There is a growing number of recent articles that attempt to link inequality as one of the causes of the US financial crisis in 2007, and even to the European contagion that followed afterwards (see here, here or here, and there's even a documentary about it). It all started with an argument from prof. Rajan in his excellent and highly recommended book Faulty Lines. The argument goes something like this:
Lower and middle-income consumers in the US experienced stagnating real incomes over the last 30 years (see here), so their response was to reduce savings and increase borrowing therefore pilling up more debt. That meant that private consumption, and hence aggregate demand and employment, were kept high, creating momentum for the credit bubble.
In addition Rajan claims that misguided government policies on the housing market contributed to the expansion of credit to households:
“He exposes a system where America's growing inequality and thin social safety net create tremendous political pressure to encourage easy credit and keep job creation robust, no matter what the consequences to the economy's long-term health...” (Faulty Lines)
Now, I’m always in favour of looking at the big picture and stressing several causes and potential variables that might have influenced an exogenous shock, but the argument of trying to link inequality to a housing market bust, its spread to the real sector and the subsequent global contagion isn’t that persuasive, and is certainly missing several important variables.
Inequality didn’t cause the crisis, the accumulation of assumingly non-existent risk in the financial sector did. The blame goes all the way from economic policies on the housing (subprime mortgage) markets where Fannie and Freddie were the instruments of the Housing and Urban Department, from the Community Reinvestment Act (its 1995 amendment to be precise), to favourable monetary policy in terms of cheep credit. All together this combination made housing much more affordable, all in favour of achieving political goals.
But this is only one half of the picture.
The other half comes from increasing systemic risk of banks by creating incentives for them to invest into MBSs, which were thought to be extremely safe securities based on a geographical diversification of risk and consistently rated AAA by the rating agency oligopoly.
Systemic risk in banking in the US increased thanks to a FED rule called the recourse rule (see an excellent book by Friedman and Kraus, 2011 on more detailed insights on this). This rule created direct incentives for banks to buy MBSs by making it much less costly (and hence much more profitable) for banks to hold MBSs relative to any other security. This encouraged an artificial demand for these types of securities as banks were producing more and more of them in order to achieve their risk diversification investment strategies.
Accusing banks for being greedy and profit-oriented isn't sensible in this case as their incentives were massively distorted and guided in the wrong direction. All this was done in order to decrease risk, as banking regulators do have good intentions, but paradoxically, from wanting to control and reduce the risk in the system they end up increasing it. After all, the profit-maximizing argument is the central microeconomic argument every company has to follow in order to succeed. There is nothing wrong with this model as long as profits are directed by the companies themselves where it can again yield the highest return, and as long as the profits aren't directed towards massive lobbying expenditures to government officials.
And this happened as well, and on a massive scale, particularly during TARP and the bailouts. But that’s a whole different story.
Re-examining the inequality issue
Filling up balance sheets with MBSs which were creating their own demand can hardly be accounted to inequality or greed for profits. It was an expected reaction steered by regulators and financial authorities. The creation of these derivatives and securitized assets was self-sustained and was done on a massive scale. It isn’t the case that inequality and stagnating incomes led to creation of these securities, but it’s due to a distorted signalization on the financial and housing markets that made it possible for low and mid-income people to remain in a relatively unequal position when they had cheep credit and affordable housing available to them. So this is pretty sure to be a case of reversed causality.
Acemoglu wraps it up pretty well in this EconTalk with Russ Roberts, and offers some additional insights.
Furthermore, there is evidence that consumption inequality was as big as income inequality which would cast a shadow of suspicion on the argument of rising consumption of the low and middle income classes supported by cheep credit.
The cheep credit argument affects companies and businesses much more than it does households, and that’s where the culprit should stand, even though the subprime mortgage market initiated the whole conundrum.
So what does inequality explain?
The inequality argument can only explain why the recovery is taking so long and why the households are having a lot of trouble deleveraging. But the reason why real wages of the middle and low-income classes stagnated was not because the rich grew richer – this did increase the absolute size of the inequality gap but it doesn’t explain why the low and middle incomes didn’t grow.
This can be due to a long-term decrease in productivity and a reshuffling in the economy towards new industries, new ways of productions, new shifts in the location of production, and new emphasis on the service sector. The new patterns of specialization and production sent clear signals of a needed restructuring of the economy but there were many breaks to it, particularly from the political side.
It was always in the interest of politicians to keep their voters satisfied, and by having laws that made sure that every American regardless of their income owns a house were just enough to make the people forget about their stagnant real wages.
Finally, the inequality argument only unveils a small part of the story. The housing (subprime mortgage) bubble to which the inequality argument links to was just a start, the broad picture points out to a more general overheating and a classical boom and bust cycle.