The Role of Income Inequality as a Cause of the Great Recession and Global Imbalances

Abstract

Is there a link between rising inequality and the ‘Great Recession’ of 2008? As noted by The Economist (22 January 2011, p. 11), ‘[s]everal prominent economists now reckon that inequality was a root cause of the financial crisis’. Similarly, IMF-ILO (2010, p. 8) conclude: ‘In the wake of the current crisis there is an emerging view about the importance of growing inequality as one of the causes of global crises past and present.’ Indeed, in recent years there has been a proliferation of analyses supporting this view (see, inter alia, UN Commission of Experts, 2009; Rajan, 2010; Reich, 2010; Kumhof and Rancière, 2010; Galbraith, 2012; Palley, 2012). The explanation is straightforward: As the benefits of rising income over the past decades were confined to a relatively small group of households at the top of the income distribution, the consumption of the lower- and middleincome groups was largely financed through rising credit rather than rising incomes. This process was facilitated by government action, both directly through credit promotion policies and indirectly through the deregulation of the financial sector. But with the downturn in the housing market and the subprime mortgage crisis starting in 2007, the overindebtedness of the US personal sector finally became apparent and the debt-financed private demand expansion came to an end. We refer to this line of argument as the ‘Rajan hypothesis’, because of the impetus his book Fault Lines (2010) has given to the renewed interest in inequality as a macroeconomic risk.

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