Inequality and the Crisis

What’s at stake

In early accounts of the financial crisis, income inequality was not seen to have played a major role. Now it’s beginning to get attention. The new conventional wisdom on the role of increasing inequality in the run-up to the crisis goes like this: Americans below the very top income had borrowed to keep spending despite stagnant or declining incomes. For a time, rising asset prices – especially home prices – masked how leveraged households had become. But when home prices began to decline in 2006, the result was a global bust.

Inequality, debt leverage and financial crises

Robert Reich draws parallels between the increase in inequality in the years ahead of the Great Recession and the Great Depression in his book “Aftershock”. Not only did the share of total income going to the richest 1 per cent of Americans peaked in both 1928 and 2007 as documented by Thomas Piketty and Emmanuel Saez, but the ratio of private credit to the national economy nearly doubled between 1913 and 1928. In the two pre-crisis eras, borrowing and higher debt leverage appears to have helped the poor and the middle-class to cope with the erosion of their relative income position.

Michael Kumhof and Romain Ranciere builds a general equilibrium model that replicates the features outlined by Reich. In their model, the crisis barely improved workers' situation (despite the decrease in total household debt from 130% of disposable income to 118% as documented by RTE). While their loans drop by 10% due to default, their wage also dropped significantly due to the collapse of the real economy, and furthermore the real interest rate on the remaining debt shoot up to raise debt servicing costs. As a result their leverage ratio barely moved, and is in fact expected to increase further later on. Looking forward the authors see two possibilities for a successful deleveraging of households. The first is an orderly debt reduction that is not accompanied by a large real crisis. The second is a restoration of workers' bargaining power and therefore income that allows them to work their way out of debt over time. Leverage drops immediately, but due to a higher income level rather than a reduced loan stock. More importantly, and unlike under a debt reduction, leverage goes onto a declining path that immediately starts to reduce the probability of a further crisis.

Ryan Avent points to David Leonhardt who documented last week that median wages for male workers have been falling sharply over the past few decades, largely because the share of men earning no income at all has risen.This argument has an advantage over the bargaining power explanation – it makes sense across the rich world. Tyler Cowen frequently points out that a "squash-the-middle" explanation for stagnating wages in America runs aground when one realises that other rich world countries – including some with far more union-friendly governments – experienced similar slowdowns over similar time frames

Policies and the inequality boom

Raghuram Rajan argues in his book “Fault Lines” that growing inequality in the US stemming from unequal access to quality education led to political pressure for more housing credit, which distorted lending in the financial sector. Broadening access to housing loans and home ownership was an easy, popular and quick way to address perceptions of inequality since easy credit has large, positive, immediate, and widely distributed benefits, whereas the costs all lie in the future. It has a payoff structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure. And this is why politicians set about achieving this goal through the agencies and departments they had ironically set up to deal with the housing debt disasters during the Great Depression.

Daron Acemoglu (see also this set of slides) considers the Rajan argument not entirely convincing. With the same structure of incentives in Wall Street and the same lack of regulation, it seems likely that similar practices and excessive risk-taking behavior would have developed even without the Community Reinvestment Act and without Fannie Mae and Freddie Mac. More importantly, the argument that Democratic and Republican governments needed to change policy to cater to the needs of subprime borrowers is not entirely convincing either. The US political system does not seem to provide much voice to those at the bottom of the income distribution. The decade during which income inequality was fueled by the poor becoming poorer was the 1980s. If anything, demand for such programmes should have been much greater during the 1980s. Instead, Acemoglu argues that the lack of regulation and the distorted incentives that have been at the root of the financial crisis may have also contributed to the rapid increase in the incomes of the financial market super earners.

Perceived distributional impacts of stabilisation policy and its availability for future generations

Mark Thoma argues that if we do things now that are economically justified, but political disasters the next time policy is needed it won't be there – the policies won't have the public support that is needed for politicians to get behind them. We have to take account of the costs to future generations of potentially not having these policies available due to the political opposition that might come about as a result of our actions to try to stabilize the economy. For that reason, we need to think a bit harder about the distributional consequences of policies that are put in place during a crisis, especially since ordinary people seems to have a hard time understanding what a counterfactual is. In particular, who gets the money first seems to be critical for how supportive people are of stabilisation policies but does not really matter economically. Why, for example, not help people pay their bills directly instead of letting them go under and then bailing out the bank when households cannot repay loans? Economically it isn't that much different from the banks' perspective – they get the money they need to survive either way, but the public perception and support for these policies would be greatly affected.

The next race between technology and education

David Autor, an M.I.T. economist who has done research on the labour market, has been the focus of blogosphere discussion lately.The very brief version of Mr. Autor’s argument is that the middle of the American job market is being hollowed out. As Larry Mishel pointed out recently the college wage premium, after rising sharply in the 80s and 90s, has stagnated lately as the structure of job opportunities in the US has sharplypolarized with expanding job opportunities in both high-skill, high-wage occupations and low-skill, low-wage occupations, coupled with contracting opportunities in middle-wage, middle-skill white-collar and blue-collar jobs.

Paul Krugman argues that the notion that putting more kids through college can restore the middle-class society we used to have is wishful thinking. Emphasizing education — even aside from the fact that the big rise in inequality has taken place among the highly educated — is, in effect, fighting the last war. It’s no longer true that having a college degree guarantees that you’ll get a good job, and it’s becoming less true with each passing decade. So if we want a society of broadly shared prosperity, education isn’t the answer — we’ll have to go about building that society directly. We need to restore the bargaining power that labour has lost over the last 30 years, so that ordinary workers as well as superstars have the power to bargain for good wages. We need to guarantee the essentials, above all health care, to every citizen.

Tyler Cowen argues that this calls for a reform of education, so that people either make effective teams with computers, or they specialize in areas where computers are not effective. The nature of "education" is not carved in stone, even if the sector is hard to reform.

David Leonhard thinks it would be a mistake to use Mr. Autor’s findings to make a broader argument that most middle-wage workers have fared worse in this recession than high-wage or low-wage workers. That doesn’t appear to be the case as data on wage changes show that middle-class workers who’ve held onto their jobs have weathered the Great Recession better than low-income workers. Rising inequality, rather than a hollowing out of the middle, seems to be the best summary of recent wage trends.

Inequality in recessions

Jonathan Heathcote, Fabrizio Perri and Gianluca Violante argue the current recession appears somewhat unusual. So far, consumption inequality has declined sharply, perhaps because declining asset prices has disproportionately hurt the consumption-rich. Recessions usually tend to increase inequality because households in the bottom percentile of the earning distribution suffer the largest declines during economic downturns. Moreover, declines at the bottom of the earnings distribution can be very persistent. For example, earnings at the 10th percentile declined by 20% in the 1980-82 recession; they did not return to pre-recession levels until the late 1990s.

Mark Thoma argues that the costs of unemployment are never distributed equally when downturns occur, the young and minorities in particular experience much larger employment shocks than, say, white middle-aged males. Tony Pugh argues that America's economic recession has hit African Americans who are middle age and older much harder over the last year than it has the general public, according to a new survey released Tuesday by the AARP. Twice as many blacks also reported losing a job and having a spouse who either lost a job or had to take a second job. These older, established black workers also lost their job-based health coverage at higher rates, were more likely to raid their retirement savings prematurely and provide financial help to their parents and children more often than their age-equivalent peers, the survey found.

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