What if the financial crash of 2008 was really caused by income inequality? Not greedy bankers, not reckless homeowners, but the ever widening-gulf between the rich and the poor?
And what if the lack of social services — like health care — made things much, much worse?
This is the startling new theory from Raghuram Rajan, the University of Chicago economist who became famous for standing up at a Federal Reserve meeting in 2005 and warning that Wall Street was out of control and headed for a global crash. As Edmund L. Andrews remembered in a recent post on the Capital Gains and Games financial blog: "I was there, and I can confirm that Raghu was greeted almost with scorn. As Justin Lahart later remarked in the Wall Street Journal, people reacted as if he were some kind of Luddite. But Raghu was right, and many of his criticisms are now conventional wisdom."
Now Rajan has a new book called Fault Lines that analyzes the structural reasons for the crash, and it's another "aha" moment, especially fascinating because it mixes free-market Chicago School economics with good-government ideas straight out of Obamaland. His thesis is expressed in one of his chapter titles:
Let Them Eat Credit.
This is how he explained it to me in a recent interview. "What I'm trying to say is there's immense pressure emerging from income inequality. Losing jobs is a very, very painful thing, so there's immense pressure to stimulate the economy at that time to bring back jobs because safety net is inadequate, with unemployment benefits lasting only six months and health care that isn't adequate."
This isn't a heinous capitalist conspiracy — or a socialist conspiracy either, for that matter. It's the structure of the system, he says, a design flaw thrown up by the conflict between the rules of capitalism and the limits of democracy. "Politicians are there to do something about the pain and suffering people have, and my sense is that home ownership and housing credit was in some ways a path of least resistance — it seemed to be working, and if you pushed it there were lots of positive consequences. It gives people a stake in society, it increases as society does well to give them a share in the growth and helps them borrow to enhance their lifestyles."
This isn't an attempt to absolve the greedy bankers, he says. "But we have to ask why did the financial sector suddenly want to lend to low-income housing?"
Ditto Fanny and Freddie, the quasi-government housing lenders right-wing ideologues like to blame for the crash. And the low interest rates set by the Federal Reserve. "I think we should recognize that this is a systemic crisis. This is not one bank gone crazy. This is many banks."
The larger problem is global, he says. "The U.S. is a country that tends to over consume and over stimulate in bad times, and as a result it tends to be a net absorber of goods from rest of the world. A counterpart to that is countries like Germany and Japan and some of the emerging markets like China and Malaysia, which have benefited hugely by exporting to the U.S. — so I'm arguing that there is this pressure both from within the U.S. and from outside to support over consumption, and that is something that gives the financial sector an incentive to go overboard."
Consider Greece. The conventional wisdom, especially among conservatives, is that Greece is a classic example of the danger of overspending on government social programs. "But the fact that Greece overspent is not totally unrelated to the fact that Germany needs to export — some of what Greece was doing was buying German goods."
So Greece buys off its people with early pensions and great services, and the U.S. buys off its people with easy credit.
But the conservative idea that the social safety net just makes people lazy isn't the answer either — that if you increase unemployment insurance, Americans will turn into Europeans and kick back in their Lay-Z-Boys?
There's some truth to it, Rajan says, as we can see from Europe's high long-term unemployment rates. "I understand that market incentives work — if you tell people they will be shot three weeks from now if they don't get a job, they'll go find a job. But is that the kind of psychological pressure we want to create?"
Again, the underlying problem is structural: when the U.S. economy was producing a lot of jobs, we didn't have to worry about long-term unemployment insurance. There was a "balance of incentives and safety net. But if the economy is going to mean that we have long-term joblessness, we need to think if we're being overly harsh."
So, to sum up the problem:
"There are three big fault lines — one is rising inequality, which pushes inappropriate spending such as encouraging households to buy houses subsidized by government lending. Second is the inadequate safety net which causes a whole lot of inappropriate stimulus in bad times, and I'd say especially stimulus coming from the Federal Reserve in the form of low interest rates. Third is the fact that many countries have grown in a way that emphasizes exports, which leads to over consumption in countries like the U.S."
For Rajan's detailed and specific answers to all these problems, many of which seem extremely smart, you'll have to go to the later chapters of Fault Lines. But here's a thumbnail version:
"Let's certainly do reforms in the financial sector, get bankers to own up the risk they're taking and penalize banks that take more risks. But we need to go beyond that, because if we don't fix this underlying source of income equality in the U.S., we're going to have a lot more people falling behind ..."
The popular panacea is the return of manufacturing jobs, which Rajan says will not happen. And trying to ride class resentment to an attack on the superrich isn't the answer either — for all his talk of income inequality, Rajan is still a Chicago School economist who believes that steep hikes in the "marginal" tax rates paid by the rich will stifle innovation. "The people who focus on the Bush tax cuts focus on income inequality at the very top, like the hedge fund guys who make billions. But I'm not so worried about that as the mass of people who can't afford a decent living with a high school education."
Instead, we need to focus on education, which, he admits, implies even larger underlying social efforts like "fixing communities and fixing families."
"I like to say, 'Let the free market operate when people reach 20 — but before that, you have to make sure they have the same access to the playing field.'"
He wants to raise taxes a little bit to bring down the public debt, also to cut expenditures a bit. "I'm not in the camp that sees a tax hike and redistribution as the answer to every problem, nor am I in the camp that says cut them to the bone, that taxes should never rise and just focus on reform — there's room for action on both sides but let's tackle the deep problem. Because if we don't try and solve them now, if we continue to rely on ad hoc measures, things will only get worse."
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