Posted on Tuesday, December 14, 2010
Edward L. Glaeser is an economics professor at Harvard and the author of the forthcoming book “Triumph of the City.”
Did inequality cause the recent housing and financial crisis? For decades, a growing literature has tried to establish links between inequality and adverse outcomes, such as low economic growth, weak social cohesion and mortality and, most recently, financial crises.
If true, these arguments would provide even more reasons to worry about our unequal income distribution. If false, we should still worry about income inequality, because in a just society everyone should have a decent standard of living and the opportunity to succeed.
Empirically, it is true that inequality has risen since the 1970s, and, by many measures, America was a more unequal country in 2005 than it had been during any year since the 1920s. The echo of the Roaring Twenties reminds us that inequality also seems to have risen during that decade, in the years before the crash. These two periods have suggested to some people that inequality was actually playing a role in generating overpriced assets.
Why might widening inequality lead to a banking crisis? The Nobel Laureate Joseph Stiglitz’s theory is that “growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can’t spend it all.” This “flood of liquidity” then “contributed to the reckless leverage and risk-taking that underlay this crisis,” he asserts.
Jean-Paul Fitoussi and Francesco Saraceno have made similar arguments. A related view, called the Stiglitz hypothesis, by Sir Anthony Atkinson and Salvatore Morelli, is that “in the face of stagnating real incomes, households in the lower part of the distribution borrowed to maintain a rising standard of living,” and “this borrowing later proved unsustainable, leading to default and pressure on over-extended financial institutions.”
Another view, associated with Raghuram Rajan, former chief economist of the International Monetary Fund, is that “the political response to rising inequality – whether carefully planned or the path of least resistance – was to expand lending to households, especially low-income households.”
According to this hypothesis, public policies, like tacit acceptance of the implicit public guarantee enjoyed by Freddie Mac and Fannie Mae, encouraged people to bet big on housing and ultimately led to an unstable financial system.
A final housing-oriented hypothesis, given in the “Superstar Cities” work of Joseph Gyourko, Christopher Mayer and Todd Sinai, is that “continued growth in the number of high-income families in the U.S. provides support for ever-larger differences in house prices.” As the rich grew richer, they were willing to pay more for access to the best housing, like that on the California coast, and this led to rising prices in places where land was inelastically supplied.
None of these hypotheses are ironclad explanations of the boom-bust cycle. The Gyourko-Mayer-Sinai view actually predicts permanently higher – and potentially rising – prices in desirable locales, not a great housing crash. One-half of the Rajan view is undebatable: Policies in the United States, such as support for Freddie and Fannie and the home mortgage interest deduction, did certainly encourage people to bet on housing markets.
But it is less clear that inequality lay behind those policies, which were well established by the early 1970s before inequality began to rise. Certainly, when George W. Bush often lauded the “Ownership Society,” he was never terribly bothered by inequality and his support for home ownership seems at least arguably motivated by a desire to turn everyone into a property-owning Republican.
Professor Gyourko, Joshua Gottlieb and I have argued that there is little evidence supporting the view that easy credit, the great “flood of liquidity,” can explain the housing boom. Any argument that relies on a “keeping up with the Joneses” effect has to reckon with the finding of Bruce Meyer and James Sullivan that consumption inequality wasn’t increasing before the housing boom.
Since theory is pretty inconclusive, we must turn to the data. We are lucky that Professor Atkinson, a distinguished English economist (and regular Stiglitz co-author), has provided a pretty overwhelming empirical examination of the link between inequality and financial crises.
Within the United States, Professor Atkinson asserts, the prevailing views linking inequality and financial crises “need to be nuanced,” because “the rise in overall inequality prior to 2007 was not evident in the case of consumption, nor in the poverty rate,” and “income inequality as measured by the Gini coefficient rose by less than 1 percentage point over the preceding 10 years.” Income inequality was certainly high, in 2006, but it wasn’t rising sharply before the crash, except for the very top of the wealth pyramid.
Professors Atkinson and Morelli’s international data also suggests little regular connection between inequality and crises. Looking at 25 countries over a century, they find 10 cases where crises were preceded by rising inequality and seven where crises were preceded by declining inequality. Moreover, “the Gini coefficient was higher to a salient extent in two of the six cases where a crisis is identified, which is exactly the same proportion as among the 15 cases where no crisis is identified,” they found.
This is hardly an overwhelming correlation. When inequality and crises do go together, it is quite possible that the asset bubble is causing inequality rather than the reverse. The great stock market boom of the 1920s and the housing boom of the 2000s made many rich people even richer, and that certainly helped inequality increase.
Moreover, the across-city data doesn’t support the idea that rising prices were accompanied by rising income inequality at the metropolitan-area level.By EDWARD L. GLAESER NYT