Credit Drives Income Inequality Drives Credit

As economists continue to sort through the causes of the financial crisis (even though Congress already fixed the problem), there's one cause you don't hear very often: income inequality. Economist Raghuram Rajan explains this point in a recent article at Project Syndicate. He says that income inequality was growing prior to the housing bubble, which is part of what drove policymakers to champion subprime mortgages. Since these individuals couldn't actually afford as much as more affluent Americans, they could now tap into credit to feel just as wealthy. The corollary to his point is what too much credit can do: help to mask income inequality and cause it to further grow.

Rajan explains what he believes happened:

Thus, politicians have looked for other, quicker ways to mollify their constituents. We have long understood that it is not income that matters, but consumption. A smart or cynical politician would see that if somehow middle-class households' consumption kept up, if they could afford a new car every few years and the occasional exotic holiday, perhaps they would pay less attention to their stagnant paychecks.

Therefore, the political response to rising inequality - whether carefully planned or the path of least resistance - was to expand lending to households, especially low-income households. The benefits - growing consumption and more jobs - were immediate, whereas paying the inevitable bill could be postponed into the future. Cynical as it might seem, easy credit has been used throughout history as a palliative by governments that are unable to address the deeper anxieties of the middle class directly.

But credit was also part of the reason for that inequality in the first place. Credit widened the income gap for three reasons. The first is psychological; the second is economic; and the third is financial.

Think about the psychology of a worker-consumer. Credit pacifies those with lower incomes to make them feel like they're better off than they actually are. If you can use a credit card to buy an iPad or new shoes, then you are more satisfied than you would be based on your income alone. If you can get a mortgage for a house you can't really afford, you'll feel like your income is adequate to attain the American Dream. The more content you are, the less need you'll feel to try to increase your income.

From a microeconomic perspective, companies are also content with the wages they provide within this context. But what if less wealthy Americans couldn't get as much credit to buy as many of the products that firms produce? Their incomes would have to rise. Management and other upper-income employees would have to accept less compensation in order to pay lower-level workers more so their consumption could remain level and sustain firms' profits.

Then, there's the pure finance. The richer you are, the less personal credit you'll need, and the cheaper it will be. The poorer you are, the more expensive your credit, but the more credit you'll feel like you need. So in order to attain the quality of life that popular culture dictates you should enjoy, Americans with low to moderate incomes go into debt. And they're paying relatively high interest rates, which further eats into their relatively lower income, reducing their wealth potential.

So while it's likely that income inequality helped to fuel the credit bubble, the reverse is true as well: additional credit increases income inequality. On a psychological level, it causes Americans with lower income to believe their pay is adequate enough. On an economic level, companies don't feel the need to pay workers more, because their products and services are selling extremely well thanks to credit. On a financial level, the poor and middle class need to rely more credit to attain an adequate standard of living, which ultimately makes them poorer.

Last month, I wrote a thought piece about imagining a nation where credit was criminalized. Of course, as I noted in a follow-up, that could never happen in the U.S., nor should it probably to the extreme I envision. I did, however, note some of the problems above in that second post, but government coercion is certainly not a preferred solution.

It's hard to see things changing otherwise, however, since Americans aren't likely to willingly reduce their quality of life. Fiscal responsibility would have to suddenly triumph, which would mean Americans would have to choose to live humbler lives. They would have to forgo that stylish Gucci wallet and that shiny Mercedes, even though their credit would allow it. If Americans began spending what they've already earned, instead of what credit dictates they can afford, the income gap would begin to shrink.