The Disparity Bubble: How Inequality Fed the Financial Crisis

By Walsh, James | Kennedy School Review, Annual 2012 | Go to article overview

The Disparity Bubble: How Inequality Fed the Financial Crisis


Walsh, James, Kennedy School Review


One of the painful lessons of the Great Recession has been that markets do not operate in a vacuum. They are influenced by a variety of external factors, including socioeconomic dynamics, norms of behavior, and institutions. Conversely, the market also has the capacity to shape our politics and society by creating and directing financial resources toward lobbying and campaign donations. The complex interplay between the market and society becomes evident when examining the relationship between economic inequality and the Great Recession. Though many economists dismiss equality as a normative concern outside their discipline, the recession demonstrates that chronic inequality can contribute to macroeconomic inefficiency. As such, today's deepening levels of inequality should be a concern not only to Occupy Wall Street sympathizers but also to all economists.

AN EMPIRICAL RELATIONSHIP

Media attention has focused on the United States' extraordinary inequality in the wake of the Great Recession. Less attention, however, has been devoted to inequality in the lead-up to the crisis. Recently, an increasing number of people have started to explore this connection between inequality and economic stability. From disenfranchised activists to prominent economists, there is growing support for the idea that the deeply unequal economic environment in the United States helped to facilitate the reckless behavior of the financial sector that ultimately led to the financial collapse in 2008.

David Moss, a professor at Harvard Business School, has graphed the association between market deregulation, financial instability, and income inequality in the United States over the past century (2010). As he notes, financial crises and bank failures were commonplace in the United States until 1933, when Congress passed the Glass-Steagall Act establishing strong federal financial regulations. For the next fifty years, financial instability was effectively eradicated. But after anti-regulation philosophy became increasingly pervasive in Washington during the late 1970s and deregulatory policies were adopted in the early 1980s, financial crises began to reemerge.

Income inequality in the United States has followed a broadly parallel trend. It increased in the years prior to the Great Depression before falling rapidly in the years immediately after. For almost forty years, it remained relatively low, then in the early 1980s it began to balloon once again. Remarkably, income inequality peaked both in 1928 and 2007, the years immediately preceding the Great Depression and the Great Recession.

Of course, this extraordinary correlation between income inequality and financial crises does not necessarily spell causation. A causal relationship requires a convincing story of how inequality led to the crisis.

MORTGAGES: ESCAPE VALVES FOR THE 99 PERCENT

Raghuram Rajan, an economist at the University of Chicago and former chief economist of the International Monetary Fund (IMF), tells this causal story as one of populist government failure caused by the rising income inequality that began in the 1980s (2010). He argues that the stagnant real wages that marked this era created political pressure to increase incomes. Responding to demands for cheap credit from their low-income constituents, politicians eased housing credit restrictions, allowing millions of low- and middle-income workers to buy homes for the first time and pay for increased consumption through the equity in their homes. The end result was the illusion of rising living standards.

As a result of this policy, home ownership rose significantly. This politically appealing solution not only appeased popular angst over flattened incomes but also fit America's narrative as a property-owning democracy. Moreover, it helped boost the economy by stimulating demand in the construction sector. Policy makers thought that the costs of expanding access could be reasonably delayed for years to come. …

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The Disparity Bubble: How Inequality Fed the Financial Crisis
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