Income Inequality: Not Your Usual Suspect in Understanding the Financial Crash and Great Recession

Abstract

Rising income inequality was a major factor in the surge of household debt that brought on the financial crash and Great Recession. Other studies have identified rising household debt as a cause of the crash but not income inequality as a cause of the rising debt. Here the unusual rise in household debt post 1995 is documented. Econometric evidence links rising income inequality to the rise of household debt. Consumer expenditure data shows that prices of major necessities — shelter, healthcare and education — rose faster than inflation as demand by high-income households surged. In order to maintain their consumption of such necessities, lower-income households resorted to massive borrowing. Their rising debt precipitated the financial crash and Great Recession. That link was overlooked by mainstream economists because they adhere to a theory of household consumption that posits no role for income inequality.