U.S. | Rising innequalities in the United States was a root cause of the financial crisis

As noted by The Economist, “[s]everal prominent economists now reckon that inequality was a root cause of the financial crisis.” Indeed, in recent years there has been a proliferation of analyses supporting this view writes Till van Treeck in Did inequality cause the U.S. financial crisis? published on boeckler.de.

The explanation is straightforward: As the benefits of rising aggregate income over the past decades were confined to a rather small group of households at the top of the income distribution, the consumption of the lower and middle income groups was largely financed through rising credit rather than rising incomes.

This process was facilitated by government action, both directly through credit promotion policies and indirectly through the deregulation of the financial sector. But with the downturn in the housing market and the sub-prime mortgage crisis starting in 2007, the overindebtedness of the U.S. personal sector became apparent and the debt-financed private demand expansion came to an end.

In his widely discussed book “Fault Lines” (2010), Raghuram Rajan argues that many U.S. consumers have reacted to the decline in their relative permanent incomes since the early 1980s by reducing saving and increasing debt.

Rajan (2010, p. 9) succinctly summarises his argument as follows:

“[T]he political response to rising inequality – whether carefully planned or an unpremeditated reaction to constituent demands – was to expand lending to households, especially low-income ones. The benefits – growing consumption and
more jobs – were immediate, whereas paying the inevitable bill could be postponed into the future. Cynical as it may seem, easy credit has been used as a palliative throughout history by governments that are unable to address the deeper anxieties of the middle class directly. […] In the United States, the expansion of
home ownership – a key element of the American dream – to low and middleincome households was the defensible linchpin for the broader aims of expanding
credit and consumption. But when easy money pushed by a deep-pocketed government comes into contact with the profit motive of a sophisticated, competitive, and amoral financial sector, a deep fault line develops.” (Rajan, 2010, p. 9)

This has temporarily kept private consumption and thus aggregate demand and employment high, despite stagnating incomes for many households. But it also contributed to the creation of a credit bubble, which eventually burst, and a large current account deficit in the United States. The author places the Rajan hypothesis in the context of competing theories of consumption, and survey the empirical literature on the effects of inequality on household behaviour beyond the largely anecdotal evidence provided in Rajan (2010).

There is substantial evidence that the rising inter-household inequality in the United States has importantly contributed to the fall in the personal saving rate and the rise in personal debt (and a higher labour supply). Aided by the easy availability of credit, lower and middle income households attempted to keep up with the higher consumption levels of top income households. This has contributed to the emergence of a credit bubble which eventually burst and triggered the Great Recession. In other words, there is strong support for the Rajan hypothesis beyond the anecdotal evidence presented by Rajan and the evidence from cross-country panel regressions. In addition, the Rajan hypothesis, while inconsistent with the permanent income hypothesis, calls for a renaissance of the relative income hypothesis.

Full Paper @ http://www.boeckler.de/pdf/p_imk_wp_91_2012.pdf