Did Income Inequality Cause the Financial Crisis?
Policymakers and academics have identified income inequality as a proximate cause for a number of society’s ills, from deteriorating social cohesion and unhappiness to high mortality rates. But could America’s widening income gap also be responsible for the 2008 financial crisis?
That’s the controversial conclusion reached by economists Michael Kunhof and Romain Rancière, whose 2011 report for the IMF explains how rising inequality incentivizes poorer households to over-leverage, eventually leading to financial crises. In their model, households are broken down into two groups—the richest 5 percent, representing capital; and the bottom 95 percent, representing labor. As in the real world, Kunhof and Rancière assume the capital group experiences large and persistent income gains over time, while wages for labor grow slowly or stagnate. But the top 5 percent cannot consume all of their disposable income (you can only buy so many cars), so they create financial wealth through loans to the bottom 95 percent, who need credit to maintain their accustomed level of consumption. As inequality grows, credit supply from the top and credit demand from the bottom expand simultaneously, increasing the probability of systemic default as risk and debt build.
If Kunhof and Rancière’s model sounds familiar, that’s because it is. In the United States, real average annual earnings for production and other non-supervisory workers peaked in 1972 at $40,884, while total consumer credit amounted to just $2,804 per person. By 2008, average annual earnings had fallen by $6,408 to $34,476, and households were making up the gap with an extra $4,940 in credit per person—more than triple the ratio of credit to earnings as in 1972.
As in Kunhof and Rancière’s model, U.S. politicians responded to growing income inequality and stagnating median wages in the years leading up to the financial crisis by promoting policies to prop up the living standards of the indebted lower and middle class. But instead of addressing the root causes of inequality (such as regressive tax policy and declining collective bargaining power), they cut the cost of borrowing even more, pouring gasoline on the already fiery housing market. Low income families were incentivized to take on second and third mortgages they could not afford, and the financial class pounced—diverting capital into financial gimmicks like mortgage-backed securities to obfuscate and distribute the underlying risk.
There is some disagreement within the economic community as to whether the relationship between higher levels of inequality and financial crises are causal or correlational. But consider this: when someone making $20,000 a year gets a raise, they spend it. When someone making $2,000,000 a year gets a raise, they invest it. And as an ever greater share of national income accumulates at the top (and discretionary income for the bottom 95 percent stagnates), the greater the demand for high-yield financial innovation independent of the faltering demand-side consumer economy. Until real median wages rise and the income gap begins to narrow, debtor nations such as ours will continue this disastrous boom-bust cycle.
Graph of the Day: Household Credit Market Recovering, But Student Debt Soars
By Benjamin Landy
Two years after the nadir of the recession in early 2009, the household credit market is slowly stabilizing. According to the latest data from the Federal Reserve Bank of New York, loan defaults and delinquency rates are falling for car payments, mortgages and credit cards, with total household debt down over a trillion dollars from its peak. In other words, Americans are finally getting their borrowing and debt payments under control—with one major exception. Student debt continues to rise ominously, with loan delinquency up 30 percent since 2009, and a whopping 400 percent in the last decade.
Bucking the deleveraging trend, total student loan debt has multiplied fivefold in the last ten years, from just $120 billion in 2001 to around $550 billion today—and shows no signs of stopping. Contra the NY Fed, the New York Times estimates that student loan debt has already outpaced credit card debt, and will likely top a trillion dollars this year.
Source: New York Federal Reserve Bank
The graph above illustrates how much better Americans have gotten at meeting their loan obligations on time: delinquency rates are generally back to where they were in late 2006, before the beginning of the financial crisis. But student loan delinquency has continued to rise, surpassing Home Equity Line of Credit (HELOC) and mortgages in growth.
The graph below zooms in on the change in loan delinquencies since 2009, at the trough of the recession, highlighting the seriousness of the problem: while students have less money than ever to pay for college, demand for higher education has only grown. Loans are the only available option for most students, even though they are finding them harder and harder to pay back.
Part of the problem is that, over time, the federal government’s commitment to student aid has changed in focus—increasingly relying on loans, rather than grants. Richard Kahlenberg, a Senior Fellow at The Century Foundation and an expert on education policy, is worried:
“Students, particularly those from low-income and working class families, are trapped in a double-bind. On the one hand, over time, federal financial aid has shifted from grants to loans. On the other hand, the institutional funds provided by colleges and universities has shifted from need-based to non-need merit aid. Low-income students are especially hurt by these trends, but in the end, we all lose out.”
View more from the Graph of the Day Series.
Graph of the Day: Is the ‘Great Recession’ Really a Household Debt Crisis?
By Benjamin Landy
“Why is everyone still referring to the recent financial crisis as the ‘Great Recession’?” asks Harvard economist and former IMF chief Kenneth Rogoff, in a recent article for Project Syndicate. “The phrase ‘Great Recession’ creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold,” he adds. “But the real problem is that the global economy is badly overleveraged.”
Unfortunately, the American household is no exception. While political discourse has been dominated in recent months by arguments over our enormous national debt, climaxing with the tense mid-summer negotiations over the debt ceiling in Washington, the problem of household debt has gone largely unmentioned in the media. Now that is beginning to change, as a consensus develops among economists, pundits, and policymakers that Americans’ paralyzing mortgage and credit card debt is the main factor holding the economy back from recovery.
The facts are these: although household debt peaked at $116,457 per household in 2008—nearly 100 percent of GDP at the time the financial markets collapsed—mortgage and credit debt has decreased merely seven percent as of 2010. The average American household would have to deleverage an additional 97 percent to return to 1976 levels. And while no one is arguing that household debt needs to be at those levels to restart the economy, it is generally understood that consumption will not increase adequately until Americans’ debts are significantly reduced.
When we last experienced a deep recession in 1982, the household debt-to-GDP ratio was about 45 percent, or $17,286. So when the government adjusted its monetary policy, the economy was able to recover quickly. Today, with the average household still holding over $100,000 of debt, a more ambitious program will be required to return demand—and thus unemployment—to pre-recession levels.
Thankfully, a recent New York Times report indicates that the Obama administration may be planning just that. According to the article’s sources, who would not be named, White House officials are currently weighing a variety of proposals to allow millions of homeowners to refinance their homes with government-backed mortgages at current low interest rates of about 4 percent, saving those homeowners $85 billion a year and creating a strong stimulus to the economy.
The Washington Post’s Ezra Klein, for one, is not optimistic that this kind of government-backed refinancing scheme could work in the current political climate, but at least it proves that the administration is paying attention to the household debt problem and trying to come up with creative solutions to stimulate demand. Until we find a way to do that, millions of Americans will remain jobless, and the economic recovery will continue at its anemic pace. At the very least, the administration’s recognition that the “Great Recession” is really a household-debt crisis sends the positive message that Obama’s “pivot” to job creation is more than just hot air.
