Did inequality cause the crisis?

In: Uncategorized

26 Nov 2012

The following Fund Strategy cover feature was first published Monday.

The notion that high inequality caused the economic and financial crisis that emerged in the US in 2007-08 has become widely accepted. This claim should not be confused with the argument that an unequal society is morally or political undesirable. Instead it holds that according to objective economics thedownturn was itself the result of excessive inequality.

This preoccupation with inequality is not confined to those associated with the egalitarian left. On the contrary, many mainstream politicians and economists, including some high profile ones, are pushing it hard. Even Barack Obama has arguably gone a long way down this road.

In some cases leading free market figures, usually associated with the political right, have also accepted all or part of the argument. Raghuram Rajan, the chief economic adviser to the Indian Government and a professor at the University of Chicago, was one of the first to blame excessive inequality for the crisis.

The pro-market Economist magazine, although not going as far as Rajan, has argued for a “new progressivism” where “the priority should be a Rooseveltian attack on monopolies and vested interests”. Its reference is to Theodore Roosevelt, the American president from 1901-09, who was an avid “trust buster”: a supporter of the break-up of corporations when it was deemed they had become too large.

This article will examine the claim that high inequality is to blame for the crisis. It will consider both whether it played a direct role or whether the impact was indirect. In addition, it will outline the political consequences of such arguments as well as outlining an explanatory alternative.

The account will focus on the US as it is widely regarded as the place where the global crisis began. It also remains the largest economy in the world by a substantial margin. However, similar claims have been made on the damaging economic impact of inequality in Britain (see “Inequality a symptom not a cause” Fund Strategy, 28 May 2012).

Widening inequality
It is almost universally accepted across the political spectrum that inequality in the US has widened substantially in recent decades. For instance, a 2011 study by the Organisation for Economic Cooperation and Development, Why Inequality Keeps Rising, noted that inequality in the US started to increase in the late 1970s and has continued to widen since.

There are numerous ways in which inequality can be measured but recent years have seen a particular focus on what is sometimes called “top inequality”. In more colloquial terms this means focusing on, say, the growing wealth of the top 1 per cent, or even the top 0.1 per cent, rather than merely the richest 10 per cent.

Two French economists have pioneered the collection of data on top incomes: Emmanuel Saez of the University of California, Berkeley and Thomas Piketty of the Paris School of Economics. Their data on many countries is freely available to examine and download on the World Top Incomes Database. Graph one shows their take on the growing income share of America’s richest 1 per cent.

This broad acceptance that inequality has widened since the 1970s still leaves much open for debate. For instance, there are disagreements on the extent to which average incomes in the US have foundered over the same period (see “Average incomes ‘did not stagnate’”, Fund Strategy, 30 April 2012).

There is also ample room for debate about the cause for this widening of inequality. Globalisation and the increasing importance of education are two of the most popular reasons given but there are alternatives.

The focus here is not on these questions, important as they are, but on whether inequality caused the crisis. In this respect Paul Krugman, a Nobel prizewinner in economics and a New York Times columnist, made some useful distinctions in a 2010 talk on how the crisis can beunderstood. For Krugman, there are three broad possibilities:

* It could simply be a coincidence that inequality rose sharply for many years preceding the crisis.
* There could be actual causation. High inequality could somehow create economic vulnerabilities.
* There could be what he called “common causation”. In other words both widening inequality and the crisis could be caused by a common factor. For Krugman, neoliberal ideology, or what is often called free market economics, could be responsible for both.

The idea that the two are a coincidence need not detain us long at this point. There are clearly other explanations for the crisis that need not involve inequality. For instance, it has been explained in relation to the misdeeds of the financial sector and with reference to global economic imbalances (“A balancing act”, Fund Strategy, 17 August 2009).

However, it is worth noting at this point that it is possible to combine these alternative explanations with the inequality argument. Most obviously, the swelling of the banking sector in the run-up to 2008 is clearly compatible with growing wealth among those who worked on Wall Street.

Direct cause: demand gap
The most straightforward explanation for the link between inequality and the crisis is what could be called the demand gap. There are many variations of this idea but at its core is the argument that most Americans, suffering from stagnating incomes, could not afford to buy everything they needed. This shortfall in consumption hit corporations, as their markets were limited, and ultimately the economy as a whole.

Most of the increase in wealth in society was, according to this view, going to those at the very top. Yet there is a limit to how much they super-rich can consume. There are only so much yachts they can sail in or private jets with which they can fly around the world. For this reason the super-rich tend to save a high proportion of their money rather than spend it all.

The next stage in the argument is typically that the financial bubble emerged in response to the lack of overall demand. Financial institutions were encouraged to lend more by the authorities as the alternative was economic lethargy. Although this approach worked well in the short-term in the long-term it led to the inflation of a financial bubble and subsequent bust.

This kind of explanation was at least hinted at in an important speech given by Barack Obama in Osawatomie, Kansas, in December 2011. The president referred to inequality six times including in the following passage:

“Now, this kind of inequality — a level that we haven’t seen since the Great Depression — hurts us all. When middle-class families can no longer afford to buy the goods and services that businesses are selling, when people are slipping out of the middle class, it drags down the entire economy from top to bottom. America was built on the idea of broad-based prosperity, of strong consumers all across the country. That’s why a CEO like Henry Ford made it his mission to pay his workers enough so that they could buy the cars he made. It’s also why a recent study showed that countries with less inequality tend to have stronger and steadier economic growth over the long run.”

Osawatomie was deliberately chosen as the venue for the speech for its symbolism. It was where Theodore Roosevelt gave an important speech in 1910 on what he called the “new nationalism”. In it he advocated both equality of opportunity for citizens and greater government control over large corporations. Obama was, at least by implication, suggesting a similar initiative against today’s super-rich “robber barons” who benefited from a new Gilded Age leading.

Robert Reich, who has acted as an adviser to Obama and was Secretary of Labor [SIC] under Bill Clinton, has promoted a more explicit version of the inequality thesis. In his 2012 book Beyond Outrage (Vintage 2012), which is dedicated “to the Occupiers”, he blames the lack of purchasing power for the anemic recovery. “Becomes so much income and wealth have gone to the top, America’s vast middle class no longer has the purchasing power to keep the economy going – not, at least, without getting deeper and deeper into debt”.

This argument follows a claim that all the economic gains from the previous three decades had gone to wealthy. Reich overtly argues that America has returned to a Gilded Age in which the US economy is dominated by the super-rich.

But it was Rajan, also a former chief economist at the International Monetary Fund, who first gave a high profile to the inequality argument. His Fault Lines (Princeton 2010) won the Financial Times and Goldman Sachs Business Book of the Year Award for 2010 (reviewed in “Faulty project fails to reach core”, Fund Strategy, 17 January 2010).

The main driver of inequality in Rajan’s telling is rapid technological change. This in turn created a situation in which the best educated could exploit to their financial advantage. The incomes of the rest of society fell behind as a result.

For Rajan technological change and educational inadequacies provide the backdrop to what has become a familiar story. In response to this growing inequality the US authorities create an artificial credit boom. For instance, the housing market was deregulated to make it easier for those on low incomes to borrow. Such measures helped created the housing boom that later turned to bust.

This story of crisis as the result of underconsumption would be familiar to earlier generations of economists. For instance, it was an important stream of thinking during the Great Depression of the 1930s. Back then many economists argued that the underlying problem was lack of consumption by the mass of the population. From this perspective it followed that economic stimulus should play a key role in any economic solution.

Indirect cause: rent-seeking
However, many contemporary accounts of inequality and the crisis add an additional twist to the argument. Typically they accept that underconsumption is a key problem but argue additional factors must be taken into account.

Although there are variations in the arguments they generally focus on how the super-rich have allegedly corrupted the political process. The basic idea is that the wealthy have increasingly engaged in what economists call “rent-seeking”: rather than creating new wealth they have concentrated on manipulating politics to help them gain control over existing wealth. In popular parlance the debate often focuses on how Wall Street have used lobbying to corrupt the political process.

Often the theory of rent-seeking is accompanied by the idea of regulatory capture. In other words powerful business interests have come to control the state institutions that are meant to regulate them.

Once again the popular focus is often on Wall Street. Regulatory institutions such as the Securities and Exchange Commission are seen as being dominated by financial interests.

Such political manipulation by the super-rich is often portrayed as a key component of the economic crisis. It is typically blamed both for widening inequality and for the creation of a bloated financial sector.

This in essence is what Paul Krugman means by common causation. Inequality and the crisis both have common roots. In his telling the fundamental problem is the free market ideology that allowed both to come about.

In Krugman’s most recent book, End This Depression Now! (Norton 2012), he focuses on how the financial system persisted with deregulation despite it being “a recipe for trouble”. This happened at the same time as the very rich were making a lot of money for unregulated finance.

So for Krugman: “while rising inequality wasn’t the main direct cause of the crisis, it created a political environment in which it was possible to notice or act on the warning signs”.

Krugman also blames neo-liberal ideology for the US’s failure to counteract the impact of the crisis. In his view the solution is to have a sufficiently large stimulus to bolster demand and get the economy moving again. For Krugman free marketeers are, selfishly and irrationally, opposed to such measures.

Joseph Stiglitz, another Nobel price winner, provides a variation on Krugman’s themes. Stiglitz was responsible for developing the one per cent as dominating the rest of society. His most recent book, The Price of Inequality (Allen Lane 2012) is probably the single most influential book on the subject.

In Stiglitz’s telling there is a damaging interaction between three factors: excessive inequality, failures of the political system and economic instability. Combined together these factors have led to the US’s current plight.

Stiglitz too puts a heavy emphasis on the dangers of rent-seeking. He accepts that the normal operation of market forces leads to a degree of inequality but political manipulation can take it much further: “Much of the inequality that exists today is a result of government policy, both what the government does and what it does not do. Government has the power to move money from the top to the bottom and the middle, or vice versa.”

For Stiglitz, as for many other commentators, the solution lies at several different levels. “Addressing inequality is of necessity multifaceted – we have to rein in excesses at the top, strengthen the middle, and help those at the bottom.”

Stiglitz is not as keen on the rhetoric of progressivism as some other commentators but his conclusions are similar. Curbing the power of the super-rich, including their ability to manipulate the political process, must be a priority. He supports measures such as tighter regulation of the financial sector, stronger competition laws and stricter corporate governance.

In essence the new progressives are not advocating equality; they are not socialists of any form. Rather they are attempting to promote a new version of nationalism that emphasises the need to rein in the effects of excessive inequality. In so doing they hope to legitimise greater state intervention to curb what they see as excessive social and economic instability.

Conclusion: missing production
It is striking that all the different versions of the inequality argument have a common blind spot. All of them focus heavily on the problem of lack of demand in the economy while downplaying the weaknesses of the supply side. In other words their explanation leads heavily on insufficient consumption while they are virtually blind to the problems of production.

This weakness is most clear in relation to those who directly blame insufficient demand for economic weakness. Their arguments are reminiscent of someone who keeps on taking painkillers for a persistent headache. It may make sense in the short-term but over the longer-term it is not wise. Certainly over a period of years anyone suffering from regular headaches is best advised to seek medical advice to divine the underlying cause of the problem.

Similarly with economics the time-horizon of the discussion is typically too short. It may be that consumers are nervous about buying goods in the midst of an economic downturn but that does not explain why the economy has got into such a mess.

To understand what is going on it is best to look back at least as far as the 1980s. During that time the US authorities consistently kept public spending high, with interest rates often low, as a way of shoring up economic activity.

This approach has worked in the short-term but at the cost of storing up further problems for the future. The reason this crisis is so severe is precisely that underlying weaknesses of the productive side of the economy were not tackled at an earlier stage. Instead the authorities opted for inflating more financial bubbles that were bound to burst sooner-or-later.

Indirect theories of the financial crisis still tend to retain the assumption of a demand gap. Krugman, for instance, insists that solving the economic crisis is simply a matter of having a sufficiently large stimulus. For him the problem is cyclical. Once demand is restored the economic cycle will regain momentum and at that point it will be necessary to impose austerity.

Krugman’s approach ignores the extent to which the crisis is chronic rather than cyclical. This is not to suggest that nothing can be done. Only that it is necessary to tackle productive weaknesses rather than simply boosting consumption.

The political problems the critics of inequality identify should be seen as a symptom rather than a cause of economic weaknesses. It is clearly true that the financial sector has become extremely bloated since the 1980s. It is also the case that non-financial corporations have become increasingly concerned with financial activity. But these trends should not be seen as the result of simple avarice.

If the incomes of the top 1 per cent are more closely examined they give some indication of what is happening. As Emmanuel Saez has pointed out the incomes of the wealthy are closely tied to share options and realised capital gains (“Striking it richer: the evolution of top incomes in the United States” March 2012) . It is also true that a high proportion of the best-paid come from within the financial sector itself.

The burgeoning of the financial sector, and financial activity more generally, can itself be seen as the flip side of the weakness of the real economy. It is often more profitable for companies to manipulate finance than to engage in the real world of production.

In a sense Krugman is right to argue there is common causation between economic crisis and widening inequality. It is true that both have the same roots but it is wrong to argue that one has caused the other.

Only the link between the two is not the neo-liberal consensus blamed by Krugman. Instead it lies in a chronically weak economy that has often succeeded in generating large financial profits but has struggled to meet the needs of most people.