Did Income Inequality Cause the Crash?

This is part two in a series about why we should care about economic inequality. Part one is here.

There is no question about whether income inequality is worse today than almost any time in the last century. There is a question about whether we should care.

We know that the share of national income held by the top ten percent in 2007 was higher than any time since the late 1920s. I don't know what this means, or what we should do about it. Still, this data point is finding its way into a new theory that income inequality could create economic crises like the one we just suffered.

Economist Raghuram Rajan explains the link between economic inequality and economic calamity this way. Middle-income wages stagnated in the 2000s, so when workers continued to increase their spending on everything from hand bags to houses, they took on more debt, which the government made readily available. When Americans realized that they had bought and borrowed more than they could pay for, the house of cards came falling down.

Many of the recession's ingredients had nothing to do with income inequality. Low interest rates encouraged Americans to take on more debt. Government homeownership incentives encouraged us to buy larger houses. Exotic and complicated securities obfuscated the health of their underlying assets and contributed to mass hysteria when the housing market imploded. All three of these variables contributed significantly to the economic crash, and they all could have happened with faster growing middle income wages or slower growing upper income wages. They might be related to income inequality, but they are not the inevitable product of the rich being very much richer than the rest of us.

Consider this data point. Before the Great Recession, we had the Great Moderation -- the period between 1982 and 2007 when we saw fewer, and lighter, recessions than any time in the 20th century. And yet during that time, income inequality yawned to its century high. Between 1944 and 1980, we suffered a recession more than every five years, even as income inequality hovered at its century-low.

The debate about income inequality is critical, because it can move public policy. If you think income inequality is an economic problem, the best way to resolve it is to tax the rich and give money to the poor. Nearly every country in the world taxes at a progressive rate to provide public services, and I think they're right to do so. But some states go even further. Greece for example, and other European countries have built big welfare states on the back of high taxes, and now they're mired in fiscal crisis. If we're willing to entertain the argument that extreme income inequality can lead to economic crises, shouldn't we also entertain the argument that extreme efforts to combat income inequality -- by larding a state budget with generous promises -- can lead to disaster, too?