Ezra Klein and Paul Krugman wonder whether income inequality can cause recessions, and they draw our attention to this graph as evidence:

Both concede it is difficult to find a mechanism that explains the relationship, which is also why I am skeptical. Ezra offers up this theory:

One theory that’s made intuitive sense to me is that the problem is not just the demand for credit but the accompanying supply of idle money. When someone making $25,000 a year gets a raise, they spend it. When someone making $2,500,000 a year gets a raise, they invest it. And the more money there is sitting around, the more demand there is for high-yield investments, which means the more reward there is for people who can invent new investment vehicles with high yields. Hence, you have explosive innovations in weird financial instruments that look good for a while because the risk is underpriced but end up making the system more fragile when their risks come clear and everyone flees.

This doesn’t seem correct to me. When they demand for investments goes up the price should go up, and since price of an investment is the inverse of the rate of return, the market rates of return on investments should go down . So if there are a lot of people with a lot of money to invest they bid down the required rate of return on a given investment.

This means that when Ezra says that the more investment demand there is the “more reward there is for people who can invent new investment vehicles with high yields“, I think he should be saying low yields. For example, if an investment can generate a 5% return, then when required market rate of return is above 6% the demand is zero. In contrast, a 10% investment will be in high demand when the required rate of return is 6%. So when investment demand increases, and thus rates fall, the marginal investments that become profitable should be increasingly low return, since high return investments were profitable in the first place.

Let me give a concrete example. If I have a factory that costs $1,000 to build and generate a $20 a year in profit, then it has a 2% return on investment. I will only be able to find investors for this factory when the market rate of return is 2% or lower. In contrast, if I have a factory that costs the same amount to build but generates $200 a year in profits, then it has a 20% rate of return, and I will be able to find investors as long as the market rate of return is 20% or lower. As market rates lower, factories and other investments with lower rates of return should increasingly be supplied.

I’m not completely averse to Ezra and Krugman’s proposed relationship between income inequality and recessions. But I don’t think this mechanism is correct, and I will be skeptical until I hear a believable story.

About these ads