How extreme inequality led to the financial crisis – and could do so again

For many, work no longer pays. Pay has stagnated for a decade and there are eight million people living in poverty in working households.

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Ever since the financial crisis economists have been adamant that inequality isn’t rising, but a recent announcement from the Institute of Fiscal Studies (IFS) has reopened the debate.

When measured using the Gini coefficient – a statistical measure of inequality between households –  inequality in Britain rose sharply during the 1980s but has plateaued since 2006. The story is largely similar for the earnings of the top 1 per cent and for wealth inequality. Across the piece, inequality rose sharply during the Thatcher years, and less sharply from then until 2006, before flattening after the financial crisis.

Yet a 2018 Oxford survey showed that more than two thirds of people thought the government should reduce inequality between rich and poor. According to another survey, more than half of people questioned want to see “a more equal distribution of wealth, even if the total amount of wealth is reduced”. 

Economists’ failure to account for people’s lived experience and adjust their models accordingly has already cost us dear. They failed to notice both the build-up of private debt before the crisis, and the asymmetric impact of globalisation on different communities before the vote to leave the European Union. Given that economists, journalists and policymakers seem convinced that inequality isn’t rising, we should probably be paying the issue a little more attention.

The IFS’s input is welcome. The think tank shows that income inequality, measured by the Gini, rose in 2017, and there was an increase in the incomes of the top 1 per cent. It also shows that, since 1994, rich households’ earnings have grown far faster than those on low and middle incomes.

Unsurprisingly, the IFS’s intervention has prompted many commentators to defend current levels of income inequality in the UK, arguing either that it isn’t rising, or that it doesn’t matter even if it is.

First, even using imperfect measures such as the Gini, inequality is rising. The trend is unambiguous, though whether it will continue is yet to be seen. Second, the arguably more important measure of the labour share of national income – the amount accruing to workers in the form of wages rather than owners in the form of profits – has been falling for a long time. For many, work no longer pays. Pay has stagnated for a decade: there are eight million people living in poverty in working households.

Third, while it is difficult to measure, several studies suggest that wealth and incomes for the top 1 per cent, 0.1 per cent and 0.01 per cent are increasing at a much faster rate in the UK than elsewhere. This trend is undoubtedly linked to falling trust in representative democracy, as the super-elite are able to use their wealth to influence political outcomes.

Inequality, above a certain level, can cause deep economic and financial instability. Because the wealthy save a greater portion of their income, rising inequality means less money is recycled back into the economy through consumption. Economists have argued for decades that this doesn’t matter because the wealthy invest their savings in production, creating jobs and allowing their wealth to trickle down to everyone else.

But when inequality gets very high, the wealthy often find they can generate higher returns from investing in already existing assets such as property and equities, rather than production. If working people aren’t earning as much, who is going to buy what businesses are producing?

Wealthy people channelling money into property and financial markets can lead to the emergence of bubbles and strangle productive economic activity. We saw this in 1929 and again in 2007. After the Wall Street Crash, much of the wealth created during the gilded age was destroyed in the Great Depression and the Second World War. But no such re-equilibration happened after 2007. That inequality has flatlined since the financial crisis should alarm commentators almost as much as the crash itself.

As it stands, most people have failed to learn the right lessons from the crisis of 2007. The high levels of inequality, booming house prices and rising private debt levels should be a harbinger of the crash to come. But most people will ignore these warning signs until it’s too late.

Grace Blakeley is the New Statesman’s economics commentator and a research fellow at IPPR. 

This article appears in the 24 May 2019 issue of the New Statesman, The Brexit earthquake