Paul Krugman asks a provocative question with his slides, which accompanied his presentation regarding income inequality and crises:
So a return of inequality to 1920s levels was followedby a financial crisis similar to the onset of theGreat Depression. Why? Three possibilities:
1. Coincidence
2. Common causation –e.g., neoliberal ideology
3. Actual causation: inequality somehow createsmacroeconomic vulnerability
Really, we can scratch off number two (at least the pet example Krugman gives). As Scott Sumner has pointed out, the US is actually behind the curve on neo-liberalism. The much more “equal” countries in western Europe have been neo-liberalizing like crazy (to the point where Denmark is the ‘freest’ economy on earth, by multiple measures), but retain their egalitarianism.
What is it that European countries do? Massive income redistribution. That may seem superficial, but it’s the answer that I’m most happy with. It has long been known to network theorists that competitive networks (with a return to scale to node connection) are characterized by power law distributions. This is a natural phenomenon; it happens in the blogosphere, the financial markets, in sports, and it happens in economies as a whole. Left to its own devices, it is inevitable that such networks will evolve an shockingly large disparity between the best-performing actors, and the mean actor. This fact is entirely independent from characteristics which make the network robust. Much like a network can be in any configuration of complexity and centrality at any given time, so can a network be in any configuration of equality and robustness.*
Remember, we are working with two data points; the Great Depression, and the Great Recession. Of course there are coincidences that may imply causation, and lead us down a twisty road looking for transmission mechanisms…but it’s not immediately clear (to me) that the simple answer isn’t the best answer — and that answer is number one: coincidence.
This may not satisfy the intellectual urge to connect crises and inequality that some people have…but at this point, I’m going to stick with the popular narrative of the Great Depression being caused by increased money demand not accommodated by the Fed. This is the same line of causality that I’ve been arguing regarding the Great Recession.
Why, you may ask, am I so eager to de-link inequality and recession? Because I think that both of these questions have to do with two things (social policy and stabilization policy) that will each inevitably be made worse off if people are eager to make desperate links. Social policy will suffer from an overbearing focus on situations which aren’t the norm — and stabilization policy will suffer from inevitable politicization.
What is my solution? Stabilize the growth path of NGDP by level targeting a nominal variable (and I favor complementary currencies), and make social transfers in ways that promote Pareto efficiency. I don’t really see a need to entangle the two.
*This is independent of the fact that violent revolutions due to perceived inequality have happened in the past…which obviously affects macroeconomic stability.

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Tuesday ~ June 29th, 2010 at 7:36 pm
Nick Rowe
You lost me a little on this post.
Aren’t you arguing (shouldn’t you be arguing) for 4: reverse causation.
Stability causes rising inequality; an economic crisis causes a return to equality.
Wednesday ~ June 30th, 2010 at 2:54 am
Niklas Blanchard
While that is obviously true to some extent from the data, I don’t know that I want to take the point so far — lest I end up looking like I’m arguing from a classical “liquidationist” perspective that recessions serve some marginally beneficial social function (something that Lord, below, has caught onto).
Sure there are plenty of natural transmission mechanisms that, left to their own devices, work toward creating vast disparities. Liberalizing markets, while obviously beneficial for all sorts of reasons, is one of these transmission mechanisms. During the 20′s, “modern” markets came into their stride…and inequality ballooned. Similarly, markets were deregulated globally during the 70′s, with the same effect (at least in the US). I don’t think that the crises that ended these two periods has any causal basis in the level of inequality. Indeed, labor’s share of the national income has been quite stable.
There may be a story of returns to labor (diminishing) vs. returns to capital (increasing)…but I don’t think that’s a particularly bad development…and I would push back against anyone who does argue that it is.
I don’t think that intervening in this natural process (of power law distribution) in a way that stabilizes growth and fosters greater equality (both on the supply and demand sides) is particularly bad. What I’m concerned with is that entangling causality in this particular recession — of which there is strikingly few analogies — with income inequality will lead us to particularly poor conclusions.
So yes, you’re probably correct that on pure cause and effect terms, I should (logically) be arguing for “4″.
Tuesday ~ June 29th, 2010 at 8:08 pm
Lord
And argue for depressions as social policy? I hope not. It is Minsky at its core though and redistribution and stabilization tend to go hand in hand.
Wednesday ~ June 30th, 2010 at 3:13 am
Niklas Blanchard
I’m not sure I follow.
As a thought experiment, assume we stabilize long run NGDP at 5% forever and ever, with no adverse shocks causing a significant deviation from trend, and also assume that we “let the chips fall where they may” in a competitive market.
You would end up with a power law distribution. Indeed, by the observed mechanics of networks, you would have to.
Then add a “leveling” redistribution to address inequality. Monetary policy would obviously have to address any supply-side inefficiencies caused by this change in policy…but your overall goal of 5% NGDP growth is unaffected.
I think this is the ‘right’ way to think about the issue (but I’ve been known to be wrong). I don’t think it’s the job of monetary policy to go around popping bubbles, or playing with interest rates in order to favor certain asset classes.
Nail stabilization, and then move some chips around…that’s what I want to do.
Wednesday ~ June 30th, 2010 at 9:29 am
Nick Rowe
Niklas: Yep. That makes sense. I follow you now.
You are arguing for 4: reverse causation.
Whether that means that crises are in any sense a good thing (it doesn’t, because pushing everyone back to a Hobbesian State of Nature would probably reduce inequality, but only by making everyone worse off) is an entirely separate question.
Now I understand you better, I think this is a really important post. I had wanted to say something along these lines, when I read Paul Krugman’s post. But I don’t understand that stuff about networks and power laws very well at all, so you did it better than I could have done. I was just thinking about investment, in human and physical capital. But I think there’s more to it than just investment.
But if you are right, and I think you are, this should be telling us something about the nature of crises, as well as about the causes of inequality. There have to be some more implications that should be drawn out.
Did you see my co-blogger Stephen Gordon’s graphs showing that the recent rise in inequality in Canada was almost all at the very top end of the income distribution?
Friday ~ July 2nd, 2010 at 10:02 am
Niklas Blanchard
Nick,
I think the long-run trend toward inequality is an artifact of the type of money that we use (and that is used around the world). That is, money that is issued by a central authority, with positive interest rates, and is characterized by scarcity. These types of things are what Bernard Lietaer has called “extreme ‘Yang’ processes”, they foster the type of competitive environments that inevitably result in power law distributions.
I also have a pet theory that I have named “Too Brittle to Sustain (TB2S)”, which implicates our money system in helping create an ecosystem that is completely focused on efficiency — at the expense of robustness.
I’m sure I should probably sit down and flesh out the concepts and how they relate.
In any case, I think I may have see the graph, but I’ll go look for it again right now.
Wednesday ~ December 15th, 2010 at 7:49 pm
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