Did income inequality help cause the financial crisis?

Income inequality is a just buzzword for redistribution of wealth and is simply a way to conceal socialist goals. The concept used to be that if you studied hard, worked diligently, avoided drugs, avoided crime, avoided gangs, avoided single parenthood, stayed in school and saved your money you could, and would, do well in America. These concepts are still true today. But liberals are afraid of and cannot accept those ideas. The politically correct want us to believe that those who succeed do so only through luck, or theft, and therefore deserve to be plucked like chickens. That is a great concept if you want the communist state, but foolish if you want the country to succeed or any economic system to actually work. Are you still a liberal? Why?

Thanks, Barbara. Good point about inappropriate financing, but don’t forget the size of the homes and thus the mortgages in addition to subprime lenders’ system gaming. Smaller homes / condos exist but bigger homes / McMansions were de rigueur for new homes during the cheap money boom …similar for cars too. Not now. If lenders everywhere had resisted greed (ha!) and nudged lower incomers away from mansions and towards smaller condos – with reasonable mortgages and honest, documented income verification – would there have been less damage? Good posts here, Barbara, more thoughts please.

Income inequality is not a buzzword. Its based on the premise that 20 years ago the average CEO earned about 25% more than his/her average worker, today a CEO makes 10 times that much. Executive pay has gone up and up while the average worker, when adjusted for inflation, actually earns less. This brings the standard of living for the working class–the factory workers, cleaning crews, secretaries and service industry personel to an all time low.
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I earn about the same as my parents did when I was growing up. And while my parents were able to afford to keep a nice, three bedroom home, have 2 cars and pay for family vacations each summer; I have trouble paying the property taxes on the house my grandmother gave to me, to keep a single car on the road and budget for needed home repairs as they become necessary. And vacations? My last “vacation” was necessary to burn time off I’d built up or lose it. I sat at home for a week, watching tv and cleaning out closets. The idea of taking a trip is a foreign concept to many people today. I can’t even afford to buy a fishing license.

How Inequality, Chinese Mercantilism, and Tax Cuts Created a Savings Glut Seeking Yield Causing a Debt Bubble Justified by a Housing Asset Bubble Leading to the Great Recession

Economists have described the causes of the great recession and the possible ways forward from a number of perspectives. One perspective that deserves more discussion is the concept of a savings glut that created pressures to seek yield. Viewing the great recession as arising from too much debt misses the other side of the coin, savings pressure seeking yield. The key is that borrowing has to equal savings. Three factors contributed to a large savings pool seeking returns. An (1) increased consumer savings pool partly arose from tax cuts which government had to replace with borrowing. The (2) financial system magnified savings through fractional banking. (3) Trading partner mercantile policies contributed diverted savings from emerging economies to the US. The following provides a simplified macroeconomic model of how wealth and income inequality contributed to this savings phenomenon and increased and contributed to causing the great recession.Macroeconomic analysis starts with four cohorts, consumers (C), businesses (B), government (G), and trading partners (F). To understand the following dynamic, consumers will be divided into two cohorts and businesses will be divided into two cohorts.

The two business cohorts are finance industry (Bf) and non-finance industry (Bn). Understanding the finance industry (Bf) cohort is critical. The finance industry (Bf) cohort is a conduit for matching savings and borrowing and a creator of an increasing level of funds for borrowing. Money is created by the Federal Reserve. Fractional banking magnifies the funds created. If bank reserve requirements are 10%, the fractional system provides an increase of $10 in loans for every $1 created by the Federal Reserve. The finance industry (Bf) cohort magnified Federal Reserve money creation even further by the creation of shadow banking units, some of which had reserves of about 3% creating $30+ dollars for every dollar of reserves.

For the consumer cohorts, approximate what happened by assuming a correlation between income level and savings. Stated simply assume low income consumers to be net borrowers and high income consumers to be net savers. Assume some percentage of consumers such as the lowest 90% in income borrow on net an amount equal to the net savings of the highest income 10% magnified through the finance industry (Bf). Whether 90% is the right number is not critical to the following discussion. The consumers cohorts are consumer borrowers (C90%) and consumer savers (C10%).

Some observations about the 2000s leading up to the great recession. Government (G) net borrowing was about equal to trading partners (F) net savings in the US. Savings by consumer savers (C10%) were about equal to borrowing by consumer borrowers (C90%) and are assumed to net to zero for the following discussion.

Here is a simplified description of what took place.

* Government (G) lowered taxes benefiting primarily the consumer savers (C10%) cohort. This increased the level of savings searching for investment.
* Consumer borrowers (C90%) wanted to buy much of our trading partners (F) products and services.
* For consumer borrowers (C90%) to buy these products and services, savings had to be made available to them.
* As we well know now, the borrowing of consumer borrowers (C90%) greatly exceeded their ability to pay from current and expected income.
* Savings was made available to consumer borrowers (C90%) through the finance industry (Bf) based on expected increases in new and existing home values used as collateral.
* Trading partners (F) on net ran mercantile policies. The US trade deficit (and current account deficit) was financed by trading partners lending to us. In other words our trading partners (F) on net had dollars they wanted to save instead of spend.

* Savings flowed from consumer savers (C10%) and trading partners (F).
* Non-finance businesses (Bn) were not major borrowers or savers.
* Savings flowed to (i.e., borrowing was made) by consumer borrowers (C90%) and government (G).
* The finance industry (Bf) was a conduit magnifying consumer savers (C10%) savings. Since the finance industry (Bf) is primarily owned by consumers savers (C10%), it can best be viewed as an extension of consumer savers (C10%). The growth of the finance industry (Bf) primarily benefited consumer savers (C10%) cohort contributing to wealth and income inequality.
* High finance industry (Bf) wages and bonuses went primarily to people who were in the consumer savers (C10%) cohort further contributing to wealth and income inequality.
* Trading partners (F) savings went primarily to fund government (G) debt.
* Consumer savers (C10%) (including finance industry (Bf) created money) went primarily to consumer borrowers (C90%).
* When home values ceased to provide collateral for consumer borrower (C90%) debt, consumer savers (C10%) and the finance industry (Bf) suffered the losses. The losses for consumer savers (C10%) were increased by the fact that this cohort was the primary owner of finance industry (Bf) equity and bonds.

What was the role of government deficits in this dynamic. If government (G) had not run deficits, consumer savers (C10%) would have had less savings and trading partners (F) would have had to make up the savings difference (or sell less) taking on consumer borrowers (C90%) credit risk. Trading partners (F) might have been less generous with credit terms. Even if the great recession still happened the risk would have been spread more broadly between beneficiaries of the boom, the consumer savers (C10%) and trading partners (F). Interestingly trading partners (F) savings placed in government (G) borrowing avoided the losses that consumer savers (C10%) suffered as result of placing savings through and having ownership interest in the finance industry (Bf).

“In the NYT piece, Glenn Hubbard is presented as having a different point of view: that policymakers inappropriately tried to address income inequality by boosting homeownership when they should have instead been focused on education—the thing that ultimately leads to more desirable workers and higher wages”
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I agree, and have discussed this idea at Salary for Attending School.
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Most ideas regarding a cure for income inequality involve some version of the “Robin Hood solution” — take from the rich and give to the poor. That never works. Give the poor money, and very quickly, they again are poor. But, give the poor a good education, and they lift themselves out of poverty.
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It’s a version of “Give a man a fish and you feed him for a day, but teach him to fish and you feed him for a lifetime.”
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Rodger Malcolm Mitchell

dgbalmer,
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I began to read you very long comment, but was interrupted by a key, completely erroneous, assumption: ” . . . increased consumer savings pool partly arose from tax cuts which government had to replace with borrowing.”

The U.S. federal government is monetarily sovereign.As such, it has the unlimited ability to create money. It needs neither taxes nor borrowing. In fact, if both federal taxes and federal borrowing were totally eliminated, this would not affect by even one penny, the federal government’s ability to pay bills of any size.
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If, in view of the above, the rest of your comment remains valid, I’ll be interested in reading it. Let me know.
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Rodger Malcolm Mitchell

Instead of blaming liberals and socialism lets look back at the big picture and see if we can agree. During both the Clinton era and the Bush era we enjoyed a good economy and jobs in most areas of the country, there didn’t seem to be a great deal of differance between the two ignoring other factors. You no doubt are aware that factory jobs have been leaving the US for some 40 years or more. Equaling less better paying options for workers. But borrowing and buying homes and reselling for a profit was an excellant way to boost your earnings from your regular job or your perception of your situation. You borrowed and spend and the consumer is responsible for some 70% of gdp.
So even though good jobs were leaving and cheaper paying service jobs emerged we didn’t notice how bad things got because we were able to make money on real estate and spend. Of course we can’t do that anymore and so here we are in the depression. What is the magic bullet to bring us out of the rut? No body knows, we can’t go back to consumer spending until consumes can feel good about it, and they don’t so here we sit until somebody comes up with the elusive fix. We are going to stay this way. So why can’t we put behind us this liberal/conservative bashing it clouds the waters, and look for some real answers if there are any.

Good points, erieangel. Purchasing power is everything and ours is getting worse. Owning a home shouldn’t be a status symbol for the rich if they’ll be the only ones to afford them from now on, thanks to tight (read: scared, overreacting) lending (or no lending at all, but I digress). If only banks / brokers had shown some restraint to keep buyers from overreaching for the bigger new homes before the bust, sigh….

If everyone is educated, then education ceases to be a valued commodity. Supply & Demand.

A High School degree isn’t enough anymore, and now an undergraduate degree isn’t enough either.

The emphasis should not be on workers becoming more educated unless that is a useful education. Ultimately, the emphasis has to be on the heads of business paying their workers a more responsible and respectable amount of money for the work they do. You’ve reported several times that these businesses are sitting on stores of extra money that could have been used to hedge the broken economy by paying their workers more.

Do you find it a coincidence that the Housing Market burst when the Gas prices rose high enough to put too much pressure on the lower and middle classes?

Its very simple. Those who control the money have the ability to squeeze harder because they aren’t already losing or in jeopardy of losing out. They have the advantageous position. So, through speculation or other means, addictive products have been marked up higher than they should have been while wages remained stagnant. Here are a list of products which most people overpaid for beyond the real value of the product:

1) I already named it, so here it goes again, gas. Everyone needs to get to work.
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2) Homes – Most attributed currently.
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3) Education (Private institutions have been taking on the same bad loans as the rest of America while raising tuition just to keep up their prestige)
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4) Electronics (Apple products are a great example, but any software or hardware company is equally guilty). Apple has consistently charged 2 – 3 times more for closed proprietary hardware where you must go through them to replace malfunctioning equipment. Similarly, software is relatively easy to produce and once made, a majority of it does not need to be reinvented. A single copy of of software costs the amount of electricity to burn it to disk, or now pipe it over the internet, yet still hundreds to thousands of dollars must be spent to buy the solution. As a C.S. major, I can say its quite disgusting the racket these companies make, and in very few circumstances is that money returned to the code monkeys.

5) Medical treatments – see health care reform debate. Its not uncommon for Hospitals to mark up pills from a couple bucks to a couple hundred.

These 5 branches of spending ultimately make up not only the base of a lot of spending in every person’s life, but they fundamentally impact every other area of our spending as well. Gas, directly impacts food or anything that is shipped by truck or plane. A mortgage cuts down your gross income, as does a car loan, the gas to run the car, and you school loan payments. Electronics are the single necessary item to work anywhere doing anything. And without medicine, we’d be left with an unhealthy workforce.

You cannot deny the impact that advancing technology and globalization have had. For most average workers, wages simply to not offer any real prospect for success.

Things are going to get worse. There is really nothing to stop income from becoming more and more concentrated at the top.

Please see this post:

“Did Advancing Technology Contribute to the Financial Crisis”

http://econfuture.wordpress.com/2010/04/06/did-advancing-technology-contribute-to-the-financial-crisis/

“The alternative, Hubbard says, is to improve education.”

Improving education is a laudable goal. But to believe that improved education would solve all our economic problems is the equivalent of believing that all the Lake Wobegon children are above average.

A young woman, suffering from sore mussels and a strange rash that she had been treating with an antibiotic ointment, presented herself to a doctor for care. After administering many tests, the doctor determined that he symptoms were caused by small parasitic trichina worms, she had ingested by eating undercooked pork. Once the cause of her disease had been discovered, her treatment was possible.

In your question, “Did income inequality help cause the financial crisis?”, like the woman’s sore mussels and a skin rash, both income inequality and the financial crisis are systems of an underlying economic disease. These economic symptoms are caused by our use of the British banking system to issue our nation’s currency.

The British banking system was developed by gold smiths, lending gold and the receipts for the gold that was held in their vaults as a reserves, and formalized in the seventeenth century as the Bank of England. It is a for-profit banking system, consisting of a privately owned central bank supporting numerous private commercial banks, producing currency as debt, creating money out of nothing by using fractional reserve lending, their issuing currency in the form of bank credit as the principal of loans. In the US, bank reserves are no longer gold or silver but government issued bonds.

Since every dollar in circulation is someone’s debt, every dollar generates interest payments to the lender. In the case of long term loans like home mortgages and long term government bonds, the interest payments often exceed the amount of the original loan. Sometimes they even exceed the cost of construction itself. Because they do not provide either materials nor labor to the project, interest payments are nonproductive expenses. Over time it seems, everyone who creates the real wealth of the world, is in debt to the bankers who only manage the money representing that wealth.

From its inception, the British system has produced consistent results: short periods of plentiful money and economic growth, followed by economic depression as the banks’ demand for interest payments expanded and loans were repaid, contracting the money supply in the economy. Historically, the system makes a few men very wealthy, while reducing the majority of the people to a state of subsistence living.

The best new thinking on income inequality, and new thinking that works, is Mr. Schuman’s The Miracle.

The results he reports are stunning and thrilling for anyone interested in inequality and the poor:

“Asia has produced the most sustained economic boom in modern history, a massive surge in income that has brought unprecedented gains in wealth and economic opportunity to three billion people.”

Continued failure using old ideas is not an acceptable option.

Fortunately, Mr. Schuman has provided the foundation for truly new ideas and actions that work that can be applied in US inner cities and suburbs, Africa and other locations where the same old, same old have not and will not work.

So you reject any suggestion that does not “solve all our economic problems”? If so, what’s your suggestion that does “solve all our economic problems”?

Rodger Malcolm Mitchell

New ideas? Oh no, the neo-conservatives would never go that. New ideas are far too progressive for them. The same old same old works fine–the rich are supposed to get richer and the poor is supposed to remain poor.

@ Roger M,
No, I don’t reject all suggestions that do not solve all our economic problems, but I am skeptical of those that have at best a tangential impact. My solution to our economic problems would be manifold, with reducing income inequality featuring prominently.