Inequality did not cause the crisis

In: Uncategorized

13 Jan 2012

Was inequality one of the main causes of the economic crisis?

The contention is supported by influential voices such as Bill Gross of Pimco and Raghuram Rajan, a former chief economist at the International Monetary Fund.

The question has to be unpicked carefully. There are two blind alleys to avoid.

The first is to focus on whether wide social inequalities are undesirable. Even if it is conceded that inequality is loathsome it does not necessarily mean it is responsible for the recent economic turmoil.

The alternative error is to mistake a link for a cause. It is true that wide inequalities have coincided with severe economic convulsions. But that does not necessarily prove that inequality is at the root of the crisis. It could be, for instance, that a third factor caused both widening inequality and economic turbulence.

To answer the question it makes sense to focus on America. It is the biggest economy in the world, the most unequal of the large developed countries and it is where the crisis first emerged.

Not only is America highly unequal but there is widespread agreement that inequality has widened substantially since the 1970s. Many authorities argue that a “winner takes all” society has emerged in which the rich have enjoyed most of the benefits of growth (although some, such as Bruce Meyer of the University of Chicago, partially dispute the evidence).

It is certainly clear that the average economic growth rate in the 1950s and 1960s was more rapid than in more recent decades. Again there is a correlation, although not necessarily a causal relationship, between slower growth and wider inequality.

Gross takes the argument further by contending that over several decades a combination of factors led to widening inequality and the creation of an asset bubble. These include globalisation and technological innovation as well as government policies that encouraged the build-up of debt.

He goes on to argue that recovery measures are likely to be unsuccessful unless inequality is tackled. “If Main Street is unemployed and under-compensated, capital can only travel so far down Prosperity Road”, he says.

Rajan’s argument, developed in Fault Lines (2010), is similar. He maintains that growing inequality meant that the mass of American society became more reliant on credit to maintain their living standards. This demand in turn created the basis for the surge in housing prices that eventually burst with such disastrous results.

The problem with both arguments is that they assume the fundamental weakness lies on the demand side of the economy. Since many people had insufficient income to consume they borrowed money to maintain their living standards.

Radically different conclusions follow if the problem is located on the supply side. From this perspective the sluggish character of the productive economy, evident for over three decades, is at the root of the crisis. If the economy had grown more robustly there would have been no need for such a rapid expansion of credit.

Politicians in turn exacerbated the problem by encouraging the extension of credit rather than promoting economic restructuring. Eventually the bubble had to burst.

From this perspective the widening of inequality was more of a symptom than a cause of economic weakness. The rich became richer with the emergence of the asset bubble but the underlying economy was far from healthy in the first place.

NOTE: After I wrote this article Foreign Affairs published a piece by Andrew G Berg and Jonathan D Ostry entitled “How inequality damages economies”.

This is my latest blog post for fundweb.co.uk