Tyler Cowen has written an article for The American Interest entitled "The Inequality That Matters." It’s about inequality, the financial sector and the possibility of reform. I really enjoyed the essay and recommend you check it out; I’m going to write a few critical comments.
The essay doesn’t tackle what I think is, in one sense, the most important question – how much did a broken financial system inflate the housing bubble, especially in the United States? It’s one thing if the financial sector drinks our milkshake a bit; it’s another if they are creating bubbles to profit on the way up and on the way down, either by choice or by accident.
The Magnetar Trade is instructive here, where you can take informational asymmetries in the private securitization market combined with opaque pricing of CDS to pump hot money into housing that you profit on if it collapses. The analogy -- a correct one -- is to Mel Brooks' The Producers, but this is at the scale of hundreds of billions of dollars.
Research by Adam Levitin and Susan Wachter in their paper "Explaining the Housing Bubble" finds that mortgage debt prices were dropping in 2004-2006 as volume was rising, which is consistent with a shift of the supply curve outward. But this supply was through private mortgage-backed securities which were both difficult to price on fundamentals and difficult to cross-compare to other instruments; the private-financial market for these MBS are thus created as complex, heterogeneous and without regulatory standards. So it’s not just that finance sits at the center of some profitable things; it reorganizes the space to its own advantage, and to the disadvantage of all other players.
The essay also talks about how the financial sector goes “short on volatility," which is a bet that things won’t go crazy in the short term, or a bet that takes on tail risk. As Kevin Drum mentions in Mother Jones, someone is on the other side of that bet. And what do we call a product that pays out in times of high volatility, in times when an event out of the ordinary happens? One thing to call it is “insurance.”
Speaking at a conceptual level, I think it is fair to say that we regulate the hell out of people who hang the sign “insurance” on their door, and do not for those like AIG (AIG), provided insurance without hanging the sign. As a result, actual insurance agents who hang the sign are kind of how we idealize the boring bankers of times gone past.
There’s good reason we regulate insurance – it needs to pay out exactly at the moment when it is the least likely to get paid. I wrote a post for The Atlantic that asked how we should think of zombie insurance. How would you price a contract that paid $100 if the world turned into The Walking Dead, where cities were overrun with zombie hoards?
The short answer is that you wouldn’t pay anything, since when you need to collect it the person on the other end is probably a zombie. This “who can credibly commit to backstopping bad events” goes towards a notion of the role the government can play in financial markets.
There are models being created where income inequality triggers financial crises. For example, Michael Kumhof and Romain Ranciere of the IMF, in their report "Inequality, Leverage and Crises," can endogenously trigger an increase in leverage and then a financial crisis in a DSGE model by shifting in bargaining power over incomes, between workers and capital owners. This chicken and egg problem isn’t solved yet.
As I’ve mentioned before, a large part of the data on the low rate of consumption inequality is driven through inequality in food prices and access. That we can get food so cheaply is a policy issue related to food subsidies and that, compared to the cheap refrigerator which works just as well as an expensive refrigerator, the secondary characteristics matter here. Poorer households substituting towards inexpensive varieties involve more complicated tradeoffs than the data is currently able to give us.
