Income Distribution, Irrational Exuberance, and Growth

The current economic crisis facing the U.S. economy, and thereby the entire world, has its origins in not just the subprime markets but is more of a systemic crisis. Its roots can be found in certain significant economic developments in the United States since the late 1970s: dramatic growth in inequality of income; restricted government sector, especially in the 1990s; growing trade deficit; and declining business investment. Given that the three main sources of demand, and thereby of growth, were declining in importance, the only way that the U.S. economy could have grown was through injection of consumption demand. Here again, an increase in income inequality had the potential of dampening consumption through the route of underconsumption. Therefore, for even the consumption demand to increase there was a need for some external impetus. I present a theoretical model arguing that the growth process in such a situation perforce becomes dependent on speculative asset price markets which have the potential of influencing consumption of households through the wealth effect. It is precisely for this reason that such a trajectory of growth becomes a “bubble in the whirlpool of speculation.†JEL classification: E2, O1, O4