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2012-03-22 10:11:01
Free exchange - Body of evidence
Mar 17th 2012 | from the print edition
IN THE search for the villain behind the global financial crisis, some have
pointed to inequality as a culprit. In his 2010 book Fault Lines , Raghuram
Rajan of the University of Chicago argued that inequality was a cause of the
crisis, and that the American government served as a willing accomplice. From
the early 1980s the wages of working Americans with little or no university
education fell ever farther behind those with university qualifications, he
pointed out. Under pressure to respond to the problem of stagnating incomes,
successive presidents and Congresses opened a flood of mortgage credit.
In 1992 the government reduced capital requirements at Fannie Mae and Freddie
Mac, two huge sources of housing finance. In the 1990s the Federal Housing
Administration expanded its loan guarantees to cover bigger mortgages with
smaller down-payments. And in the 2000s Fannie and Freddie were encouraged to
buy more subprime mortgage-backed securities. Inequality, Mr Rajan argued,
prepared the ground for disaster.
Mr Rajan s story was intended as a narrative of the subprime crisis in America,
not as a general theory of financial dislocation. But others have noted that
inequality also soared in the years before the Depression of the 1930s. In 2007
23.5% of all American income flowed to the top 1% of earners their highest
share since 1929. In a 2010 paper Michael Kumhof and Romain Ranci re, two
economists at the International Monetary Fund, built a model to show how
inequality can systematically lead to crisis. An investor class may become
better at capturing the returns to production, slowing wage growth and raising
inequality. Workers then borrow to prop up their consumption. Leverage grows
until crisis results. Their model absolves politicians of responsibility;
inequality works its mischief without the help of government.
New research hints at other ways inequality could spur crisis. In a new paper*
Marianne Bertrand and Adair Morse, both of the University of Chicago, study
patterns of spending across American states between 1980 and 2008. In
particular, they focus on how changes in the behaviour of the richest 20% of
households affect the spending choices of the bottom 80%. They find that a rise
in the level of consumption of rich households leads to more spending by the
non-rich. This trickle-down consumption appears to result from a desire to
keep up with the Joneses. Non-rich households spend more on luxury goods and
services supplied to their more affluent neighbours domestic services, say, or
health clubs. Had the incomes of America s top 20% of earners grown at the
same, more leisurely pace as the median income, they reckon that the bottom 80%
might have saved more over the past three decades $500 per household per year
for the entire period between 1980 and 2008, or $800 per year just before the
crisis. In states where the highest earners were wealthiest, non-rich
households were more likely to report financial duress .
The paper also reveals how responsive government is to rising income
inequality. The authors analyse votes on the credit-expansion measures cited in
Mr Rajan s book. When support for a bill varies, the authors find that
legislators representing more unequal districts were significantly more likely
to back a loosening of mortgage rules.
Inequality may drive instability in other ways. Although sovereign borrowing
was not a direct contributor to the crisis of 2008, it has since become the
principal danger to the financial system. In another recent paper Marina
Azzimonti of the Federal Reserve Bank of Philadelphia, Eva de Francisco of
Towson University and Vincenzo Quadrini of the University of Southern
California argue that income inequality may have had a troubling effect in this
area of finance, too.
The authors models suggest that a less equitable distribution of wealth can
boost demand for government borrowing to provide for the lagging average
worker. In the recent past this demand would have coincided with a period of
financial globalisation that allowed many governments to rack up debt cheaply.
Across a sample of 22 OECD countries from 1973 to 2005, they find support for
the notion that inequality, financial globalisation and rising government debt
do indeed march together. The idea that inequality might create pressure for
more redistribution through public borrowing also occurred to Mr Rajan, who
acknowledges that stronger safety nets are a more common response to inequality
than credit subsidies. Liberalised global finance and rising inequality may
thus have led to surging public debts.
Reasonable doubt
Other economists wonder whether income inequality is not wrongly accused.
Michael Bordo of Rutgers University and Christopher Meissner of the University
of California at Davis recently studied 14 advanced countries from 1920 to 2008
to test the inequality-causes-busts hypothesis. They turn up a strong
relationship between credit booms and financial crises a result confirmed by
many other economic studies. There is no consistent link between income
concentration and credit booms, however.
Inequality occasionally rises with credit creation, as in America in the late
1920s and during the years before the 2008 crisis. This need not mean that the
one causes the other, they note. In other cases, such as in Australia and
Sweden in the 1980s, credit booms seem to drive inequality rather than the
other way around. Elsewhere, as in 1990s Japan, rapid growth in the share of
income going to the highest earners coincided with a slump in credit. Rising
real incomes and low interest rates reliably lead to credit booms, they reckon,
but inequality does not. Mr Rajan s story may work for America s 2008 crisis.
It is not an iron law.
Sources
Inequality, leverage and crises by Michael Kumhof and Romain Ranci re, IMF
Working Paper, November 2010
Trickle-down consumption by Marianne Bertrand and Adair Morse, Working paper,
February 2012
Does inequality lead to a financial crisis? by Michael Bordo and Christopher
Meissner, NBER Working Paper, March 2012
Financial globalization, inequality, and the raising of public debt by Marina
Azzimonti, Eva de Francisco and Vincenzo Quadrini, Federal Reserve Bank of
Philadelphia Working Paper, February 2012
http://Economist.com/blogs/freeexchange
from the print edition | Finance and economics