Comment: Inequality is the real cause of the financial crisis

Wednesday, 12 October 2011 4:29 PM

The rising inequality of the post-Thatcher era has produced consumer societies without the capacity to consume.

By Stewart Lansley

At the depth of the downturn in October 2009, St Paul's Cathedral hosted a spirited debate on the growing income gap. One of the speakers, Brian Griffiths, the vice-chair of Goldman Sachs and a former adviser to Margaret Thatcher, defended higher inequality "as the way to achieve greater prosperity for all".

That the accumulation of large fortunes fuels wealth creation and boosts growth is a creed that remains embedded in mainstream economic thinking. So is it true? The answer is no. The wealth gap has soared, but without the promised pay-off of wider economic progress.

On all measures bar inflation, the post-1980 era of rising inequality has a much poorer record than the egalitarian post-war decades. Growth and productivity rises have been lower, unemployment rates much higher, financial crises more frequent and more damaging.

The post-1980 experiment has delivered an economy that is both much more polarised and much more fragile. So what does this tell us about cause and effect? Has rising inequality contributed to today's crisis? No, according to the report of the US official Commission into the 2008 crash. It failed to mention 'inequality' once in its 662 page report.

Yet the historical evidence points to a clear link from inequality to instability. The two most damaging recessions of the last century – in the 1930s and today – were both preceded by sharp rises in inequality.

So why do excessive concentrations lead to economic turmoil? The principal explanation lies in the impact of the growing gap between pay and economic output. First, a rising earnings-output gap sucks demand out of the economy. If wages fall substantially below the level of economic output, as they did in both the 1920s and the build up to 2008, purchasing power does not keep pace with the extra output being produced. Consumer societies suddenly find they lack the capacity to consume.

Secondly, high inequality leads to asset bubbles. In 1920s America, enrichment at the top fed years of speculative activity in property and the stock market. The build-up to 2008 followed a near identical pattern. Rising corporate surpluses and burgeoning personal wealth led to a tsunami of hot money that helped to create the asset bubbles that eventually brought the British and global economies to their knees.

A fair division of the spoils of the economy is critical in ensuring that economies work. In the post-war decades to the end of the 1960s - a period of relative economic stability -wages and profits moved roughly in line with output. During the 1970s, the wage share soared creating a profits squeeze that threatened the long run sustainability of capitalism. The 1920s and the post-1980s, in contrast, brought a falling wage that destroyed the natural process of economic equilibrium. On both occasions, allowing the richest members of society to accumulate a larger and larger share of the cake merely brought a dangerous mix of demand deflation and asset appreciation which ended in prolonged economic turmoil.

These lessons have yet to be learnt. If we are to avoid the risk of near-permanent recession, this fundamental imbalance needs to be restored. The great concentrations of income and wealth need to be broken up – as they were from the 1930s - and the wage share restored to the post-war levels that brought equilibrium and sustained stability.

Stewart Lansley is the author of The Cost of Inequality: Three Decades of the Super-Rich and the Economy, published by Gibson Square.

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