Inequality and the crisis: the other missing link of macroeconomics?

August 7, 2012

Ever since an epic financial crisis hit the United States in 2008, mainstream economists, most of whom utterly failed to foresee the oncoming train wreck, have been scrambling to introduce a financial sector dimension to their models. It was a conventional approach that detached the study of financial stability from macroeconomic variables, the narrative goes, that prevented the experts from seeing the build-up of an unsustainable housing bubble that, when it crashed, took down the economy down with it.

Research by James Galbraith, professor of public policy at the University of Texas at Austin, suggests finance is only one blind spot for the economics profession. Another key and increasingly relevant factor in the public debate that has been largely ignored is the issue of inequality. The first chapter of Galbraith’s latest book, “Inequality and Instability,” begins like this:

In the late 1990s, standard measures of income inequality in the United States – and especially of the income shares held by the very top echelon – rose to levels not seen since 1929. It is not strange that this should give rise (and not for the first time) to the suspicion that there might be a link, under capitalism, between radical inequality and financial crisis.

The link, of course, runs through debt. For those with a little money, it is said, the spur of invidious comparison produces a want for more, and what cannot be earned must be borrowed. For those with no money, made numerous by inequality and faced with exigent needs, there is also the ancient remedy of a loan. The urges and the needs, for bad and for good, are abetted by the aggressive desire of those with money to lend to those with less. They produce a pattern of consumption that at times appears broadly egalitarian; the rich and the poor alike own televisions and drive automobiles, and until recently in America members of both groups even owned their homes.

But the terms are rarely favorable; indeed, the whole profit in making loans to the needy lies in getting a return upfront. There will come a day, for many of them, when the promise to pay in full cannot be kept.

Galbraith says one major problem with studying inequality is that there has been such narrow interest in it from the academic field that even basic data gathering faces major challenges compared to other economic indicators, such as those closely followed by businesses.

This book originated in a dissatisfaction with an economics of inequality pushed to the backstage of comparative welfare analysis and development studies, and especially with the limitations of the evidence underlying these various lines of research.  […] And there was of course a greater dissatisfaction with the larger economics – with an economics that denied the possibility of financial instability, was unprepared for the Great Crisis and takes no account of inequality at all.

Fair warning: Galbraith’s book is highly technical and has its fair share of graphs and equations – it’s more of an effort to fill that gap in the data than a Sunday afternoon paperback for the lay reader.

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