Is there a connection between income inequality and economic collapses

I heard a podcast by Paul Krugman several months ago where he would talk (before the economic collapse, pre-2008 so the 2001-2008 period) about how income inequality during that time was approaching or at the level it was at in 1929. Then he said bloggers would comment that the great depression came soon after, so maybe the US was facing another great depression due to the income inequality. Krugman said he blew off the idea at the time, but thinks there might be something to it since we are now in another depression.

His argument from what I remember was that the inequality seen in the 20s and 90s-current era was due to more wealth in the financial industry. As risk goes up, so does compensation and reward. So income inequality doesn’t cause collapses per se, but it is a symptom of a financial system that is becoming wealthier in part because it is becoming too risky and fragile.

Corporate profits skyrocketed starting in the 90s, and the financial sectors share of them also grew dramatically around the same time, although they seem to have gone down by 2007. I have no idea what happened after that.

http://6ampacific.com/wp-content/media/2010/01/financial-industry-share-of-profits.png

Is there any connection between income inequality, risk/compensation in financial industries and economic collapses? Is income inequality problematic by itself or is it a symptom of too much risk in financial markets, or is it unrelated?

There is definetly a connection. Bubbles causes wealth in certain areas to skyrocket, those not in those areas tend to grow slower than normal due to capital flight to bubbling assets. Then when the bubble is popped a lot of people lose wealth and there is a period of slow growth because of capital reallocation. This is exacerbated when the bubbling area involves banking because the banks are the source of capital for the rest of the economy. Income inequality does not cause economic collapses they are caused by the same thing.

The theory I found most convincing was that income inequality meant an ever increasing amount of investment capital without a corresponding increase in demand. The result was that you had a bunch of people looking to invest their money, but no good investments, since there wasn’t a corresponding amount of dollars to chase the produced goods.

The result was the money went either into a) lending the money back to the Middle Class, who had a historical expectation of rising incomes (a reasonable expectation, since productivity was still rising), but found those rises never materialized and that they couldn’t end up paying back those loans and b) fueling investment bubbles.

One can sort of see how that will lead to increasing finances for the

At least Simplicio was able to get part of his message out before the Illuminati got him.

Slightly off-topic since this isn’t specifically about inequality and economic collapse, but: Just this past Monday, Bruce Meyer and Russ Roberts discussed on EconTalkthe idea that the general meme of ‘rising inequality for the poor and middle class’ is either false or misleading.

BTW, EconTalk is an excellent resource and a must-download every Monday, and archives going back several years. Highly recommended.

Two data points is not a set of data.

The US has always had the widest income gap of any modern nation, due to our focus on drawing in immigrants. If Krugman’s theory were true, then the US would have more economic collapses than any other modern nation (UK, France, Germany, Japan, etc.) While I’ll grant that I don’t have any data to prove it, I’d be fairly willing to bet that we have not.

To be certain, an economic bubble means that more focus is being put on a particular area of the economy than is wise, and in some way might cause a wider income gap within that field. But really I doubt it, as I would believe that any industry, regardless of the wisdom of its being, won’t have all that drastically different a pay structure from any other industry. But even if it were true, you’re still not looking at the cause of the recession when you notice the rising income gap disparity, you’re just seeing a side effect. E.g. influenza isn’t a “heating up of your body” or a “cough”. The flu is a disease – an invasive species, gunking up your body – and while the symptoms of it may allow you to identify the cause, they are not the cause itself.

But as said, I really doubt it. When there was the Dot.com bubble, I’d be fairly certain that all those Dot.com companies had janitors, and those janitors were making something like a janitor’s wage. The programmers were making programmers’ wages. The CEOs were making CEOs’ wages, and getting CEOs’ stock options. The only difference was that the money to support all of this was coming from investors, not customers. If anything, that means that you’d be taking from the TOP of the income hierarchy and moving it downwards, not the other way around.

Thats not true. But in anycase:

No it wouldn’t. Krugman’s theory (according to the OP) is that rising income inequality is a signal of unhealthy growth in the financial sector due to bubbles. That doesn’t really have anything to do with the relative sizes of income inequality between countries, just the growth rate of inequality.

Well so explain to me how a market driven by investors (money coming from the top), not customers (money coming from the bottom), manages to cause a widening income gap to do so faster?

That assumes the US is a closed economy. Those rich fat cats can also invest outside the US.

No doubt, but:

a) its not like (domestic) financial bubbles and Mortgage loans to the Middle class had bad returns (in the short term, anyways), and the financial sector managed to convincingly obfuscate the risk, so from a investors point of view, there were plenty of domestic investment opportunities.

b) Much of the economy in other countries was also based on selling exports to American consumers. So investing in a factory in China or Germany vs investing in a factory in the US doesn’t really solve the problem, either way your customer is the same people with stagnant wages and no other method of increasing consumption except to borrow.

c) There was a general glut of wealth with no place to go. If your the last Doper who hasn’t listened to A Giant Pool of Money, I recommend it.

These two graphs probably demonstrate what I’m talking about better then typing:

Here’s Household debt and here’s productivity and mean wages over a similar time period.

Productivity increased rapidly the last couple decades. Wages have been stagnant or dropping. They have dumped a lot of workers. The difference has been huge profits for corporations. Huge salaries for the people on top. They have had enormous amounts of money to play with. They have not shared with the workers.
They had money to spend buying politicians and regulators. So they did. The pols kept cutting taxes to the rich in return for donations. It kept feeding on itself until we have the worst concentration of wealth since the Gilded Age. It is the worst concentration in an industrial country on the globe.
The Gilded Age was the time before the Great Depression. Our gilded age preceded the 2008 crash. But we did not fix the problems. The rich still will not share the money with the workers. So we will have another crash that will harm the poor who are unprotected from the ravages of the rapacious on the top.
Someday it will end with mobs and pitchforks.

I think political instability, not economic instability, is the greater danger of excessive economic inequality.

They are not divorced. The economic crisis has put people in the streets fighting the inequities in America. They are sending a message to the politicians.

You leave us out of this.

You’re confusing an effect with a cause, I think.

The market being driven by investment rather than consumers is a symptom of growing income inequality, which is itself a symptom of increased risk-taking in the financial sector.

Which is then exacerbated by there being even fewer remaining good investments with more money chasing them, since the only way to sustain long-term growth is with consumer demand. Which isn’t rising with GDP, because the GDP gains being realized are being realized mostly in the financial sector.

In other words, rising income inequality is a signal that the financial/investment sector is building up bubbles on speculative things rather than growing at a healthy (that is, tied with demand) pace.

My two cents.

IMO an economic system can only tolerate so much of making money by the methods of borrowing money and lending money. At some point it becomes meaningless and no “real wealth” is generated and its all an illusion. Then finally it collapses. Now, if there if a significant fraction of the really rich folks are getting rich with those methods I could see how income inequality = collapse/problems when it goes to far.

:rolleyes: Oh, right, I’m sure you guys have nothing to do with any economic problems ever.

Damn, our smoke screen is foiled! :stuck_out_tongue:

Stating something as being so does not make it so. You and Simplicio are saying that there is a correlation between a market bubble and growing income inequality and further that investment in a bubble causes the rate of income equality to change even faster. But neither of you have explained how either of these processes actually work, just that it is. I’m not saying that either of you are wrong, just that I don’t see how you are coming to this conclusion.

Say that I have a population of 100 people, distributed into five groups of the following income:

60 :: $500 per person :: $30,000 total
30 :: $1500 per person :: $45,000 total
5 :: $3000 per person :: $15,000 total
4 :: $3500 per person :: $14,000 total
1 :: $5500 per person :: $5500 total

They all work for a company which makes hamburgers. All of them buy and eat only hamburgers from their employer. Each hamburger costs $3. Every day, each one of my 100 people buys one hamburger:

60 * -$3 = -$180 total
30 * -$3 = -$90 total
5 * -$3 = -$15 total
4 * -$3 = -$12 total
1 * -$3 = -$3 total

From all revenue ($300), wages are paid for that day:

60 * $1.37 = +$82.19 total
30 * $4.11 = +$123.29 total
5 * $8.22 = +$41.10 total
4 * $9.59 = +$38.36 total
1 * $15.07 = +$15.07 total

As you might notice, the lowest income group is paying more than they earn every day. The top income group is making back five times as much as they spent every day. In this economy, where we only have consumers and no investors, money flows upwards, increasing the income gap. If money is coming from the bottom of the economy and then being distributed according to wage (and stock holdings, etc.) then you get an increasing income disparity.

If you reverse the math and have an all investment economy, then everything flops. Money comes from the top, is distributed across the economy, and income disparity shrinks.

This is pretty basic math, using nothing more than addition, subtraction, and multiplication in a circulating economy. In a real economy, consumer based inflow and investment based inflow have converged on an equilibrium so that the system is maintainable. But if investment grows relative to consumerism, we should expect to see declining income disparity.

Since a bubble is, by definition, a market which exists due to investment, not consumerism, you would expect a declining income disparity and as investors pile on, you would expect this to go even faster. This is exactly the opposite of what you’re saying happens.