Social Inequality and the Great Contraction

Till van Treeck in the Guardian talks about higher inequality and easy access to credit being a reason for consumers to borrow beyond their means. There is mention of Rgahuram Rajan’s book “Fault Lines” which argues that lower and middle-class consumers in the US have saved less and borrowed more in order to increase their real incomes. This obviously kept aggregate demand and employment high but meant there was a huge amount of debt which contributed to the financial crisis of 2009-10. Rajan criticises the textbook theory of consumption as he believes that there is a link between income inequality and overall private consumption. Most would tend to agree with this statement as consumers tend not to be rational about their long-term income.

In 1996, Alan Greenspan, then chairman of the Federal Reserve Bank, noted in response to growing concerns about rising inequality that “wellbeing is determined by things people consume [and] disparities in consumption … do not appear to have widened nearly as much as income disparities”. In a similar vein, Fabrizio Perri and Dirk Krueger suggested in an influential scholarly article published in 2006 that “consumers could, and in fact did, make stronger use of credit markets exactly when they needed to (starting in the mid-1970s), in order to insulate consumption from bigger income fluctuations”.

Recent research has shown that the rise in inequality over the last few decades has been due to many households living beyond their means and being attracted into suspect credit they couldn’t pay back.

Bring back Keynes!

Keynesian economists believe that consumers care about their consumption relative to others as an indication of their social status. Therefore the further you get behind in your ability to purchase goods and services – in relation to others – the more pressure there is for you to borrow money.

Similarly, the basic Keynesian insight that middle-class incomes need to grow in line with productivity in order to sustain robust aggregate demand appears today more relevant than ever.

In the US the increase in inequality has meant that household have worked longer hours, saved less, and borrowed more in order to maintain a social status. Till van Treeck alludes to the fact that the dominant textbook economic theories of consumption look almost as toxic as some of the credit products that ultimately caused the crisis.

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