How Inequality Fueled the Crisis
Raghuram Rajan
CHICAGO – Before the recent financial crisis, politicians on both sides of the aisle in the United States egged on Fannie Mae and Freddie Mac, the giant government-backed mortgage agencies, to support low-income lending in their constituencies. There was a deeper concern behind this newly discovered passion for housing for the poor: growing income inequality.
Since the 1970’s, wages for workers at the 90th percentile of the wage distribution in the US –such as office managers – have grown much faster than wages for the median worker (at the 50th percentile), such as factory workers and office assistants. A number of factors are responsible for the growth in the 90/50 differential.
Perhaps the most important is that technological progress in the US requires the labor force to have ever greater skills. A high school diploma was sufficient for office workers 40 years ago, whereas an undergraduate degree is barely sufficient today. But the education system has been unable to provide enough of the labor force with the necessary education. The reasons range from indifferent nutrition, socialization, and early-childhood learning to dysfunctional primary and secondary schools that leave too many Americans unprepared for college.
The everyday consequence for the middle class is a stagnant paycheck and growing job insecurity. Politicians feel their constituents’ pain, but it is hard to improve the quality of education, for improvement requires real and effective policy change in an area where too many vested interests favor the status quo.
Moreover, any change will require years to take effect, and therefore will not address the electorate’s current anxiety. Thus, politicians have looked for other, quicker ways to mollify their constituents. We have long understood that it is not income that matters, but consumption. A smart or cynical politician would see that if somehow middle-class households’ consumption kept up, if they could afford a new car every few years and the occasional exotic holiday, perhaps they would pay less attention to their stagnant paychecks.
Therefore, the political response to rising inequality – whether carefully planned or the path of least resistance – was to expand lending to households, especially low-income households. The benefits – growing consumption and more jobs – were immediate, whereas paying the inevitable bill could be postponed into the future. Cynical as it might seem, easy credit has been used throughout history as a palliative by governments that are unable to address the deeper anxieties of the middle class directly.
Politicians, however, prefer to couch the objective in more uplifting and persuasive terms than that of crassly increasing consumption. In the US, the expansion of home ownership – a key element of the American dream – to low- and middle-income households was the defensible linchpin for the broader aims of expanding credit and consumption.
Why did the US not follow the more direct path of redistribution, of taxing or borrowing and spending on the anxious middle class? Greece, for example, got into trouble doing precisely this, employing many thousands in the government and overpaying them, even while it ran up public debt to astronomical levels.
In the US, though, there have been strong political forces arrayed against direct redistribution in recent years. Directed housing credit was a policy with broader support, because each side thought that it would benefit.
The left favored flows to their natural constituency, while the right welcomed new property owners who could, perhaps, be convinced to switch party allegiance. More low-income housing credit has been one of the few issues on which President Bill Clinton’s administration, with its affordable-housing mandate, and that of President George W. Bush, with its push for an “ownership” society, agreed.
In the end, though, the misguided attempt to push home ownership through credit has left the US with houses that no one can afford and households drowning in debt. Ironically, since 2004, the homeownership rate has been in decline.
The problem, as often is the case with government policies, was not intent. It rarely is. But when lots of easy money pushed by a deep-pocketed government comes into contact with the profit motive of a sophisticated, competitive, and amoral financial sector, matters get taken far beyond the government’s intent.
This is not, of course, the first time in history that credit expansion has been used to assuage the concerns of a group that is being left behind, nor will it be the last. In fact, one does not even need to look outside the US for examples. The deregulation and rapid expansion of banking in the US in the early years of the twentieth century was in many ways a response to the Populist movement, backed by small and medium-sized farmers who found themselves falling behind the growing numbers of industrial workers, and demanded easier credit. Excessive rural credit was one of the important causes of bank failures during the Great Depression.
The broader implication is that we need to look beyond greedy bankers and spineless regulators (and there were plenty of both) for the root causes of this crisis. And the problems are not solved with a financial regulatory bill entrusting more powers to those regulators. America needs to tackle inequality at its root, by giving more Americans the ability to compete in the global marketplace. This is much harder than doling out credit, but more effective in the long run.
Raghuram Rajan is Professor of Finance at Chicago’s Booth School and author of Fault Lines: How Hidden Fractures still Threaten the World Economy,
Copyright: Project Syndicate, 2010.
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jonbonanno 02:44 10 Jul 10
Silly me. I always figured it was the banks, now able to securitize the loans and sell them to unsuspecting Germans, who were the major supporters of subprime. But no, Barney Frank's good intentions were the root of all the trouble!
One wonders if people like Rajan actually believe this nonsense. Mr. Rajan, like they say in All the President's Men, follow the money.
If only bleeding hearts like myself actually had the power granted us by the likes of Rajan and Wallison.
richardcoronado 10:26 10 Jul 10
One thing is for sure. Attempting to solve the inequality problem by relying on education will simply produce more inequality. The evidence is found in our non-response to the growth in inequality over the last thirty years and in the profound resistance to help those on the bottom of American society in the midst of the current financially induced crisis.
This proposed solution is one of the refuges - certainly not the last - of scoundrels.
dbalmer 12:45 11 Jul 10
Here is another perspective about how inequality fueled the crisis.
Economists have described the causes of the great recession and the possible ways forward from a number of perspectives. One perspective that deserves more discussion is the concept of a savings glut that created pressures to seek yield. Viewing the great recession as arising from too much debt misses the other side of the coin, pressure to lend from too much savings. Borrowing has to equal savings. Three factors contributed to a large savings pool seeking returns through lending. An (1) increased consumer savings pool partly arose from tax cuts for which government had to replace with borrowing. The (2) financial system magnified savings. (3) Trading partner mercantile policies contributed diverted savings from emerging economies to the US. The following provides a simplified macroeconomic model of how wealth and income inequality increased and contributed to causing the great recession.
Macroeconomic analysis starts with four cohorts, consumers (C), businesses (B), government (G), and trading partners (F). To understand the following dynamic, consumers will be divided into two cohorts and businesses will be divided into two cohorts.
The two business cohorts are finance industry (Bf) and non-finance industry (Bn). Understanding the finance industry (Bf) cohort is critical to the following model. The finance industry (Bf) cohort is a conduit for matching savings and borrowing and a creator of an increasing level of funds for borrowing. Money is created by the Federal Reserve. Fractional banking magnifies the funds created. If bank reserve requirements are 10%, the fractional system provides an increase of $10 in loans for every $1 created by the Federal Reserve. The finance industry (Bf) cohort magnified Federal Reserve money creation even further by the creation of shadow banking units, some of which had reserves of about 3% creating $30+ dollars for every dollar of reserves.
For the consumer cohorts, assume a correlation between income level and savings. Stated simply assume low income consumers to be net borrowers and high income consumers to be net savers. Assume some percentage of consumers such as the lowest 90% in income borrow on net an amount equal to the net savings of the highest income 10% magnified through the finance industry (Bf). Whether 90% is the right number is not critical to the following discussion. The consumers cohorts are consumer borrowers (C90%) and consumer savers (C10%).
Some observations about the 2000s leading up to the great recession. Government (G) net borrowing and trading partners (F) net savings in the US were about equal. The finance industry (Bf) accounted for more GDP and profit growth in the 2000s than non-finance industry (Bn). Consumer savings were low and are assumed to be zero for the following discussion. Consumer income and wealth inequality did increase.
Here is a simplified description of what took place.
* Government (G) lowered taxes benefiting primarily the consumer savers (C10%) cohort. This increased the level of savings searching for investment.
* Consumer borrowers (C90%) wanted to buy much of our trading partners (F) products and services.
* For consumer borrowers (C90%) to buy these products and services, savings had to be made available to them.
* As we well know now, the borrowing of consumer borrowers (C90%) greatly exceeded their ability to pay from current and expected income.
* Savings was made available to consumer borrowers (C90%) through the finance industry (Bf) based on expected increases in new and existing home values used as collateral.
* Trading partners (F) on net ran mercantile policies. The US trade deficit (and current account deficit) was financed by trading partners lending to us. In other words our trading partners on net had dollars they wanted to save instead of spend.
* Savings flowed from consumer savers (C10%) and trading partners (F).
* The finance industry (Bf) was a conduit magnifying consumer savers (C10%) savings. Since the finance industry (Bf) is primarily owned by consumers savers (C10%), it can best be viewed as an extension of consumer savers (C10%). The growth of the finance industry (Bf) primarily benefited consumer savers (C10%) cohort contributing to wealth and income inequality.
* High finance industry (Bf) wages and bonuses went primarily to people who were in the consumer savers (C10%) cohort further contributing to wealth and income inequality.
* Non-finance businesses (Bn) were not major borrowers or savers.
* The flow of savings was to consumer borrowers (C90%) and government (G).
* The source of savings was trading partners (F) and consumer savers (10%).
* Trading partners (F) savings went primarily to fund government (G) debt.
* Consumer savers (C10%) (including finance industry (Bf) created money) went primarily to consumer borrowers (C90%).
* When home values ceased to provide collateral for consumer borrower (C90%) debt, consumer savers (C10%) and the finance industry (Bf) suffered the losses. The losses for consumer savers (C10%) were increased by the fact that this cohort was the primary owner of finance industry (Bf) equity and bonds.
What was the role of government deficits in this dynamic. If government (G) had not run deficits, consumer savers (C10%) would have had less savings and trading partners (F) would have had to make up the savings difference (or sell less) taking on some of the consumer borrowers (C90%) credit risk. Trading partners (F) might have been less generous with credit terms. Even if the great recession still happened the risk would have been spread more broadly between beneficiaries of the boom, the consumer savers (C10%) and trading partners (F). Interestingly trading partners (F) savings placed in government (G) borrowing avoided the losses that consumer savers (C10%) suffered as result of placing savings through and having ownership interest in the finance industry (Bf).
AnonAnon 04:02 11 Jul 10
Surely Professor Rajan makes a huge leap here - it was not inequality itself that caused the crisis, but a series of political decisions to "fix" inequality - and to regard the inequality between US homeowners and non-homeowners as somehow consequential, meaningful, non-trivial. By world standards - by historical standards - by humane standards, the condition of US non- homeowners should never have been a cause for concern and hand-wringing. What are the ill consequences of relative inequality when the bottom fifth is healthy, employed, well-fed and has access to all the opportunities and enjoys all the rights of the top fifith? It is refusing to ask this question, and merely assuming that "inequality" defined this way matters to anyone, that caused the crisis. In this respect, Professor Rajan is part of the problem, not part of the solution, because he will advance some other scheme to solve this triviality that will doubtless cause other harm (without ever bothering to tell us why inequality matters, and why he has any expertise to determine that a certain level of inequality that he designates is permissible, while a higher level is not).
bumticker 05:56 13 Jul 10
If globalization benefits the country but all of the benefits flow to the top 10% of the workforce while the bulk of the population suffers economically how should a democracy be expected to react?
hernando 07:39 16 Jul 10
R Rajan is right when he suggests that: "we need to look beyond greedy bankers and spineless regulators (and there were plenty of both) for the root causes of this crisis"
in fact, the solution is so simple that because it is so simple it is almost impossible to see it.
the only way to create wealth is through the production of goods and services.
the trillion dollar question is: ¿what is the social force that enhances the production of goods and services?. the answer is: the power of money.
¿in whose hands is today the power of money?: in the hands of a few people who operate the central banks worldwide.
as a consequence, the operators of the central banks, the House of Rothschild, have had enough ressources to obtain control of the agricultural, the industrial, the mineral, the financial and trade processes of the entire world.
the concept of globalisation is, therefore, an euphemism vis-a-vis a world economy under the control of the House of Rothschild.
now, the major asset in the hands of the world emperor is his control of all the states through the bosses of the political parties. they constitute his world aristocracy.
and through the control of the states he has the control of all the supranational organisations, the imf is his world ministry of finance, wto that of production and trade, nato his ministry of war and the pentagon simply his world policeman....
the 2007 crisis is a step to cover his world economic empire with a political umbrella, a world state.
just as the 1907 new york financial crisis was an excuse to create the federal reserve bank.
¿IS THERE AN ALTERNATIVE TO THE WORLD EMPIRE OF THE HOUSE OF ROTHSCHILD?
the first question we have to answer is whether there is any reason or need to have the management of the power of money in the hands of any private group, be it that of the Rothschilds, or any other.
in other words, ¿is it possible to create a world project managers' bank to provide financing to producers of goods and services in all nations...at a fee?
governments would then simply become coordinators and guarantos of the liberties of individuals and nations...under the umbrella of a world nation.
then, we would start all over again, no public debts, no private debts.
should the House of Rothschild abdicate the throne, the world would move to the Heavens on Earth which has been promissed to us since times immemorial.
otherwise, it would be up to us to recall that liberties are not granted...we must deserve and conquer them!
Andrew 01:51 17 Jul 10
Banking and credit would not have had as much an effect as they have if a large number of the borrowers had been able to keep their jobs. Outsourcing or the shipping jobs oversees and technology (hisghspeed internet especially) have displaced many workers whose paychecks would have used to service those mortgage loans.
josefski 10:17 03 Aug 10
Throwing more education at the problem won't fix anything. I have a masters degree and can't find gainful employment. The education system does not create jobs, it just gives you a credential. But what do I know? I'm only a high school teacher.
Nico 02:21 10 Jul 10
Hasn't this been refuted countless times? The subprime crisis was NOT a result of government policy, as the vast majoirty of subprimes were done outside the direct auspecious of the pro-housing law from the Carter Administration. If I am not mistaken, those individuals who bought homes under that law are those with some of the lowest rates of foreclosure.
I agree that the problem, fundamentally, is a question of wages and effective demand among workers. However, what is the solution? It seems Rejan is trotting the same ideological response, i.e. globalization, skills-upgrading, etc., to make these wages go up, but this has to ignore that millions of people in the thirld world now have access to the same education and still will be working for less than someone in the US. So, no matter how much you may upgrade, you can be replaced and your wages will remain stagnant or even decline. This is the reality of globalization, and its not surprising that a Chicago economist would dole out this 'contradictory consciousness' as a coherent piece of work.
Recently, Rajan's work has been incoherent, as Paul Krugman and DeLong show. Not impressed...
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