Income Inequality Doesn't Cause Economic Crises

Earlier this year, I wrote a series of articles asking the question, Why does economic inequality actually matter? The purpose was not to rationalize away stagnating median wages (those are a real crisis) nor to argue against higher taxes on the super-wealthy (those are inevitable). Instead, the goal was to ask what were the real implications of our historic income inequality now that the top one percent of earners today takes home a fourth of all the cash earned in America.

The most compelling argument that income inequality caused the credit crunch goes like this. Through the 2000s, the US government backed a consumption surge with low taxes and low interest rates to encourage families at all levels to borrow and spend. The real estate industry and financial sector, smelling a housing boom, got in on the action by pushing out more mortgages and spinning them into complex instruments of profit. At the same time, middle class wages froze -- indeed, they have barely budged in real terms since the 1970s. As a result, Americans saw opportunities to spend but they lacked the means. So they stopped saving and started borrowing. How much? So much that by the time the whole house of cards fell in 2008, the average American household's debt was 130 percent of income.

Upshot: With real income flat, less wealthy households had to borrow to maintain a rising standard of living, just as the stewards of the US economy chose, or were incentivized, to extend credit to these households.

It's a clear-eyed case, but it seems incomplete. First, the credit crunch had worldwide ripples in countries with varying levels of income inequality. Second, it's not clear that inequality guided Lehman Brothers's (or Bear Sterns', etc) lending strategy. Third, how do we reconcile the argument that inequality causes crises with the fact that between 1944 and 1980, we suffered a recession once every five years, even as income inequality hovered at its century-low?

If you want to understand the housing bubble, you have to look at its epicenters: Florida, Nevada, California, and Arizona. Economist Edward Glaesar points to research showing that at the metro level, home prices did not always increase where there was the most income inequality. That calls into question the claim that income inequality was inflating the housing bubble. He goes on:

Professors Atkinson and Morelli's international data also suggests little regular connection between inequality and crises. Looking at 25 countries over a century, they find 10 cases where crises were preceded by rising inequality and seven where crises were preceded by declining inequality. Moreover, "the Gini coefficient was higher to a salient extent in two of the six cases where a crisis is identified, which is exactly the same proportion as among the 15 cases where no crisis is identified," they found.

To read more on the Does Income Inequality Matter? series, read Part I on why we should care, Part II on the relationship between inequality and economic crashes , and Part III on why middle income Americans added so much debt in the 2000s.