How soaring inequality contributed to the crash

By Stuart Lansley

Although global imbalances, excessive bank leveraging and reckless financial risk-taking helped trigger the meltdown of 2008/09, the crisis has it roots in the rising income and wealth gap, and the way a new domestic and global super-rich elite created economic fragility.

The rise in inequality of the last 30 years has been driven by a steady fall in the share of wages in UK national output – from a high of 64.5% in 1975 to as little as 53.2% in 2007 – along with a rise in the share of profits which has fuelled the personal wealth boom at the top.

These trends have played a major role in financial instability. First, because of the negative effect of greater inequality on spending power. To maintain rising living standards, ordinary families, faced with declining relative wages, became increasingly indebted with the debt/income ratio rising from 45% in 1980 to 157.4% in 2007. Moreover, because lending was extended to groups with few if any tangible assets, the level of default risk in the economy rose along with the fragility of the banking system.

Secondly, this increase in risk was multiplied because the personal wealth boom boosted financial speculation at the top as the super-rich attempted to use their mounting wealth portfolios as the source for quick profits. In doing so, they aped financial institutions, leveraging their wealth – sometimes by huge amounts – by borrowing. Record returns together with cheap credit encouraged the wealthy to borrow not to finance consumption but to take large speculative bets. Money poured into hedge funds, private equity, takeovers, commodities, rare art, commercial and private property in a speculative frenzy that created the multiple bubbles that triggered the credit crunch and the subsequent recession.

A similar mechanism was at work in the build-up to the great depression of the 1930s with, in the United States, a great surge in the concentration of wealth and in the volume of speculative loans during the 1920s. During that decade, the poor and the middle stagnated while the rich prospered – as they have in the UK and the US in recent times – and soaring profits poured into real estate and stock markets, leading to the 1929 crash.

The role of inequality in fuelling financial instability has long been recognised. Keynes made it clear that because of the lower marginal propensity to consume of the rich, and their propensity for speculation, wealth inequality increases the risk of financial instability and economic collapse. In his book The Great Crash, JK Galbraith identified “the bad distribution of income” and its impact on the pattern of demand as the first of five factors causing the crash and the great depression.

The global distribution of wealth today is almost as uneven as it was in the 1920s, and its speculative element and impact has been accentuated by both greater leveraging and the rise of an avalanche of footloose capital owned by the world’s nomadic super-rich. The combined wealth of the world’s richest 1,000 people is almost twice as much as the world’s poorest 2.5 billion.

The third way high levels of inequality have fuelled instability is via shifts in the global and domestic power nexus. Over the last three decades, the rise of the global financial elite has shifted power from nations to a small coterie of individuals and corporations. Awe-struck political leaders stood on the sidelines as the new wealthy elite ensured what Citigroup global strategist Ajay Kapur has called “favourable treatment by market-friendly governments”. Over the last decade this elite has used its growing political muscle to guarantee weak financial regulation by the state and lower taxes on the wealthy. According to Simon Johnson, former chief economist at the IMF, a dominant financial oligarchy “played a central role in creating the crisis, making ever-larger gambles…until the inevitable collapse”.

The fault lines of Britain’s low wage, high debt, finance-dependent economy are now only too evident. The wage squeeze meant that real wages were not growing fast enough to underpin final and stable demand without excessive personal borrowing. By fuelling borrowing by households with a limited or zero asset base and encouraging rampant financial speculation, rising inequality brought unprecedented asset bubbles alongside an increasingly fragile banking system.

Today’s most urgent task beyond recovery is to rebalance the real economy. This means plans which halt and reverse the sliding wage share, reduce the gap between rich and poor, shrink the size of the financial sector and increase the flow of funds into productive and sustainable economic activity.

Such a strategy would make the economy less dependent on debt for maintaining demand, limit the level of financial speculation, moderate the cycle of asset prices and reduce the degree of economic volatility.

Stewart Lansley is the author of Rich Britain: The rise and rise of the new super-wealthy; Unfair to Middling: The TUC Touchstone Report; and co-author of Londondgrad: From Russia with cash.

The unabridged version of this article is published in Soundings issue 44, Spring 2010.

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