Paul Krugman and Ezra Klein suggest that inequality leads to recessions. Adam doesn’t find the mechanism plausible.
My gut reaction is that there is likely a connection and it likely runs through common causation. That is, there is another force which produces both inequality and recessions.
Unlike Paul, I am skeptical that the force is political.
My patchwork general theory runs as follows
1) There are recessions caused by shocks to money supply (see 1980s)
2) There are recessions caused by shocks to money demand (see 1929, 2008)
The BIG money demand recessions come about when there has been a mispricing of risk. The world appears to be much safer than it is and people are willing to invest in riskier assets.
Overconfidence is almost a precondition for big swings in money demand because it is much easier to suddenly become aware that one has been overconfident than to suddenly become aware that one was under confident. Very fast changes in expectations are needed to produce huge swings in money demand. Thus large changes in money demand are more likely to come in the form of surges in money demand rather than collapses in money demand.
This increased investment in risky assets yields higher returns. And, note these are higher real returns. There is a fundamental risk reward tradeoff and if people mistakenly believe that risk is less than it really is they will push into investments that do in fact yield high rewards.
This high rewards mean that highly leveraged individuals see their wealth increase rapidly. It also means that industries which produce high yielding assets (tech and finance) do very well.
This is what produces the run-up in inequality.
This is as opposed to the smoke and mirrors financial asset model that Klein proposes. Klein suggests that inequality comes first and that wealth is chasing illusory returns.
Nonetheless, once it becomes clear that expectations were misplaced money demand surges. This is accompanied by a collapse in the price of risky assets. If this surge in money demand is not met by an increase in money supply the result is a deep recession.
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Tuesday ~ June 29th, 2010 at 1:05 pm
Lord
I am not so sure these explanations are inconsistent as it is fairly easy to see these feeding back on each other, reduced risk seeming to provide higher risk adjusted returns, leading to more investment, reducing risk further due to investment inflows, increasing capital gains and asset values, a small increase in inequality leading to larger deviations as asset bubbles are formed increasing inequality as assets become the route to wealth and investment becomes preferred to consumption. That long range fundamentals expose this as smoke and mirrors in the aftermath, doesn’t prevent short term real diversions of income flows and increased investment and returns that lead to the belief something has changed and this time is different.