A provocative idea: linking income inequality and the subprime crisis

cited in The EconomistHe was called Raghuram Rajan, the economist introducing the controversal hypothesis about a causal link between increasing income inequality and the financial crisis, at the annual meeting of the American Economic Association.

One of the articles in the Economist’s ‘special report on the global elite‘ presents this theory the inventor published in his book ‘Fault Lines’.

The core statement is, that the political response to the increasing gap between the ‘rich and the rest’ helped causing the crisis. But how come?

Starting of with the technological revolution, Rajan argues it created a higher demand for skilled workers. Being hard to keep the supply of skilled ones close to the demand, the difference in wages to the rest of the workers increased majorly.

And now comes the point where the government’s response has to provide. Though especially the American state didn’t meet the new need with educational means, but took the easy way out: the short-termed solution of boosting living standard by ensuring access to credits.

Enabling this ‘strategy’, the two state-backed housing companies, Fannie Mae and Freddie Mac, took the lead.  Therefore, instruments like subprime mortgages rose from 4% to 15% soaring a the housing bubble.

So far so good, but not everybody was convinced of this explanation.
– Mr Acemoglu (MIT) argues only the rich became even richer, yet the poor didn’t get    poorer. So where is the point of necessity to boost living standards. He does believe in a link between both sides, though he doesn’t think of it as a causal one. Moreover, are both aspects consequences of the deregulation of the finance sector, enforced by lobbying power.
– Mr Glaeser (Harvard University) even questions the role of easy credits in the housing    bubble, prices only been pushed by 4.3%.

To read even more about what Mr Rajan has to say about the idea behind the scenes, you are welcome to an interview by the New York Times.

As we have probably all recognised by now, bankers didn’t suddenly develop a conscious for the poor. Thus, the derivation of the influence of income differences on our today’s crisis could sound sensible; at least where the culture and government environment really did react as described above to sooth the problems of inequality. Though finally, I would be careful when making a statement about the impact of this linkage.

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6 Responses to A provocative idea: linking income inequality and the subprime crisis

  1. vivipre says:

    Thanks for presenting this interesting thesis as to the trigger of the financial crisis. It’s a very good theory I haven’t thought about before.

    Just last week the Financial Crisis Inquiry Commission released their results of nearly a year and a half of research on the causes of the crisis. The report “Inquiry Is Missing Bottom Line” in the New York Times critically summarizes the outcome, naming several people and institutions that could be blamed. However, the focus of the research was rather on investigation than analysis and not even a consensus of opinions among commissioners was reached. So the question as how to prevent another crisis could not really be answered.

    Watch also this video for a short insight to the commission’s press conference.

  2. Pingback: The Financial Crises and Income Inequality?

  3. Eric Gardner says:

    Enjoyed your analysis. Perhaps a little conspiratorial, but if you look at the campaign contributions to powerful leaders during the run-up to the crises, you see a lot of donors who have a lot to gain by extending credit.

    Campaign Finances

  4. As far as I am concerned, it seems very difficult to pick out the scapegoats of this crisis. Nevertheless, one can emphasize that there are definitely several institutions/people which must be blamed for it.
    To name a few, I would list up the following “bad guys”:
    rating agencies
    governments
    investment banks (with intent, I did not mention them in the first place; guess why!)
    mortgage brokers
    mortgage lenders
    “subprime families” (who agreed on the mortgage conditions)
    – etc.
    I am sure the list can be continued. Perhaps, we can figure out more institutions/ people.

    Here is another interesting source that tries to point out how the G20 could prevent another financial crisis.

  5. olexa5 says:

    Many thanks Eric Gardner for your interaction at this point.
    Especially, your link to ‘OpenSecrets’ above is a real treasure box for interesting charts and tables, enabling further deep research.

    I also had a look at the ‘Top Contributors’ ranking on the same website and this led me to something I was reading about a year back, when Goldman Sachs (who is on position 5 of this list) got bashed by the media because of the firm’s involvement in any political seat one can imagin. A nice display of this issue could be found in Vanity Fair at that time.

    Center of the Universe

    Also the ‘Belfast Telegraph’ had an article ‘How Goldman Sachs took over the world‘ listing several former and current employees and their influence they have due to other political post they hold.

    I think it’s quite right what Kizzel Keller said above, the reasons for the financial crisis is a topic one could debate about for years.

    I will hang on to the development of this theory.

    By the way, I had a look at your blog as well. Nice headlines line up. Really!

  6. stuerzele says:

    This is a great topic, thanks for the work olexa!

    Well, I wouldn’t say its so easy. Sure, Kizzel, you are right to say that there are many people who need to be blamed.
    But I wouldn’t dispose of the view of Raghuram Rajan either. Maybe the inequality between incomes was not the sole trigger for a crisis like this, but it may have enhanced the lending of poor families. I found a blog post by R.A. on The Economist. He is giving a critical comment on Rajans book and whether the statement, that income inequality fueled the crisis could be true. He states at the end “inequality created the economic and political opportunity for the financial hocus-pocus that generated the crisis.”

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