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Prescient people saying scary things

Raghuram Rajan, the Chicago economist who famously skunked Alan Greenspan's retirement party by offering a prescient paper arguing that the financial sector has put the world at risk of a major economic crisis, has a new book coming out:

Entitled “Fault Lines,” Rajan argues that the initial causes of the breakdown were stagnant wages and rising inequality. With the purchasing power of many middle-class households lagging behind the cost of living, there was an urgent demand for credit. The financial industry, with encouragement from the government, responded by supplying home-equity loans, subprime mortgages, and auto loans. ... The side effects of unrestrained credit growth turned out to be devastating -- a possibility that most economists had failed to consider.

The subtitle, apparently, is "How hidden fractures still threaten the world economy." Terrific.

By Ezra Klein  |  January 12, 2010; 10:26 AM ET
Categories:  Economic Policy  
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Comments

There's a decent interview with Rajan on these and other topics in the current quarterly from the Minnesota Fed, at http://www.minneapolisfed.org/pubs/region/09-12/rajan.pdf

Posted by: gagkk | January 12, 2010 10:50 AM | Report abuse

And what are some of the factors contributing to stagnant wages? That's right! Rising healthcare costs - as employers spend more to provide benefits to employees, there is less money available for direct compensation.

Though I do question this statement: "With the purchasing power of many middle-class households lagging behind the cost of living, there was an urgent demand for credit." If credit were demanded by consumers, wouldn't creditors have been charging more for credit? Whereas the credit offered was actually quite cheap - due to excess supply, leading me to believe that cheap credit enabled by obscure financial instruments misunderstood by the investors was an equal or greater contributor as stagnant wages.

Posted by: bsimon1 | January 12, 2010 12:07 PM | Report abuse

History professor James Livingston from Rutgers has written on this topic of stagnant wages as one of the causes for the current collapse. The piece was published in two parts

http://hnn.us/articles/55368.html
http://hnn.us/articles/55614.html

and is worth a read. He looks at the underlying macroeconomic factors and not so much the particulars of the financial crisis itself. His views are parallel to views I've read from Brad DeLong and Robert Reich on this topic, but he looks at historic parallels with the Great Depression. Interesting throughout.

Historians (and historians of economics) seem to be doing a better job at understanding this economic collapse than most economists. That's a sad state of affairs.

Posted by: enormousturnip | January 12, 2010 3:12 PM | Report abuse

enormousturnip: "Historians (and historians of economics) seem to be doing a better job at understanding this economic collapse than most economists. That's a sad state of affairs."

Sad but unsurprising. Historians as a rule consider real world facts to be the most important thing in their discipline. Most economists would rather create fantasy worlds to amuse themselves and ignore the ugly reality of facts when they cast doubt on their beloved theories (or more likely blow those theories to pieces).

Posted by: alex50 | January 12, 2010 5:27 PM | Report abuse

Cornell economist Robert Frank has also said that increased inequality has been a large factor in the greatly increased indebtedness of Americans in the Republican era. He gives positional/context/prestige externalities as a key reason.

In his 2007 book, "Falling Behind: How Rising Inequality Harms the Middle Class", Frank writes:

For middle class families, the losses from positional arms races have been made worse by rising inequality. As I will presently discuss, most of the income gains in the United States during the past several decades have gone to people at the top of the income distribution. Not surprisingly their higher incomes have led these people to build larger houses. There is little evidence that middle class families envy the good fortune of the wealthy. Yet through a chain of indirect effects [expenditure cascades] I will describe, the larger houses at the top have led families in the middle to spend sharply higher fractions of their incomes on housing...(page 5)

...Using U.S. census data at the county level from 1990 and 2000, Adam Levine and I studied the relationship between increases in inequality and changes in the probability of filing for bankruptcy. We found that even after controlling for income and other known causal factors, bankruptcy factors grew significantly more rapidly in those counties that experienced the greatest growth in income inequality. (page 80)

Posted by: RichardHSerlin | January 12, 2010 5:46 PM | Report abuse

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