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Blaming inequality for the financial crisis

By Justin Fox

There's a whole crop of financial-crisis-related books out this summer and fall that pin at least part of the blame for what happened on income inequality. I know because I reviewed several of them for the September issue of the Harvard Business Review. On Sunday, the New York Times (I hereby apologize to this blog's proprietors for all the Times links, but I just can't help myself) looked into the same question via the work of Harvard Business School historian David Moss. As Louise Story paraphrased Moss:

Mr. Moss said that income inequality might have complicated links to financial crises. For instance, inequality, by putting too much power in the hands of Wall Street titans, enables them to promote policies that benefit them — like deregulation — that could put the system in jeopardy.
Inequality may also push people at the bottom of the ladder toward choices that put the financial system at risk, he said. And low-income homeowners could have better afforded their mortgages if not for the earnings gap.

This is a topic Ezra has discussed before, and so far there's nothing even remotely close to conclusive evidence that there is a link. But it does at least feel like there's something to it. And it's striking just how little the mainstream economic research of the past 50 years has to say about it. Inequality was seen as a side effect (unfortunate or not, depending on your political leanings) of Great Economic Forces, not something that itself had an impact.

One of the many things that's great about Jacob Hacker and Paul Pierson's "Winner-Take-All Politics," the best of the new inequality books, is how it quickly dispenses with Great Economic Forces as the sole explanation for rising inequality and offers an alternative explanation that has far more to do with politics. That's still a long ways from making a case for how inequality caused the crisis. But it's a hint that the answers may end up coming from historians like Moss and political scientists like Hacker and Pierson, not necessarily from economists.

Justin Fox is editorial director of the Harvard Business Review Group and author of "The Myth of the Rational Market."

By Justin Fox  |  August 23, 2010; 4:06 PM ET
 
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Comments

or maybe greater inequality yields more 'idle' money sitting around for the financial industry to get its hands on (poor, buy dinner; well off, but stocks). And all of that extra money sloshing around, chasing returns, might just push everything too far.

it doesn't have to be a political / policy story (i.e. greater inequality tilts the rules).

Posted by: damnpost1 | August 23, 2010 5:06 PM | Report abuse

I'm glad to hear this is finally getting some focus from the macroeconomic world. I think there's a strong intuitive argument that one can make linking income inequality to first the increase in debt amongst the middle class as they struggle to keep their lifestyle as inflation eats away at stagnant income (i.e., ~1980-2007), then the large crash once the debt capacity is filled (2007), and finally slow growth with persistent unemployment as the velocity of money is "permanently" lowered (sitting in the bank accounts of the rich and corporations) until something comes along to fix the inequality. The middle class has a tendency to spend much of their income, which would seem to favor an equilibrium with high employment and capacity utilization, whereas the rich tend to sit on their money in safer investments at best or inflate asset bubbles at worst (i.e., the supply-side argument that the rich will invest in new enterprises may only be true to a point, with more capital being sent to chase safe investments into asset bubbles instead of actual funding risky new enterprises).

The above, however, is simply an intuitive argument, so some numbers or a model would be very helpful. I sometimes wonder if we could return to the excellent middle class years of the Great Prosperity if the government would have a more confiscatory tax regime and spend those collected taxes on infrastructure. Such "guaranteed" spending might favor stronger unions thanks to the need for labor and thus better working conditions.

Posted by: scotbrad | August 23, 2010 5:11 PM | Report abuse

Common sense:

It's better for the economy for 100 people to buy 1 car, since 1 person isn't buying 100 cars.

Posted by: stevie314 | August 23, 2010 5:11 PM | Report abuse

Check out "Inequality as Policy: The United States Since 1979" by John Schmitt of the Center for Economic and Policy Research: http://www.cepr.net/index.php/publications/reports/inequality-policy/. Summary below.

Since the end of the 1970s, the United States has seen a dramatic increase in economic inequality. While the United States has long been among the most unequal of the world’s rich economies, the economic and social upheaval that began in the 1970s was a striking departure from the movement toward greater equality that began in the Great Depression, continued through World War II, and was a central feature of the first 30 years of the postwar period. This is not due to chance circumstances but is the direct result of a set of policies designed first and foremost to increase inequality.

Posted by: nwoo | August 23, 2010 5:23 PM | Report abuse

Does anyone really, really believe this country isn't ruled by the rich for the even richer?

Posted by: AZProgressive | August 23, 2010 6:24 PM | Report abuse

If the crisis reduced inequality does that mean it was good thing?

Posted by: MrDo64 | August 23, 2010 6:55 PM | Report abuse

@MrDo64 Financial-market crashes always temporarily decrease economic inequality, because the rich tend to have a higher proportion of their income and net worth tied up in financial markets. The question is whether the crisis had any impact on the longer-term trend toward greater inequality. Nobody really knows the answer to that yet.

Posted by: JustinFox | August 23, 2010 7:34 PM | Report abuse

Journolist Journolist Journolist thus your argument is invalid because SHUT UP THAT'S WHY.

Posted by: lol-lol | August 23, 2010 7:48 PM | Report abuse

Complete nonsense. Inequality didn't keep interest rates low and encourage the housing bubble. Even the quote you bring up says that inequality "might have complicated links"- which you stretch into "blaming" in your headline.

"And low-income homeowners could have better afforded their mortgages if not for the earnings gap."
Why? That simply doesn't follow. People were buying as expensive of a house as they could as they rode the corrupt Realtors' Ponzi scheme, with low down payments, high and low income. If the government wasn't (still!) subsidizing high housing prices (with 3.5% down loans and mortgage interest deductions), do you think we'd have lower housing prices? Low-income people should not have big mortgages. End of story.

Income inequality causes one thing- "Status Anxiety".

Posted by: staticvars | August 23, 2010 9:33 PM | Report abuse

Inequality of income had absolutely nothing to do with it. However, if it did (which it did not), you should be cheering for the collapse of real estate prices, which have been artificially inflated by more forces than you can shake a stick at. We now have an enormous stock of housing, and unprecedented low interest rates, which should bode quite well for the ability of the average and below average income Americans to buy, except for the fact that the Obama administration has proven quite obstinate about propping up valuations in order to save banks.

Posted by: bgmma50 | August 23, 2010 10:04 PM | Report abuse

This article represents another sad chapter in the study of economics. Blaming inequity for the financial crisis is precisely the wrong way to go.

Why?

Imagine two tables with streams of sand falling on each. One table is held steady while the sand continually falls. The other table is shaken from time to time. It would appear that the steady table is the superior system because it does not experience the small collapses of the shaken table. Except, there is a problem. As the sand keeps falling you notice that the sand on the steady table is getting too high. Dangerously steep areas are starting to form. The entire sandpile on the steady table reaches a state where the entire pile could collapse at any moment.

Notice that the sand on the shaken table never is allowed to get very high. The collapses are always small, so the damage can never be too great. Also, the sand cannot reach a state of catastrophic collapse.

The distribution of collapses in sandpiles, forests, economies and war follow the power law. That means the collapses of our economy and sandpiles work in a similar manner due to system feedback.

What was the cause of the financial crisis? Government policies that suppressed or mitigated smaller collapses for many years. It never allowed the table to shake.

Posted by: Mattw0699 | August 23, 2010 11:22 PM | Report abuse

Great inequality is the result of both Great Economic forces and politics. Recent politics has all been toward laissez-faire and that inevitably leads to wealth disparity, particularly when there is an abundance of workers (outsourcing). That would be bad enough but the politics goes beyond that and stacks the deck against workers. The resulting disparity does indeed leave great amounts of cash in the hands of the top (major companies had record amounts before the crash) which they want to do something with. Since there was great disparity the absent middle class couldn't buy enough to justify putting all that cash into production so it went into financial gamesmanship. Predicatble result.

Posted by: TomCantlon | August 24, 2010 12:58 AM | Report abuse

As if it's so unthinkable that it might actually be bad for everyone when some of us are left to die like animals.

Posted by: HilaryLo | August 24, 2010 2:13 AM | Report abuse

@Ron, Get your education online on your own time http://bit.ly/a45y6d

Posted by: Rozziecharles | August 24, 2010 4:17 AM | Report abuse

--"But it does at least feel like there's something to it."--

Good enough for the Klein Clown Crew.

The hole in the air that surrounds the dog is the dog.

Posted by: msoja | August 24, 2010 10:29 AM | Report abuse

This is such an unexplored aspect of this present crisis, and of economics in general.

Income inequality per se creates all kinds of downstream effects. There's capture of government, there's excess capital itself driving down the returns on investments, there's middle and lower class people engaging in ultimately destructive behaviors to maintain their standard of living (and people with excess capital helping them along, with things like credit cards and NINJA loans), there's social unrest, scapegoating and resentments generated by a pervasive sense of unfairness in outcomes. It all adds up to destabilization, and threatens long-term growth.

I am absolutely mystified that so many economists so blithely dismiss the distributive effects of various policy changes.

It's simply not a coincidence that the greatest crashes in American history were both preceded by immense wealth inequality. It's also not a coincidence that the gilded age was fraught with fiscal collapses (even as its growth was spectacular, thanks to the industrial revolution).

Every time we have implemented policies that democratized wealth, we have seen sustainable, long-term growth. And when we have implemented policies that enhance inequality, we see crashes and a destruction of growth.

Economic equality is very, very important for growth. It is absolutely incredible that so many economists ignore it.

Posted by: theorajones1 | August 24, 2010 10:40 AM | Report abuse

On the mortgage side, you've got the interesting perverse incentive that higher-cost loans, which are more profitable to intermediaries, actually increase the risk of default precisely because of their higher cost. So instead of being a recompense for risk, higher rates (whether immediate or delayed) can actually increase risk.

Posted by: paul314 | August 24, 2010 10:48 AM | Report abuse

The likely causal chain here is that credit bubbles promote income gains at the very top, and that credit bubbles eventually become painful recessions.

Inequality is not a driver, it is a symptom.

Posted by: justin84 | August 24, 2010 11:14 AM | Report abuse

stevie314 wrote:

Common sense:

It's better for the economy for 100 people to buy 1 car, since 1 person isn't buying 100 cars.

------------------------------------------

It makes more sense if one person has enough capital to give 99 people jobs rather than having 100 people sitting around waiting for their next govt handout, which is exactly where we are headed now.

Posted by: dcharlson | August 24, 2010 2:21 PM | Report abuse

damnpost1, Mattw0699 = great comments!

dcharlson: why would that one person invest if the other 99 don't have any money to spend on the product? currently the rich and corporations currently have record levels of cash, and yet it doesn't seem to be helping much.

Posted by: SnowleopardNZ | August 25, 2010 1:59 AM | Report abuse

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