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.