he ne-foreign-asse posiion declines. A he same ime, here is enough domesic demand for foreign goods as credi is largely used o compensae he income losses so ha consumpion goods impors remain sable and foreign goods supply maches domesic demand. A he peak of he simulaion period, he op 5% income share, in his scenario represening mosly he income of rich households (raher han corporae income), has risen up o more han seven percen, which is in line wih UK daa from he World Top Incomes Daabase. 4.3 Increased inequaliy accompanied by changes o he financial sysem 4.3. Germany joining he moneary union Figure 7 depics addiional simulaion oupu for Germany. Here, in addiion o he income disribuion shock from he previous scenario (Figure 5) domesic bank spreads are shocked posiively (+5 base poins over en years). Following Kalemli-Ozcan e al. (2), he euro s impac on financial inegraion is primarily driven by eliminaing he currency risk. Accordingly, we use he banking spread shock o ake ino accoun Germany s joining he European Moneary Union roughly en years before he financial crisis. Indeed, German bank lending margins wih crediors in oher euro are member saes increased as credi raes did no decrease proporionally, while i was no longer necessary o consider he exchange rae risk coss in he margin calculaion. In he model, he ransmission mechanism of an increasing banking spread is as follows: 8

20 Deposi raes decrease, while credi raes remain almos consan. As a consequence, domesic deposis and hence domesic credi supply (given he low domesic credi demand) become less appealing. Insead, he volume of foreign bond ransacions (lending abroad) increase so ha he domesic household leverage becomes less pronounced, while he resuling curren accoun surplus becomes more pronounced Financial liberalizaion in he UK Figure 8 presens he simulaion oupu for he Unied Kingdom. Here, in addiion o he scenario illusraed in Figure 6 domesic bank spreads are shocked negaively (-25 base poins over en years). Following Kumhof e al. (22), his is a simple represenaion of UK financial liberalizaion.... To be more precise, we connec financial liberalizaion (as a supply-side argumen) wih he dramaic increase in Briish household leverage. In he model, he ransmission mechanism of a decreased banking spread is as follows: The deposi rae increases slighly, while he credi rae remains almos consan (compare he difference beween he corresponding plos in Figures 6 and 8). As a consequence, domesic deposis and hence credi supply (given he high domesic credi demand) become more appealing. Thus, no only domesic bu also foreign credi supply inermediaed by he domesic invesors and hence he increase in household leverage become more pronounced. So does he curren accoun defici. Finally, i is worh menioning ha among he considered shocks he model is mos sensiive o changes in he financial sysem (srucural banking spread shocks). However, in his paper we mainly focus on macroeconomic effecs of rising income inequaliy. Wha we find is ha, given he observed changes in income disribuion, srucural changes like he sar of he European Moneary Union and financial liberalizaion produce amplifying effecs. I cerainly goes beyond he scope of his paper o analyse hose srucural evens in deail. 4.4 Robusificaion analysis: Invesmen dynamics as an alernaive explanaion of curren accoun imbalances? In all previous scenarios we absraced from changes in physical capial formaion. By conras, some economiss argue ha real invesmen dynamics are he main driver of curren accoun imbalances, see Secion 4.5 and in paricular Foonoe 2. In order o robusify our resuls, we run scenarios in which we generae curren accoun posiions from invesmen shocks for Germany and he UK ha are similar o ha obained from he inequaliy shocks. We hen consider wheher he size of hose shocks ha is necessary o produce hese resuls is realisic. 9

21 Figure 9 presens simulaion oupu for Germany resuling from a one percen increase in foreign (res of he world) invesmen over en years. A he peak of he depiced impulse response he effec on he curren accoun is very similar o he evoluion in Figure 5. So far, i may sound plausible ha invesmen dynamics relaive o changes in income disribuion may have a comparably large influence owards curren accoun imbalances worldwide. Bu, if his was so, we should also be able o explain a similar par of he Briish defici in pre-crisis ime. 4 Before running such a scenario i is worh menioning ha by definiion over 9% of he resof-he-world perspecive are he same for Germany and he UK. Tha means we have o apply a posiive foreign invesmen shock up o almos he same amoun also for he UK scenario. Figure presens simulaion oupu for he UK, in which a similar curren accoun defici evolves as in Figure 6, bu his ime as a consequence of invesmen shocks. In order o obain such a resul, i is necessary o posiively shock domesic invesmen by six percen cumulaed over en years relaive o baseline. This corresponds o a one percen increase in he Briish invesmen-o-gdp raio. Bu as illusraed in Figure 2, his endency maches in no way he empirically observed downward rend in he daa. Moreover, from a sales expecaions perspecive, i does no seem likely ha companies exend producive capaciies when a he same ime mos of he consumers are subjec o persisen real income losses. We conclude from his analysis ha real invesmen dynamics are no a main driver of persisen curren imbalances worldwide. 4.5 Policy Implicaions Some observers have argued ha absen poliical inervenions in inernaional capial flows, he German curren accoun surplus will shrink auomaically and Germany will experience a domesic demand boom in he decade o come (Sinn, 23). The explanaion for his view is ha German savings will no longer be invesed in crisis-burdened curren accoun defici counries bu raher in he domesic economy. 5 However, five years afer he beginning of he eurozone crisis such a response wih a significan reducion of Germany s curren accoun surplus canno be observed. A more healhy developmen would be for he corporae secor o increase is demand for producive invesmen and o move back ino a ne borrowing posiion again (afer 4 Noe he main feaures of he Briish case - rising income inequaliy, rising household deb and widening curren accoun deficis - also apply for oher Anglo-Saxon counries in pre-crisis ime - mos prominen o he US, see Behringer and van Treeck (23) for a panel analysis. 5 Afer years of exensive and excessive capial expors o he souhern counries, invesors from he norh now have realized heir misake and look more owards invesmen in he home harbor. This is he reason for he invesmen and propery boom ha Germany has experienced since he summer of 29 and ha has accorded i an above-average growh rae since hen. (Sinn, 23, pp.5-6). 2