Has greater income equality in the United States since the 1970s, as documented by Thomas Piketty and Emmanuel Saez; (Feb. 2003 Quarterly Journal of Economics), led to greater financial instability of the financial markets, and perhaps precipitated the ‘Great Recession’ of December 2007 we are just now recovering from?
The Center for Budget and Policy Priorities (CBPP), using Piketty and Saez data, documents that income and asset inequality since the 1970s has risen to levels last seen in the 1920s (see graphs).
The amount such inequality contributes to recessions has not been well documented. Birdsall, Pinckney, and Sabot in a March 1996 Inter-American development Bank Working Paper 327 maintain that higher levels of income inequality “appear to be a constraint on growth”. But there has been no research on what level of inequality might lead to two consecutive quarters of negative GDP, the common definition of a recession.
This debate goes back to the Great Depression, when Roosevelt’s Federal Reserve Chairman Martin Eccles maintained that income inequality was a major cause of the Great Depression:
“… a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand (my italics) for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”
By effective demand, Eccles was referring to what economists today define as aggregate demand. Eccles was maintaining that the growth in income inequality created a credit bubble that burst and so led to diminishment in aggregate demand, which economists express as a formula:
where aggregate demand (Yd) is the sum of all personal consumption (C) + private investment (I) + government expenditures (G) + any net of exports over imports (X-M). There was a precipitous drop in all 4 components of aggregate demand at the beginning of the Depression. Consumers in particular cut back spending 10 percent by mid-1930, in response to their stock market losses and reluctance to add new debt.
It was JM Keynes who tied aggregate demand to aggregate output, and Robert Samuelson who refined it: “The equilibrium level of output is potentially any level up to the full employment level. Which level of output actually happens to be the equilibrium depends entirely upon aggregate demand – hence aggregate demand is the primary determinant of the equilibrium level of output. This is indisputably the central message of Keynes’s theory: given any level of aggregate demand, producers will try to meet that demand and thus aggregate output will rise or fall to equate the given aggregate demand.”
Murat Iyigun and Ann Owen in the April 2004 issue of Economic Journal, “Income Inequality, Financial Development and Macroeconomic Fluctuations” maintain that in more developed economies, an increase in inequality means that there are more poor households, and so a decrease in aggregate demand.
Because poor households do not have the same ability to borrow as the rich, when they fall on hard times, they must reduce their spending, say Iyigun and Owen. Rich households, however, are able to borrow and do not have to reduce their consumption when their income is temporarily low. As a result, when there are more poor people in an economy, consumer spending will be more variable. Because consumption accounts for such a large portion of GDP (or national income), more variable consumption leads to greater GDP volatility as well.
Iyigun and Owen’s conclusion is that “the distribution of income can affect an economy’s ability to adapt to external shocks when the ability to obtain credit depends on income”.
The Great Recession of December 2007 began with such a shock—the collapse of the housing market. It precipitated a sharp drop in consumer spending, and so caused the plunge in GDP growth. This led to a “bank panic”, according to Yale economist Gary Gorton.
In a February 20, 2010 report to the U.S. Financial Crisis Inquiry Commission, Professor Gorton maintained that our most serious financial crises of the nineteenth and twentieth centuries were caused by bank panics. Whereas the 1929-30 panic was due to a run on bank deposits (due to a lack of deposit insurance), the current bank panic began on August 9, 2007 in the unregulated ‘repo’ market for sale and repurchase agreements, conducted within the highly leveraged ‘shadow’ banking system of non-bank financial entities that had escaped regulators’ scrutiny.
The discovery of links between income inequality and recessions may therefore lie in more historical research that measures the factors that lead to extreme volatility in aggregate demand. The large increase in income inequality that happened since 2000 in conjunction with the housing and credit bubbles probably raised household debt-to-income ratios to historic highs and decreased the personal savings rate to a historical low, as middle and lower-income households struggled to maintain their standard of living with declining income. High credit usage with low savings rates creates tremendously unstable financial markets, and so could have been the ultimate cause of the Great Recession.
We do have some current research that shows “credit booms gone wrong”, are a major cause of recurrent episodes of financial instability, per a recent NBER Working Paper No. 15512 by Moritz Schularick and Alan Taylor. In “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial crises, 1870-2008”, Schularick and Taylor maintain that the huge growth in the use of credit and increasingly complex forms of leverage led to an unprecedented level of risk throughout the credit system up to 2008.
The existing evidence seems to imply that the bank panics of 1929-30 and 2007-08 (that burst their respective credit bubbles) were caused by such an unequal distribution of income, as the historical record implies.
Harlan Green © 2010
