Did Inequality Cause The U.S. Financial Crisis?

In his widely discussed book ‘Fault Lines’ (2010), Raghuram Rajan argues that many low and middle income consumers have reduced their saving and increased debt since income inequality started to soar in the United States in the early 1980s. This has temporarily kept private consumption and employment high, but it also contributed to the creation of a credit bubble. This surge in household indebtedness turned out to be unsustainable in the financial crisis starting in 2007. Although Rajan and others emphasize the role of government in promoting credit to those households with declining relative (permanent) incomes, other strands of the literature have focused more explicitly on the implications of rising inequality for aggregate demand and households’ demand for credit. These differences in emphasis may explain why the literature on the inequality-crisis nexus appears somewhat disparate, even though the various strands are far from mutually exclusive but rather complement each other. We therefore place the ‘Rajan hypothesis’ in the context of competing theories of consumption, and survey the empirical literature on the effects of inequality on household behaviour. We conclude that the empirical evidence calls for a renaissance of the relative income hypothesis of consumption.