Musings on the Link Between Income Inequality and the 2007-08 Financial Crisis

By Akhil Raj Gupta

Edited by Liz Maria Kuriakose, Associate Editor, The Indian Economist

Recently, I completed two distinct (yet highly interlinked) subjects as a part of my fourth semester exams in Economics at Delhi University. These were Intermediate Macroeconomics and Economy, State, and Society. Around the same time, I also started reading Raghuram Rajan’s 2010 novel, Fault Lines, which offers a compelling analysis on how toxic subprime mortgages were a symptom but not the cause of the Wall Street disaster and how we need to look deeper for a better understanding of the reasons underlying the same. Of course, reading too much of Psychology warns me to tread lightly whenever drawing causations but I am only trying to shed light on a specific theory that might help explain the phenomena that we still don’t quite clearly understand. As the context for this article is set, let me go back to the stark contrasts (and similarities) between Intermediate Macro and ESS.

The theme of our story is economic growth, its distribution, and a very crude explanation of how inequality might possibly arise. (I openly admit that my hunch (and yes it is only a hunch) might be egregiously wrong and I am more than willing to discuss this in greater detail with minds more enlightened than myself).

How does economic growth arise? The conventional theory (also referred to as the ‘Solow model’ in Economics literature) argues that there are three variables broadly impacting any production function that characterizes an economy viz; capital, labor, and technology. A mathematical approximation (differentiating the function) yields an equation that states (again quite crudely) that total economic growth equals the rate of growth of labor (population growth) + rate of growth of capital stock (investment) + rate of growth of efficiency (or technology depending on how you write out this production function.) That’s about it.

The Solow model doesn’t go quite far in explaining how output (or income via the circular flow of money) is distributed amongst different classes and by a natural extension, how income inequality might arise in society. It simply talks about the determinants of economic growth and concludes by stating that for an economy to stay on a constant growth trajectory and for standards of living to rise, technological progress must continue at some pre-determined rate. That is sufficient for the Solow model to act as a suitable albeit elementary framework for understanding the economics of growth.

Except that isn’t it. A model that tells us so little leaves us high and dry about the question of how or why such an important aspect of human life, namely inequality, arises. For that we must look for inspiration from Karl Marx and his ideas (of which I have but a preliminary understanding), then try to weave it into a potential theory of how or why the crisis took place, without resorting to meaningless data or mathematical models. Our honorable governor Raghuram Rajan argues that the greedy bankers were certainly guilty of over-lending, fudging up credit ratings, and then betting against the entire charade. For a jolly discussion of how the crisis unfolded, I would strongly recommend watching The Inside Job (2010).

Anyway, the central argument given by Mr. Rajan is that as the United States witnessed unprecedented growth for over three decades, there were some or rather many, who could just not keep up. He substantiates this by arguing that the wage difference between the worker at the 10^th and the 50^th percentile v/s the worker at the 50^th and the 90^th percentile is enormous and has accelerated over time. The idea being that as you move higher up the income distribution scale, you tend to capture more of society’s resources. Note that this is just a way of restating a common tool to capture inequality called the Gini Coefficient. The reason for this inequality, according to Mr. Rajan anyway, is the lack of good college education. He quotes that the number of graduates (proportionally) in America has been the same roughly since the 1970s.

Moreover, in an increasingly automated society, simple jobs like filing income tax returns can now be done via mobile apps (thus leaving many accountants jobless.) Technological progress and the fruits thereof have been increasingly concentrated in the hands of a few massive firms (look no further than the Googles and Apples to verify this) and those without access to elite college educations have had to be content with a smaller and smaller share of the pie. The political solution to this potentially alarming (remember the class revolutions from eighth grade social science) has been a steady expansion of housing credit, either via quasi-government agencies like Fannie Mae and Freddie mac or via the magnificent investment banks. You can’t redistribute income without antagonizing some section of the society, but you can create money artificially (through mortgages), insure that money (credit default swaps, what else) and ensure that everybody lives the much-touted American dream. Except when there isn’t a base to support such highly risky lending and one default can have a cascading effect, you should know that this is a recipe for disaster. But there is enough literature expounding the enormity of the crisis. Here we’re trying to explore why (through the prism of inequality.)

Now let’s return to our basic Solow model and re-examine the determinants of economic growth, making a few simplifying assumptions along the way. Our three variables for growth are population, investment, and technology. Except there arises also a question of ownership of each resource and when you think about it, technology and investment both belong to a specific capitalist class. So the distribution of income is inevitably skewed towards higher and higher inequality. More crucially, until we are able to equip the mass of labor to reach such a stage itself (through the medium of higher education or specialized training), the situation seems likely to be stuck in limbo. This isn’t very different from Thomas Piketty’s central argument that inequality increases as and when the returns to capital (from investment and technology) are higher than economic growth. Perhaps it is time we revisited the conventional economic theory and tried to restructure the society from the bottom-up, by empowering the masses to continuously increase their productivity rather than maintaining artificially low interest rates and hoping that it all goes away one day.

Akhil is currently in his second year at college, pursuing a Bachelor of Arts degree in Economics (Hons) at Sri Ram College of Commerce, University of Delhi. He has been passionate about writing since an early age and is currently involved with the official College magazine and Economics Department magazine at SRCC. His areas of interest include behavioural economics / finance, econometric analysis, macroeconomic policy, and political theory. He spends his free time reading extensively, watching interesting videos on YouTube, and trying to convince everybody around him that he really does know a thing or two about economics in the midst of all the pontification!