Income Inequality Lies At The Root Of The 2007/2008 Financial Crisis And The Subsequent Economic Recession In The US And The EU

The current global capitalist system is unfair and exploitative and can be changed into something that distributes economic output in a more just manner. Although it can be argued that the current global capitalist economy is an effective driving force in society in forging wealth for peoples within their respective states, the discussion, however, of how this wealth is distributed between social classes remains determined in political discussions on economic and financial reform. What is currently described as neo-liberalism, which came up after the failure of the Keynesian model that has determined United States and West-European countries economic policies post 1929 up until the 1970s, is often referred to in political discussions on the premise that the distribution of wealth is unequal and that capitalists investors gain enormously more than the working class. In this often moral argument, the question has risen to what extent the capitalist investors in fact invest in societies’ economies and whether this current neo-liberal mindset driven by OELs is sustainable on the long run. As is the narrative driven by OELs: wealth flowing to capital investors leads to job growth, which in term should lead to economic growth. However, results are lacking. So, what does stimulate the economy? Over four thesis statements, the main thesis, that the economic down-turn due to income inequality lies at the root of the financial crisis of 2007/2008, which is formerly known as the economic recession, will be explained and an alternative to the current flow of capital will be suggested.

  1. Debt-financed consumption coincides with economic inequality and the collapse of the subprime market.

As stated before, income inequality is a root cause behind the financial crisis of 2007/2008 or maybe more specific, the subprime mortgage crisis. Marxians and post-Keynesians have continued to form theories on the possible negative impacts of income inequalities and one of their leads is the observation that income inequality was very high prior to the outbreak of the crisis; describing a decrease of the wage share coupled with an increase of top incomes (Goda, 2013). In this theory, most often referred to as the overproduction/underconsumption theory, also known as Marx law of disproportionality or problem of underconsumption, the point is stressed that crises are caused by poverty and thus restricted consumption (Balaam & Dillman, 2014) (Goda, 2013). It must be noted that in all Marxian crisis theories, the issue of capital distribution and the class struggle between capitalists and workers is characteristic and will be further discussed in this paper according to various events leading to the crisis of 2007/2008.

  1. OELs, or orthodox economic liberals, who have determined the western monetary and economic policies from the 1980s onwards, have contributed to the rise of inequality throughout societies.

Structuralists argue, like post-Keynesians, that instability and disequilibrium are inherent in free market economics, but they also believe that state intervention can stabilize the economic system to some degree. To be more precise, in contrast to Marxists they think that crises can be avoided if the macro-economy is well-managed, financial markets are sufficiently regulated, and that real wage growth lies in line with labour productivity growth; in other words, that wage share should be consistent to the how the market behaves.

The assumption on which Marxists agree with OELs, is that crises are associated with the rate of profit to fall and that an economic crisis is a result from an economic downturn (Clarke, 1994) (Stiglitz, 1992). However, OELs see inequality in terms of market laws of supply and demand and justified in terms of productivity (Goda, 2013). Furthermore, OEL theory states that misguided government regulations lead to too high government debt levels and can only be abolished by the ‘self-correction’ of the market (Reinhart & Rogoff, 2010). This theory is supported by when national debt accumulates and capital outflow rises, this consequently undermines the viability of the financial system of a country (Stiglitz, 2000). Through this, firms will consequently hire fewer workers due to their incapacity to invest but also because of the possibility of bankruptcy due to high debt levels and the resulting lending restrictions and equity issues (Goda, 2013). However, a deregulation of the market can lead to perverse effects on the distribution of functional income and how much is distributed to workers and how much of the national income goes to investors and rentiers (Goda, 2013). Through the wealth share over social classes, the HILs overproduction/underconsumption theory is applied when income inequality increases, consumption demand decreases and systemically leads to lower capital accumulation and unemployment (Goda, 2013).

In order to overcome a decrease of consumption demand, neo-liberalism has led to the further deregulation of debt accumulatory policies and, especially in the United States, to greater national inequality due to greater debt accumulation among households; also known as credit consumerism (more on this later). When personal credit debt accumulates, economic shocks such as bankruptcy and refusal of credit may be regarded as unimportant events, but can be significant enough to change the perceptions of market participants or to bring an important facet of a national financial system into trouble. This leads to market instability and when the market becomes unstable, speculation among financial actors rises and crashes can occur (market speculation will also be treated later in accordance to Minskyan theories). Poorer households will then participate in less capital output, whereby richer households will not spend more, which leads to a demand shortage. This is known as the behavioral finance theory and is determined by OELs only by supply and demand, not taking into account institutions, power relations, and demand saturations and they see the optimization of economic behavior according to personal earnings, debt and savings (Shiller, 2000) (Shleifer, 2000) (Akerlof, 2002).

The first developments of this were seen in the dotcom bubble and, after its collapse, the investment boom in the housing market followed because mortgages are securitized and high returns for capitalists were fostered, which was a convenient solution for financial institutions to escape the problem of profit rate (Goda, 2013). The general pressure on capitalists to make money is regarded as the general law of the tendency of profit and ultimately the root cause of the subprime crisis. HILs argue therefore that the prevention of underconsumption due to credit consumerism is crucial to the rise of inequality, but also argue that low profit rates in the producing sector can be a result of that. Banks targeted low income minorities to grant credit to when at the same time the number of working hours per family increased due to lower wage shares. US households stopped saving and this led to an increase of their debt-to-income ratios (Goda, 2013). A lack of regulations, financial greed on the part of banks and the undervaluation of risk has expanded lending to households with the broader aim to expand credit and consumption, which led to the consumption boom in order to delay a possible demand shortage.

  1. Financial markets only serve rentiers, but rely on shareholders, investors and public funding when things go bad.

The growth of the financial sector meant an increasing pressure of achieving high profits to satisfy rentiers and this led to bad effects on personal income. The economy was further financialized due to the importance of the sector itself and due to an increasing demand on credit. For rentiers, the profitability of invested capital is measured as success. But when things go bad and market speculation occurs, the profitability of invested capital decreases. What is described as “super-speculation” has a big chance of occurring due the pressure of satisfying rentiers in an economic downturn, which ultimately can lead to an economic crisis (Minsky, 1986, 1992). When the debt levels are ultimately too high, prices fall, uncertainty increases and liquidity preferences are determined, which consequently leads to economic units suddenly becoming bankrupt, this surely triggers a recession (Minsky, 1986, 1992).

Ultimately, the debt that is created by the financial sector is only recovered through the investors and shareholders and public funding. Through this process of shifting liabilities, households and non-financial companies are financialized by their rentiers and become increasingly leveraged and have more difficulty in obtaining external finance with which capital accumulation declines (Stockhammer, 2005). Poorer households that have a bigger chance of accumulating debt due to greater availability of finance and have over the process of accumulating more debt become more dependent on financial institutions that in turn ask higher interest obligations – in the long-run redistribute their wealth to the richer households (Palley, 2007). And when capital diminishes due to lower wage shares and therefore consumption is constrained, then this can directly be attributed to an increasing demand on cheap subprime mortgages which leads to an increasing demand of capital and therefore top salaries ultimately increase (Goda, 2013).

The financialisation of society has since the 1980s restricted consumption demand from ordinary households due to stagnant wages. As a result, speculative finance became an engine for growth given the weakness of productive investment (Bellamy Foster & Magdoff, 2009). But this growth model relied on an increase of credit and subprime mortgages to poor households, which deemed unsustainable in the long run. Financialization of society, which has led to the increase of the rentier income share, has influenced the stability of the economy negatively. This has led to lower wage shares, higher inequality of household incomes and an increase in their debt levels.

  1. Economic equality brings about more purchasing power for more people, which stimulates the global economy

To sum up, the degree of income redistribution from poorer households to higher income families depends on real wages, labour time, and the productivity of workers (Goda, 2013). Consumption is driven by economic output and an increase in wages tends to have a positive impact on the economy (Jespersen, 2009). Post-Keynesians furthermore argue that stimulating the economy leads to more employment and triggers investment by firms, which in turn raises productivity and makes a possible wage increase viable (Palley, 2010). This would also stimulate the economy and makes financial institutions less relevant considering credit based loans. Through this process, the financialization of society diminishes. Also, more liquidity means less risks on market speculation. Nevertheless, a better regulated financial system that discourages speculative financing would also discourage cheap loans and ultimately lower households’ debts.


“Have you seen the little piggies
Crawling in the dirt?
And for all the little piggies,
Life is getting worse;
Always having dirt to
Play around in.

Have you seen the bigger piggies
In their starched white shirts?
You will find the bigger piggies
Stirring up the dirt
Always have clean shirts to
Play around in.

In their styes with all their backing,
They don’t care
What goes on around.
In their eyes there’s something lacking.
What they need’s a damn good whacking.

Everywhere there’s lots of piggies
Living piggy lives.
You can see them out for dinner
With their piggy wives.
Clutching forks and knives to
Eat their bacon.”

– by the Beatles

Literature list

Akerlof, G.A. (2002) Behavioral macroeconomics and macroeconomic behavior. American Economic Review.

Balaam, D.N. & Dillman, B. (2014) Introduction to International Political Economy. Pearson.

Bellamy Foster, J. & Magdoff, F. (2009) The Great Financial Crisis: causes and consequences. Monthly Review Press.

Clarke, S. (1994) Marx’s Theory of Crisis. Macmillan Press: Basingstoke

Goda, T. (2013) The role of income inequality in crisis theories and in the subprime crisis. Post Keynesian Economics Study Group.

Jespersen, J. (2009) Macroeconomic Methodology, A Post Keynesian Perspective. Edward Elgar Publishing.

Minsky, H.P. (1986) Stabilizing an Unstable Economy. Yale University Press.

Minsky, H.P. (1992) The Financial Instability Hypothesis. Jeromy Levy Economics Institute.

Palley, T. (2007) Financialization: What it is and why it matters. PERI Working Paper.

Palley, T. (2010) Macroeconomic causes of the financial crisis and great recession. New School Economic Review, Vol4.

Reinhart, C. & Rogoff, K.S. (2010) Growth in a Time of Debt. NBER Working Paper.

Shiller, R.J. (2000) Irrational Exuberance. Princeton University Press.

Shleifer, A. (2000) Inefficient Markets: An Introduction to Behavioral Finance. Oxford University Press.

Stiglitz, J.E. (1992) Capital Markets and Economic Fluctuations in Capitalist Economies. European Economic Review.

Stiglitz, J.E. (2000) Capital Market Liberalization, Economic Growth, and Instability. World Development, Vol 28.

Stockhammer, E. (2005) Shareholder value orientation an the investment profit puzzle. Journal of post Keynesian Economics.

The Beatles (1968). The White Album. Apple Records.

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