[p2p-research] Does income inequality cause financial crises?

[Ryan]

  Sent to you by Ryan via Google Reader: Does income inequality cause
financial crises? via Ezra Klein by Ezra Klein on 6/28/10



Paul Krugman posted some slides (pdf) this morning from a talk he gave
exploring the connection between inequality and major economic crises.
They're a bit incomplete without Krugman's accompanying remarks, but in
them, Krugman says that he used to dismiss talk that inequality
contributed to crises, but then we reached Great Depression-era levels
of inequality in 2007 and promptly had a crisis, so now he takes it a
bit more seriously.

The problem, he says, is finding a mechanism. Krugman brings up
underconsumption (wherein the working class borrows a lot of money
because all the money is going to the rich) and overconsumption (in
which the rich spend and that makes the next-most rich spend and so on,
until everyone is spending too much to keep up with rich people whose
incomes are growing much faster than everyone else's).

I've long been interested in this question but, unfortunately, am not a
Nobel-level economist, and so don't have great answers. One theory
that's made intuitive sense to me is that the problem is not just the
demand for credit but the accompanying supply of idle money. When
someone making $25,000 a year gets a raise, they spend it. When someone
making $2,500,000 a year gets a raise, they invest it. And the more
money there is sitting around, the more demand there is for high-yield
investments, which means the more reward there is for people who can
invent new investment vehicles with high yields. Hence, you have
explosive innovations in weird financial instruments that look good for
a while because the risk is underpriced but end up making the system
more fragile when their risks come clear and everyone flees.



Paul Krugman - Economic - Social Sciences - People - Great Depression
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