Blog Post by: Benjamin Landy, on May 29, 2012
Policymakers and academics have identified income inequality as a proximate cause for a number of society's ills, from deteriorating social cohesion and unhappiness to high mortality rates. But could America's widening income gap also be responsible for the 2008 financial crisis?
That's the controversial conclusion reached by economists Michael Kunhof and Romain Rancière, whose 2011 report for the IMF explains how rising inequality incentivizes poorer households to over-leverage, eventually leading to financial crises. In their model, households are broken down into two groups—the richest 5 percent, representing capital; and the bottom 95 percent, representing labor. As in the real world, Kunhof and Rancière assume the capital group experiences large and persistent income gains over time, while wages for labor grow slowly or stagnate. But the top 5 percent cannot consume all of their disposable income (you can only buy so many cars), so they create financial wealth through loans to the bottom 95 percent, who need credit to maintain their accustomed level of consumption. As inequality grows, credit supply from the top and credit demand from the bottom expand simultaneously, increasing the probability of systemic default as risk and debt build.
If Kunhof and Rancière's model sounds familiar, that's because it is. In the United States, real average annual earnings for production and other non-supervisory workers peaked in 1972 at $40,884, while total consumer credit amounted to just $2,804 per person. By 2008, average annual earnings had fallen by $6,408 to $34,476, and households were making up the gap with an extra $4,940 in credit per person—more than triple the ratio of credit to earnings as in 1972.
As in Kunhof and Rancière's model, U.S. politicians responded to growing income inequality and stagnating median wages in the years leading up to the financial crisis by promoting policies to prop up the living standards of the indebted lower and middle class. But instead of addressing the root causes of inequality (such as regressive tax policy and declining collective bargaining power), they cut the cost of borrowing even more, pouring gasoline on the already fiery housing market. Low income families were incentivized to take on second and third mortgages they could not afford, and the financial class pounced—diverting capital into financial gimmicks like mortgage-backed securities to obfuscate and distribute the underlying risk.
There is some disagreement within the economic community as to whether the relationship between higher levels of inequality and financial crises are causal or correlational. But consider this: when someone making $20,000 a year gets a raise, they spend it. When someone making $2,000,000 a year gets a raise, they invest it. And as an ever greater share of national income accumulates at the top (and discretionary income for the bottom 95 percent stagnates), the greater the demand for high-yield financial innovation independent of the faltering demand-side consumer economy. Until real median wages rise and the income gap begins to narrow, debtor nations such as ours will continue this disastrous boom-bust cycle.
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