Does Inequality Cause Financial Crises?

A debate is brewing about income disparities, modern finance, and the prevention of future economic cataclysms

What caused the Great Recession? This question, not surprisingly, is proving divisive. Just today, The Huffington Post reported that the Republican members of the congressionally-appointed Financial Crisis Inquiry Commission have decided to splinter off from the bipartisan committee and issue their own report, blaming the government (for inflating the housing bubble by encouraging subprime mortgages) and downplaying Wall Street's responsibility for the meltdown.

Meanwhile, a number of economists and commentators are scrutinizing another possible root cause of the crisis: mounting income inequality. The discussion has veered into a debate about the nature of modern finance as well.

• Inequality Was Only Small Part of Story, decides economics professor Edward L. Glaeser at The New York Times. Theories linking income inequality to the financial crisis are inconclusive, Glaeser says, and research by the English economist Tony Atkinson indicates that while income inequality in the U.S. was high in 2006, "it wasn’t rising sharply before the crash, except for the very top of the wealth pyramid." Surveying 25 countries over a century, Atkinson and co-author Salvatore Morelli found 10 cases where crises were preceded by rising inequality and seven where crises were preceded by declining inequality, suggesting a weak correlation between inequality and crises. Glaeser concludes:

When inequality and crises do go together, it is quite possible that the asset bubble is causing inequality rather than the reverse. The great stock market boom of the 1920s and the housing boom of the 2000s made many rich people even richer ... To understand the crisis, we need to understand people’s willingness to pay absurd amounts for houses in Las Vegas and Phoenix and Florida, in areas where new houses are easy to build, and we need to understand why creditors [were] willing to lend to them.

• Arguments That Inequality Caused Credit Crunch Are Incomplete, adds Derek Thompson at The Atlantic. He points out that the credit crunch hit countries with different levels of income inequality, that it's not clear whether inequality informed Wall Street lending practices, and that the U.S. endured a recession once every five years between 1944 and 1980 while income inequality remained at its century-low.

• It's The Financial Sector That's Endangering the System, asserts economist Tyler Cowen at The American Interest. Cowen posits that finance professionals are raking in money by collectively betting against unexpected changes in market prices, thereby contributing to growing inequality and imperiling the market system as a whole. To illustrate his point, Cowen explains how betting against a major decline in home prices is similar to betting against basketball's "perennially hapless" Washington Wizards winning the NBA championship: "Every now and then such a bet will blow up in your face, though in most years that trading activity will generate above-average profits and big bonuses for the traders and CEOs." He continues:

Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably. Maybe that’s simply the price of modern society. Income inequality will likely continue to rise and we will search in vain for the appropriate political remedies for our underlying problems.

• Yes, Inequality Is A Symptom, Not a Cause, agrees The Economist's Will Wilkinson: "The deeper problem is that Wall Street can and continues to drink our milkshake--that there is a draining hole in the social till that has already caused our economy to collapse once--not that the banker's portions of milkshake are growing faster than ours."
  

• Now We Know our Bellwether, remarks Ezra Klein at The Washington Post: If the U.S. is experiencing high levels of inequality, Klein says, it must examine "whether that money is coming from the financial sector. If it is, it probably means there are a lot of people on the same side of a bet. And if there are a lot of people on the same side of a bet, the prospects for a major financial crash are pretty good. Maybe not this year, or the next year. But eventually, even the Wizards win."
  

• But If Wall Street Is Betting Against the Wizards, Who's Taking the Other Side of the Bet? wonders Kevin Drum at Mother Jones: "There's still a mystery here that no one has ever adequately explained ... As I've mentioned before, the primary metric for determining if financial reform is effective is the profitability of the financial industry. If it goes down a lot--by about half, I'd say--then it will have been successful. If not, then not. So far, the signs don't look good."