Unequal = unstable
The key mechanism is that investors use part of their increased income to purchase additional financial assets backed by loans to workers. By doing so, they allow workers to limit their drop in consumption following their loss of income, but the large and highly persistent rise of workers’ debt-to-income ratios generates financial fragility which eventually can lead to a financial crisis.
Prior to the crisis, increased saving at the top and increased borrowing at the bottom results in consumption inequality increasing significantly less than income inequality. Saving and borrowing patterns of both groups create an increased need for financial services and intermediation.
As a consequence the size of the financial sector, as measured by the ratio of banks’ liabilities to GDP, increases. The crisis is characterised by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. financial crisis.
Basically, the rich lent to the poor, enabling them to buy more. The extra saving and borrowing by both groups made the financial sector much bigger, leading to huge debts and eventually default.
It’s certainly true that inequality lay at the heart of the financial crisis. I’d add that in the United States, inequality was purposefully made central to the mortgage model of the last decade or so. Banks actually sought out borrowers who they didn’t think would be able to repay their mortgages, offering them enormous loans — often in excess of the value of their property. Few questions were asked about sub-prime borrowers’ ability to repay because the bank actually wanted them to default, gaining them a valuable asset cheaply. It was almost as if the rich were preying on the poor.
This recognition doesn’t bode well for future economic growth. Many economists would prefer a consumption-led recovery rather than an export-led race to the bottom. The problem is, old habits die hard. We don’t seem to have made any attempt to tame the banks. In any case an upturn in consumption is a vain hope, and even if it did happen, without an increase in lower to middle-class incomes it would just create the same debt-laden predicament as before.