Inequality, credit and financial crises: establishing a link

Rising inequality of income and wealth has been a much documented trend in the richest countries during the last three decades. Free-market economists have readily embraced this as necessary for improved economic performance, claiming that it improves individual incentives to work, invest and create wealth. The benefits are held to ‘trickle-down’ to all levels of society.

Even if this analysis is correct, there are other economic forces creating more complex chains of causation when it comes to the impact of inequality. Incentives matter, but can be affected by many factors. More left-wing economists, in particular, have drawn attention to stagnating incomes for lower and middle earners as one cause of an unsustainable rise in household borrowing in many countries. The bursting of this credit bubble was a major cause of the financial crisis and the rest is history.

A paper in the January issue of the heterodox Cambridge Journal of Economics investigates the link between the levels of inequality and private credit in 18 OECD countries from 1970-2007. After controlling for factors such as deregulation, monetary policy and GDP growth, they find a significant positive relationship between the concentration of income at the top of the scale and private credit levels. If the latter was a major cause of increasing financial fragility and the subsequent crisis, the authors suggest that policy-makers should focus on inequality and its potentially detrimental effects on financial and economic instability. At the moment the policy focus has been on the regulation of systemic risk and monetary policy, so perhaps a shift in thinking is in order.

The relationship uncovered by the paper also lends support to the ‘relative income hypothesis’. This would explain why stagnant incomes for the poorer members of society could lead to increased borrowing in order to maintain and increase their consumption levels relative to others in similar or slightly higher income groups. Thus material aspirations are in part socially determined. It also weakens the explanatory power of permanent income and life-cycle hypotheses of consumer behaviour.

That consumption, credit growth and, potentially, financial fragility, have social causes should come as no surprise to many. Such links are typically neglected in mainstream economics, focussed as it is on the utility maximisation of representative rational individuals subject to constraint. According to economist Paul Ormerod, in his book Positive Linking, (social) networks are increasingly important in a more interconnected world and can lead to unpredictable outcomes in behaviour.

If there is a level of inequality which makes the economy more prone to financial crisis, then the effects of this could overwhelm that of, say, lower tax rates on incentives to work and invest. Policy-makers should reconsider their neglect of inequality. There are plenty of beneficiaries of the current system who are likely to come out against ideas which could include redistribution, improved public goods, and stronger trade unions. The politics of inequality make radical change difficult, but the stakes, in terms of a reduced likelihood of serious crisis, could not be higher. Perhaps another serious crisis will tip the balance.

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