Could inequality have caused the financial crisis?

In the last of his three posts on ‘Increasing inequality: Causes, Consequences and the Great Recession’, Robert de Vries looks at whether high levels of inequality could have actually been one of the causes of the economic crisis we now face.

So last week we talked about whether working towards greater equality could help us out of economic crisis. This week we’re going to rewind a bit and talk about whether high levels of income inequality could actually have caused the crisis in the first place. This possibility was the topic of a number of the talks at the Westminster event, including those by Sir Tony Atkinson, and Jonathan Portes. Their talks covered a lot of ground, but I was mainly interested in their discussions of how inequality could have caused the crisis. What is it about an unequal income distribution that could have caused financial institutions to implode in the way they did?

As far as I can discern, there are two broad schools of thought about inequality’s role in the current crisis. Both focus on how it might have caused the sub-prime mortgage crisis which set the whole thing in motion, but take significantly different perspectives.

First is the demand side explanation – put forward by the likes of Joseph Stiglitz and Robert Frank. They suggest that inequality was problematic primarily because it caused a rise in demand for risky credit. Either by trying to maintain their existing standard of living, or by aspiring to the higher and higher standards of the increasingly relatively rich, people on the wrong side of inequality started to live more and more beyond their means. Their consequent demand for credit resulted in the banks making riskier and riskier loans until the whole thing blew up in our collective faces.

Economists like Raghuram Rajan put a slightly different spin on things. Rajan suggests that the increased availability of credit for poorer people, particularly mortgage credit, was directly encouraged by the Clinton administration to stifle the discontent of those left behind by the economic boom. As wages at the top increased, but those at the bottom stagnated, the best way to keep those on the losing end quiet was to make sure they could still at least participate in the dream of owning their own home.

That there was a bubble in lending to risky borrowers (on both sides of the Atlantic) is not in question. As Jonathan Portes pointed out, in the UK, prior the financial crisis, there were truly vast numbers of mortgage products available to ‘sub-prime’ borrowers. Post-crisis there are now precisely none. The question is whether this increase in unsustainable borrowing was a direct consequence of high levels of inequality, or whether inequality and borrowing just happened to be going up at the same time. The stories told by Stiglitz/Frank, and Rajan represent very plausible causal connections between inequality and crisis, but the truth is that the evidence just doesn’t exist to make either case definitive. However, on the bright side it looks like inequality isn’t going to start going down again anytime soon, so before too long we might be helped towards an answer by data from a whole new crisis!

That would seem to be a suitably pessimistic note to end on, but there is one more thing that I wanted to mention; that is the potentially important role of ‘civic morality’ in the financial sector.

The explanations I’ve already mentioned for how inequality could have caused the financial crisis deal very specifically with risky lending as the proximate cause. But what I’m talking about is a more subtle and general way in which high levels of inequality could have made the crisis more likely. I’m not the only one to have noticed that levels of civic morality at the top of society have reached a particularly parlous state in recent times. The attitude, particularly at the top financial institutions seems to have basically been ‘Do everything you can get away with’. Don’t worry about the risks to investors or the wider economy – if it makes a profit, do absolutely everything that is not specifically and harshly regulated against.

Was it always this way? Or may our current staggering levels of inequality have something to do with it? After all, why worry about the wider economy when your wealth means you’re not really a part of it? Why worry about societal impacts when you don’t really live in society as most people experience it; and neither does anyone you know or whose opinion you value? I think this might be the root of the ‘banking culture’ we hear so often maligned. And I think it’s something we’re going to have to deal with if we’re going to seriously tackle the problems of the financial sector.

About Robert de Vries

I'm an Early Career Research Fellow in the Sociology department at the University of Oxford. I'm mainly interested in how people are affected by concerns about their social status; how it colours the way they think, feel, and behave. I try and contribute here regularly, but my addiction to writing excessively long posts keeps getting in the way.
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3 Responses to Could inequality have caused the financial crisis?

  1. Pingback: GREED TODAY… « Corporate Whoredoms & the American Kleptocracy

  2. Pingback: Why more equal societies have more stable economies | Inequalities

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