Was income inequality a key cause the financial crisis and the Great Recession?
President Obama and the Democratic Party think so. Their theory of the case is that the top 1% scooped up pretty much all the economic gains of the past three decades. So to make up for their stagnant or falling incomes — partially due to money “spent” on tax cuts for the rich instead of public “investments” in education and infrastructure — middle-income Americans turned to their credit cards and houses (via home equity credit lines). Too much debt created financial fragility and, eventually, a financial meltdown.
Economist Raghuram Rajan has presented a more balanced version of this argument that concedes a rise in inequality but mostly blames Washington’s response of pushing home ownership. His thesis is outlined in new study, “Does Inequality Lead to a Financial Crisis” by economists Michael D. Bordo and Christopher M. Meissner:
1. Rising income inequality and stagnant incomes led to a policy response by Washington.
2. Starting in the early 1990s, successive administrations and Congress pushed for affordable housing for low income families using Fannie Mae and Freddie Mac as instruments for redistribution.
3. In 1992 the Federal Housing Enterprise Safety and Soundness Act encouraged HUD to develop affordable housing and allowed the GSEs to reduce their capital requirements.
4. This led the agencies to take on more risk. Lending was encouraged, and rising prices raised the GSE’s profits, leading to more lending. The Clinton administration encouraged the GSEs to increase their allocations to low income households and urged the private sector “to find creative ways to get low income people into houses.”
5. The FHA in the 1990s also took on riskier mortgages, reduced the minimum down payment to 3%, and increased the size of mortgages that would be guaranteed. The housing boom came to fruition in the George W. Bush administration, which urged the GSEs to increase their holdings of mortgages to low income households.
6. The private sector also joined the party as they recognized that the GSEs would backstop their lending. During this period, lending standards were relaxed and practices like NINJA and NODOC loans were condoned.
7. These developments led to the growth of subprime and Alt A mortgages, which were securitized and bundled into mortgage backed securities and then given triple A ratings that contributed to the financial fragility. Mortgage backed securities (MBS) were further repacked into collateralized debt obligations (CDOs). Credit default swaps (CDS) provided insurance on many of these new products. Financial firms ramped up leverage and avoided regulatory oversight and statutory capital requirements with special purpose vehicles (SPVs) and special investment vehicles (SIVs).
8. In this view, the financial crisis is directly linked to the explosion in credit and the inequality that drove it. Extending loans to low income households worked to increase home ownership in the short-run. … Ultimately the lending was deemed to be fundamentally unsound. Once housing prices began to decline in 2006 and 2007, the stage was set for the subprime mortgage crisis. SIVs faced liquidity runs due to their maturity mismatch problems. Correlated defaults overwhelmed the quality of the lower tranches of MBSs and CDOs and the leverage that begat high returns led to fires sales of all assets. CDS insurance exposure rendered AIG insolvent in this market. Further, the lack of transparency for investment bank balance sheets and uncertainty about Federal Reserve and government liquidity support led to a total collapse in the intermediation system.
But Bordo and Meissner have a different explanation then either Rajan or the Obamacrats:
Our paper looks for empirical evidence that might corroborate Rajan (2010) and Kumhof and Rancière (2011). Both attributed the US subprime crisis to rising inequality, redistributive government housing policy and a credit boom. Using data from a panel of 14 countries for over 120 years, we find strong evidence linking credit booms to banking crises, but no evidence that rising income concentration was a significant determinant of credit booms. Narrative evidence on the US experience in the 1920s, and that of other countries in more recent decades, casts further doubt on the role of rising inequality.
So why the credit boom and bubble and collapse?
The authors give two possible explanations. First, the economic stability of the past 30 years — the Great Moderation — led to overconfidence by consumers and business and, thus, more borrowing:
Expectations of monetary policy credibility and stable inflation can lead actors to believe that recessions induced by monetary tightening will be less likely since limiting rising inflation is the monetary objective. Workers and consumers have balance sheets that improve in the boom and they may be able to easily sustain consumption growth with credit rather than demanding wage increases.
Second, blame the Fed for keep rates too low for too long after the collapse of the Internet bubble:
The negative and significant relationship of short-term interest rates and credit growth may also be consistent with the story of for example Taylor (2009) or Meltzer (2010) who attribute the U.S. housing boom to expansionary policy by the Federal Reserve in the early 2000s in an attempt to prevent perceived deflation. Moreover, housing booms and busts in other countries did not reflect redistributive housing policy. In the period before the Great Moderation they occurred during episodes of expansionary monetary policy … it now seems fairly clear from our examination of the data that neither have much to do with rising income inequality.
This is a bombshell study and will surely be much debated.