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Does income inequality lead to global busts?

US demographics | Does income inequality lead to global busts? Anthony Harrington

Back in 2010, Raghuram Rajan of the University of Chicago put the spotlight on income inequality as the real villain behind the 2008 global bust in his book, Fault Lines. With almost everyone else looking at global credit imbalances, light-touch regulation of financial services, and dangerous innovation in the derivatives space as the probable causes, Rajan’s proposition seemed less than intuitively obvious. The general sense of things is that income inequality has been around for about as long as we’ve had civilized societies. The Biblical quotation attributed to Jesus, “The poor have ye with you always,” just about sums it up. There have always been haves and have-nots.

However, the case for income inequality as the root cause of crashes is rather subtle and worth stating. At bottom the argument is a simple one. In democracies, governments have to take note of deep groundswells of public opinion—the issues that move the masses—or they get heaved out of office at the next election. This means that if income inequality is growing, or people think it is growing, and it is causing a rise in dissatisfaction among large numbers of the voting public, politicians will respond.

They can’t do a “helicopter Ben” and shower dollar bills down on the population, but what they can do is to pass laws and put pressure on banks to lower their lending criteria, so that it is easier for Joe Public to get credit.

In a very thoughtful article on this theme, The Economist cites one of Rajan’s key arguments:

“From the early 1980s the wages of working Americans with little or no university education fell ever farther behind those with university qualifications, he (Rajan) pointed out. Under pressure to respond to the problem of stagnating incomes, successive presidents and Congresses opened a flood of mortgage credit.

“In 1992 the government reduced capital requirements at Fannie Mae and Freddie Mac, two huge sources of housing finance. In the 1990s the Federal Housing Administration expanded its loan guarantees to cover bigger mortgages with smaller down-payments. And in the 2000s Fannie and Freddie were encouraged to buy more subprime mortgage-backed securities. Inequality, Mr Rajan argued, prepared the ground for disaster.”

Some time ago I wrote a blog post citing a transcript of the historic meeting where President Bill Clinton signed away the Glass–Steagall Act. That transcript shows that Clinton’s prime motivation appeared to be his belief that if banks were unfettered two things would happen. One, they (the banks) would grow enormously in wealth, to the great benefit of the US economy. (And of course we’ve all seen how that turned out). And two, as a quid pro quo for the abolition of Glass–Steagall, the banks would step up and lend more to poorer people so that the great American dream of home ownership could percolate downwards and come within everyone’s reach, which would redound to the credit of the Democratic Party. The end result of this vision, again as we have all had ample opportunity to witness, was the grand US subprime mortgage debacle.

The temptation is to join the dots, as many a Republican does, and lay the blame for the 2008 smash firmly at Clinton’s door. But of course, in Rajan’s account, Clinton is simply behaving as most politicians would, in that he is responding to democratic pressures whose root cause lies in income inequality. So, blaming Clinton is ultimately all about blaming income inequality, and most Republicans are staunch supporters of “earn it, keep it,” which is, of course, the capitalist way, and a great formula for enhancing income inequality. Blaming Clinton, in that sense, for a Republican, is like trying to have your cake and eat it. It flouts the logical rule, “Not both ‘A’ and ‘not-A.’” Which makes it nonsense.

The twin propositions that politicians in democracies respond to pressure and that income inequality generates pressure seem irrefutable. The Economist cites a paper by two International Monetary Fund economists, Michael Kumhof and Romain Rancière, which argues that:

“… an investor class may become better at capturing the returns to production, slowing wage growth and raising inequality. Workers then borrow to prop up their consumption. Leverage grows until crisis results.”

However, one can also find economists, The Economist points out, who argue that while inequality may give rise to politically inspired credit booms which lead to busts, there is no “iron law” here. Rising real incomes and low interest rates reliably lead to credit booms. Inequality, on the other hand, may or may not lead to a credit boom, depending on the circumstances. Sometimes in history, the poor just stay poor and no politician comes along to “fix” things… Rajan might just as well have argued that the root cause of busts is not income inequality, but idiot politicians…

Further reading on demographics and democracy:

Tags: Bill Clinton , demographics , Fault Lines , Glass-Steagall Act , global busts , income inequality , Raghuram Rajan , Republicans , United States of America
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