From squeeze to crash: the role of living standards in the financial crisis

Economist Cover, Nov 2007While almost no-one predicted the financial crisis of 2007, there’s been no shortage of people rushing to explain it with the benefit of hindsight. Amid all the competing explanations, one caught my eye: the idea that rising US income inequality somehow caused the financial crisis.

But while this conveniently slots into the ‘inequality-is-bad-for-everything’ narrative, is this really true?

I’m not an economist working on the financial sector, so I’m not going to pass judgement on this myself. (Any readers with more expertise and a strong opinion should get in touch and write a post!). But there’s an interesting conversation going on across the blogosphere that I thought I’d share.

The argument that inequality played a role goes something like this, as nicely captured by Kumhof & Ranciere, who argue that the same was true of the 1929 Crash.  Rising income inequality was associated with squeezed living standards for Americans in the bottom half of the income distribution.  Then:

“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 by borrowing to maintain higher living standards. Meanwhile, the rich accumulated more and more assets and in particular invested in assets backed by loans to the poor and the middle class. The consequence of having a lower increase in consumption inequality compared to income inequality has therefore been a higher wealth inequality.”

Some form of this view has been set out by a number of economists, including by Kumhof & Ranciere in a paper for the International Monetary Fund, and spawning a documentary called ‘The Flaw’ (by the creator of ‘Wife Swap’, no less).

Others, however, aren’t convinced. In this review of a number of posts by The Atlantic, they point out that (i) rising inequality in general doesn’t predict crises; (ii) inequality might be a symptom of a deeper problem, not a cause in itself. And this thoughtful post at The Economist points out that the main problem in the inequality-caused-the-crash explanation is one of timing:

The 50th (and below) percentile struggled most, he [Daron Acemoglu] demonstrated, in the 1980s. During the period in which this credit expansion was supposedly taking place, the bottom half wasn’t really falling behind the 90th percentile. Politicians reacting to that inequality would be targeting a phantom.

So who is right? While I have no special expertise here, the account on the Economist seems plausible – that inequality had a role to play, but within a highly complex, multi-causal picture of what led to the financial crisis (I recommend reading their long-ish post).

Either way, it’s fascinating stuff, and a reminder that inequality may have economic as well as social and ethical consequences.

About Ben Baumberg

I am currently a Lecturer in Sociology and Social Policy at the School of Social Policy, Sociology and Social Research (SSPSSR) at the University of Kent. I also helped set up the collaborative research blog Inequalities, where I regularly write articles and short blog posts. I have a wide range of (too many...) research interests, at the moment focusing on disability, the workplace, inequality, deservingness and the future of the benefits system, and the relationship between evidence and policy. You can find out more about me at http://www.benbaumberg.com
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2 Responses to From squeeze to crash: the role of living standards in the financial crisis

  1. Mel Bartley says:

    Thanks for this thoughtful post Ben. I am reading “The Big Short” trying to understand these matters (after “Liar’s Poker” which is hilarious but not as informative. What you point out, I think, is that as Americans on lower incomes needed to borrow more to sustain the appearance of stable living standards, the people they paid interest to on their loans of course got richer. It figures. So in this way, it has been the stagnant US living standards for workers that has in fact added to the inequality by enriching those whose earnings include the fruit of interest. Members of this list might like to look at what has been written about how “social class” is perceived in The Independent by the way. The definition of middle class that focus group members came up with was ownership of a cafetiere. At the same time, the term “working class” was associated with things like the word “Chav”, loud jewellery and, amazingly, with cosmetic surgery that went wrong. It used to be that your were working class unless you could maintain your present lifestyle for at least 3 months after losing your job. I guess nowadays that in itself would depend on the value of your house that you could re-mortgage (see “The Big Short” however for a cautionary tale about this).

    • Ben Baumberg says:

      Thanks Mel – I should really read some of those books as well…

      I’ve always thought it would be interesting to do a more detailed examination of household budgeting – how people adjust their expenditure to their income; how much leeway they allow for things to go wrong (as you mention) etc. This may well already exist – if anyone knows of anything, then let me know. John Hills did some really interesting work on week-by-week income fluctuations, but I’m thinking of something more qualitative.

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