Inequality & the crisis

Was rising inequality to blame for the financial crisis? Two things I’ve seen recently suggest so.
Raghuram Rajan says in Fault Lines that “the political response to rising inequality [in the US]…was to expand lending to households, especially low-income ones.” And Jean-Paul Fitoussi and Francesco Saraceno claim (pdf) that increasing inequality involved a shift in income from people with a high propensity to consume to people with a low propensity, and this created a tendency towards weak aggregate demand which in turn led to low interest rates and asset price bubbles.
Personally, I’m a little sceptical here. Rajan’s argument seems crudely functional; I’d rather stress that lower- income people borrowed heavily in an attempt to keep up with the Jones’. And Fitoussi and Saraceno give us no evidence on the size of the demand shortfall created by increased inequality.
I suspect, though, that inequality matters in other ways.
First, a major cause of inequality was also a cause of the crisis. Ravi Jagannathan and colleagues say the crisis (pdf) originated with the increased labour supply coming from China in the late 90s. This at least contributed to increasing inequality in the west. And it led to the crisis by giving China a huge current account surplus, which it tried to recycle into AAA-rated securities, which in turn fuelled the demand for mortgage derivatives. In this sense, equality might not have caused the crisis, but it was on the scene of the crime.
And it might have been one of the villains in another sense. One of the ideological justifications for “winner-take-all” inequalities was that top bosses had the skill to “add value” to huge companies. This contributed to a combination of over-confident bosses and a lack of adequate control of them - what Nick calls a “dictatorship of the manageriat“ - which  bred the poor corporate governance that destroyed some banks.
So, maybe inequality did generate the crisis - not (just?) through macroeconomic channels, but through an ideological one.

Comments

[John Terry's Mum]

Two points
"'Of every US dollar of real income growth that was generated between 1976 and 2007, 58 cents went to the top 1 per cent of households. “
The political response to rising inequality... was to expand lending to households, especially low-income ones'. This led to the financial breakdown." Raghuram Rajan

SECOND:
Ravi Jagannathan is correct, but does not go far enough: The world has a massive oversupply of human labour. It is here to stay -- this puts massive downward pressure on the living stands of the richest (now suddenly overpaid) workforces -- us aka you and me and others in the west.

The value of human labour is starting a process of terminal collapse.

This isn't a financial crisis, this is the start of a new way of life.

Where does leave put yer labour-theory of value?

[Luis Enrique]

Can you explain what you mean by crudely functional? And why a 'keeping up with the Jones' argument isn't crudely functional?

(Have you looked at Rajan's new blog and seen his arguments for raising interest rates?)

[Jimmy Hill]

"Ravi Jagannathan and colleagues say the crisis (pdf) originated with the increased labour supply coming from China in the late 90s. This at least contributed to increasing inequality in the west."

What mechanism means that increased Chinese productivity casuses inequality in the West?

I've seen some papers suggesting that with regard to consumption inequality, increasing Chinese productivity has had a positive impact. Now pretty much everyone can afford a fridge and chill their food. Of course not everyone can afford a top of the range model, but the difference between a top of the range fridge and a bottom of the range fridge is much smaller than the difference between someone having a fridge and someone not having a fridge.

[chris]

@ Jimmy - yes cheap goods from China help reduce consumption inequality. But this is offset (surely?) by the increased supply of labour bidding down wages, especially for the unskilled.
@ Luis - what I meant is that Rajan seems (I think) to be saying that free credit served some function - (to increase aggregate demand? to legtimate inequality?)without spelling out politicians' motives more clearly. He doesn't give us a mechanism linking inequality to liberal credit.
I don't think "keeping up with the Jones" is so functional. It's just drawing attention to a psychological motive - that people spend more when they see others doing so. Robert Frank has written a lot on this. See also this:
http://economistsview.typepad.com/economistsview/2008/06/the-social-effe.html
This paper is also germane:
http://econpapers.repec.org/paper/amuwpaper/1908.htm

[Luis Enrique]

I getcha. Yes I don't understand how the boom in household borrowing was a political decision. Unless he's just talking about that Community Reinvestment Act, which I don't imagine he is.

[Milton Recht]

Except the GINI index, which measures inequality, for families in the US, as measured by the Census Bureau, shows almost no change in inequality in the US after 2000 and very little change (on the order of 15 percent) since it was first officially reported in 1967.

Additionally, this measure does not include the income value to the poor of government benefits, such as food stamps, subsidized housing, Medicaid, Earned Income Tax Credit, etc., which have been the main modern means of dealing with poverty and inequality in the US.

Owning a home is a separate political agenda unrelated to inequality, and mortgage defaults and foreclosures were/are occurring in all income brackets at an alarming rate during this financial crisis.

[Matthew]

A 15% change in Gini index is quite large!

[daniel]

I personally have no problem with growing inequality as long as the average wealth per person is increasing, which is how we have designed our economy to work. Its the only way forward.

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[Duncan]

Luis,

In terms of political decisions in the UK, there was also the reform of building societies , allowing them to engage in more unsecured lending.

(Although I agree, this isn;t huge)

http://www.bsa.org.uk/consumer/factsheets/100003.htm

[Luis Enrique]

Duncan,

thanks. I know you're not suggesting this, but it's not obvious that "making it easier to lend to people" had anything to do with inequality - a more equal society might also like easy unsecured lending.

[Innocent Abroad]

Daniel [July 28, 11:34am], I simply don't believe you.

Consider the following cases:

(A) You earn $100 a day. Everyone else earns $100-$200 a day.

(B) You earn $99 a day. Everyone else earns $50-$150 a day.

You really think you'd feel better off in case (A)? You really expect us to swallow that?

[charlieman]

As a non-economist, I have to ask whether Chris is right on this: "And it led to the crisis by giving China a huge current account surplus, which it tried to recycle into AAA-rated securities, which in turn fuelled the demand for mortgage derivatives."

And these Chinese people who are contributing to the country's surplus? Exchange surplus means that a nation has exported more than imported. China has done it year after year. Is that a sustainable way of running an economy?

[milgram]

What you aren't making explicit in you article is that (in the UK for sure), that “dictatorship of the manageriat“ has come about on the backs of a collapse in worker militancy and organisation, unionised and otherwise. That's why the size of the pie going to the top has ballooned.

I think the political decision behind the increase in household credit was this: replacing workers' rising wages and conditions with cheaper credit and house price booms (for those who got in on it). So their desire for a better life could (appear to) be met without hurting "social partnership" while our pensions were eaten and bosses massively enriched.