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Wednesday, June 13, 2012

Did Income inequality Contribute to the Great Recession?

I recently questioned the strength of the evidence supporting the hypothesis that income inequality caused the Great Recession. Till van Treeck explains why we should believe its causal:

How income inequality contributed to the Great Recession, by Till van Treeck, Commentary, guardian.co.uk: The idea that the Great Recession of 2008 may have been caused not just by careless banking but also social inequality is currently all the rage among macroeconomists.
Much of the impetus for the current debate stems from the widely discussed 2010 book Fault Lines, written by Raghuram Rajan... Rajan argues that many lower- and middle-class consumers in the United States have reacted to the stagnation of their real incomes since the early 1980s by reducing saving and increasing debt. This has temporarily kept private consumption and thus aggregate demand and employment high, but also contributed to the creation of the credit bubble which eventually burst.
In Rajan's view, a large portion of the blame for this falls on misguided government policies, which promoted the expansion of credit to households. ...
In 1996, Alan Greenspan, then chairman of the Federal Reserve Bank, noted in response to growing concerns about rising inequality that "wellbeing is determined by things people consume [and] disparities in consumption … do not appear to have widened nearly as much as income disparities". In a similar vein, Fabrizio Perri and Dirk Krueger suggested in an influential scholarly article published in 2006 that "consumers could, and in fact did, make stronger use of credit markets exactly when they needed to (starting in the mid-1970s), in order to insulate consumption from bigger income fluctuations". ...
There is ample evidence that, especially in the US, households reacted to higher inequality by working longer hours, lowering savings, and increasing debt in an attempt to maintain their relative consumption status. Up to a point this allowed them to pay for medical bills, the ever-increasing costs of children's college education and a house; but eventually the bubble burst. ...
The renewed interest among economists in inequality as a macroeconomic risk is highly encouraging. Undoubtedly more research is needed to pin down the macroeconomic implications of inequality under different country-specific circumstances. But it should be clear that, in hindsight, the dominant textbook economic theories of consumption look almost as toxic as some of the credit products that ultimately caused the crisis.

A couple of things. First, new evidence suggests that consumption inequality has been just as bad as income inequality. That casts doubt on stories that rely upon consumers using debt to finance consumption growth while income remained stagnant. Second, the story is more consistent with a general credit bubble than a bubble in housing in particular. Third, I have pushed back strongly against stories that say the crisis was caused by government support of housing programs to lower income households. The evidence for this simply isn't there.

Again, I am not saying that the evidence stacks up against the idea that inequality contributed to the recession, it could very well be true. What I'm saying is that the evidence I'm aware of doesn't tell us much one way or the other. (And I certainly don't want to imply that there are no problems associated with rising inequality beyond the risk of credit bubbles.)

    Posted by on Wednesday, June 13, 2012 at 10:24 AM in Economics, Income Distribution | Permalink  Comments (32)


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