Thomas Palley does an admirable job summarizing and discussing the implications of four different stories about the relationship between inequality and the financial crash of 2007-08. The only problem is, he completely overlooks a fifth story about that relationship, one that hinges on the existence and use of the surplus.
According to Palley, there are four major stories of the financial crisis and the role they attribute to income inequality. They are identified with (1) Raghuram Rajan (according to whom inequality has not really been a problem per se but the government responded to populist pressures to do something about growing inequality by extending home mortgages to unwarranted buyers), (2) Michael Kumhoff and Romain Rancière (who developed a model in which worsening income distribution, caused by declining union bargaining power, led to a persistent surge in borrowing as workers tried to maintain their living standards, which rendered the economy fragile to a financial sector shock), (3) Gauti B. Eggertsson and Paul Krugman (who leave out inequality entirely and focus instead on the idea that a financial bubble drove excessive borrowing and leverage in the US economy—which, when the bubble burst in 2007-08, led to a financial crisis and a deep recession, which in turn prompted a wave of deleveraging as borrowers shifted to rebuilding their balance sheets and excess saving that reduced aggregate demand), and (4) Palley himself (who , in his “structural Keynesian” account, focuses on the shift from wage-led growth to neoliberal financialization).
Thus, according to Palley,
Income inequality did not cause the financial crisis. The crisis was caused by the implosion of the asset price and credit bubbles which had been off-setting and obscuring the impact of inequality. However, once the financial bubble burst and financial markets ceased filling the demand gap created by income inequality, the demand effects of inequality came to the fore.
Viewed in that light, stagnation is the joint-product of the long-running credit bubble, the financial crisis and income inequality. The credit bubble left behind a large debt over-hang; the financial crisis destroyed the credit-worthiness of millions; and income inequality has created a “structural” demand shortage.
Palley then proceeds to discuss the implications, for economic policy, of each one of these four stories.
The entire essay is worth a good, careful read. But let me focus here just on the causal stories, and leave for another post the implications of the stories for policy.
While I am sympathetic to Palley’s critique of the other three stories, what’s missing from his own account is the role inequality played in the financial crisis itself.
Consider, for example, what happened to profits and wages in the long run-up to the crash of 2007-08. What we can see, from 1970 onward, is a steady decline in the wage share of national income and an initially halting and then uneven increase in corporate profits (measured here in terms of “net operating surplus”).* The argument is that the decline in the wage share led to increased profits both directly and indirectly: directly, as wage costs for producing enterprises declined; and indirectly, as some of those corporate profits were recycled through financial enterprises to lend to workers, thereby further boosting the profit share of national income. That combination fueled the housing and asset bubbles that eventually burst in 2007-08.
So, on my account—on my structural class account—inequality played an important role in creating the conditions for the most recent financial crash. And now, during the Second Great Depression, the class inequality that was such an important factor before is on the rise again.
Now, I understand, that’s not a complete story about the relationship between inequality and the crash of 2007-08. But it’s a start. It shows that such a story is possible. And, as I will explain in another post, it has implications for economic policy very different from the other four stories out there.
*My chart doesn’t show all of what I consider to be the economic (class) surplus. To get there, we’d have to transfer some of what is included in wages and salaries (e.g., the salaries of CEOs, which put them in the top 1 percent) to “net operating surplus.” I’m still searching for a good way to do that.