Increasing Inequality and the Financial Crises of 1929 and 2008

Jon Wisman and Barton Baker

Working Papers from American University, Department of Economics

Abstract: The most widely embraced explanations of the financial crisis of 2008 have centered upon inadequate regulation stemming from laissez-faire ideology, combined with low interest rates. Although these widely-acknowledged causal factors are true, beneath them lies a deeper determining force that has received less notice: the dramatic increase in inequality in the U.S. over the preceding 35 years. Heightened inequality generated three dynamics that made the economy vulnerable to systemic dysfunction. The first is that inequality constrained consumption, reducing profitable investment potential in the real economy, and thereby encouraging an every wealthier elite to flood financial markets with credit, helping keep interest rates low, encouraging the creation of new credit instruments, and fueling speculation. The second dynamic is that greater inequality meant that individuals were forced to struggle harder to find ways to consume more to maintain their relative social status. The consequence was that over the preceding three decades household saving rates plummeted, households took on evergreater debt, and workers worked longer hours. The third dynamic is that, as the rich took larger shares of income and wealth, they gained more command over ideology and hence politics. Reducing the size of government, cutting taxes on the rich and reducing welfare for the poor, deregulating the economy, and failing to regulate newly evolving credit instruments flowed out of this ideology.

Keywords: Underconsumption; deregulation; speculation; real estate boom; credit; conspicuous consumption; social respectability (search for similar items in EconPapers)
Date: 2011-01
New Economics Papers: this item is included in nep-his and nep-hme
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