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Does income inequality cause financial crises?

Thumbnail image for inequalitygraph.jpg

Paul Krugman posted some slides (pdf) this morning from a talk he gave exploring the connection between inequality and major economic crises. They're a bit incomplete without Krugman's accompanying remarks, but in them, Krugman says that he used to dismiss talk that inequality contributed to crises, but then we reached Great Depression-era levels of inequality in 2007 and promptly had a crisis, so now he takes it a bit more seriously.

The problem, he says, is finding a mechanism. Krugman brings up underconsumption (wherein the working class borrows a lot of money because all the money is going to the rich) and overconsumption (in which the rich spend and that makes the next-most rich spend and so on, until everyone is spending too much to keep up with rich people whose incomes are growing much faster than everyone else's).

I've long been interested in this question but, unfortunately, am not a Nobel-level economist, and so don't have great answers. One theory that's made intuitive sense to me is that the problem is not just the demand for credit but the accompanying supply of idle money. When someone making $25,000 a year gets a raise, they spend it. When someone making $2,500,000 a year gets a raise, they invest it. And the more money there is sitting around, the more demand there is for high-yield investments, which means the more reward there is for people who can invent new investment vehicles with high yields. Hence, you have explosive innovations in weird financial instruments that look good for a while because the risk is underpriced but end up making the system more fragile when their risks come clear and everyone flees.

By Ezra Klein  |  June 28, 2010; 3:48 PM ET
Categories:  Financial Crisis , Inequality  
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Comments

[no kidding] Al Sharpton has been interested in this topic for many years and can, without posturing, offer some well-collected thoughts. Sharpton's thoughts are not presently considered Nobel-level economic theory but they are useful. Doug Wilder (former governor of Virgina) also has some thoughts collected over a few decades.

It would be interesting to hear the positions of all three (Krugman, Sharpton, and Wilder) without engaging them in argument.

Posted by: rmgregory | June 28, 2010 4:36 PM | Report abuse

I can suggest a mechanism. When top level incomes were so low, there was a virtually unused sttep progressive income tax that republicans said stifled incentive for people to try to make those large incomes.

That it did. As the marginal top rates went away, it once again became profitable to try to amass Plutocratic wealth. Eventually it became worth Ivan Boesky and Michael Milkin's risking criminal prosecution to pull frauds like Milkin's Junk Bond desk, or Boesky's insider trading. When you are giving back 95 cents of every dollar you steal, the profit in such theft schemes isn't enough to be worth the risk. When you get to keep at least 60% plus whatever over that you can concoct a scheme to protect, it becomes a lucrative game.

CEO's soon realize that their primary objective should be to get as much personal wealth out of their company as possible, and that wealth comes either right out of the pockets of ordinary shareholders or out of the capital needed to keep their company up to date. In either case, or more typically in the combined case, the pursuit of personal enrichment invariably leads to severe or lethal wounds to the company.

Again, where 95 cents of every dollar siphoned from the company goes back to the Government, the fun of concocting schemes that get you massive incomes ceases to be worth it.

We could try a pragmatic experiment:

Since we need every source of revenue we can find, return to those high marginal rates for ten years and watch what happens to the economy. More importantly watch what happens to industry and commerce. When it isn't personally profitable to try buying up your competition, maybe the destruction of quite viable companies like Gold Circle, (condemned to death by Campeau's grandiose ambition to own the nations retail business as his personal fief.) Or all the Oil Refiners that have been bouight up and closed down over the decades since those marginal rates werte eliminated would cease.

Take the personal profit out of massive salaries and see if the species of CEOs evolves to be men interested in the business they run, and not in running their businesses into the ground for their personal enrichment.

Posted by: ceflynline | June 28, 2010 4:47 PM | Report abuse

"I mean, if a mandate was the solution, we can try that to solve homelessness by mandating everybody to buy a house. The reason they don’t buy a house is they don’t have the money."

-Obama, Feb. 05, 2008

Posted by: daveredhat | June 28, 2010 5:00 PM | Report abuse

Wonder if maybe this is analogous to the case of Greece-Germany conundrum.

e.g. as imbalances grow credit becomes cheap, as credit becomes cheap, borrowers divert a greater and greater share of their income back to creditors (both in the form of profit margins from consumer goods and interest on credit used to purchase the goods), which is then pumped back into the consumer credit market, which continues until the imbalance becomes so great that it produces a crisis.

Study of the Panic of 1873 might provide some additional parallels and credence to this idea.

Posted by: JPRS | June 28, 2010 5:04 PM | Report abuse

I suppose in a very broad sense, it's a heck of a lot easier to mishandle a few people's trillions of dollars than it is to collectively mishandle millions of people's billions of dollars.

Posted by: jasonarewhy | June 28, 2010 5:09 PM | Report abuse

Two more points: A lot of the Superrich's money goes abroad, whether it is in third and fourth homes in Dubai or Gstaad, or a bank account in Leichtenstein or the Caymans. It's multiplier goes to some other ocuntry.

Second, ceflynline's point is somewhat akin to James Galbraith's argument in "The Predator State" that when individual income tax rates were high, corporate wealth was retained by the corp, which invested it to grow or improve, since otherwise over half would go the the gov't. Lowering the top individual tax rates, beginning with Reagan, coincides with the immense transfer of corporate wealth to top management and directors in the form of compensation (not so much to shareholders--dividends dropped in that period, until GW Bush's secoind tax cut lowered the rates on dividends).

Posted by: Mimikatz | June 28, 2010 5:15 PM | Report abuse

"Cause?" - probably not.
Enable? Fuel? - probably so.

A huge pile of dry twigs doesn't "cause" a fire, but it sure helps it grow larger, faster when the match is struck.

I think a non-Nobel-level look at 1873, 1929, and 2008 would be helpful.

Posted by: Rockfish66 | June 28, 2010 5:30 PM | Report abuse

Since when is 'investment' considered 'idle money'? Granted the MBS investments turned about to be bad investments, but that money was directed to people buying homes. It wasn't sitting in a box.

Posted by: justin84 | June 28, 2010 6:16 PM | Report abuse

Just like to point out that I've been making this point for the better part of a year.

My idle money theory is that the primary driver of our current crisis is an investment glut created by income inequality. There's too much money chasing too few investments with the right kind of returns (privatizable). So, decent investments start giving poor returns, and very risky investments have a low rate of return that suggests they should be safe. This sets up a feedback loop that stimulates people to come up with increasingly crazy schemes, and for others to vette those streams as little as possible, since they are just desperate for a place to put the ever-increasing pile of cash so they can make their quarterlies. Bubbles are an inevitable feature of this inequality-driven system of idle wealth, they are not an aberration.

In my story, the pernicious impact of ridiculously low marginal tax rates is not just that it creates more idle wealth, but also that it also systematically starves the country of critical long-term public investments upon which private growth depends. We send more money to Wall Street and less to schools & bridges. And, in fact, the case of the 80's to the present (except under Clinton), it's arugably worse, because we deficit spend on non-productive things like the military and keeping the world's most inefficient health care system spectacularly inefficient. This juices the economy in the short-term while robbing it in the long-term, making the system not only unsustainable, but even harder to break out of because it's even more short-term beneficial and long-term costly.

And then there's the capture of Congress by the investment classes, the driving of more and more funds to Wall street, the ascendance of insane philosophies like the rational market and the deification of the executive (and the demonization of things like public investment). In this world, 401ks, which by changing tax revenue into mandatory Wall Street 40-year investments magically turn bridges into CDOs, we can see that 401ks are not a good thing. People should just be paid more salary.

Frankly, I think there's a little of "all the above" going on here in terms of the problem. Idle capital perverted the entire market, not just the investment side, but even the consumption side. We had UNDERconsumption of things people actually wanted to buy, because lower income people who consumed had relatively less money. We had OVERconsumption of things that people could get loans for--where the idle money had figured out a way to be used profitably in mortgages and credit cards.

But in all of this, income inequality is not a sideshow. It is the prime mover of our current problems.

Posted by: theorajones1 | June 28, 2010 6:20 PM | Report abuse

"Again, where 95 cents of every dollar siphoned from the company goes back to the Government, the fun of concocting schemes that get you massive incomes ceases to be worth it."

Well sure, but investing in a lot of things becomes pointless. Why invest in anything if your return is going to be gobbled away by taxes?

Posted by: justin84 | June 28, 2010 6:44 PM | Report abuse

with all the zombies still believing "government is the problem" and the mind set long ago instilled by bipartisan St. Ronnie's and the constant PR, we have long way to go before the reality hits these walking dead. these people still believe any government is bad, anything from local to state to federal laws are "bad". it is quite a thing to behold when they speak these "memes" from the Real America PR book. Paying for what we want. like all these "services, water, roads, schools, bridges and so on. pay for them with that nasty five letter word: TAXES.

Americans would rather listen to liars than pay taxes. and have for the last 40 years. now the bill are coming due.

the only way the zombies are going to wake up is when the "bad economy" hits their neighborhood. it is starting little by little. we now have Ayn Rand's free market. devoid of any rules other than the survival of the fittest/richest. no one/(gov) to stop the thieves. amazing these zombies think the rich will help them. give the rich money they might create jobs in China, where they will make more cash than if the jobs were here in America. most Americans still don't understand the poor will spend the money while the rich send it Dubai, Switzerland along with the corporations. As if the rich cared about anything more than getting richer. buying Congress certainly helped!!!

there's still too much pretending by these zombies. and when the zombies wake up, will it be more Tea Baggers. so idiotically confused about who is screwing whom. Americans are so special they want to be told what to think. they will pay mightily for gladly doing what the rich told them under St. Ronnie's PR campaign. Demonizing the "other" another form of "divide and conquer" American pocketbooks. lol. what a scam these zombies brought upon themselves. but don't' dare tell it to their face. they wont see it, even while they deny it could ever be.

America can't last too much longer economically, with Europe starting the ball rolling. it will not be pretty. but this is what the Zombies wanted. Talk about faith based chicanery.

as ye sow,so shall ye reap

Posted by: Beleck31 | June 28, 2010 6:54 PM | Report abuse

The combination of underconsumption and overspeculation didn't used to be a particularly unusual explanation for the Great Depression.

For example, see John Kenneth Galbraith's the Great Crash, and to lesser amounts the New Industrial State, Affluent Society, etc..

Posted by: StevenAttewell | June 28, 2010 7:25 PM | Report abuse

"The combination of under-consumption and over-speculation didn't used to be a particularly unusual explanation for the Great Depression."

Interesting.

Posted by: rmgregory | June 28, 2010 7:33 PM | Report abuse

theorajones1:

Add in the fact that money invested in Wall Street has virtually no impact on established companies unless they are doing a stock issue. Once a share of GM is sold, nothing it does in the form of going up, down, or sideways benefits GM in the least. The only people at GM who care after the stock is sold for the first time are the executives who need their bonus shares to rise sharply so they can make massive profits. Once they have cashed out, in fact, it behooves them to let the stock drop sharply so they can repeat the process. Most of the big investors are no longer the Al Sloans or DuPonts, but quick kill artists who need market volatility and enough inside information to know when to get in and when to get out. Long term big money stays away because it doesn't get the long term benefit of a stable, (if very large) or growing (if it isn't too large to easily grow) company over time.

If you want to be a Boss Kett or an Ermil Fraze you need smarts and patience. Low tax rates discourage either trait.

Posted by: ceflynline | June 28, 2010 8:01 PM | Report abuse

Ezra--

Didn't Dan Ariely show that above a certain threshold, increasing the financial compensation for a cognitively-demanding task causes an increase in recklessness risk-taking and a decrease in performance?

Furthermore, isn't there evidence that having a huge pile of personal wealth makes people more willing to make reckless investment decisions and engage in speculation? After all, if a multimillionaire loses half his money, he's probably still a multimillionaire.

A guy who makes half a milliom dollars a year, or even a few million, can't afford to lose his job; that puts some caution into his behavior. But what about a guy who makes 10 million a year? If he loses his job, he can probably just take an early retirement.

Posted by: matt297 | June 28, 2010 8:15 PM | Report abuse

Rutgers historian James Livingston has written on this issue of inequality. In his story,

"The Great Depression was the consequence of a massive shift of income shares to profits, away from wages and thus consumption, at the very moment—the 1920s—that expanded production of consumer durables became the crucial condition of economic growth as such. This shift produced a tidal wave of surplus capital that, in the absence of any need for increased investment in productive capacity[...], flowed inevitably into speculative channels, particularly the stock market bubble of the late 20s; when the bubble burst [...] demand for securities listed on the stock exchange evaporated, and the banks were left holding billions of dollars in distressed assets. The credit freeze and the extraordinary deflation of the 1930s followed; not even the Reconstruction Finance Corporation could restore investor confidence and reflate the larger economy."

Of course "a massive shift of income shares to profits, away from wages and thus consumption" is another way of describing income inequality - wages were stagnant, and in order to consume, people borrowed. Profits were made by the rich, who invested them in whatever gave them the best return for their risk profile.

Posted by: enormousturnip | June 28, 2010 8:27 PM | Report abuse

" "Again, where 95 cents of every dollar siphoned from the company goes back to the Government, the fun of concocting schemes that get you massive incomes ceases to be worth it." Well sure, but investing in a lot of things becomes pointless. Why invest in anything if your return is going to be gobbled away by taxes? Posted by: justin84"

Hey, the man understands the principle. Now watch carefully as it is put into practice. The part of all personal incomes over 100 times the annual minimum wage is declared excess income. (currently that is a bit more than a million a year income.) Excess incomes are taxed with no possibility of exceptions, reductions, deferrals, or other reductions.

That portion of excess incomes between 100 times tha minimum wage and 200 times the minimum wage gets taxed at 50%. From 200 times to 300 times gets taxed at 55%, etc, until the total tax rate from INCOME TAXES, (property, sales, intangibles don't qualify) from all taxing authorities is 95%, at 1000 times the minimum wage. no need for high priced tax attorneys and accountants, tables do it nicely.

Most even more than medium investors don't earn a million a year from all sources and don';t worry. They live in the world of tax deductions and set backs and averaging. THEY have an incentive to invest. once they hit the 50% bracket things become less and less worth trying for that decreasing marginal benefit.

This puts investing back into the hands of the more than middle class, as compared now to the more than middle class being small fry for the too big to fail people to devour. Yeah, nobody has any good reason to try to earn half a billion dollars a year because 475 million of it goes to the government. Nice disincentive to wrecking economies.

And by the way, those big wig investors paying themselves these massive bonuses? If you are one of their investors, it came out of your dividends.

See, if they make lots of money they pay themselves lots of money and and pay you a dividend. They used your money and made lots of money for themselves. You get some of it but they get most of it. Because they were so brilliant with your money.

Of course if they screw up, and wreck the worlds economy, it was YOUR money they lost, and more of your money they used to pay themselves the big bucks for screwing up. Mad at them and want out? Pay them a transaction fee to cash out.

Maybe disincentives to bankers to keep them from doing this isn't such a bad idea after all.

Posted by: ceflynline | June 28, 2010 8:43 PM | Report abuse

If you go back and read contemporary accounts from the 1930s, income disparity from the 1920s very much was thought of as a contributing factor to the crash. It's amazing how completely people forgot this in later decades.

Posted by: leoklein | June 28, 2010 8:45 PM | Report abuse

Krugman's talk shows all the familiar charts, but he leaves one out:

http://en.wikipedia.org/wiki/File:MarginalIncomeTax.svg

Income tax rate changes preceded a lot of these other changes, and directly led to huge changes in income inequality.

Posted by: Ulium | June 28, 2010 10:13 PM | Report abuse

Its been a while since I've read his stuff, but I believe Ravi Batra has proposed a theory. Of course, he initially predicted a financial crisis in the early 90's. So, on one hand he was wrong, but maybe the internet/tech revolution merely postponed it.

The basic mechanism (if I recall) is akin to what people here have said. Following the drastic reduction in top marginal tax rates, companies had an incentive to keep earnings as profits (esp. CEO's who make a killing via stock options when profits go up), rather than reinvest that money back into the company or compensate labor with it. The workers see no real wage gains ("real" in the economic sense), and must borrow increasingly more every year while the excess of savings by the top overwhelms worthwhile investment and ends up in speculative endeavors. The increased corporate profits also lead to asset bubbles. I think there is also something in there about how increased profits lead to increases in production, but aggregate demand cannot keep up since workers do not see any increase in their real wage. I've probably got some of the details wrong. I've been meaning to go back and reread his stuff.

But on a more fundamental sense, prices serve a very specific function in capitalism. It is in fact the basis for the arguments proposed by Friedman, Hayek, etc. regarding the efficiency of capitalism. But how can prices do that when prices mean entirely different things to the haves and have-nots? How can one single price level exist when we have, in essence, two separate populations with entirely different views of what a dollar is worth? To some, $1,000 is a month's pay. To others, its 5 minutes of work. A standard macro model with a sole representative agent will never capture that phenomena.

Posted by: nylund | June 29, 2010 12:04 AM | Report abuse

Please be more honest and show a graph that shows AFTER TAX income. Since the lower half pay no income tax and the rich pay pretty much all of the tax burden, it will look differently.

Also, our "poor" enjoy cellphones, free housing, free food, they all have color TVs and computers.

They are rich by any world standard. To look in others' pockets for more than you're willing to earn is simply envy and jealously.

Posted by: WrongfulDeath | June 29, 2010 9:01 AM | Report abuse

Prof. Fred Block of UC Davis has an article talking about this as well

http://www.longviewinstitute.org/blckmortgage

Posted by: boing3887 | June 30, 2010 3:35 PM | Report abuse

umm...WrongfulDeath...even with aftertax income the rich have way more than the poor. by any measure used by statisticians and economists, income inequality is at an all-time high. you can go look for statistics that were brought up using methods that would ensure a favorable result, but you would probably have to go to AEI or Heritage for that kind of thing. you look at expert after expert, from the Economic Policy Institute to the Peterson Institute to Brookings, they all show that income inequality is at an all-time high and that income mobility is extremely low - we're at the level of a third-world country when it comes to income mobility. i guess libertarians like you don't care that in america the biggest determinant of future income is basically hereditary

Posted by: boing3887 | June 30, 2010 3:38 PM | Report abuse

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