Does inequality lead to a financial crisis?

by on March 5, 2012 at 3:16 pm in Economics, History | Permalink

Michael Bordo and Christopher Meissner say basically no (NBER gate):

The recent global crisis has sparked interest in the relationship between income inequality, credit booms, and financial crises. Rajan (2010) and Kumhof and Rancière (2011) propose that rising inequality led to a credit boom and eventually to a financial crisis in the US in the first decade of the 21st century as it did in the 1920s. Data from 14 advanced countries between 1920 and 2000 suggest these are not general relationships. Credit booms heighten the probability of a banking crisis, but we find no evidence that a rise in top income shares leads to credit booms. Instead, low interest rates and economic expansions are the only two robust determinants of credit booms in our data set. Anecdotal evidence from US experience in the 1920s and in the years up to 2007 and from other countries does not support the inequality, credit, crisis nexus. Rather, it points back to a familiar boom-bust pattern of declines in interest rates, strong growth, rising credit, asset price booms and crises.

Here is their earlier paper (pdf, ungated) on whether crises boost inequality.

Ryan March 5, 2012 at 3:29 pm

Somewhere, Mises’ ghost is saying, “See? I told you!”

Doc Merlin March 5, 2012 at 4:43 pm

+1 You beat me to it.

AC March 5, 2012 at 3:34 pm

Debates are wars, arguments are soldiers…

mark March 5, 2012 at 3:48 pm

Haven’t read the paper but what jumps out from the quote is that it seems to be addressing a different argument than Rajan et al. made. he argument of Rajan et al is that the most recent credit boom stemmed from policies to increase the relative and absolute wellbeing of lower and middle classes by lending them money for consumption as opposed to outright transfers. It may be true that over a long period of time inequality did not cause either credit booms or financial crises in general – and I would be glad to know that – but I don’t think that is the argument. The argument is that this past one stemmed from an effort to flow benefits to the less well off.

Tom Waye March 5, 2012 at 6:36 pm

Indeed, Rajan offers income inequality – perceived or otherwise – as the political motivation for the low interest rates that help fuel the credit boom, not as a factor competing with interest rates in directly causing the boom. Has anyone suggested that inequality directly causes financial crises? Through what mechanism?

Barney March 5, 2012 at 4:12 pm

I have only skimmed through the paper by Bordo and Meissner, so I apoligise if an error has crept in my analysis of their paper. From my reading of the paper, they look at the effect of inequality on financial crisis in 16 different countries over a number of years, they find that in countries such as France the link is not there ( i.e. inequality would not cause a crisis).
I would suggest this is confusing two separate issues: the cause of the crisis in the US and similar anglo-saxons countries and the propagation of the crisis to other countries in a globalised context.
If one supposes that the crisis starts in the US ( and the UK for example), that is to say that the increase in lending due to the political economy and inequality was a feature of the US economy (which it was) then one should not expect the link between inequality and crisis to be valid in other countries.
In sum, I would suggest that using a cross-country analysis is answering correctly the wrong question!

Floccina March 5, 2012 at 4:38 pm

I think that a logical argument could be made the other way. That is that if the rich had all the money to lend that they tend to be more conservative. That is compare Warren Buffet to the typical investor who thinks he can beat the market and get higher returns by taking more risk.

I am not saying this is the case, it is an empirical question.

Charles March 5, 2012 at 5:47 pm

Papers like this always make me wonder about the political biases of the authors.
I almost want to see a statement of the authors political leanings accompany the article.
Is it possible to untangle the role of political biases?
In physical science it is well known that bias can play an important role, particularly when the author must make a series of qualitative choices about what to measure. Example: mid-to-late twentieth century work on the Hubble constant, two competing camps, each making different assumptions or using different methods for measuring distances, and each obtaining consistently different answers.

Jason March 5, 2012 at 6:06 pm

“Instead, low interest rates and economic expansions are the only two robust determinants of credit booms in our data set.” Bordo and Meissner

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy….” Milton Friedman

Therefore: Tight money => credit booms.

Seems weird, but maybe tight money creates market demand for non-traditional channels of creating money via new instruments to make up for the Fed not stepping up. These new instruments have risks that aren’t well understood so they can lead to collapses.

Jason March 5, 2012 at 6:18 pm

And since interest rates and inflation are correlated, maybe our “stable prices” 2% inflation Fed target caused the credit booms.

http://research.stlouisfed.org/fredgraph.png?g=5uo

Jason March 5, 2012 at 6:27 pm

Yglesias made this point but I couldn’t find the post. It is possible the post-1970s lack of tolerance for catch-up growth (allowing unemployment to drop well below nairu and inflation to spike) may have lead to increasing inequality …

http://research.stlouisfed.org/fredgraph.png?g=5ur

This means that the link between interest rates and financial crises would be robust, but the transmission mechanism from inequality is more complex and clouds the signal in the inequality-crisis correlation.

Doc Merlin March 5, 2012 at 7:34 pm

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy….”

1) People always quote Milty on this but never give a reason why it must be so?
2) Its wrong. Rising real interest rates means that money was easy in the past.
3) “high and low” have little meaning in this context. Is 4% high? is it low? What does that even mean?

Jason March 5, 2012 at 11:00 pm

I thought it was understood. Persistently low interest rates imply that you never had to raise them to reign in NGDP growth/inflation which means that your NGDP target is too low and money is tight. If you’ve never had to use your brakes, you’re not going too fast.

Jason March 6, 2012 at 1:12 pm
Josh S March 5, 2012 at 8:22 pm

Didn’t the idea that financial crises are caused by inequality of wealth come from Marx? I thought that was part of what drove his “final crisis of capitalism” idea.

Benny Lava March 5, 2012 at 8:51 pm

“Anecdotal evidence from US experience in the 1920s” whoa, anecdotal evidence is one of the main pieces of evidence for this argument? Is this wizard level trolling or is everyone really that stupid.

David H March 6, 2012 at 1:02 am

I have been wondering lately about a sort of Austrian(ish) inequality-inefficiency story.

Q: At what point does private wealth concentration begin approximate central planning?

That is, how many of the super-rich have the cognitive wherewithal to direct their resources efficiently? Don’t they suffer from the same, or worse, boundedness of rationality that plagues any central planner? If so, then concentration of wealth could produce agency costs and reduce inefficiency relative to some first-best world in which the wealth endowment of each agent is equal to the quantity that she can allocate efficiently.

Have I missed a paper exploring a similar line of reasoning?

David H March 6, 2012 at 1:04 am

*reduce efficiency, not *in*efficiency

Robert March 6, 2012 at 6:52 am

well, duh!

Deadbeat mortgage borrowers caused our crisis. And sadly, our Government sees them as victims, and throws money and handouts at them.

(I would have audited every stated income mortgage application and if their stated income didn’t match their 1040 reported income, I would have given them a choice: jail for mortgage fraud, or jail for tax evasion)

David H March 6, 2012 at 6:20 pm

“Duh” indeed

The sub-prime (i.e. black/brown) borrowers are to blame story is one of the simplest and dumbest explanations of the crisis. That the general public first became aware of symptoms of the unfolding crisis through reporting on what was then called the subprime crisis is not evidence of causation. There were earlier symptoms quite unrelated to subprime or mortgages more generally.

One might hope that readers of a blog such as this one would have developed a bit more economic sophistication, but apparently not.

sigh

Robert March 6, 2012 at 10:41 pm

you are despicable. most sub-prime borrowers are white. by calling me a racist, you reveal yourself to be a petty troublemaker.

David H March 7, 2012 at 5:52 am

Fair enough. I didn’t intend to call you a racist, but I can see why you took it that way. I should have chosen my language more carefully.

Your original assertion that “[d]eadbeat mortgage borrowers caused our crisis” is wrong and long ago debunked independent of the fact that it was originally popularized by others who did couch their versions of the story in racist rhetoric.

e.g.:
http://mediamatters.org/mmtv/200809190021

Likewise, not every international banking conspiracy theorist is aware of, or agrees with, the original anti-Semitic version. However, when those who are aware of the theory’s origins hear it repeated sans direct references to Jewish bankers, we’re likely to assume that we’re hearing a dog whistle even if the speaker doesn’t realize that they’ve blown one. cf. states’ rights

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