Monday, 22 August 2011

Inequality – a cause of the financial crisis?

By Carlos Fortin

Some weeks ago I sent a message via the Recovery with a Human Face Network in which I mentioned an intriguing thesis put forward by Ranghuram Rajan in his book Fault Lines: How Hidden Fractures Still Threaten the World Economy. 1

Rajan links the 2008-2009 financial crisis to income inequality in the United States via populist political responses.  He argues that rising income inequality led to political pressures for housing credit, and that the response was ‘populist credit expansion, which allowed people the consumption possibilities that their stagnant income otherwise would not support’.  This, in the face of the ‘difficulty, given the increasing polarization of U.S. politics, of enacting direct income redistribution’ (Rajan 2010: 42). The result was the subprime debacle and the subsequent global crisis.

While the main target of Rajan’s critique is government intervention in low-income housing credit, what I found remarkable is that such an establishment figure should essentially be arguing that the crisis was, at least partially, due to the highly unequal character of the US society and economy. In fact, he writes that rising income inequality is the most important endogenous fault line in the U.S. today. Given his impeccable orthodox credentials - he is Professor of Finance at the University of Chicago and a former chief economist at the International Monetary Fund - I thought this refreshing.

But Lance Taylor rightly pointed out in a subsequent message that a similar thesis has been argued from a less conservative viewpoint.  His book, Maynard’s Revenge. The Collapse of Free Market Macroeconomics 2 (2011), contains an illuminating Keynesian analysis of the falling labour share of income in the U.S. in the post-1980 period.  It illustrates how this in turn led to household over borrowing through what was ‘effectively an alliance between mostly non-affluent households, finance, and politicians in power […] in support of more debt’ (Taylor 2011: 346). Similar arguments, also from a progressive perspective, are put forward by Gabriel Palma (Palma 2009) 3 and Guy Standing (Standing 2011) 4.

It would seem therefore that both on the right and on the left inequality is being seen not only as dangerous politics but also as bad economics.

1 Rajan, R. (2010) Fault Lines: How Hidden Fractures Still Threaten the World Economy, Woodstock: Princeton University Press
2 Taylor, L. (2011) Maynard’s Revenge. The Collapse of Free Market Macroeconomics, Cambridge, MA: Harvard University Press
3 Palma, G. (2009) ‘
The Revenge of the Markets on the Rentiers. Why Neo-Liberal Reports of the End of History Turned Out to be Premature’, Cambridge Journal of Economics 33.4: 829-69
4 Standing, G. (2011) The Precariat – The New Dangerous Class, London: Bloomsbury