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Posted at 5:43 PM ET, 12/14/2010

The Washington Wizards theory of inequality and the financial crisis

By Ezra Klein

Thumbnail image for inequalitygraph.jpg

The graph atop this post is one I think a lot about: It charts pre-tax income inequality over the last 100-or-so years, and seems to suggest that income inequality is a potential indicator for massive financial crises. As you can see, the two highest points on the graph directly precede both the Great Depression and the Great Recession.

The problem has been coming up with a mechanism. In his essay for American Interest, however, Tyler Cowen proposes one: The financial sector.

The story of the current run-up in income among the very rich is, Cowen says, basically a story of people involved in the financial sector making a ton of money. And so many of them are making so much money because so many of them are betting the same way at the same time. The way they're betting is "short on volatility," which put more simply means against unexpected things happening.

Cowen gives the example of the Washington Wizards: If you bet every year that the Wizards wouldn't win the championship, you'd pretty much always make money. If everyone bet that way every year, everyone would pretty much always make money. If everyone borrowed lots of money so they could make bigger bets on the Wizards losing every year, they'd make even more money. But if the Wizards then won, everyone would then go bust, and they'd go bust all at the same time, losing lots of borrowed money, and wreaking untold havoc on the economy.

Well, not "untold." That's pretty much what happened in 2007. In this story, one of the things to watch for when we see very high levels of inequality is whether that money is coming from the financial sector. If it is, it probably means there are a lot of people on the same side of a bet. And if there are a lot of people on the same side of a bet, the prospects for a major financial crash are pretty good. Maybe not this year, or the next year. But eventually, even the Wizards win.

By Ezra Klein  | December 14, 2010; 5:43 PM ET
Categories:  Inequality  
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Comments

"But eventually, even the Wizards win."

Lies. Dirty, dirty lies.

Posted by: genericOnlineID | December 14, 2010 5:46 PM | Report abuse

Well, sure, if you actually look at the data it looks like there's growing income inequality. But if you forget all of that and just go with your gut, you know that there aren't that many poor people around and the ones that are poor just can't control themselves around tattoo parlors and truck sales.

Posted by: willows1 | December 14, 2010 6:06 PM | Report abuse

It's also behavior one would expect from an Old Boys club sharing privileged information on the latest sure thing.

The more people involved means more money chasing around forming a boom, and then guaranteeing a bust when those in the know switch bets, knowing that their action will trigger the bust.

It would explain why a secret society of nine men "share a common goal: to protect the interests of big banks in the vast market for derivatives..."

Posted by: tomcammarata | December 14, 2010 6:27 PM | Report abuse

I'd be interested in your comments on the corollary from Tyler Cowen that Ross Douthat pointed out in the NYT, namely that the reason the finance sector exists the way it does and successfully resists real change is that it is necessary to fund the Federal Governments perpetual budget deficits.

"If you do wish to break or limit the power of the major banks, running a balanced budget is probably the most important step we could take. It would mean that our government no longer needs to worry so much about financing its activities."

http://douthat.blogs.nytimes.com/2010/12/14/cowens-counsel-of-despair/#more-11387

http://www.marginalrevolution.com/marginalrevolution/2010/04/do-big-banks-control-our-government-thoughts-on-johnson-and-kwak.html

Posted by: jnc4p | December 14, 2010 6:32 PM | Report abuse

So, finally Klein admits that inequality isn't the problem. It's the way the financial sector is set up- in particular we had an issue with the AAA bond requirements and subsidized home loans. We set up the whole banking system so that the legal way to get leverage required buying bonds from the government and the mortgage market.

Posted by: staticvars | December 15, 2010 12:44 AM | Report abuse

What the hell is wrong with the left that stars like Ezra Klein and Matt Yglesias are always linking to Tyler Cowen?

Come on guys, Steve Keen is right there. Or at least Dean Baker.

Posted by: chrismealy | December 15, 2010 1:25 AM | Report abuse

It's hard to be too nostalgic for the economy of the early 1970s, despite the top 1%'s income share being that much lower.

Posted by: tomtildrum | December 15, 2010 12:37 PM | Report abuse

This seems to be further evidence of the abject failure of the War of Poverty. In fact, it makes a good argument for it having made things worse. BTW, wealth is not finite and there is no reason everyone can't have more of it.

Posted by: jeff001 | December 15, 2010 1:19 PM | Report abuse

This seems to be further evidence of the abject failure of the War of Poverty. In fact, it makes a good argument for it having made things worse. BTW, wealth is not finite and there is no reason everyone can't have more of it.

Posted by: jeff001 | December 15, 2010 1:20 PM | Report abuse

I think Robert Reich's latest book delves into this. I'm not sure you're going to identify a single mechanism, and indeed Reich seems to argue that income inequality is as much a symptom of dysfunction as a cause. He gave an interview to Fresh Air in which he proposes his theory. I don't always like the way he expresses himself, but I think there are a lot of solid ideas here:

http://www.npr.org/templates/story/story.php?storyId=130189031

Posted by: roquelaure_79 | December 15, 2010 2:47 PM | Report abuse

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