Extreme Inequality Helped Cause Both the Great Depression and the Current Economic Crisis → Washingtons Blog
Extreme Inequality Helped Cause Both the Great Depression and the Current Economic Crisis - Washingtons Blog

Friday, December 17, 2010

Extreme Inequality Helped Cause Both the Great Depression and the Current Economic Crisis

It is clear that when banks become too big, it harms the economy. Economist Steve Keen says that "a sustainable level of bank profits appears to be about 1% of GDP", and higher bank profits lead to a Ponzi economy and a depression.

But most mainstream economists dismiss the idea that wealth inequality among individuals causes economic crises.

Of course, some ideologues will argue that even discussing inequality is waging class warfare, and smacks of an attack on capitalism.

However, the father of modern economics - Adam Smith - disagreed.

And as Warren Buffet, one of America's most successful capitalists and defenders of capitalism, points out:

There's class warfare, all right, but it's my class, the rich class, that's making war ....

And as I have previously noted, radical concentration of wealth actually destroys capitalism, turning it instead into socialism for the rich.

Is There a Causal Connection Between Extreme Inequality and Economic Crises?

More to the point, most mainstream economists do not believe there is a causal connection between inequality and severe downturns.

But recent studies by Emmanuel Saez and Thomas Piketty are waking up more and more economists to the possibility that there may be a connection.

Specifically, economics professors Saez (UC Berkeley) and Piketty (Paris School of Economics) show that the percentage of wealth held by the richest 1% of Americans peaked in 1928 and 2007 - right before each crash:

Figure 1

As the Washington Post's Ezra Klein wrote in June:

Thumbnail image for inequalitygraph.jpg


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).

Robert Reich has theorized for some time that there are 3 causal connections between inequality and crashes:

First, the rich spend a smaller proportion of their wealth than the less-affluent, and so when more and more wealth becomes concentrated in the hands of the wealth, there is less overall spending and less overall manufacturing to meet consumer needs.

Second, in both the Roaring 20s and 2000-2007 period, the middle class incurred a lot of debt to pay for the things they wanted, as their real wages were stagnating and they were getting a smaller and smaller piece of the pie. In other words, they had less and less wealth, and so they borrowed more and more to make up the difference. As Reich notes:

Between 1913 and 1928, the ratio of private credit to the total national economy nearly doubled. Total mortgage debt was almost three times higher in 1929 than in 1920. Eventually, in 1929, as in 2008, there were “no more poker chips to be loaned on credit,” in [former Fed chairman Mariner] Eccles' words. And “when their credit ran out, the game stopped.”
And third, since the wealthy accumulated more, they wanted to invest more, so a lot of money poured into speculative investments, leading to huge bubbles, which eventually burst. Reich points out:

In the 1920s, richer Americans created stock and real estate bubbles that foreshadowed those of the late 1990s and 2000s. The Dow Jones Stock Index ballooned from 63.9 in mid-1921 to a peak of 381.2 eight years later, before it plunged. There was also frantic speculation in land. The Florida real estate boom lured thousands of investors into the Everglades, from where many never returned, at least financially.

Wall Street cheered them on in the 1920s, almost exactly as it did in the 2000s.
But I believe there may be a fourth causal connection between inequality and crashes. Specifically, when enough wealth gets concentrated in a few hands, it becomes easy for the wealthiest to buy off the politicians, to repeal regulations, and to directly or indirectly bribe regulators to look the other way when banks were speculating with depositors money, selling Ponzi schemes or doing other shady things which end up undermining the financial system and the economy.

For example, as John Kenneth Galbraith noted in The Great Crash, 1929, Laissez-faire deregulation was the order of the day under the Coolidge and Hoover administrations, and the possibility of a financial meltdown had never been seriously contemplated. Professor Irving Fisher of Yale University - the Alan Greenspan, Robert Rubin or Larry Summers of his day - had stated authoritatively in 1928 that "nothing resembling a crash can occur".

Indeed, when enough money is concentrated in a couple of hands, the affluent can lobby to appoint to government positions, pay to endow prominent university chairs, and create think tanks and other opportunities for economics professors who spout the dogmas "everything will always remain stable because we've got if figured out this time" and "don't worry about fraud" to gain prominence. For example, Bill Black has written about The Olin Foundation's promotion over the last couple of decades of these dogmas.

I believe that the fourth factor exacerbates the first three. Specifically, when the wealthy have enough money to drown out other voices who might otherwise be heeded by legislators and regulators, they can:

  • Skew the tax code and other laws so that they can get even wealthier
  • Encourage a debt bubble (Bill Black has repeatedly explained that the fraudsters blow huge bubbles, knowing that the government will bail them out when the bust leads to defaults)
  • And create new Ponzi schemes for speculation

(Admittedly, there might not always be a direct connection, but all of the factors are at least intertwined.)

Reuters wrote an excellent piece on the issue of inequality and crashes (discussing the first three factors) last month:

Economists are only beginning to study the parallels between the 1920s and the most recent decade to try to understand why both periods ended in financial disaster. Their early findings suggest inequality may not directly cause crises, but it can be a contributing factor.


America has one of the largest wealth gaps among advanced economies. Based on an inequality measure known as the Gini coefficient, the United States ranks on a par with developing countries such as Ivory Coast, Jamaica and Malaysia, according to the CIA World Factbook.


There is little agreement among economists about what precisely links high inequality to crises, which helps explain why so few officials saw the financial upheaval coming.

Rapid expansion of credit is one common thread.


Raghuram Rajan, a professor at the University of Chicago's Booth School of Business and a former chief economist of the International Monetary Fund, believes governments tend to promote easy credit when inequality spikes to assuage middle-class anger about falling behind.

"One way to paper over the rising inequality was to lend so that people could spend," Rajan said.

In the 1920s, it was expansion of farm credit, installment loans and home mortgages. In the last decade, it was leveraged borrowing and lending, by home buyers who put no money down or investment banks that lent out $30 for each $1 held.

"Housing credit gave you an instrument to assist those falling behind without them feeling they're beneficiaries of some sort of subsidy," Rajan said. "Even if their incomes are stagnant, they feel really good about becoming homeowners."

Another theory is that concentration of wealth at the top sends investors searching for riskier interest-bearing savings. When so much cash is sloshing around, traditional safe investments such as Treasury debt yield very little, and wealthy investors may seek out fatter returns elsewhere.

Mark Thoma, who teaches economics at the University of Oregon, wonders if the flood of investment cash from the ultra-rich -- both in the United States and abroad -- encouraged Wall Street to create seemingly safe mortgage-backed securities that later proved disastrously risky.

"When we see income inequality rising, we ought to start looking for bubbles," he said.

Kemal Dervis, global economy and development division director at Brookings and a former economy minister for Turkey, said reducing inequality isn't just a matter of fairness or morality. An economy based on consumption needs consumers, and if too much wealth is concentrated at the top there may be times when there is not enough demand to support growth.

"There may be demand for private jets and yachts, but you need a healthy middle-income group (to drive consumption of basic goods)," he said. "In the golden age of capitalism, in the 1950s and 60s, everyone shared in income growth."

The fact that economists are even examining the link between inequality and financial crises shows just how much the thinking has changed in the wake of the Great Recession.


Ajay Kapur, a Deutsche Bank strategist, spotted the inequality parallels between the 1920s and the most recent decade, but didn't see the meltdown coming. The former Citigroup strategist created a stir five years ago when he built an investment strategy around his thesis that essentially divided the world into two camps: the rich and the rest.

Kapur told clients in 2005 that the United States and a handful of other economies were developing into "plutonomies" where the wealthy few powered economic growth and consumed much of its bounty, while the "multitudinous many" shared the leftovers.

Plutonomies come around only once or twice a century, he argued -- 16th century Spain, 17th century Holland, the Gilded Age. The last time it happened in the United States was during the "Roaring 1920s".


At least one new arrival to Washington's policy-making scene, Fed Vice Chairman Janet Yellen, has expressed concern that extreme inequality could ultimately undermine American democracy.

"Inequality has risen to the point that it seems to me worthwhile for the U.S. to seriously consider taking the risk of making our economy more rewarding for more of the people," she wrote in a 2006 speech.

For further background, see this, this and this.

Note: The graphics above are slightly misleading, as Saez notes that inequality is actually worse now than it's been since 1917.


  1. Might I suggest you have a look at David Harvey's 'The Enigma of Capital and the Crises of Capitalism'? It's a splendid book, and he goes a bit further than Reich does in his 'Aftershock' in analyzing crisis formation.

  2. Excellent article. Politicians tell us over and over that the wealthy need their estate tax to remain at 0% so that the small business owners among them will create jobs. I wish the people who believe that would read this article.

  3. Supporting data here:


  4. You nailed the problem. What about solutions? Have you considered binary economics? One widely overlooked way to empower economically poor and working people in market economy is to universalize the right to acquire capital with the earnings of capital. This right is presently largely concentrated, as a practical matter, in less than 5 % of the population. The concentration of the right to acquire capital with the earnings of capital helps to explain how people either remain poor or end up poor no matter how hard they work or are willing to work.

    Binary Economics offers a conception of economics that is foundationally distinct from the economic theories presently employed by government, private enterprise, charitable institutions, and individuals to formulate and evaluate economic policy. Because it is foundationally distinct from classical, neoclassical, Keynesian, monetarist, and socialist economics, binary economics specifically offers a distinct explanation for the persistence of poverty, unutilized capacity, and suboptimal growth. First advanced by Louis Kelso, binary economics holds that (1) labor and capital are equally fundamental or "binary" factors of production, (2) technology makes capital much more productive than labor, (3) the more broadly capital is acquired with the earnings of capital the faster the economy will grow.

    Most binary economists conclude that universal, individual participation in the right to acquire capital with the earnings of capital (the binary property right) is a necessary condition for sustainable growth, distributive justice, and a true democracy. Binary economic analysis reveals a voluntary market-based strategy for producing much greater and more broadly shared abundance without redistribution. Based on objective standards of (1) reasonable, workable assumptions, (2) internal consistency, and (3) plausible descriptions, predictions and prescriptions, binary economics should be considered wherever other economic approaches to growth, sustainability, development, investment, poverty, and economic justice are considered!

  5. First, I think Adam Smith is right - we do need SOME regulations and not the crony capitalism that we have in America now

    Second,Warren Buffet, one of America's most successful CRONY capitalists and defender of CRONY capitalism was about to go broke, if it wasn't for the bailouts received from the taxpayers and the stimulus money given to him by our government.

    He once might have been what many consider "the greatest investor of all times", but not seeing what is coming in 2008...that is a big MISS. He is not that great in my list of great investors

    Third, have you ever look at the Emanuel Saez study? Here is a link to it
    Now, go to page 4, third paragraph...

    "The evidence suggests that
    top incomes earners today are not “rentiers” deriving their incomes from past
    wealth but rather are “working rich,” highly paid employees or new
    entrepreneurs who have not yet accumulated fortunes comparable to those
    accumulated during the Gilded Age."

    Got that? The so called "rich" are entrepreneurs and highly paid employees. That are two groups of people: One - the entrepreneurs like Bill Gates and Steve Jobs, who invent and make products, that WE ALL BUY VOLUNTARILY, in millions... and
    the second - the highly paid employees - like the banksters getting bonuses and extracting fees and the public employees (the new millionaires)

    If you ask me I would say, the second group has a lot more to do with recessions(fraud that is not punished, but instead rewarded by bailouts and unsustainable public salaries and pensions)than the first one, selling in big volume and for the right price products and services (bought by us voluntarily)

    You even say it yourself:
    "Second, in both the Roaring 20s and 2000-2007 period, the middle class incurred a lot of debt to pay for the things they wanted..."

    Gee, is that mean that the iphone will sell for less than $500, if there are no people to buy it for such a high price? I think so

    Did the "rich" forced the "middle class" to go into debt to pay for things they (the middle class) wanted? I do not think so

    Forth, I agree with your forth point - special business interest and the politicians are about to get the American people by the balls.

    We have to prevent the crony capitalism.
    We have to prevent business pay outs to the politicians to be re-elected and we have to prevent political bail outs for failing businesses to stay afloat

  6. I think you've certainly drawn some correlations... but correlation does not imply causation, and it never will.

    Good post, though.

  7. Nice summary of the dangers of high inequality.

    I would add that the possibility of "pension fund socialism," whereby the legal owners of corporations, often the pensions funds of the workers, exercise control over executive compensation and the general distribution of spoils. Peter Drucker wrote a book about this in the 1970s in a rare show of neo-socialist fantasizing.

    Corporate governance has been tied up in administrative plans that effectively exclude the legal owners of corporations from exercising control. Berle and Means wrote about this in the 1930s in "The Separation of Ownership and Control," and it persists today.

  8. A simple way of looking at inequality is the game of Monopoly. Every one starts out with the same amount of money and through chance (Go directly to jail, do not pass go,...) and sometimes skill, eventually the hotels will go up on Boardwalk and Park Place and it's game over.

    That's not good for society.

    In the long run, concentrated wealth destroys democracies. That's why taxes and government regulations are a necessary part of a functioning capital market. It's all about how you slice the pie.

    So the simplest solution is the Job Guarantee (Employer of Last Resort) and a tax structure that encourages company production in the US and penalizes unearned income and speculation.

  9. Of course we all know that credit money is created from nothing - it involves a debit and credit, an asset and a liability. Once the borrower has spent their newly borrowed money, that money tends to concentrate in wealthy hands unless steps to re-balance are taken.

    The financial crisis occurs when the borrowers become over indebted and the entities (mostly banks) holding their loans do not have the readies to make good the loans when the borroweer defaults and go bust.

    So the income disparity and extreme wealth is both a symptom and warning signal that certain sections of the population are becoming dangerously over indebted.

  10. Great post. This is a discussion we should be having on national TV and what to do about it, including increasing the tax rates on the wealthiest individuals AND on corporations - IMMEDIATELY! Instead, we watch Dancing with the Stars and wonder if Kim Kardashian has put on a few pounds. What a foolish, hopeless country this is......

  11. How can you not mention the Fed reserve bank policies, especially after the onset of failure at Lehman? The market was attempting to cleanse itself of the poisonous companies infecting. Now the treasury and fed have leveraged our currency on the world stage. New and existing regulation will guarantee that the treasury succeeds at the expense of the taxpayers.

  12. Fantastic article!
    Just discovered this site...
    BUT where's your sitemap or contents? I'd like to see a contents link list of any other articles you may have written. Or is this your first article??

  13. Fantastic article!
    Just discovered this site...
    BUT where's your sitemap or contents? I'd like to see a contents link list of any other articles you may have written. Or is this your first article??

  14. You've pulled together a number of relevant sources which suggest that something may be going on between wealth inequality and economic instability. It is possible that wealth inequality is problematic for any economy, but it seems like some people require absolute proof before they will consider something even possible.

    I don't think absolute proof is possible in economics. There are too many interacting factors. We can still examine things systemically and then suggest action.

    I've resumed blogging at http://envision-something-better.blogspot.com/ and I've been reading Thom Hartman and thinking a lot about this topic. We know that reducing taxes hasn't helped the economy, but it's made a few people very wealthy. Maybe it's time to progressively raise taxes again to see what happens.

    Saying this likely sounds to some people like saying we should reconsider whether the world is really flat or round, but we did have a more robust economy and middle class from the 1940s to 1970s when taxes were much higher, so we do have some evidence that higher taxes don't prevent an economy from prospering.

    It seems that the wealthy, and those who trust them to lead the way, may not be willing to consider the link between taxation, wealth inequity and economic instability, but we must take another look the relationship between these factors to try to get our economy restarted.

  15. The study Emmanuel Saez and Thomas Piketty does not include Realized Capital Gains. The problem is therefore understated.

    I think the income is before 401k’s and other deductions that would further reduce reported income through tax avoidance strategies.

    Does anyone have an idea of the magnitude of this issue?

    This is to be found in the report, see below. Please follow the link for the original report. -------------------------------------------------------
    Page 6
    Realized capital gains are not an
    annual flow of income (in general, capital gains are realized by individuals in a lumpy way) and form a very volatile component of income with large aggregate variations from year to year depending
    on stock price variations. Therefore, we focus mainly on series that exclude capital gains.7 Income, according to our de.-nition, is computed before individual income taxes and individual
    payroll taxes but after employers’ payroll taxes and corporate
    income taxes.8

    Page 21
    24. In particular, capital gains not realized before death are never reported on income tax returns, but are included in the value of assessed estates.


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