Monday, May 21, 2012

Inequality: the cause of crisis and depression?

by michael roberts

The inequality issue has risen its head again.  Paul Krugman took it up big time again in his New York Times column: "Did the rise of the 1 percent (or, better yet, the 0.01 percent) cause the Lesser Depression we’re now living through? It probably contributed. But the more important point is that inequality is a major reason the economy is still so depressed and unemployment so high. For we have responded to crisis with a mix of paralysis and confusion — both of which have a lot to do with the distorting effects of great wealth on our society.....There would have been a broad bipartisan consensus in favor of strong action, and there would also have been wide agreement about what kind of action was needed.  But that was then. Today, Washington is marked by a combination of bitter partisanship and intellectual confusion — and both are, I would argue, largely the result of extreme income inequality."

Krugman sees the role of inequality in policy action i.e. rich people don't want to change anything.  But there is a much bigger body of left economists including Marxists who reckon inequality is not just unfair, it is the main economic cause of the crisis.  There is a long line of academic papers supporting this view.  I cannot go through all of them in this post.  Indeed, I don't know where to start and to stop, with so many books and papers coming out explaining that the rising inequality of income and wealth in the major capitalist economies has created instability and depression.  But let me outline some the key arguments presented.

Take James Galbraith's new book called Inequality and Instability.  In this book, by the son of the famous 'New Deal' Keynesian economist, JK Galbraith, it is argued that "As Wall Street rose to dominate the U.S. economy, income and pay inequalities in America came to dance to the tune of the credit cycle."  Galbraith argues that the rise of the finance sector was the driveshaft that linked inequality to economic instability.

And the ex-chief economist of the World Bank, Nobel prize winner and now scourge of mainstream economics, Joseph Stiglitz, takes the same position.  Why might widening inequality lead to a banking crisis?  Stiglitz's theory is that  “growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can’t spend it all.”  This flood of liquidity then “contributed to the reckless leverage and risk-taking that underlay this crisis,” he asserts.  In a related view, called the Stiglitz hypothesis, Sir Anthony Atkinson and Salvatore Morelli propose that “in the face of stagnating real incomes, households in the lower part of the distribution borrowed to maintain a rising standard of living,” and “this borrowing later proved unsustainable, leading to default and pressure on over-extended financial institutions.”  And in previous posts, I have noted that the great guru of crisis economics, Nouriel Roubini, raised growing inequality as the key cause of capitalist crisis (see my post, 1% versus 99%, 21 October, 2011) - in particular, see Roubini’s, The instability of inequality, 

Michael Dumhoff and Romain Ranciere from the IMF argue that "long periods of unequal incomes spur borrowing from the rich, increasing the risk of major economic crises"  (  According to Dumhoff and Ranciere, something happens to lead to income stagnation for middle and low-income workers, while high-income households acquire more capital assets.   This increases the savings of wealthy households relative to lower-income households.  In order to keep their living standards from declining, the middle class borrows more.  Financial innovations, including new types of securitization, increase the liquidity and lower the cost of loanable funds available to the borrowers.  So the "bottom group’s greater reliance on debt— and the top group’s increase in wealth — generated a higher demand for financial intermediation and the financial sector thus grows rapidly as do the debt-to-income ratios of the middle class relative to the wealthy. The combination of rising middle class debt and stagnant middle class incomes increases instability in financial markets, and the system eventually crashes."

It's true that US aggregate debt-to-income across all income groups grew consistently with the income share of the top 5% both before the Great Depression and Great Recession.  This increase was a considerably sharper in recent years for the bottom 95% than the top 5%.

But is this growing inequality and rising debt the cause of slumps?  A paper by Michael Bordo and Christopher Meissner from the Bank of International Settlements analysed the data and concluded that inequality does not seem to be the reason for a crisis. Credit booms mostly lead to financial crises, but inequality does not necessarily lead to credit booms. "Our paper looks for empirical evidence for the recent Kumhof/Rancière hypothesis attributing the US subprime mortgage crisis to rising inequality, redistributive government housing policy and a credit boom. Using data from a panel of 14 countries for over 120 years, we find strong evidence linking credit booms to banking crises, but no evidence that rising income concentration was a significant determinant of credit booms. Narrative evidence on the US experience in the 1920s, and that of other countries, casts further doubt on the role of rising inequality."

Edward Glaesar also points to research on the US economy that home prices in various parts of the US did not always increase where there was the most income inequality. That calls into question the claim that income inequality was inflating the housing bubble. He concludes: "Professors Atkinson and Morelli's international data also suggest little regular connection between inequality and crises. Looking at 25 countries over a century, they find ten cases where crises were preceded by rising inequality and seven where crises were preceded by declining inequality."  Moreover, inequality was higher in two of the six cases where a crisis is identified, which is exactly the same proportion as among the 15 cases where no crisis is identified.

Now don't get me wrong.  I am not saying that there has not been rising inequality of income and wealth in most major capitalist economies during the so-called 'neoliberal ' era from the 1980s.  Indeed, in various posts (Karl Marx was right (partly),16 August 2011; Inequality, poverty and riots, 6 December 2011), I have highlighted the growing body of research that reveals this grotesque feature of modern capitalism.

Now let me add the very latest research to that.  In a working paper from the OECD, Kaja Bonesmo Frederiksen (Income inequality in the European Union, OECD Working paper 952, 16 April 2012), found that inequality had risen quite substantially since the mid 1980s and that the large gain accruing to the top 10% of earners was the main driver of this inequality.   The reason that the top 10% did better was down to a decline in progressive taxation, rising capital gains from property and share ownership, so-called performance related pay, weaker trade unions and globalisation - indeed all the elements of the neo-liberal era.

I did some analysis of the OECD paper and found that the ratio of the share of real disposable income growth going to top 10% over growth in income going to the bottom 10% averaged 2.6 times for the European Union, 9.1 times for the UK and a staggering 21.9 times for the US.  That means the top 10% of income earners in the US got 22 times more growth in income that the bottom 10% between the mid-1980s and 2008.  Only in France and Greece was income growth for the bottom 10% faster than for the top 10%.  The most 'neo-liberal' capitalist economies saw the most unequal expansion in incomes.  While the bottom 10% of income earners in Europe managed just 0.87% annual increase in real disposable income from the mid-1980s to 2008, the top 10% got 2.23% a year.  And the top 10% of British income earners did best in the whole of the OECD, experiencing 4.2% average annual growth in real disposable income, while the bottom 10% got only 0.5% annual increase a year over the last 30 years.

But it is one thing to recognise that inequality has rocketed in the last 30 years and quite another to claim that this explains the credit crunch and the Great Recession.  What is wrong theoretically with this argument is that it assumes, as the Keynesians do, that the fundamental weakness of capitalism 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 (with the cause to be found in profitability).  From this perspective, falling profitability explains the sluggish character of the productive economy and is at the root of the crisis.  If the economy had been more profitable, there would have been less need for such a rapid or 'excessive' expansion of credit.   From this perspective the widening of inequality is 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.

Also it is odd to claim that the cause of the Great Recession of 2008-9 was growing inequality.  We did not hear that argument to explain the crises of the 1970s and 1980s.  The cause then was not assigned to inequality of income or wealth.  Indeed, many mainstream and heterodox economists argued the opposite, namely that it was caused by wages rising to squeeze profits in overall national income – see chapter 20 in my book, The Great Recession.  But now, many Marxist economists argue that this current crisis is a product of wages being too low and profits too high.  This leads to low wage earners being force to borrow more and thus eventually causing a credit crisis.  So it seems that the underlying cause of capitalist crisis can vary.  The trouble with this eclectic approach is that it becomes unclear what the cause of capitalist crisis is – is it wages squeezing profits as in the 1970s or is it low wages leading to excessive credit in the 2000s and then a collapse of demand in 2008?

And then there are the policy implications.  If the cause of capitalist crisis - or at least this particular crisis - is due to growing inequality of income and wealth, then it easy to see what the policies are needed to correct this faultline in capitalism: more equality.  With higher wages, more progressive taxes and more regulation of bankers and their bonuses, the current depression can be overcome and future crises can be avoided.  There is no need to replace the capitalist mode of production, just the current structure of distribution.

That this the policy conclusion that will be reached is confirmed by a recent post from Robert Reich on his blog (  Reich, a former advisor to Clinton, has been a tireless fighter against the bankers, the neo-liberal Republicans and injustices of modern capitalism.  He wrote a book arguing that inequality was the main cause of crisis (Aftershock, 2010).  In a recent post, he drew the following policy conclusions: "Socialism isn’t the answer to the basic problem haunting all rich nations.The answer is to reform capitalism. The world’s productivity revolution is outpacing the political will of rich societies to fairly distribute its benefits. The result is widening inequality coupled with slow growth and stubbornly high unemployment. The problem is not that the productivity revolution has caused unemployment or under-employment. The problem comes in the distribution of the benefits of the productivity revolution. A large portion of the population no longer earns the money it needs to live nearly as well as the productivity revolution would otherwise allow. It can’t afford the “leisure” its now experiencing involuntarily.  Not only is this a problem for them; it’s also a problem for the overall economy. It means that a growing portion of the population lacks the purchasing power to keep the economy going."

So what's the answer?  "It doesn’t mean socialism. We don’t need socialism. We need a capitalism that works for the vast majority. The productivity revolution should be making our lives better — not poorer and more insecure. And it will do that when we have the political will to spread its benefit. "

Inequality of wealth and income: the rich alongside a mass of poverty.  This has always been a feature of class societies, including capitalism. As Marx said, all history is really the history of class struggle.  What that means is the struggle to control the surplus created in any society.  But inequality is not the cause of crises.   Booms and slumps took place before inequality rose to current extremes. They can take place even when there is relative equality: indeed the drive for equality of income now would eat into profit shares and could exacerbate the crisis.  And more equality will not stop slumps

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