If there’s any point of agreement amongst the many ten-year anniversary eulogies of the 2008 recession, it is that at some point the crisis ended. The nearly nine million jobs that were lost in the crisis are just as cemented in the history as the most popular phone at the time — the Motorola RAZR. Disagreements remain on the success of the recovery, but the world, and especially the surging U.S. economy, has moved on.
Yet, for all the efforts to eliminate the causes of the crisis on Wall Street, one of the root causes of the financial crisis remains unresolved — namely, income inequality. In 2010, a report by the Democrat-controlled joint economic committee suggested that income inequality, which led middle income households to take on unthinkable levels of debt, may have been “part of the root cause of the Great Recession.” Ten years after the crash, income inequality continues to grow. Moreover, as debates surrounding what to do, if anything, about the United States’ massive inequality problem persist, the financial crisis conspicuously remains a separate question altogether. Recognizing income inequality’s hand in the recession will reframe efforts to resolve inequality, shifting the debate about economic redistribution from the question of economic justice to the question of how to prevent another crisis.
This theory of income inequality as one of the recession’s key causes was recently advanced by economists John McCombie and Marta Spreafico, of the universities of Cambridge and Milan, respectively. The logic goes, as American incomes began to stagnate in the 1970s — due to an emergent trend of globalism and automation that made low-skill labor competitive on an international scale — members of the once-prosperous American middle class took on unmanageable debt in order to maintain their financial comfort. Meanwhile, the blooming of the financial sector spurred rapid growth at the upper end of the income distribution.
A recent chart made by inequality researchers Thomas Piketty, Emmanuel Saez, and Gabriel Zucman illustrates this rising inequality with striking clarity. The graph notes the change in income for every income percentile, every year, from 1980 to 2014. In 1980, Americans within the 50th percentile of the income distribution enjoyed the highest levels of average annual income growth, averaging between 20 and 30 percent after over a decade. The average rates of the highest earners were less than 1.5 percent per year. In 2014, after four decades of income stagnation for the middle class and unprecedented growth for the top 10 percent, the average annual income growth rate for the bottom 50 percent fell to a range between 0 and 1 percent; the highest income earners took in a rate of more than 6 percent.
The causal link between income inequality and The Great Recession stems from the idea that spending and saving habits are socially determined; how we spend and save our money is significantly influenced by how others, especially the wealthy, spend and save theirs. McCombie and Spreafico adopt Cornell economist Robert Frank’s theory that wealthy consumption patterns cascade down to the lower ends of the income range. From a purely rational basis, one would expect consumers to save more and spend less when incomes stagnate. Instead, the household debt-to-income ratio nearly doubled between 1980 and 2007. Rather than save more and spend less, middle class Americans took on more debt in order to keep up with an increasingly prosperous upper class. Hence the credit bubble, and hence the crisis.
While lackluster financial regulations, which allowed for risky lending schemes, were some of the crash’s main catalysts, the culprits of the recession’s depth were these massive levels of debt shared by the majority of Americans. McCombie and Spreafico cite economists Barry Cynamon and Steven Fazzari, who argued that if the bottom 95 percent had saved at a benchmark figure of 7 percent instead of the actual rate of 2.2 percent in 2005, aggregate demand would have fallen by roughly 8 percent of GDP in 2005 and 2006. This corresponds with the 8 percent drop in 2009. In other words, McCombie and Spreafico write, “if the share of income of the bottom 95% had not declined, there would not have been a collapse in the savings rate and a concomitant rise in debt to maintain the desired pattern of expenditure.” Even if it was not the direct cause, inequality was at least partially responsible for making the recession the worst economic crisis since the Great Depression.
These would seem insignificant assumptions if the nation had solved the problems of debt and income inequality after the crash. Encouragingly, the Fed currently reports a low level of household debt service payments as a percent of personal disposable income. Still, the debt-to-GDP ratio for American households is currently around 80 percent — much lower than the nearly 100 percent mark during the recession, but still substantially higher than the 50 percent range hit during the mid-1970s. Americans are also saving increasingly less money; last December, the savings rate dipped to its lowest point since 2005.
Additionally, inequality has only worsened since the recession. According to a January note by Deutsche Bank on “Income and Wealth Inequality” in the United States, the top 10 percent owned roughly 75 percent of household wealth in 2013. As of 2015, the top 10 percent also took in more than 50 percent of the pre-tax income share, slightly above the high-40s range of the early 2000s, and substantially higher than the roughly 35 percent rate recorded in 1983. And despite the soaring success of the economy at large, Americans in the middle and lower class have yet to see a substantial gain in real income: the rising costs of living, health care, housing, and auto insurance have erased recent gains in wages.
Considering income inequality’s crucial role in causing, or at least exacerbating, the financial crisis would reframe the current debate about income redistribution in the United States. As it stands, there is little bipartisan agreement about whether income inequality is worth tackling, or if it is even a problem at all. Proponents of income redistribution are currently hamstrung by their reliance on moralistic appeals to right and wrong, and subjective debates about how much inequality is too much. Revealing the causal link between income inequality and the recession would transform this debate into a shared endeavor to prevent another crisis. Rather than ask whether income inequality is an issue at all, Americans can now ask how they can reverse the current trends of inequality to prevent the next Great Recession. Though the answer remains unclear, reframing our view of the last crisis remains a vital step towards finally tackling the fundamental issues that could cause the next one.
Image Credit: Wikimedia Commons/Ed Yourdon