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There is a reasonable case to be made for suggesting that rising inequality has been a significant cause behind the financial crisis, here is a first take from us.

Wage and Productivity Growth

Up until somewhere in the 1970s, median wages grew roughly in line with the growth in labor productivity, an arrangement known to political scientists as 'Fordism.' Ford was perhaps the first entrepreneur (if he wasn't the first, he certainly was the most famous) to see wages as more than just cost.

When he instigated his $5 a day wage policy, not only was the amount of workers quitting their job greatly reduced (and thereby the cost of selecting, hiring and training new workers), and providing an incentive for increased effort, it also expanded the market for his products. The first two benefits are known to economists as efficiency wages, the second as 'Fordism.'

According to many, Fordism (by which we will simply assume wages rising in step with productivity growth) underpinned the Golden Era of growth in the Western world from the late 1940s to the early 1970s.

Productivity Slowdown

Then, around 1970, productivity growth started to slowdown everywhere in the Western world. Until today we don't fully understand why, but since it was such a widespread phenomenon its roots are probably technological (some form of organizations having reaped all the low-hanging fruit of the previous wave of technological innovation).

If productivity rises at say 3%, wages can also rise at 3% before they exert an upward push on inflation. Since unemployment was extremely low, and hence unions negotiating position very strong, and since at the time it was by no means clear whether the lower productivity growth was a statistical aberration or the emergence of a trend, this led to a situation in which wage setter refused to adapt to the new lower productivity growth reality and wage growth temporarily exceeded productivity growth.

The economics of this is very well captured by the so called competing claims models of the likes of Soskice and Carlin (authors of the best macro textbook ever written, in our humble opinion). This had two effects, higher inflation and increases labor cost, which translated into higher unemployment, the famous stagflation of the 1970s was born. One has to realize two things. The main supply shock wasn't the rise in oil (and other commodity) prices, it was a slow-down in productivity growth.

Secondly, the 1970s, while having a bad rep, weren't the economic disaster area some claim they were.

Rising Inequality

While date and developments in individual countries differ (for sake of simplicity, we'll concentrate on developments in the US), median wages started to lag productivity growth somewhere in the 1980s and this went hand in hand with rising inequality. That is, a disproportional amount of economic growth went to an increasingly small part of the population.

There are at least three different -- and by no means mutually exclusive -- explanations for that. The first centers around globalization and the revolutions and reforms in China and the former Soviet Union (and the opening up of the Indian economy). This basically doubled the world's labor force available for capitalist production.

This new labor force was (and still is) very cheap and significant parts of it are very well-educated. Globalization connected them to the world economy at lower cost, where they were directly competing with workers in richer countries.

The second reason is technological. The advent of automation and the advent of the ICT revolution have reduced the demand for low skilled work and increased the productivity of high skilled work.

The third is social, there was a reduction in union membership, a retreat in manufacturing employment where unions were strong and there was a general move away from collective solutions towards individual solutions. This is (if you still have doubts at this point) no attempt to provide anywhere near a thorough analysis of the rise in income inequality or even an exhaustive list of its causes, it merely serves as an illustration.

Taxes also became much less progressive:

For the purposes of this article, we're actually less concerned about the causes than about the forms and consequences of inequality. Three main forms:

  • The top 10%, and more especially the top 1% or even the top 0.1% took an increasing disproportional part of the wealth creation.
  • Median wages lost touch with productivity growth.
  • Profits embarked on a rising proportion of GDP

For instance, the net income share of the top 1% of households was 10.2% in 1980, 14.4% in 1990, rising to 21.5% in 2000. From 1993-2008, the top 1% captured 52% of income growth. The bottom 99% of households experienced just a 0.75% income growth between 1993 and 2008, most of it during the second half of the 1990s).

Not only did the median household lose out against the top, wage earners lost share while corporate profits and corporate balance sheets are standing at record levels, while investment isn't.

The last decade saw profits rise much faster than wages:

Productivity rising faster than most wages:

Here is Dani Rodrik:

Labor productivity increased by 78 percent between 1980 and 2009, but the median compensation (including fringe benefits) of 35-44 year-old males with high school (and no college) education declined by 10 percent in real terms.

Now, simple economics simply shows that different incomes have different propensities to consume. In general, the higher the income, the more is saved. But Krugman pointed out that there has not been a general rise in American savings, so discarding any underconsumption theory of the crisis out of hand.

However, we think that's by no means the whole picture. How did the average household, plagued by relatively stagnant wages, share in the increased wealth? The answer is rather simple, of course, by saving less and borrowing more. Helped by financial liberalization, a fall in interest rates and rising asset prices providing handy (albeit risky) collateral, households embarked on a credit binge to keep up with the Joneses.

First, the reduction in personal saving:

And here you see the increase in household debt:

So a pretty good case can be made for stating that credit was the main way for many, perhaps most households to share in the wealth creation they saw around them, but their lagging income growth increasingly made it difficult to pursue.

The credit binge went ok as long as the collateral (housing) kept rising, but now that this shoe has dropped, it's difficult to see how we can return to the heady days of credit induced, consumption driven growth.

In fact, the danger is the opposite. A balance sheet recession:

... occurs when asset prices drop significantly below the value of their corresponding liabilities and thus alter the behavior of the owners of the affected balance sheets. In these situations, the balance sheet owners, whether they be individuals or corporations, seek to pay down their debt with their incoming cash flows and forgo future investment and spending. Consequently, such actions lead to a reduction of aggregate demand. [Richard Koo]

Now, you'll recognize this:

Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs. [Martin Feldstein]

And the international environment isn't helping either, there is a growing global savings glut:

The global saving rate will rise 3.3% points from 22.8 to 26.1% of world GDP between 2010 and 2016, according to estimates by the IMF (World Economic Outlook, April 2011) [Mees]

We have attended readers to the work of Steve Keen, who argues that the increase in household debt was very expansionary, but a reduction in household debt will be very deflationary. We think rising inequality has been an important factor in the surge in household debt.

Source: Rising Inequality And The Economic Crisis