A lot of ink has been spilt about the botched Cyprus bailout, and for good reason. But few have looked into why it happened.
   Yesterday's Wall Street Journal article rightly looks at how the 2nd largest bank in Cyprus doubled-down in Greece's bad debt while every other investor was running away. Why did they do that? Basically because they had so much excess capital that they had to invest it somewhere.
  That excess foreign capital was coming from Russian oligarchs (those same Russian oligarchs managed to get their money out of Cyprus before the crash).

 Paul Krugman touched on the lesson we should learn from this.

 What’s the common theme in these episodes? Runaway bankers; they played a role in a number of these crises, from Chile to Sweden to Cyprus. Best predictor of crisis is large inflows of foreign money: in all but a couple of the cases I just mentioned, the foundation for crisis was laid by a rush of foreign investors into a country, followed by a sudden rush out.”
 Krugman is totally correct in this statement, but he draws the wrong conclusion from it. His conclusion is that capital controls are the solution.
   Besides the fact that you'll never get capital controls implemented evenly, and thus defeat the purpose, they would only be a bandaid on a much larger and more important issue: wealth inequality.

    There is a massive amount of savings shifting its way around the world right now, creating one asset bubble after another, and acting just like a global savings glut.
   But there is no global savings glut, so how is this possible?
    To understand this, you have to look at the one place that today's economists refuse to look at.

 A major determinant of macroeconomic vulnerability that is either totally neglected or barely mentioned by these studies is that of rising income inequality. The staggering escalation in inequality contributes to global and domestic economic and financial instability by fostering a political environment that lends itself to risky investment behaviour and the emergence of asset bubbles. The critical importance of inequality as a driver of crisis is clear when one is confronted with the fact that the average income of the world's richest five per cent is 165 times higher than the poorest five per cent. In a world where the richest five per cent earn in 48 hours as much as the poorest in one year, understanding the linkages between rising income inequality and the greater frequency and severity of the financial and economic crises is central to proposing policies that build systemic resilience and enable a less volatile growth process.
 Economist Steve Keen, in his excellent and readable book Debunking Economics, describes how economists treat all consumers exactly the same. To paraphrase, the economic models that economists use say that both the impoverished migrant worker and the millionaire in the mansion, will spend roughly the same percentage of their income on housing, food, clothing, and transportation.
    Obviously that is absurd. Only by buying diamond-covered suits, eating gold-plated caviar, and buying a Rolls Royce every week would the millionaire be spending the same percentage of his income on food, clothing, and transportation as the guy cutting his lawn.
   Yet, this is what passes for science in today's world of economics.

Why is this important?

   Ever since the start of the Depression in 2008 and the Occupy Wall Street movement, wealth inequality has been getting more attention.
   Obama says that inequality hurts everyone because it distorts our democracy. Which is entirely true, but that's not (directly) an issue of economics (although it deserves more attention).

   Nobel Prize Economist Joseph Stiglitz says inequality hurts the economy. His major complaint is the lack of fairness and justice, which is also entirely true, but is more of an emotional appeal than a scientific one.
   Stiglitz also covers such items as the wealthy using corrupt politicians to change to rules for more profitable "rent-seeking". This is a very important topic and deserve a diary of its own.
   But I want to examine a different aspect that I feel is being largely ignored.
I refer again to our millionaire in his mansion. As Stiglitz put it:

 Consider someone like Mitt Romney, whose income in 2010 was $21.7 million. Even if Romney chose to live a much more indulgent lifestyle, he would spend only a fraction of that sum in a typical year to support himself and his wife in their several homes. But take the same amount of money and divide it among 500 people—say, in the form of jobs paying $43,400 apiece—and you’ll find that almost all of the money gets spent.
 So what does the millionaire do with all that extra money? He puts it to work for him.
   In a healthy economy with a reasonable amount of equality, this is a good thing. The millionaire will build a factory, or create a service that society needs, while getting a fair return for his investment.

  But what about in an economy with dramatic inequality, like we have today? Why would the millionaire build a factory when the workers can't afford what is produces? With the middle class collapsing all over the western world, consumption is also collapsing. So building a factory is a bad investment, and the people managing the millionaire's money know it.
   So what gets done with all that money? It goes into speculation.

  Speculation, as opposed to investing, is driving food prices up across the world. This speculation causes starvation in the poorer nations, as well as political unrest and violence.
   It isn't just food. You can also attribute high gas prices to all this excess cash floating through the system, looking to make a quick buck.

  In fact, you can attribute pretty much all the asset bubbles and economic distortions of the past few decades to this excess of speculative money (helped along, of course, by unnaturally low interest rates from central banks).
   This means that the uncertainty, the instability, and the irrationality of the economic system can be directly attributed to global wealth inequality.

  Societies that manage a narrower gap between rich and poor enjoy longer economic expansions, according to research published this year by the International Monetary Fund. Income trends in the U.S. mean that future U.S. expansions could last just one-third as long as in the late 1960s, before the income divide began widening, says economist Jonathan D. Ostry of the IMF.

  It's like a bolling ball rolling around in a china shop, crashing into thing. It drives up property prices, or commodity prices, or financial asset prices, to unsustainable levels then flees at the first hint of trouble, crashing the economy with it.
   It does the same thing with currency values, thus causing distortions in global trade. However, the biggest distortions are in the political systems.
 Expansions fizzle sooner in less equal societies because they are more vulnerable to both financial crises and political instability. When such countries are hit by external shocks, they often stumble into gridlock rather than agree to tough policies needed to keep growth alive. Raghuram G. Rajan, the IMF’s former chief economist, says political systems in economically divided countries become polarized and immobilized by the sort of zero-sum politics now gripping Washington.
 It doesn't take much imagination to see how big money will corrupt the political process, thus effecting regulations and reforms, but if you examine the idea in detail you will see how it has direct and immediate economic consequences as well.
   The corruption of the political system directly effects the justice system as well, and this is the rot that destroys the economic system that the wealthy feed upon.
 Barry Ritholtz, chief executive officer of the investment research firm Fusion IQ, says millions of potential investors may conclude, as they did after the Great Depression, that the market is a rigged game for insiders. Such seismic shifts in popular sentiment can have lasting effects. The Dow Jones industrial average didn’t regain its September 1929 peak of 355.95 until 1954. “You’re going to lose a generation of investors,” says Ritholtz. “And that’s how you end up with a 25-year bear market. That’s the risk if people start to think there is no economic justice.”
  Which brings up the question of whether this case is true of today. In fact, this is exactly what is happening.
 The portion of Americans invested in the stock market dropped this year to its lowest level since Gallup started asking, every two years, in 1998 — 53 percent said they were in the market in April, compared with a high of 67 percent in 2002 and 65 percent as recently as 2007, before the financial crisis. A Bankrate poll in April found that only 17 percent of respondents were more likely to invest in the stock market, even with the small amount of interest they earn on bank deposits.
   Perhaps the best indicator of the broader movement away from stocks is an annual survey done by the Investment Company Institute, which has shown that the percentage of American households invested in domestic stocks, including directly or through any other vehicle whether through mutual funds or exchange-traded funds, has fallen every year since the financial crisis to a low in 2011 of 46.4 percent, down from a high of 53 percent in 2001.
  Increasingly, the retail investor is using the rebound in the stock market to dump shares. While this is good for the wealthy speculators that dominate the stock market, it also leaves a growing lack of "dumb money" to sell to once the inevitable correction happens, thus making the future inevitable downturn worse.

  Wealth inequality in America today is worse than many Latin American banana republics and twice as bad as ancient Rome which was built on slave labor.

  It's a shame that economists today are so beholden to their wealthy benefactors, and thus don't examine the detrimental effects of wealth inequality. They would find that the inequality creates severe distortions in economic activity, the same "uncertainty" and "volatility" that they complain about holding back the economy is coming from the same source that they refuse to examine because it would raise uncomfortable questions for the wealthy elite.
    If we want a more stable world economy and a better business environment for investing, we need to control and reduce the wealth inequality in the world.

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