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Rising Inequality and the Financial Crisis Revisited

February 5th, 2013 · No Comments

Debate among the big beasts..

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)

Nobel prize winning economist Joseph Stiglitz has forwarded an interesting theory, which argues that rising inequality holds back the recovery and growth in general and leads to a situation known as an underconsumption crisis. Why? Well, the rich tend to save more and spend proportionally less of their money, so rising inequality will lead to less national buyers for our output.

Another Nobel prize winning economist, Paul Krugman has several good arguments against this thesis:

  • Rising inequality since the 1970s has gone hand in hand with falling savings, not rising savings.
  • Rising inequality went hand in hand with robust demand, at least until 2007.
  • A cross-sectional evidence of saving and spending isn’t very useful at any particular point in time.

Krugman is right on the first two points, the last needs some explanation:

Consumer spending tends to reflect expected income over an extended period. If you take a sample of people with high incomes, you will disproportionably include people who are having an especially good year, and will therefore be saving a lot; correspondingly, a sample of people with low incomes will include many having a particularly bad year, and hence living off savings. [Krugman]

However, there is plenty of evidence that the rich indeed save more (for instance, here and here). Falling real interest rates is also indicative of a savings glut.

The funny thing is, we advanced an early version of the thesis that rising inequality was an important factor in causing the financial crisis. There has undeniably been a rising gap between labor productivity growth and stagnating median wages since the 1970s.

(click to enlarge)

[Read on here]

Tags: Financial crisis · Inequality